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Chile mood

CHILEAN FINANCE MINISTER NICOLAS EYZAGUIRRE LIKES to tell of a chat he had with a friend who was mocking the government's attempt to equate the country with the Asian Tigers by adopting the nickname Chilean Jaguar. That, said Eyzaguirre's pal, only applies in good times. "Chile," he declared, "is really a manic-depressive cat."

Chileans wryly describe themselves as hyper-self-critical and given to extremes of emotion over their country's often troubled state. As Jorge Schaulsohn, founder of the centrist Partido por la Democracia, one of the members of the ruling center-left coalition, the Concertación de los Partidos de la Democracia, laments: "Chile is always in crisis, in hysteria. This country needs Prozac." In fact, Chileans living in cities have twice the rate of depression of urban Brazilians.

These days the mood in Chile is especially anxious. For most of the 1990s, this country of 15 million people was held up as a showcase of many of the democratic, free-market policies that came to be dubbed the Washington consensus (see page 129). Chile's per capita GDP doubled in that decade, while its poverty rate fell by half. From 1991 until 1997 the country's GDP surged at an average annual rate of 8 percent; average unemployment stayed below 5 percent.

But a severe drought and the global economic turmoil that followed the Asian financial crisis tipped Chile into recession -- it had negative growth of 1.1 percent in 1999 -- and it has yet to really recover. Growth last year was just 2.1 percent, and unemployment is a painful 8 percent. Last month in Santiago labor union workers seeking better pay and health and social security benefits staged Chile's first general strike since 1986.

"For a long time there was a view that Chile was a Swiss-run country in Latin America," says Gray Newman, chief Latin America economist at Morgan Stanley. "What we are beginning to realize is that it still resides in Latin America."

No less worrying to Chileans than the lackluster economy is the way that the center-left government of President Ricardo Lagos cannot seem to sidestep scandal. Serial incidents of influence peddling, insider trading and kickbacks have claimed the jobs of two cabinet ministers and a central bank chief.

Lagos has had little choice but to tackle corruption head-on. "We have seen another face of Chile, a face that we don't like," he told fellow Chileans in a state-of-the-nation address in May. The president pledged reforms aimed at rooting out the causes of scandal. Congress has now passed laws to prevent the president and other powerful politicians from doling out plum civil service jobs (instead, independent search committees recommend appointees) and has increased the salaries of government workers, to reduce their susceptibility to bribes and to attract talented candidates. Congress has also adopted laws to provide public funding for political campaigns and to require that private campaign contributors be named. Lagos urged the country to rally behind a pro-growth agenda calling for more flexibility in Chile's labor laws.

"If you want growth with equity, the Washington consensus is a necessary condition but not a sufficient condition," Lagos told Institutional Investor (see page 34). "We fulfilled the Washington consensus, but we decided it was essential to pass these laws. A crisis can be an opportunity, when you use it the right way."

The questions that worry Chileans, though, are: Do Lagos's reforms represent that right way? And can they help return the economy to rapid growth and low joblessness?

Of less concern to Chileans, perhaps, but of great moment to global policymakers is a broader question: What does Chile's boom-bust experience say about the Washington consensus -- the controversial notion championed by the U.S. that by deregulating industries, opening domestic markets to trade, privatizing state enterprises and in general wholeheartedly embracing free markets, developing countries can achieve not only economic prosperity but also, by implication, social well-being?

Chile, for all its economic gains, remains a highly stratified society. Just 20 percent of the population controls 61 percent of the wealth; the poorest 20 percent, barely 3 percent. That, say observers, helps explain why so many Chileans remain dissatisfied. According to polls, only 50 percent support democracy as opposed to other forms of government, down from 75 percent in 1990. Just 14 percent trust political parties.

"People are very frustrated," says political scientist and Mori International pollster Marta Lagos (no relation to the president). "Everyone acknowledges the impact of economic growth, but they aren't happy. That's because society has not changed, there is no transparency in access to power. They haven't become empowered citizens."

