Chile: a Changed Jungle for the Latin American Tiger

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CASE REPORT
Chile: A Changed Jungle For the Latin American Tiger
By:
Beck Cheung
Yingfang Chu
Hang Gu
Sarah Yan
Tian Zeng

2011-11-10

Executive Summary
This report first analyzes the economy of Chile in terms of strengths, which are the abundance in natural resources, and the weakness of heavy reliance on copper. Then identified two severe threats the nation was facing in 1998: Asian financial crisis and current account deficit. The two threats interact with the characteristics of Chilean economy which lead to the risks of currency crisis and a economic slowdown. The second section then investigates Chile’s current policies on inflation, trade and exchange rate. In terms of inflation, the central bank uses tight monetary policy and controls on capital inflows such as Unremunerated Reserve Requirement. For trade, the country relies on entering free trade agreements. For foreign exchange policy, Chile maintains a crawling peg system but is increasing the trading band. Facing the current challenges, we recommend that Chile should focus first on solving the potential currency crisis, then the economic slowdown. To avoid a currency crisis, the central bank of Chile should continue the tight monetary policy by raising interest rate. This practice can stabilizes the domestic currency value, attracts international capital and increases domestic savings. Focus directly at reducing current account deficit, Chile should also introduce tax free saving programs and avoid running budget deficit. To address the economic slowdown, Chilean government should use the stabilization fund to stimulate economy and create employment. In long run, the nation needs to reduce dependence on mining by developing manufacturing and technology industries and should continue on entering trade agreements with other countries.

Economy Analysis
Chile, which underwent free-market reforms since 1970s, is considered as the most developed and transparent market in Latin America and experienced significant growth in the last decade. This could be attributed to the economic strengths of the Chilean economy (See Exhibit 1 for full list of strengths). The most remarkable one is the abundance in natural resources, especially copper, which enabled Chile to run a successful export-led growth model. Another strength is the sound economic policies by the central bank and government. Chile uses a free-market system with high autonomy provided to central bank to implement necessary policies to manage the macro environment while government actively liberalizing the economy. Despite the aforementioned strengths of the Chilean economy, the nation has a notable weakness, which is the reliance on copper. In addition, with the disappointed import-substitution industrialization in 1950s and failed to develop an infant industry, Chile has a relatively weak manufacturing sector which accounts for about 10% of export and is mostly forward linkages of the natural resources sector. As a result, Chilean economy has a high exposure towards the volatile demand of copper and may suffer Dutch disease. As in 1998, the Chilean economy was facing two severe threats, and the first threat is the Asian financial crisis. There was a growing risk aversion in the financial market thus vast amount of funds were withdrew from emerging markets along with a significant drop in the world’s demand for copper. Particularly, Asia, the origin of this financial crisis, accounted for 38% of the copper consumption in 1997. The second threat faced by Chile was that the nation was running a current account deficit since the second quarter of 1997. The two threats through the interaction with the weakness of the Chilean economy can put the nation in risks of recession and currency crisis. To better analyzing the situation and generating the potential solutions, Chile’s four main economic policies of inflation,...
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