Sovereign risk: Chile’s enduring miracle
One country showed the way forward for Latin American sovereigns nearly 35 years ago. Many have tried to follow. Have they succeeded?
The year 1985 was marked by the implementation of the most important set of economic reforms ever to be introduced in Latin America. ‘The miracle of Chile’, as Milton Friedman was to call it later, was forged by the country’s finance minister between 1985 and 1989, Hernán Büchi.
As one of the ‘Chicago boys’ (a group of Chilean economists educated at the University of Chicago), he pushed through a three-pronged strategy: economic liberalization, privatization of state-run industries and the stabilization of inflation.
The success of Büchi’s approach shows up clearly in the Euromoney Country Risk (ECR) data. In 1985 Chile was ranked 12th strongest sovereign in Latin America and the Caribbean, and had a score of 11.6. A decade later Chile topped the rankings with a score of 75.9 (15 points clear of second-placed Colombia).
Since that climb to the regional peak, Chile has been the unchallenged leader in the ECR rankings in the region, with a nominal score of 78.1 in 2019.
The specifics of the miracle have been well covered elsewhere, but an important factor for the risk ratings of Chile and Latin America was the change it had on the psyche of economic policymakers in the region in the following decades.
Not only did future Chilean governments continue to build upon that financial base – the country was the first to adopt a fiscal stability rule, a sovereign wealth fund, and was the first Latin American country to be awarded an investment grade rating and join the OECD – but it provided a model that many copy to this today.
The rating agencies share this view.
“Chile is by far and away the highest-rated sovereign that we have in the region,” says Lisa Schineller, managing director, Latin America sovereign at S&P Global Ratings. “That reflects the strength the country has in terms of very low fiscal risk and its track record on the monetary side.”
Recently, Paraguay has been the stand-out performer. The small land-locked nation has bounced back strongly from the 2008 crisis and surprised many regional economists by growing at around 5% annually, despite slumps that have impacted large neighbours Brazil and Argentina.
I had the opportunity to speak with Bolsonaro, and he clearly realizes that the problem in Brazil is fiscal, and that the fiscal deficit will not be addressed unless structural reforms are done, and part of that means pensions reform - Felipe Larraín
Paraguay’s ECR rating has improved steadily (as have its ratings from the agencies). In 2007 the country was ranked 13th strongest regional sovereign with a score of 38.9; this has now improved to ninth with a score of 44.2.
Paraguay’s upward path reminds many, including Shelly Shetty, who heads the Latin America team in the sovereign group at Fitch Ratings, of a ‘young’ Chile.
“It’s a country with a very low level of public debt,” she says, “and it’s a country that over time has proven its resilience to economic shocks coming from its neighbours.”
Part of Paraguay’s success has been its fiscal responsibility law, copied from Chile. It is a policy that has been almost too successful; the government recently tried to increase some counter-cyclical flexibility to enable the country to maintain investment in infrastructure through cycles.
Santiago Peña, then Paraguay’s finance minister, told Euromoney in 2017 that a simple cap of a 1.5% fiscal deficit was an unnecessary straitjacket on a country with such low debt (18.4% of GDP) and cyclical tax revenues – external revenues related to trade and the Brazilian economy – and internal exposure to weather and agricultural productivity.
“We have exceeded capacity,” said Peña. “Not financially, but legally in terms of the fiscal responsibility law. [The law] is extremely tight and it doesn’t make any sense for a country like Paraguay that has the lowest debt-to-GDP [in the region] to have a maximum deficit of 1.5%.”
Working with Chile’s finance minister, Felipe Larraín, the proposals met with surprisingly fierce resistance from lawmakers who were sensitive to any easing of the fiscal framework that has been widely acknowledged as part of the foundation of the country’s economic progress.
It’s not just Paraguay that looks to Chile for inspiration today. Paulo Guedes, Brazil’s new finance minister, in power since Jair Bolsonaro won the presidency at the end of 2018, is another ‘Chicago boy’ who openly cites Chile as the economic model for Brazil.
Guedes has even endorsed the adoption of a Chilean-style capitalization pension scheme as the solution for Brazil’s enormous pension liabilities.
There has been a lot of talk about Brazil’s new pension laws, but perhaps no conversation was as important as the one that Chile’s Larraín had with Bolsonaro in Davos in January this year.
As Larraín told Euromoney at the time: “I had the opportunity to speak with him, and he clearly realizes that the problem in Brazil is fiscal, and that the fiscal deficit will not be addressed unless structural reforms are done, and part of that means pensions reform.”
