Sound fundamentals and strong macroeconomic management have provided a buffer against the global economic recession, which nevertheless hit Chile both through a sharp deterioration in its terms of trade and the collapse of world trade. There was room for decisive macroeconomic stimulus thanks to sound monetary policy and prudent fiscal policy during the boom years. This, together with the rebound in copper prices – Chile’s main export – and the revival of global trade, has contributed to a turnaround in activity. The economy is now coming out of recession, yet unemployment is projected to remain initially high and inflation is likely to stay low. Macroeconomic policy should thus remain supportive in the near term. Assuming that the recovery becomes more robust, as projected, policy stimulus should be gradually withdrawn so as to set growth on a medium-term sustainable and non-inflationary path.

The economy of Chile has performed strongly since the early 1990s, establishing a track record of robust growth, rising living standards, well contained inflation and recurring budget surpluses. This enviable outcome owes a lot to the sound macroeconomic framework implemented by successive governments. However, despite its strengths, the economy was not immune to the global financial and economic crises. As a small open economy relying on exports, particularly of copper, Chile was hit hard by the meltdown of international trade and the plunge in commodity prices, which exerted negative effects on domestic demand and activity. The government rapidly introduced counter-cyclical policies and, with the help of a rebound of copper prices, the economy is coming out of recession. Once the upturn is under way, the challenge will be to return to a path of rising living standards on a sustainable basis. Although income per capita on a purchasing power parity basis has increased sharply over the past two decades, it remains at only 44% of the OECD average. To foster convergence, key policy reforms require further enhancing product market competition, improving the conditions for entrepreneurship and innovation and improving the quality of education. Despite fast growth of per capita GDP and a reduction in poverty, income inequality, as measured by the Gini coefficient, has not declined markedly over the past 20 years and remains very high by OECD standards, notwithstanding some recent improvement. Sustained growth will need to be accompanied by the right social policies to further reduce poverty and improve income distribution. Against this background the key challenges discussed in this Survey are:

Chile’s robust pace of expansion hit a roadblock when the global financial crisis erupted in mid-2008, and trade flows tumbled. Despite strong fundamentals, Chile was hit severely by the crisis, notably because of its high exposure to commodity prices. Output contracted severely, at a pace similar to that following the Asian crisis, and there was mild deflation. However, the recession was relatively shortlived. The economy bottomed out in mid-2009, helped by the rebound in export prices and a bold macroeconomic policy stimulus. Reflecting past prudent macroeconomic management, Chile was in a good position to easily finance a strong fiscal stimulus, and an aggressive reduction in interest rates was possible thanks to relatively stable inflation expectations. Activity and employment growth are projected to pick up pace in 2010 and reach rates above potential in 2011, but the unemployment rate is likely to stay at a high level and a large negative output gap will persist. Unless the recovery proves significantly stronger than expected, monetary and fiscal policy should remain supportive well into 2010. Ensuing policy tightening should be adapted to the pace of the recovery. Chile should be careful not to withdraw the stimulus too fast, not least to avoid a repeat of unemployment persistence observed after the Asian crisis.

Chile’s fiscal rule has provided a powerful protection against global headwinds, making a sizable counter-cyclical stimulus possible without disrupting financial markets and helping to jumpstart activity. This chapter suggests ways to further bolster the economy’s resilience against shocks by sharpening the fiscal rule in copper price booms, while making room to relax it more in severe downturns. Further strengthening the insurance element of the unemployment benefit system would enhance the automatic stabilisers, while allowing for better matches between employment seekers and job vacancies as well as more effective protection for the unemployed. Lowering severance pay in turn would reduce employers’ incentives to favour short term employment to avoid paying it. This could also help attenuate the strong duality of the labour market, with a considerable share of short-term and informal employment. As it embarks on the recovery and on a path of rising living standards, Chile will need to meet a growing demand for public services and work toward achieving a more equitable society. Compared to OECD countries Chile employs relatively small, but well-targeted social spending programmes to reduce poverty and inequality and it has recently expanded many of these along with higher education spending targeted at poor children. Limiting some of the more regressive and less efficient tax expenditures could help finance these spending increases or target the commensurate subsidies more at lower-income households.

Productivity growth has declined since the late 1990s, slowing the catching-up process. Structural reforms to strengthen competition, entrepreneurship and innovation would go a long way toward enhancing it. Recent competition policy reforms that strengthen enforcement of cartel law must now be implemented effectively. The National Economic Prosecutor should receive sufficient resources and the ceiling on fines against cartels, which has recently been raised, may need to be reviewed again. Entrepreneurship should be strengthened by reducing regulatory “red tape” for start-ups and simplifying bankruptcy procedures. Recent reforms to the innovation policy framework are welcome but the focus on sectoral priority clusters will need to be accompanied by appropriate monitoring procedures and sunset clauses for public support.

Chile has made impressive progress in educational attainment. Yet, despite recent improvements, outcomes, as measured by PISA results, still need to catch up with OECD standards and equity problems should be addressed. One decisive ingredient will be better teachers. Chile should aim to attract qualified individuals to the profession and bolster initiatives to improve initial teacher education and training. A second ingredient will be stronger quality assurance mechanisms. For a long time, Chile has relied to a considerable extent on competition to ensure school quality. But there has been limited success, in part due to very unequal conditions for public and private schools to compete in terms of their ability to select children, their flexibility to employ teachers and in terms of financing. Chile has started to address this by prohibiting the selection of students until 6th grade. The ongoing introduction of a nation-wide quality assurance system based on independent evaluation of results is a welcome complement. Finally, Chile will have to improve outcomes for students with poor results even more than for the rest which would lift the average and improve equity at the same time. The government has recently made important changes to invest more in students from weak socio-economic backgrounds. These extra resources can help to make considerable progress.