The Case of Chile:

Export Orientation as a Model for Development in Latin America

By: Pamela Oakes

This paper will examine Chile's model of export-led growth. I will start with a brief analysis of the economic chaos during the Allende administration between 1970 - 1973 and the factors that led up to it. Next, the four phases of the neoliberal experiment from 1973 to 1981 will be closely examined. Then, the export orientation development model will be discussed. In particular, I will examine fiscal policy, privatization and liberalization of trade. Finally, I will conclude with an analysis of Chile's export-led growth model.3

Introduction

Economic growth and stability have put Chile in the forefront of Latin America. Chile has been able to do what many its Latin American neighbors only hoped for. It has created a stable economic environment that has maintained a low rate of inflation, increased savings, diversified exports, produced capital inflows, and debt reduction. Chile has become a model of economic development for Latin America. "Chile has been the guiding light for many of the region's market-oriented economic policies," according to Gert Rosenthal, head of the Economic Commission for Latin America. Chile's model of export orientation has been so successful that it is now being considered to join the North American Free Trade Agreement.

Chile's Latin American neighbors are trying to duplicate Chile's economic success. "Basically Latin America is copying the Chilean model in terms of export orientation. Countries are looking at private pension fund programmes, at fiscal policies of restraint, at establishing an autonomous central bank and at macroeconomic management." This paper will examine Chile's model of export-led growth. I will start with a brief analysis of the economic chaos during the Allende administration between 1970 - 1973 and the factors that led up to it. Next, the four phases of the neoliberal experiment from 1973 to 1981 will be closely examined. Then, the export orientation development model will be discussed. In particular, I will examine fiscal policy, privatization and liberalization of trade. Finally, I will conclude with an analysis of Chile's export-led growth model.

Background

The military coup that abruptly ended Salvador Allende's socialist government in 1973 also changed state participation in the economy. "The significant role of the Chilean state in the social sphere under the Allende administration was rooted in the policies developed prior to the first World War." The state had assumed the responsibility for needs of the poor and working classes by creating numerous social programs. "Between 1920 and 1930, the government implemented a social security program, an income tax, and a labor code; social expenditures, which were mainly in education, increased five-fold." Like many of its Latin American neighbors, Chile adopted import substitution, an inward-looking economic model of development, in the 1930s.

From the early 1930s to the mid 1950s, government addressed the needs of the poor and working classes. The government imposed price controls, a minimum wage and increased social spending three-fold. As a result of inflation, social spending decreased during the 1950s. The socio-economic inequalities continued to grow until 1964 when the Christian Democrats resumed power. The government attempted to improve the widening division between the classes.

Between 1965 and 1970 public spending grew from 35.7 percent to 46.9 percent of Chile's gross domestic product (GDP), the public's share of gross national revenue climbed from 61 percent to 77 percent, and state expenditures on social programs rose from 8.2 percent to 9.4 percent of GDP.

However, the Christian Democrats were unsuccessful in closing the gap between the classes. "The perceived failure to correct social inequalities in Chile and the political divisions between the Left, Right, and Center led to Allende's victory in the fall of 1970 and the `Chilean road to socialism'."

By 1971, the Chilean economy began to fall apart. Production fell and there were substantial losses at the large firms Allende had nationalized

in 1970. The annual rate of inflation had reached 605.9 percent by 1973. The nationalization of the copper mines scared foreign investors away and agricultural exports declined. The international community lost confidence in the Chilean economy. There were strikes by the middle class and Allende's opponents called for his resignation by mid-1973. On September 11, 1973, a bloody military coup abruptly ended Chile's socialist experiment.

The Neoliberal Experiment

Phase One - Transition

Economic reforms were introduced without delay soon after the military regime came to power. Controlling inflation was a priority for General Pinochet's new government. In 1974, the government launched a privatization program and introduced tax reform. With the exception of the State Bank, all of the banks were sold to the private sector through a public auction. By the 1980s, the government had privatized 288 state-owned enterprises. In an effort to reduce the fiscal deficit, the government introduced a tax reform "under which taxes on wealth and capital gains were abolished and taxes on profits were reduced." A 20 percent value added tax which covered basic consumer goods replaced the revenues lost by the tax cuts.

The government returned approximately 30 percent of the land expropriated under the two previous governments to the former owners. In addition, the exchange rate was devalued and the government eliminate price controls on most products. "By the end of 1974, the annual inflation rate stood at 370 percent, industrial production had decreased, and unemployment had more than doubled."