Resentment against the entrenched elite may help explain why Chileans were so incensed by the scandals in Santiago. "There is a contrast between what the locals look at and what the rest of the world does," says Morgan Stanley's Newman. "In Chile the scandals were huge." Before the uproar quieted down following Lagos's speech, Santiago newspapers were full of stories suggesting that the president would have to resign before his six-year term is up in two and a half years.

The president's troubles began in mid-2002, when state investigators found that a Chilean businessman had paid bribes to government agencies and that some of the money was used to finance the election campaigns of legislators in Lagos's Concertación coalition. Despite denying the charges, five left-wing members of Congress were expelled. Soon afterward, the investigators uncovered a multimillion-peso kickback scheme at the Ministry of Public Works, which was overpaying a consulting company that in turn padded the salaries of ministry employees. Among those now facing criminal charges: former Public Works minister Carlos Cruz, a close friend of Lagos's.

Those purported misdeeds were still generating headlines when the Inverlink­Corporación de Fomento de la Producción (Corfo) scandal broke early this year. A computer technician discovered that then­central bank governor Carlos Massad's secretary had been e-mailing confidential bank data to her former lover, a general manager at brokerage firm Inverlink. He allegedly used the inside information to trade money market instruments owned by state development fund Corfo that had been illegally endorsed over to Inverlink. Though not personally implicated, Massad was forced to resign in the resulting political hubbub (Massad says he left for personal reasons); Inverlink went out of business; and the head of Corfo, Gonzalo Rivas -- who happens to be Lagos's son-in-law -- lost his job, though he wasn't charged with wrongdoing.

Lagos moved swiftly to halt the damage. To portray himself as tough on corruption, he reshuffled his cabinet in February, replacing Justice minister Jose Antonio Gomez with independent criminal lawyer Luis Bates. To take over for Massad at the central bank, he appointed prominent conservative economist and monetary hard-liner Vittorio Corbo, who has a Ph.D. from Massachusetts Institute of Technology and taught at Catholic University in Santiago.

To pull off his reforms, Lagos has gone so far as to put his own coalition's electoral prospects at risk by forging an alliance with Chile's strongest opposition party, the conservative Unión Demócrata Independiente. The Concertación, Lagos's unruly coalition, consists of the centrist Partido Demócrata Cristiano; Lagos's own left-of-center Partido Socialista de Chile; the umbrella socialist party, Partido por la Democracia; and the statist Partido Radical Socialdemócrata. The Concertación has held power since Chile's transition to democracy in 1990, but it may now find it hard to distinguish itself from the right-wing coalition, the Alianza por Chile.

"Lagos had always been looking for a joint venture with the opposition," says pollster Lagos. "It is good for Chile, good for Lagos -- but not for the Concertación." The president, who by law cannot seek a second term, appears almost indifferent to the Concertación's fate. "The coalition is the one that has to talk about the future," he says. "My job is to do the right things up to March 2006. That the government is successful doesn't necessarily mean that the coalition is going to be successful."

Indeed, the right sniffs opportunity. "The perception is that this time the opposition has a chance in the polls," says Gustavo Canonero, an economist in Deutsche Bank's Buenos Aires office. "People are disappointed with economic performance, and there is a perception that the right wing will be more aggressive on some issues." The right is expected to move more boldly on labor reform and deregulation. The most likely conservative presidential candidate, Joaquín Lavín, the mayor of Santiago, lost to Lagos in the 2000 election runoff by a mere 200,000 votes out of 12 million cast. Current polls show Lavín defeating whoever is the Concertación candidate by a solid margin in 2005.

The state of the economy come election time will be pivotal. But neither the Concertación nor the Alianza has presented a cohesive program for recovery. "The Chilean economy is running below potential -- there's a lot of infighting and hesitation," says Eduardo Aninat, a Christian Democrat and Finance minister in the previous Concertación administration, who stepped down as International Monetary Fund deputy managing director for Latin America in June to run for a seat in the Senate. "The basic challenge is to create confidence in Chile. There is a lack of a broader vision of change long term."

