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 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. However, the Chilean economy has slowed over the last three years, reflecting in part the sharp decline in copper prices and weak demand from trading partners. Headwinds to growth could intensify if global interest rates rise faster than expected or the Chinese economy experiences a sharp slowdown, potentially dampening global demand for copper. Nevertheless, Chile has adjusted well to less favorable conditions. Supportive fiscal and monetary policies have cushioned the copper-price shock and exchange rate flexibility has facilitated an external rebalancing. Moreover, inflation is subdued, fiscal policy is accommodative but set to gradually tighten, and the financial system remains healthy.

In DBRS’s view, Chile’s principal credit challenges are medium-term in nature. They include diversifying production, boosting productivity, and responding to the rising demands of society, particularly in areas such as education and pensions, in a manner that is financially and politically sustainable.

The Chilean economy has slowed amid less favorable external conditions and supply-side constraints. The IMF estimates GDP growth in Chile will average 2.0% from 2014-2017, compared to 5.3% during the previous four years. The deceleration has been driven by a contraction in private investment amid lower copper prices and weak business confidence. At the same time, Chile’s trend growth is moderating due to population aging and lower investment. Although the economy is expected to experience a mild recovery in 2017 and 2018, medium-term growth prospects remain modest compared to Chile’s past performance.

Despite slower growth, 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.

Chile’s strong public sector balance sheet has allowed the government to provide fiscal support to the economy without generating sustainability concerns. The deficit widened to an estimated 3.1% of GDP in 2016 and is expected to remain at a similar level in 2017. The public balance sheet continues to benefit from low – albeit rising – debt ratios and a large stock of financial assets. Central government debt in September 2016 amounted to 21% of GDP. Financial assets held by Chile’s sovereign wealth funds total 11% of GDP ($25.5 billion). As a result of these assets as well as other Treasury holdings, the central government is a small net creditor.

As fiscal policy starts to tighten, expansionary monetary policy will continue to support to the economy. Chile’s central bank is independent and benefits from a high degree of credibility. Inflation expectations over a two-year horizon are anchored on the 3% target. This credibility allowed the central bank to provide expansionary monetary policy even when inflation ran near or above the upper band of the target from April 2014 to July 2016. More recently, price pressures have dissipated, with inflation falling to just 2.7% in December 2016. This month the central bank lowered its policy rate 25 basis points, and DBRS expects additional monetary stimulus in 2017, particularly if disinflation trends intensify or economic activity weakens.

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, roughly 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 other OECD countries or emerging economies in Eastern Europe. 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 hamper productivity and weaken employment prospects, particularly for young workers and women. While the new labor law, passed in August 2016, aims to strengthen the negotiating framework between workers and employers, it is still unclear, in DBRS’s view, how the reform will impact labor market outcomes over the medium term.

In addition to economic challenges, several high-profile corruption scandals combined with a period of weak growth have fueled voter discontent. Approval ratings for both coalitions averaged less than 20% in 2016. Voter dissatisfaction could create space for political newcomers, adding a degree of unpredictability ahead the November 2017 general elections. Nevertheless, DBRS believes that the consensus across the political spectrum on sound macroeconomic policymaking will be sustained through the electoral cycle.

RATING DRIVERS
DBRS views the ratings as Stable. However, in the unlikely scenario that the political commitment to sound fiscal management weakens following the November 2017 elections, 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.

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. These can be found at http://www.dbrs.com/about/methodologies.

The sources of information used for this rating include the Chilean Ministry of Finance, Central Bank of Chile, National Institute of Statistics, U.S. Energy Information Administration, National Society of Mining, IMF, World Bank World Governance Indicators, The Conference Board, Wall Street Journal, GfK Adimark, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities.

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.

Lead Analyst: Michael Heydt, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global Financial Institutions Group and Sovereign Ratings
Initial Rating Date: May 30, 2006
Last Rating Date: January 29, 2016

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