On Friday, March 11, a new administration under President Gabriel Boric took office in Chile. The new government will face a variety of economic and political headwinds and challenges, which in a sense may also offer up their own opportunities. Given Chilean history of the past two and a half years and the landslide nature of the recent election, the new president enters the scene with a strong mandate and high expectations. Managing and tempering these expectations in the context of a polarized country and a politically charged constitutional reform process will not be easy.
On the external front, the administration faces the lingering effects of the COVID-19 Pandemic, rising global inflation and interest rates, and high energy prices due to the war in Ukraine. Chile’s currency and financial markets have underperformed in this environment, offering some interesting investment opportunities if and when domestic and external conditions normalize and uncertainty dissipates. The new president enjoys a strong mandate, and so far he has demonstrated pragmatism and a willingness to listen to different opinions, as evidenced by the selection of Mario Marcel, former President of the Central Bank of Chile, as Finance Minister. In this note, we review domestic expectations and challenges around the new administration as well as external risks. We also explore base case, downside, and upside scenarios for the future of the Chilean economy and its financial markets
1. The Boric administration faces a wide range of political uncertainties
The biggest unknowns derive from the outcome of the Constitutional Convention later this year, the subsequent national plebiscite on the draft constitution, and the broad implications for governability posed by a new document. The 155 members of the convention are tasked with a re-drafting of the current constitution, which dates to 1980 during the military dictatorship. Most of the assembly tilts to the left or center left. The convention must finish drafting the new document by July 2022, and a national plebiscite is expected to take place later in 2022. The new constitution must garner two-thirds approval in that referendum.
Based on current discussions, the convention will likely produce a document that significantly alters the institutional framework of the country. While it is still early to draw solid conclusions about its final product, the convention has taken a far-reaching approach, addressing every aspect of Chilean society and its operation and calling for a broad rethinking of the role of the state in the economy and society. Much of what has come out of the various commissions has a leftist tilt, and this has alarmed segments of Chilean society that feel the reputation of a consolidated, rules-bound country, painstakingly built over the past 40 years, is at risk. For example, the convention is tackling issues such as the country’s bicameral system, the decentralization of the bureaucracy and development of a federal system, and the role of the state as ultimate benefactor. Given that there are so many unknowns on the horizon as to what Chile will look like in 12 months, it will be hard for Boric to plan for the latter years of his administration.
Figure 1. Composition of the Constitutional Convention by political bloc
Another challenge for the new administration is that, unlike the Concertación alliance that governed Chile for much of the post-dictatorship period, Boric’s governing coalition, Apruebo Dignidad (AD), is a narrow alliance, with only 21 percent of seats in the Chamber of Deputies and 20 percent of the Senate. Significantly, the Chilean Communist Party is one of five parties in the alliance, representing more than a third of the AD coalition’s members in congress, and bringing a far-left impulse to policymaking. Mitigating this, on the other hand, is the fact that both chambers of congress are split ideologically, implying a degree of difficulty getting any policy implemented.
Figure 2. Current political composition of the Chilean Senate
Finally, the crisis among the Araucanía Indigenous communities in the south of Chile poses another challenge for the administration, one with long historical roots. For years protesters have been demanding greater recognition of Indigenous rights, increased autonomy, and the return of land. In October 2021, faced with violent demonstrations, outgoing President Sebastian Piñera declared a “state of emergency” in two southern regions. The renewal of that state of emergency is likely to constitute one of the first challenges for the incoming administration. The Constitutional Convention does have 17 representatives (11 percent of its members) who hail from the Indigenous communities, and the final text will most likely have clauses that grant these communities more say in Chilean politics and greater ascendancy and recognition within society. It is noteworthy that the current constitution does not recognize the Indigenous communities.
2. President-elect Boric, the individual, may represent a historic break with the past and the ushering in of a new generation of leaders in Chile
Fourteen out of 24 ministers in Boric’s cabinet are women, and the cabinet’s average age is 49, though outside of the economic cabinet, he seems to have privileged ideological affinity over skills and experience. After all, Boric ran a clearly left-of-center campaign promising to do away with Chile’s “neoliberal” economic model. However, he has also been portrayed as fiscally prudent. Importantly, he is widely perceived as a good listener who asks the right questions, but someone who ultimately makes his own well-thought-out decisions. In the end, Boric does not seem to shy away from making mistakes and learning from them. Notably, during the transition, he has displayed a willingness to adapt to circumstances and to be pragmatic when necessary. The selection of Mario Marcel, a former national budget director and head of the Chilean Central Bank, as his Minister of Finance, is a sign of economic continuity and an indication that the administration will maintain a degree of fiscal prudence. His endorsement of Rossana Costa as the new governor of the Central Bank also augurs well for the preservation of Central Bank autonomy. If the fiscal and monetary pillars are maintained, as we expect, they can function as macroeconomic stability anchors to an array of potentially less market-friendly policies.