Conservatives shun specifics at this stage. Rodrigo Vergara, a former economic adviser to Lavín and now an economist at Santiago's Center for Public Research, says: "In the past few years, we have been complacent, just waiting to grow. That didn't happen, and we realized that we are not invulnerable to the rest of the world and to our own mistakes. We will focus on [government] efficiency and growth -- and away from old ideas of more taxes." Another conservative, central bank governor Corbo, contends that "we need more flexible labor markets and better management of education resources." As Corbo sees it, "two thirds of the blame [for Chile's economic plight] is the external environment, and the other third is labor and micro problems."

Lagos's plans to liberalize Chile's burdensome labor laws address at least one third of the problem. Employers are required to pay such generous severance -- typically, one month's salary for each year of employment -- that they put off hiring workers and hesitate to let marginally productive workers go. The reforms would give companies more flexibility in setting employee working hours. This would allow service companies, like call centers, to operate around the clock. Government and business have begun negotiations with labor unions over revising the rules.

Lagos and his allies point to external factors as the primary cause of Chile's disappointing economic performance. That's easy to do, of course. The global economy is sluggish, and closer to home, Chile has had to contend with the unsettling news from both Argentina and Brazil (see page 25).

Yet some critics say that Santiago is letting itself off the hook. "The Chilean economy did very well in the early 1990s when the world economy wasn't very good," points out John Williamson, an economist at the Institute for International Economics in Washington, D.C., and the coiner of the term Washington consensus. He argues that Chile has abandoned its willingness to experiment with unorthodox (for Latin America) policies, such as the more aggressive countercyclical fiscal and monetary measures that helped to make it an economic success. Chile is the only Latin American country, for instance, that increases government spending -- albeit cautiously -- during slumps.

Since the mid-1990s Chile has become more and more conventional in its economic policy, Williamson says, focusing more on fighting inflation than on stimulating growth. "The success of Chile was based on microeconomic liberalization and an enlightened macro policy," he says. "Now macro policy is more laissez-faire and doesn't give hope to the economy." He contrasts the central bank's preoccupation with inflation to its past willingness to promote growth. Chile, Williamson says, "is not as much of a model as it used to be."

Finance Minister Eyzaguirre rejects the contention that Chile could have done more to avoid a downturn. "The reality is that the world economy was terrific to Chile from 1986 to 1997," he says. "We had high capital flows and buoyant investment. During the early '90s the copper price did not fall and dollars were coming in. What beats you is huge capital outflows." Foreign direct investment in Chile fell from $9.77 billion in 1999 to $2.69 billion in 2002, mainly for external reasons but also because Santiago didn't do enough to stimulate demand at home. Copper, Chile's chief export, dropped from 94 cents per pound in September 2000 to 80 cents per pound early last month.

Nevertheless, Chile's economy fared better than those of most Latin American countries in 2002, and the central bank projects it will grow by 3.5 percent this year as the world economy recovers. Moreover, Chile should benefit from the free-trade agreement with the U.S. that it signed in June. The White House delayed approving the deal -- the negotiations had mostly concluded last December -- to show displeasure at Chile's not supporting the war on Iraq.

Lagos dissipated much of the goodwill that the trade deal generated in Chile's business community by promptly asking for an increase in value-added taxes to offset forgone tariff revenues and help close a budget deficit expected to be 0.7 percent of GDP this year. In June, Congress approved a 1 percentage point VAT increase, to 19 percent, over two years, but the debate preceding the vote produced a storm of controversy. The government's plans to also increase taxes on alcohol, diesel fuel and tobacco were shot down. Says Andres Concha, secretary general of the Sociedad de Fomento Fabril, the Chilean federation of industry, "The government could have made an effort at fiscal savings to cover its deficit instead of resorting to taxes."

The opposition has seized on the issue. Former Lavín adviser Vergara says, "Not only was there a plan to raise taxes to make up for lost tariffs, but there was also talk of increasing taxes on specific industries." The tax furor underscored Lagos's credibility problem with businessmen. A Wall Street economist who covers Latin America observes: "The business community never accepted Lagos; they never trusted him."