Phase Two - Shock Treatment

The second phase of the neoliberal experiment began in April 1975. "The shock treatment entailed steep reductions in government expenditures and in the size of the public, an increase in income taxes, and a tight monetary policy." The plan reduced inflation and the fiscal deficit but resulted in a severe recession. In 1975, unemployment increased 20 percent while GDP fell 12.9 percent, meanwhile the fiscal deficit fell from 10.5 percent in 1974 to 2.6 percent and inflation still remained high at 343 percent. Moreover, the shock treatment had a negative effect on output. "The fall in demand led not to a fall in prices but to a fall in output, to a fall in the volume of production, particularly in the industrial sector."

Phase Three - Economic Boom

There was a shift in strategy of controlling inflation during the third phase of the neoliberal experiment. Instead of controlling the fiscal deficit and money supply, the government decided to manipulate the exchange rate in order to combat inflation. This new phase which lasted until 1981 "laid the groundwork for the `economic miracle' in Chile." Inflation had been brought down to 84 percent in 1977 but declined even further to 9 percent in 1981. By 1979 the government considered that Chile had been fully integrated into the world economy. In June of the same year the government fixed the exchange rate at 39 pesos to the dollar. "In such an economy, it was argued, inflation was not determined by changes in the domestic money supply but by the changes in the nominal exchange rate."

The new government strategy was successful. The GDP increased an average of 8.5 percent per year between 1977 and 1981. The price controls imposed in the transition phase were eliminated and fiscal deficits had been eradicated. A new labor law enacted in 1979 suppressed labor by sharply reducing the power of the labor unions. In a series of structural reforms, the government reduced its role in the social sector, giving more control to the private sector and local governments. In particular, the government privatized the social security system, which ultimately proved to be a model for the rest of Latin America.

The government made substantial changes in international trade and investment. By 1979 tariffs had been reduced from an average rate of 94 - 220 percent to a flat rate of 10 percent. The multiple exchange rate system was replaced by a unified exchange rate and foreign direct investment (FDI) regulations had been liberalized. "The new FDI regime generally treated domestic and foreign capital equally and ceilings on profit remittances were removed." Finally, the government diversified its exports, relying less on copper and developing new export industries including fish, fruit, and timber.

Phase Four - Collapse

The economic miracle of the late 1970s and early 1980s collapsed by late 1981 as a result of the debt crisis. "The roots of Chile's debt crisis can be traced to the poorly regulated liberalization of Chile's financial sector in the mid-1970s, which led to astounding debt held by the private sector."

The government eased reserve requirements and eliminated controls on interest rates on banks and financial lending institutions in 1974. "The critical liberalization occurred in June 1979, when the government lifted the ceiling on the banks' foreign liability/equity ratio and soon thereafter eliminated the limits on monthly increases in foreign liabilities." The economic miracle had been financed by loans from foreign commercial banks to the private sector using a floating interest rate.

Chilean banks increased their foreign obligations by a mere $500 million between 1975 and 1978, the years when most foreign loans were contracted by the nonfinancial private sector, but then went on to borrow $6 billion during the next three years. By 1981, over sixty-five percent of Chile's external debt was owed by the private sector, with two-thirds of that portion owed by commercial banks.

Additional factors contributed toward Chile's economic collapse. The fixed exchange rate policy adopted in 1979 led to the overvaluation of the peso and expectations of a devaluation. Speculation against the peso increased as well as interest rates. As a result, Chile was flooded with imports and its export sector suffered. Moreover, the government financed its current account deficit between 1978 and 1981 with loans from foreign commercial banks.

Chile's foreign creditors reduced Chile's foreign credit substantially, from $4.3 billion in 1981 to $0.4 billion in 1983. The government reacted by devaluing the peso in June 1982 and imposing exchange controls in December 1982. Furthermore, Chile's economy suffered a deep recession. In real terms, GDP fell 15 percent and wages fell 30 percent between 1982 and 1983. Chile's terms of trade experienced one of the sharpest declines in Latin America, falling 27 percent between 1979 and 1983.

While the total debt was less than that of Mexico or Brazil, Chile had the highest external debt relative to GDP in 1982. Foreign commercial banks were owed 85 percent of Chile's external debt. The Chilean government set out to resolve its financial crisis immediately by placing a high priority on its debt being serviced on time.

[The Chilean government] adopted a highly cooperative and "successful" approach to negotiations with its commercial bank creditors. This approach could be predicted in light of Chile's radical efforts in the 1970s to shed the inward-looking model of development in favor of integration into the world economy.

