In the context of the stress encountered in the market and seeing that the spread on Chile's sovereign debt increased less than the average in Latin America (and Asia) I argued that perhaps this was a sign that Chile's currency would not be hit as hard, in the context of increasing volatility, as its emerging market peers. My argument in a nutshell was that since the Peso was amongst one of the best performing emerging market currencies against the USD (back in April) this was perhaps due to the relatively high standing Chile had with international investors. Stefan Karlsson would have none of this however arguing in stead that the relative strength in the context of Chile's Peso was to be found in relation to the increase in the price of Copper. I conceded that Stefan was right in so far as goes the obvious fact that Copper is a very important driving force for the Chilean Peso regardless of whether investors were also targeting Chile as a relative safe haven amongst emerging markets.

However, in the spirit of good argument I decided to let me and Stefan's arguments suffer the, not always flattering, test of empirical validity. To that end I cooked up the following small model;

 

Y = a + b1X1+b2X2

Where Y is the exchange between the Peso and the USD (quoted directly), X1 is the price of Copper, and X2 is the sovereign spread. I use monthly data from Jan-00 to May-09 for a total of 112 observations and as per convention I am estimating this model in the first difference to avoid issues of stationarity (2). Given the hypothesis one would expect a negative sign for X1 (i.e. an increase in the price of Copper is associated with an appreciation of the Peso) and a positive sign for X2 (i.e. an increase in sovereign spread is associated with a depreciation of the Peso). The estimation (with OLS) returns the following result;

 

Y = 0.0016 - 0.16X1 + 0.09X2 + ut (F = 33.25, R-sq = 0.38)

Now, both variables (X1 and X2) are significant at 1% (3) and thus I am inclined to stick my neck out a little bit more vis à vis Mr. Karlsson and conclude that the extent to which investors see Chile as a relative safe haven amongst emerging markets will in turn make Chile's sovereign debt spread increase less relative to its peers in relation to market turmoil which, in turn, has a measurable effect on the exchange rate.

Don't worry, this will be the first and last regression analysis you see in this note and just to sum up; Copper does matter for Chile and with net revenue expected to drop 69 percent this year to $1 billion from $3.2 billion in 2008, it will have a noticeable impact on Chile's economic performance although I need to emphasise that, to my mind, Chile posseses sound fundamentals which move far beyond the benevolence of its Copper ressources.

Employment

In terms of the labour market Chile cannot escape the fact that the crisis has taken its toll. The latest figure for April has the unemployment rate running at 9.6% which makes it almost certain that it is above 10% in the time of writing. 10% hardly constitute a dramatic number in a relative context (although of course it is big in an absolute sense), but given the fact that Chile entered the crisis running at 7-8% the lagged effect of the recession on the labour market may push the unemployment rate to uncomfortable levels which is sure to become a big topic for the elections later this year.

The number of persons employed peaked in August 2008 at 6.693.400 persons and has since declined to 6.574.500 persons for a total loss of employment of 118.900 people in April 2009. At the same time the registered number of persons in the labour force increased by 120.140 people from 7.196.110 to 7.316.250. These figures highlight one of the challenge with having a large and growing labour force in the sense that you need to maintain momentum in order to be able offer the jobs which the people rightfully demand.

Of course, a growing labour force is a good thing in itself, but in the current environment we should not rule out the case that it can become a source of "unrest" and fierce political debate. Should the employment situation continue to deteriorate on the margin (that is unemployment reaching some 15%) it will be very interesting to see how this drives the discourse in the upcoming elections.

Policy and Inflation

As noted, the last time I had Chile under the loop the central bank perceived the risks to economic stability in a wholly different light than it does now. At the time, inflation was running at some 10% on an annual basis and the central bank was busy moving up nominal interest rates. That has changed now.

Chile's central bank is formally targeting an inflation rate of 3% and just as it was running way above this target in the period leading up to the crisis, so has it plummeted accordingly and is currently running at negative values on a monthly basis. This has prompted the central bank to lower rates to an unprecedented level of 0.75% in June and most analysts expect another nudge downward come the July session (the graph to the right plots the interbank rate). If this turns out to be the case, the central bank will have lowered interest rates by 7.75 % over the course of the last 6 meetings. Just as it has been the case with other more prominent central banks, the Chilean derivative is trying to steer expectations in an environment where long term yields have begun to inch upwards to reflect the solidification of the second derivative discourse. In general, the central bank is tracking inflation closely with its target interest rate as can been in the graph to the right.

On the fiscal front Chile is in a much better position than most. Alongside the measures taken on the monetary front the government has, so far, initiated US $4 billion package of government spending and tax cuts. According to the budget office the budget deficit will amount to 4.1% of GDP this year, a position one finds it difficult to believe that Chile will have trouble financing. On June the 15th Chile's fiscal authorities announced a bond issuance worth $ 1.7 bn as well as its intent to use $4 bnfrom its offshore savings to fund spending.

Not too Shappy

All in all this does not look too bad now does it? In many ways I agree with CitiGroup's research department as they wrote in their latest overview of the Latin American economies;

We believe that the Chilean economy is one of the best positioned to capitalizefrom a global recovery. The openness of the Chilean economy made it one ofthe most vulnerable to the global slowdown, certainly after Mexico. But thestrength of its domestic fundamentals helped the economy withstand the globalshock.

Clearly, there are downside risks here and these come mainly from any adverse shocks Chile might suffer from another global fallout or simply the risk that global growth won't recover to the extent many are currently expecting. Yet, it is important to point out here that Chile's relative strength has two sides. On the one hand there is no doubt that the presence of Copper and the important of this commodity in the global value chain as well as the sound management of the windfall from this is very significant. On the other hand I have also, as per usual, emphasised demographics as a key variable and specifically that Chile is still riding the waves of the demographic dividend, or more aptly the afterburner of this process. In fact, what is important for Chile at this point is to lock in the favorable path by avoiding that fertility falls too much below replacement level. If Chile succeds in this, it may truly turn out to be an example to follow on more than one front. 

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(1) - I distinctly remember that he has been quoted for something like this, but I don't remember the exact wording. 

(2) - I use the following formula ln(t0/t-1).

(3) - If you run regressions as single linear models in turn with X1 and X2 respective as explanatory variables this pattern is repeated with almost identical R-sq values albeit somewhat higher for Copper prices.