DBRS Confirms Republic of Chile at AA (low), Stable Trend

DBRS, Inc. has confirmed the Republic of Chile’s long-term foreign currency issuer rating at AA (low) and its long-term local currency issuer rating at AA. In addition, the short-term foreign currency issuer rating has been confirmed at R-1 (middle) and the short-term local currency issuer rating has been confirmed at R-1 (high). The trend on all ratings remains Stable.

The rating confirmation is underpinned by Chile’s (1) sustained commitment to sound macroeconomic policymaking, (2) strong public sector balance sheet, and (3) high-quality public institutions. These factors have contributed to three decades of robust growth and macroeconomic stability. In the near term, Chile faces a difficult international environment characterized by lower copper prices, weak demand from trading partners and tighter external financing conditions. Amid these headwinds, the Chilean economy has slowed. However, fiscal and monetary stimulus along with exchange rate flexibility have cushioned the shock and facilitated an external rebalancing.

DBRS views the ratings as Stable. In the unlikely scenario that the political commitment to sound macroeconomic management weakens, the ratings could face downward pressure. On the other hand, further diversification of the Chilean economy into high value-added sectors, thereby enhancing economic resilience, could result in upward pressure on the ratings over the medium term.

The sharp decline in copper prices has led to slower growth in Chile. Economic deceleration in China reinforced by U.S. dollar appreciation has put downward pressure on international commodity prices. The price of copper has declined approximately 55% from its peak in February 2011 to mid-January 2016. The IMF estimates GDP growth in Chile will average 2.2% from 2014-2016, compared to 5.2% during the previous three years. The deceleration is largely the result of a contraction in private investment. Sluggish growth among regional trading partners and weak business and consumer confidence domestically have added to the challenging outlook.

Despite the slowdown, the Chilean economy has adjusted to the copper-price shock. The current account deficit is small and fully financed with stable net inflows of foreign direct investment. The banking system is well-capitalized and profitable. Real exchange rate depreciation has improved competitiveness without de-anchoring inflation expectations or generating excessive stress on the corporate balance sheets. Over time, a weaker currency should encourage a reallocation of resources to productive non-mining sectors of the economy. In the event of further shocks, reserves are sufficient to counter potential overshooting. Furthermore, falling copper prices have been accompanied by lower oil prices, thereby mitigating the deterioration in Chile’s terms of trade.

Given the country’s low debt level and high public sector savings, the government has space to provide strong fiscal support to the economy without generating sustainability concerns. The deficit widened to an estimated 3.3% of GDP in 2015 and is expected to be at roughly the same level in 2016. Chile continues to benefit from an exceptionally strong public balance sheet. Central government debt in September 2015 amounted to 17% of GDP, a very low debt burden compared to other advanced and emerging economies. In addition, financial assets held by Chile’s sovereign wealth funds total $25.8 billion. As a result of these assets as well as other Treasury holdings, the central government is a small net creditor.

Expansionary monetary policy has complemented fiscal stimulus to support the economy. The central bank is transparent and independent with a high degree of credibility. This has allowed monetary policy to be expansionary even as inflation has run near or above the upper band of the target since March 2014. Inflation expectations over a two-year horizon remain anchored on the 3% target. The central bank started to withdrawal stimulus in the fourth quarter of 2015 but monetary policy remains accommodative and domestic credit conditions are favorable.

While macroeconomic policy is helping cushion the adjustment in the near term, Chile faces a medium-term challenge of diversifying the economy and expanding the export base. Even after the large decline in metal prices, more than half of Chile’s exports are concentrated in the mining sector. While Chile’s macroeconomic policies are designed to dampen the effects of copper price fluctuations on the real economy, economic output and fiscal revenues are still exposed to the commodity price cycle.

Generating strong growth over the medium term without the support of global tailwinds will likely require improvements on the supply side. The quality of education is one major challenge. Education outcomes in Chile do not compare favorably with emerging economies in Eastern Europe or East Asia. On the PISA reading, science, and math assessments, Chilean students score below all OECD countries, with the exception of Mexico. Education reforms initiated by the Bachelet administration, which aim to increase funding for public schools, provide greater access to tertiary education and improve teacher quality, could foster better outcomes.

In addition, labor market rigidities – such as high dismissal costs – tend to hamper productivity and weaken employment prospects, particularly for young workers and women. Strict employment protections for workers with permanent contracts can lead firms to hire temporary workers, with adverse effects on worker productivity.

Chile also faces a deficit of energy infrastructure. Major power projects have been delayed or canceled due to lengthy legal disputes and public concerns over environmental damage. Importing energy from resource-rich neighbors has not been viable due to longstanding political disputes. In addition, transporting domestic power from rural production sites to densely-populated and energy-intensive urban areas requires costly investments. As a result, electricity in Chile is comparatively expensive. However, the government aims to reduce energy costs by the end of the decade by unifying Chile’s two main electricity grids, increasing competition within the grids, and expanding generation capacity in non-conventional renewable energy.

Notes:

All figures are in U.S. dollars unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales.

The sources of information used for this rating include Ministry of Finance, Central Bank of Chile, National Institute of Statistics, National Society of Mining, The Conference Board Total Economy Database, U.S. Energy Information Administration, WSJ, World Bank, GfK Adimark, IMF, OECD, Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

DBRS does not typically accept editorial changes other than to correct for factual, accuracy and/or to remove confidential, material non-public, or sensitive information that might otherwise be inadvertently disclosed.

Lead Analyst: Michael Heydt
Rating Committee Chair: Roger Lister
Initial Rating Date: 30 May 2006
Most Recent Rating Update: 20 February 2015

For additional information on this rating, please refer to the linking document under Related Research.