Chile loses haven status as inflation and populism deter investors

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Felipe Larraín fondly remembers the moment when Chile’s status as an investment haven peaked. “I was finance minister in 2012 when we happened to place over $2bn of sovereign bonds at the best possible conditions,” he told the Financial Times. “We paid just 55 basis points over US Treasuries.”

But almost a decade later, the South American nation no longer “looks like an oasis” in a neighbourhood of problem economies, as President Sebastián Piñera once described it.

Yields on the government’s 10-year local currency bonds have surged from 2 per cent in May 2020 to more than 5.5 per cent this month, taking borrowing costs to their highest level in more than seven years.

“The key explanation for the rise in yields has been the political deterioration,” said Esteban Jadresic, chief economist and global investment strategist at Moneda Asset Management in Santiago.

Chile is also a victim of surging global inflation, led by food and energy. Consumer prices rose 4.8 per cent in the year to August, well above the central bank’s 3 per cent target. The central bank has raised its policy rate twice this year, most recently by 75 basis points (0.75 percentage points) to 1.5 per cent on August 31. It promised to tighten policy in future much more aggressively than its previous guidance had suggested.

“What they had previously said they would do in two years, they are now saying they will do in six months,” said Kieran Curtis, an emerging market debt manager at Aberdeen Standard Investments in London. This, he said, had sent bond yields skywards this month.

The abrupt hawkish turn in monetary policy comes against an increasingly troubled backdrop. Only days after Piñera, a billionaire businessman, used the flattering “oasis” description of his country in an October 2019 interview with the FT, a modest rise in ticket prices on the Santiago metro triggered a nationwide eruption of social protests that lasted for months.

Demonstrators filled the streets demanding Piñera’s resignation and complaining of expensive, poor quality public services, inadequate pensions and a deeply unequal society. Tensions were only assuaged after the president agreed to big increases in social spending and the election of a constitutional assembly to rewrite Chile’s market-friendly constitution, which dated back to the era of dictator General Augusto Pinochet.

Pressure from the streets has pushed congress into populist measures including the authorisation of three successive early withdrawals of savings from the private pension system despite warnings from economists about how this would stunt local capital markets and make the pension problem worse.

Chile’s congress continues to debate a fourth withdrawal of funds from private pension pots, with votes expected next week.

Yet Larraín, who served two terms as finance minister and is now professor of economics at the Catholic University of Chile, said a fourth withdrawal would be “very bad for the people, with higher inflation, higher interest rates and lower pensions, and a very big blow to local capital markets”. He added that it had no economic rationale.

“What the government has produced in terms of a fiscal package means there is no reason to do a fourth withdrawal,” he said. “It is extremely negative and inexplicable, except for the fact that it is popular and we are in an election period.”

The withdrawals have forced Chile’s pension funds to offload bonds into the market to fund redemptions, adding to the pressure on yields. The prospect of more withdrawals ahead has turned that vicious circle tighter. “Markets are worried that [the pension funds] will have to sell so many of their holdings,” Curtis said.

Chile elects a new president and renews most of congress on November 21. Opinion polls show Gabriel Boric, a 35-year-old former radical leftist student leader, in the lead.

Whoever wins the election is expected to face heavy pressure to increase social spending further and expand the scope of the Chilean state, something the left-dominated constitutional assembly is also pushing for.

Years of prudent macroeconomic management have left Chile with one of Latin America’s lower debt to GDP ratios, but also with inadequate public health and education systems and pensions that do not provide a decent retirement for many. This provides plenty of scope for the next government to boost spending further.

“The question is whether it will be done in a responsible way,” said Alberto Ramos of Goldman Sachs in New York. “They are slowly deviating from the macro model that made Chile the poster child of fiscal responsibility.”

Igal Magendzo, chief economist at Pacifico Research in Santiago, said it was becoming increasingly hard for investors to put a price on Chilean risk because of the level of political uncertainty. “There’s an attitude of wait-and-see,” he said.

“There are doubts around the effects [of a fourth pension fund withdrawal] on the liquidation of assets, around the commitment to Chilean institutionality, economic stability and the sustainability of fiscal accounts,” Magendzo added. “The gap between Chilean returns and those of other Latin American economies is closing.”

“The fiscal space Chile has is very big,” he said. “For many years it has been very hard to have a default regardless of what was done by the government. But that [financial space] is there for the next five years, not the next 10.”