3. President Boric’s biggest political challenge may be managing high expectations
Expectations for change are running high in Chile following the October 2020 landslide vote in support of a new constitution, Boric’s presidential campaign in 2021, and his election in December. The new government will have to balance the expectations of robust economic growth, improvements in income, and fairer wealth distribution for its constituents with the constraints imposed by a slowing economy, a deteriorating fiscal picture, and strong external headwinds, as discussed below. In addition, the stimulus engineered during the pandemic led to a deterioration in Chile’s fiscal and debt position. While a tax increase early in the administration and strong copper prices will allow for a bit more fiscal flexibility in the short term, significant budgetary constraints will reign further out. Even abstracting from the Constitutional Convention’s outcome, Boric will face resistance from groups that aim to dismantle the country’s economic model and are willing to risk Chile’s status as the best managed economy in the region.
Boric first gained notoriety as a student leader in the protest movements of a decade ago, and his political roots lie in those movements. The Constitutional Convention was a direct response to the large-scale demonstrations and violent riots that affected all major Chilean cities in 2019 and 2020 (the so-called Estallido Social). To some degree, the discontent persists. During the runoff to the presidential election, the two final candidates outlined starkly different views of Chilean society and its future. While Boric won the election by a large margin, 44 percent of Chileans voted for a right-of-center candidate who campaigned on the need for greater law and order. Delivering on expectations that arose during the social movements and protests, while keeping calm a critical mass of Chileans who hold an opposing view of what Chile needs, will prove a significant challenge.
What’s more, the reality imposed by an ideologically split legislature and the potentially dramatic changes that may result from a new national constitution will further complicate Boric’s attempts to achieve this balance. Boric may have to not just manage expectations, but also tone them down.
4. Economic challenges
The new administration will inherit a challenging economic picture as the effect of the various stimulus initiatives of the past two years wanes and the global economy finds itself at a very difficult juncture (see next section). Growth in Chile is slowing and is expected to run around 2-2.4 percent this year, down from nearly 12 percent last year (data from Bloomberg). Inflation— fueled by last year’s rebound in consumer demand, high energy prices, and a steep depreciation of the Chilean peso —is presently running at 7.8 percent year-on-year, up significantly from the 3-4 percent levels of the past two years. It is expected to average almost 6 percent this year (data from Bloomberg). In response, the Central Bank has been aggressively raising interest rates since the middle of 2021. Chile engineered a significant fiscal stimulus during the pandemic. Congress supplemented this by allowing Chileans to make three large withdrawals from the private pension system, which added significant fuel to the recovery. The result has been a higher fiscal deficit of about 7 percent of GDP the past two years (with 4 percent expected this year) and an increase in the government’s debt-to-GDP ratio from 26 percent in 2018 to 34 percent in 2021 (data from Bloomberg). While debt levels are still comparatively low by emerging market standards, some of the goals of the Boric administration could call into question Chile’s long history of responsible fiscal management and jeopardize its credit rating. Boric has stated that to fund his spending programs, he intends to raise taxes. In all, the economic challenges will likely test his administration’s resolve even before the outcome of the Constitutional Convention is known.
5. External challenges
The Russian invasion of Ukraine has complicated an already challenging external environment for Chile and emerging countries. Due to supply shocks caused by the COVID-19 pandemic and the large fiscal and monetary stimulus deployed over the past two years, central banks around the world are now facing inflationary pressures not seen in 40 years. This heralds the end of a long period of “free money” as central banks in most countries move to tighten liquidity conditions, causing a generalized increase in interest rates. Historically, such environments have not been supportive of emerging economies and markets, since they have often led to a stronger dollar and weaker emerging market currencies.
Until a few weeks ago, the increase in global interest rates was expected to take place in an environment of economic growth. However, the war in Ukraine and the sanctions imposed on Russia have provoked a sharp increase in energy prices and a “risk off” investment environment, which could undermine the ongoing global economic recovery. If prolonged, these developments have the potential to tilt the world into “stagflation”—i.e., inflation combined with stagnating growth. The unprecedented nature of the war in Ukraine and risk of escalation has also led investors to seek investment safe heavens such as gold, U.S. dollars, U.S. Treasury bonds, and cash, to the detriment of investments in relatively risky assets, like those of emerging markets.