Eyzaguirre counters that the VAT increase doesn't make up for revenues lost from reduced or eliminated tariffs, so it actually amounts to a tax cut. "Our tax burden of 17.4 percent of GDP is moderate compared with other countries," he says. "Unless you are ideologically obsessed, you cannot claim that the size of government is impeding growth." Central bank governor Corbo supports the VAT increase but acknowledges that "there was too much confusion about taxes."

Chile's new democracy is barely a decade old, and the country's politics are deeply polarized. Many on the right openly want a return to the era of former dictator Augusto Pinochet. "With Pinochet, things were better, there were rules -- now everything is vague," says an engineer with national airline LanChile. Many on the left see any accommodation with business as tantamount to treason.

Presidential candidate Lavín's slogan in the 1999 election campaign was simple -- "Long live change!" -- and it may be what Chileans want to hear in 2005. He has positioned himself as a doer with a theatrical flair: He trucked sand to the banks of the Mapocho River in Santiago to create a poor people's beach -- and now that it's winter in the southern hemisphere, Lavín has turned the beach into a ski center. The Concertación has no comparably charismatic potential candidate.

If Lavín does win in 2005, the onus is on him as a doer to get the economy moving again by whatever means possible -- and to transform the country in the process. As pollster Lagos says, "There is now an expectation that whoever comes to power will transform Chile into a modern society." The alternative would be for Chile -- for years the shining star in Latin America -- to look more, not less, like its struggling neighbors. 


LAGOS ON HIS LEGACY

Compared with the typical heavily fortified Latin American presidential palace, Chile's La Moneda seems almost too accessible. No concrete barriers seal off the neoclassical structure, which used to be the federal mint (hence the name, which means "money" in Spanish). Through the unbarred windows of President Ricardo Lagos's second-floor reception room come sounds from Santiago's Plaza de la Constitución below: chattering tourists, boisterous office workers, honking taxis, protesting students.

The ostentatious lack of security -- apart from sidearm-packing presidential guards, a number of them women -- is all the more striking considering that Lagos is Chile's first Socialist president since Salvador Allende, who died in a 1973 military coup led by Augusto Pinochet during which La Moneda was bombed. "In how many countries do you have people walking in front of the president's palace?" asks Lagos. "This is a quiet country. Nothing happens here."

That is an understatement. Chile, once Latin America's model economy, is struggling to regain its momentum amid mounting popular discontent over Lagos's center-left coalition -- the Concertacíon de los Partidos de la Democracia -- which has become embroiled in headline-grabbing corruption scandals (story).

In a wide-ranging interview at La Moneda, the 65-year-old president reflected on his six-year term near its midpoint with Institutional Investor Senior Writer Deepak Gopinath.

Institutional Investor: What are you most proud of?

Lagos: That's difficult to say. In spite of the international economic crisis, we've been able to grow GDP by 10 percent over three years. Maybe it's not very good, but it's more than two and half times the growth rate of Latin America as a whole. But more important, we've been able to open up the Chilean economy, with trade agreements with Europe, the U.S. and South Korea and others in the pipeline. In addition, we've passed laws to improve social cohesion.

Such as?

Unemployment insurance. Now more than 20 percent of our workers have such insurance. It is run as a private fund, and once it is working at full speed, we'll increase our ratio of savings to GNP by 1 or 1.5 percentage points. So you get two things: increased savings and an important social policy benefit.

What are your disappointments?

The shortcomings are many. We have problems with unemployment because our rate of growth has not been big enough. We have an unemployment rate of about 8 percent, when we used to have 5 percent. Even though we are creating jobs, the rate of labor market participation is increasing. During the past year we created 160,000 jobs, but 150,000 people entered the labor force. That has to do with women working, which is good for the country.

Chile's economy performed exceptionally in the early 1990s, when the global economy was also weak. What's the difference between then and now?

During the period you refer to, Chile was receiving external savings [foreign investments] that were very important. Now external savings have almost stopped. True, we've been able to go to Wall Street and place our bonds on very convenient terms, but what we can sell is $1 billion, $1.5 billion, $2 billion, but no more. And even though our private firms are well regarded on Wall Street, they feel uneasy going there. Second, more than 65 percent of our GDP comes from exports, and therefore what happens abroad, such as Europe's slow growth, is very important to us. Plus we had the oil shock -- Chile depends too much on oil. And the other big difference with the early 1990s is the price of copper [Chile's chief export]. In 1991­'93 copper was $1.10, $1.15, $1.25 a pound, and now it is 70 cents. If Chile had the terms of trade of the early 1990s, our growth rate now would be more than 6 percent.