Chile’s capitalization model is essentially a defined contribution (DC) system where individuals have individual accounts. That could be a future model for Brazil, but as Larraín points out, transitioning to such a system does not address the fiscal liabilities inherited from the unfunded defined benefit system. Without addressing that issue, Brazil will continue to build up its debt-to-GDP ratio, which could lead to a crisis of confidence in the currency.
“We could move to this system because we have a fiscal surplus in Chile,” said Larraín. “This has lots of benefits for the financial sector in terms of deepening the financial markets and the roles of institutional investors. There are many good benefits in having a DC, but how would Brazil fund the transition? Because if you take away the contributions of people who are currently working [from paying retirees], you are going to increase the fiscal deficit in the long term.”
Brazil will need to copy Chile’s discipline but not necessarily its rules.
“Rather than saying: ‘We are a model for Latin America’, I would say that we have some economic rules and institutions that are respected throughout the region,” summarizes Larraín.
Brazil has subsequently made progress on a pension bill that limits fiscal spending, without introducing a new capitalization system. That should stem the collapse in Brazil’s ECR rankings – from second-strongest regional economy in 2012 with a score of 61.5 to sixth place and a score of 53.5 in 2019. But most economists agree that Guedes will have to do more to get the country’s economy firing again.
The performance of the country’s equity markets – up at record levels this year – is a better reflection of the structural move of local investors to equity products in the face of the record-low interest rates rather than any relative improvement of the country’s risk profile.
Indeed, more than R$20 billion ($4.8 billion) was removed from the country’s stock exchange by international investors in 2018, while the currency’s weakness signals lack of global appetite for Brazilian assets.
But if Brazil has yet to rebuild its risk fundamentals, its neighbour, Argentina, is locked into another cycle of economic collapse that can surely only end in default. The fourth-strongest economy in Latin America in 1995, Argentina has been slowly recovering its risk perception under the administration of president Mauricio Macri, who assumed power in December 2015.
According to ECR data, Argentina had been narrowing its risk score in relation to the average for the region: from 12.28 points shortly before Macri’s victory to 4.12 in September 2018. However, the government’s failure to meet its own targets has led to a collapse in confidence in its strategy of gradual reform, a collapse in its currency, while the evaporation of its credit standing has brought the IMF in to prop up the economy.
The next round of ECR data will reflect the collapse in the country’s risk profile – Fitch has already cut the sovereign to triple-C.
“The peso collapse will probably trigger a sovereign default… perhaps within the next few months,” says Edward Glossop, Latin America economist at Capital Economics. “If the peso stays at its current level [it has subsequently fallen further], the public debt ratio will rise to 100% of GDP by year end, from 86% of GDP last year. We think this will be enough for the IMF to request a debt restructuring as a condition of future loan tranches.”
Argentina also highlights the crucial importance of having access to local currency financing. With no depth to its domestic capital markets, the Macri administration has been forced to meet the country’s fiscal adjustment with dollar financings. If the peso collapses, the dollar-debt burden becomes unsustainable.
Meanwhile Brazil’s external debt profile remains strong, despite the real falling from nearly $1.50 in 2011 to more than $4.00 today.
The country’s reliance on local debt has been expensive during this period and, while its debt position has deteriorated, it has avoided any crisis in investor confidence – Brazil’s FX reserves have remained much higher than its foreign currency liabilities over the last decade.
“Deeper local markets offer predictable and alternative sources of financing if there is an increase in investor aversion,” says Schineller. “The other factor we look at is the share of public debt help by foreign investors.”
The example of Chile for debt-burdened, insolvent countries such as Argentina and Venezuela is, sadly, academic. Only countries with low sovereign debt can have Chilean-level ambitions – because perhaps the biggest reason for its success is that it happened when debt was low. Its reforms also took place under a military dictatorship.
Those, such as Macri, trying to bring about reforms while encumbered by democratic challenges have much less ability to push through policies that cause economic pain in the short term.
According to Domingo Cavallo, Argentina’s reformist finance minister between February 1991 and August 1996, there isn’t the imperative to embrace painful reforms that will ultimately prevent a crisis.
He points to the attempts by Argentina’s president to cut the country’s fiscal deficits as part of this structural problem.
“During Kirchnerism, they expanded the number of people eligible for retirement payments to six million from 3.5 million and the cost of social security went from 6% of GDP to 10%,” he says.
“How do you then reduce that 4% of GDP? Once an economy is disorganized by governments spending too much and financing that spending with distortive taxes, it is a very difficult political act to move towards the reasonable fiscal policy that is necessary in order to implement a monetary policy that will help to reduce inflation.”