Chile: Strong Recovery After Devastating Earthquake

Recovery is fully under way, helped by reconstruction spending

Challenge: reduce structural deficit while spending on reconstruction

Further financial system and productivity-enhancing reforms needed to boost long-term growth

The IMF, in its regular annual assessment, noted that Chile’s economy has shown remarkable resilience in the past two years. The economic recovery is fully under way, helped by appropriate policy responses to the two large adverse shocks—the earthquake and last year’s recession.

In early 2010 the Chilean economy was poised for a strong recovery. But on February 27, 2010 the country suffered a massive earthquake. Reconstruction costs were estimated to be close to US$30 billion. Yet, the economy rebounded in the second quarter of 2010 after a short contraction (see Chart 1).

Based on these trends, the IMF projects that the Chilean economy will grow by 5 percent in 2010 and 6 percent in 2011. “Strong private consumption and large public and private investment, including on inventories, are expected to sustain domestic demand growth,” the report said.

Reducing the structural deficit

Fiscal policy played a critical countercyclical role, drawing on the public savings accumulated prior to the global crisis (see Chart 2). The 2009 fiscal stimulus helped support an early recovery of economic activity. And after taking office in March 2010, the new administration put in place an ambitious earthquake reconstruction program.

Now in the recovery phase, the Chilean authorities are committed to finish their term in office with a sharp reduction in the structural deficit (with revenues measured at potential output and long-term copper prices). They intend to achieve a structural deficit of 1 percent by 2014, even after allowing for the spending needed to support the earthquake reconstruction efforts.

To achieve this goal, they are prepared to drastically trim the growth of nonessential expenditure, reallocate spending, temporarily increase taxes, and carry out some additional borrowing. In late July, Chile placed 10-year bonds worth $1 billion with a spread of only 90 basis points and peso-denominated debt worth $500 million at a 5.5 percent interest rate in international financial markets, signaling strong market confidence that economic stability will be preserved.

The IMF report welcomes the government’s decision to review the fiscal rule, which allows automatic stabilizers to work freely during the business cycle...