Export Orientation as a Development Model

Chile continued to develop its export oriented economy with exports increasing nearly one billion dollars between 1980 and 1987. Exports increased dramatically by 1992 as Chile exported one-third of its production, an increase from 12 percent in 1972. The post-war economies of Germany and Italy have served as models of export-led growth for Chile. Both economies experienced their own economic miracles as a result of export-led growth. According to Alejandro Foxley, Chile's Finance Minister until last year, Chile's experience "is that export-led growth is the only way to sustain stable growth" in an economy as open as Chile's. "Export-led growth can only take place, though, in an atmosphere of economic stability, with the country's exchange rate movements well under control."

Fiscal Policy

The key to Chile's economic success has been fiscal discipline. Inflation is estimated to be approximately 10 percent in 1994, slightly lower than the annual inflation rate in 1993. Capital inflows have been limited in an attempt to avoid appreciation of the peso and inflationary pressure. Exchange controls are in place to slow capital inflows and alleviate the pressure for the exchange rate to appreciate. Foreign investment, which accounts for 5 percent of Chile's GDP, is attracted by Chile's reputation for economic stability.

Investment, however, has been financed mainly by domestic savings, which at 21 percent of GDP, are the region's highest. This has reduced its dependence on foreign inflows and allowed it to maintain capital controls. Although the rising current account deficit does imply a higher dependence on foreign capital, most economists see it as short- term and easily financed.

While the government has maintained tight control over expenditures, it has neglected the need of sustaining Chile's infrastructure, a vital component of its export orientation.

Privatization

In order to maintain a balanced budget in 1980, the government relinquished control of Chile's social security system. "In 1981, Chile's social security system was radically changed by the creation of a new pension system based on privately owned, professionally managed funds." Benefits from the pension system are determined by an individual's contribution. The pension management companies, often called AFPs (Administradoras de Fondos de Pensiones), are involved in different sectors of the economy, including privatization. APFs are encouraged to finance the privatization of Chilean state-owned enterprises.

APFs have played a significant part in the privatization of several major Chilean companies including Chile Metro, Endensa, Entel, Schwager and Telefonos. In fact, equities acquired through participation in privatization transactions accounted for nearly 90% of APFs' corporate equity holdings at the end of 1990.

Many Latin American countries are looking Chile's pension program as a model to duplicate.

Trade Liberalization

Free trade has sustained Chile's economy. Chile has "the lowest tariff rates in the region, and the open economy has been credited for improving efficiency in Chilean industry." Chile is focusing on traditional commodity-based sectors such as agriculture, forestry, and mining instead of leaping into high-technology manufacturing. Although Chile has diversified its exports, the economy is still heavily dependent on copper. Copper exports accounted for nearly 40 percent of Chile's foreign exchange income in 1993, down just 10 percent since 1989. According to the current economic minister, Alvaro Garcia, "mining, agriculture, fishing, forestry and industrial goods produced from these sectors form the dynamic nucleus of [Chile's] export development." Value-added industries have also been established which include wine and furniture production as well as food processing.

Chile has moved towards regional integration in the 1990s. Chile has established bilateral free trade agreements with Mexico (1991), Venezuela (1993), and Colombia (1993). All three bilateral agreements require zero tariffs between four to six years.

As a complement to this strategy of bilateral negotiations, Chile is in the midst of a process of clear incorporation to multilateral regional accords with which it has natural geographic and economic ties. Chile's membership in the Pacific Economic Cooperation Conference (PBEC) and the Asia Pacific Economic Cooperation (APEC) are a result of this natural trend.

In addition, Chile has "proposed to associate itself with the Southern Cone Common Market (Mercosur)." Finally, Chile is deciding where to seek full accession into the North American Free Trade Agreement (NAFTA) or negotiate a bilateral trade agreement with the United States.

Analysis of Growth Model

Chile has indeed become a model of economic development for Latin America. Chile's economy is expected to grow a modest five percent in 1994.

This is a slight decrease from previous years but Chile has still been able to "complete 10 years of sustained growth at an average rate of 6.3 percent a year," according to Alvaro Garcia. Chile has also been able to hold inflation down despite large amounts of foreign investment. The government is willing to impose fiscal belt tightening to keep inflation at a low rate. Moreover, "despite the international downturn in commodity prices last year, the export-dependent economy still managed to grow by 6 percent."

The diversity of Chile's trading partners, the U.S., Asia, and Latin America do not create a dependency on one particular region for Chile. With a diversified economy that includes primary exports as well as semi-manufactured exports and multiple export markets, Chile is not completely vulnerable to domestic policy changes or economic downturns in a country or region. Finally, the mere fact that Chile is considered a potential addition to the NAFTA indicates the international community's confidence in the Chilean economy. Chile has been successful in finding its niche in the global economy.

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