Will Chile ever resume 7 to 8 percent growth?

Yes, I think so. Chile was able to discover fruit, salmon, forest products, wine as major exports. Now we must recognize that services are going to be more and more important. We have very good telecommunications -- broadband, fiber-optic -- very cheap by international standards. We have a number of call centers now; the major airlines have their call centers in Chile. Our major challenge is teaching English. We have quite a number of international banks' Latin American back offices in Chile. We have a large number of international companies. Unilever opened a major office here. General Electric has established a center to provide information about its airplane engines. If you have a problem with your engine, the answer is going to be coming from Chile. We are trying to be a launching pad for Latin America.

How much damage have the corruption scandals caused?

There were signs of corruption in some areas, and we reacted in a very rapid way -- all the political forces, the government and the opposition. The president had the ability to nominate 3,000 civil service jobs; now that has been reduced to 700. Now there is a maximum expenditure allowed for running for public office, and of that maximum the state will pay 40 percent. Private contributions over a particular amount have to be made public. In terms of transparency, that has been very important.

What are you doing to achieve greater flexibility in Chile's labor laws?

First, we want to have unemployment insurance, which has to do with flexibility. If you, the employer, have the flexibility to fire somebody because demand for your product is going down, well, it is only fair to have unemployment insurance for those fired. The other question has to do with trade unions. If you have a firm and you don't want to have a trade union, and a worker tries to form a trade union and you fire him -- I will not accept that. Therefore I want to have labor flexibility, but I also want to reform labor tribunals so that [aggrieved workers] can have access to justice.

You opposed the Iraq war. Hasn't that engendered hard feelings in Washington?

I was very open and very honest and very frank with our American friends. I said, "Look, people who want to be partners in trade must talk the truth, so I have to be very open." I didn't think it was possible for Chile to go along with a resolution whose mandate meant war, because there was still some time for Iraq to fulfill disarmament benchmarks. At the beginning the world was against Saddam Hussein, because he represented not only a dictatorship but a threat to mankind. At the end it was a war of the U.S. against Iraq. I thought it was possible, using the United Nations resolution and benchmarks, to rally the world against Saddam again.

What advice would you give Latin America's newest left-of-center leaders, like Brazil's Luiz Inácio Lula da Silva and Argentina's Néstor Kirchner?

Seven months ago who would have believed that Lula would be talking about the need to have a balanced fiscal budget? Now he realizes how important it is to reduce Brazil's country risk to lower the interest payments on its debt. There is a virtuous circle, and that is very important for the new president of Argentina to consider.

Is Chile still a development model for Latin America?

Perhaps the president of Chile is not the right person to talk about that. But what we are trying to do is to have growth, to have investment, to increase productivity in the long run -- which involves spending a lot on education -- and at the same time try to be a country that is honest and whose people are honest.


II'S FALL 2003 COUNTRYCREDIT RATING

CHILE

COUNTRY CREDIT RATING


65.2

SIX-MONTH CHANGE


0.5

ONE-YEAR CHANGE


­0.9

Compared to the melodramas that have played out in other Latin American countries, Chile's recent economic and political history is pretty dull. "It's the good boy of Latin America," says Juan Carlos Cure, country risk manager at Royal Bank of Canada. Chile, he explains, has "orthodox fiscal and monetary policies and a government that is committed to building a strong institutional framework." The results show in Chile's rating inInstitutional Investor's semiannual Country Credit survey of sovereign credit analysts, beginning on page 85. Chile scores at least 20 points higher than any other major Latin American country. Still, the good boy has strayed a bit: GDP growth last year was just 2.1 percent, well below its annual average of 8 percent from 1991 to 1997. As a result, survey participants cut Chile's rating by 0.9 points over the past year. Although it has improved recently, it is still below its September 2000 all-time high of 67.2.