Chile enjoys a relatively privileged position within the universe of emerging markets— being the only economy in Latin America with an A credit rating for its external and domestic debt, underpinned by low levels of debt and solid institutions. However, domestic uncertainty combined with a worsening external environment have led to underperformance of Chilean assets, which currently seem generally undervalued relative to history.
6. Market opportunities in Chilean assets
The peso and peso-denominated bonds
The Chilean currency took the brunt of the adjustment to internal and external risks in Chile last year. As can be seen in Figure 3, the peso depreciated more than 20 percent from May 2021 to January 2022.
Figure 3. Chilean peso vs. U.S. dollar, 2020-2022
The peso then started to regain some ground as the Central Bank of Chile embarked on a rate-hiking cycle, bringing the policy rate up from 0.5 percent in 2021 to 5.5 percent today.
Figure 4. Chilean Central Bank policy rate, 2008-2022
Figure 5. Chilean peso vs. the Brazilian real and the Mexican peso, 2021-2022. Pesos per USD Jun 1, 2021=100
The trend toward appreciation was halted as risk aversion set in amid the war in Ukraine. Despite its recovery, the Chilean peso has underperformed peers such as the Brazilian real and the Mexican peso in the runoff to the presidential elections (see Figure 5). And though the currency has staged a recovery in recent weeks, it is still about 10 percent below its value in early 2021 (see Figure 5). Higher domestic interest rates, other things equal, can be expected to help reduce this valuation gap in months to come.
The attractiveness of local bonds can be illustrated by the local yield curve (see Figure 6). The curve has recently inverted, with 2-year rates at around 7 percent and 10-year rates at 6 percent. Given the scope for currency appreciation, local currency-denominated bonds could potentially deliver returns in the high single or low double digits.
Figure 6. Chile’s yield curve, March 10, 2022
Hard Currency Bonds
Chilean sovereign bond spreads over U.S. Treasuries widened meaningfully in the runup to the presidential election, though less than regional peers. Chilean hard currency bond spreads remain the narrowest in Latin America and Chile (see Figure 7). Similarly, credit rating agencies have all maintained an A rating for Chile’s hard currency debt. Yet despite all the positives, Chile’s bonds appear undervalued by 25-50 basis points relative to similarly traded A-rated emerging market bonds (see Figure 8).
Figure 7. Select hard currency bond spreads in Latin America
Figure 8. Chilean hard currency credit ratings and valuation comparison, March 1, 2022
Stock market
As is the case with other Chilean assets, the stock market has exhibited inferior performance amid the run-up to the election, the headwinds implied by rising inflation and tight monetary policy, and external uncertainty (see Figure 9). Due to this underperformance, Chilean price-to-earnings (P/E) and price-to-book (P/B) ratios are both below historical averages. In Figure 10, we show detail of valuation and other parameters for the Chilean market and other emerging markets. As the table shows, if Chilean valuations were to recover their valuation average as measured by the average P/E or P/B of the last 15 years, the upside to the market would be 34 percent or 38 percent, respectively.
Figure 9. Chile stock market performance and valuation indicators, January 2021=10,000
Figure 10. Chilean stock market valuation and performance relative to EM countries, February 23, 2022
7. Conclusions and scenarios
As President Boric assumes power, the internal and external environment for Chile could hardly be more uncertain. As discussed in this paper, his administration is under pressure to meet high expectations for change and satisfy many constituencies, some of which are mutually incompatible. The outcome of the Constitutional Convention and its referendum will not be known until late 2021, leaving Chile in a policy limbo until then. On the external front, the rise in global interest rates, the lingering effects of the COVID-19 pandemic, and the war in Ukraine present a very murky outlook for policymakers. Judging by the more stable performance of Chilean assets as of late, markets have incorporated a fair amount of uncertainty and could deliver attractive returns if this uncertainty resolves in more favorable ways than markets currently expect.
Yet, owing to the unprecedented nature of the current issues worrying the markets, predictions about the future of Chile are subject to a large margin of error. Despite these difficulties, we outline three illustrative scenarios, out of a wide range of possibilities (see Figure 11).
Figure 11. Hypothetical scenarios for the Chilean economy in 2022-23
In our base case, we assume a healthy degree of pragmatism to President Boric’s administration and account for the split nature of Chile’s Congress, which can be expected to provide a degree of checks and balances and help mitigate the risk of wide policy swings in either direction, at least in the short run. Under this scenario, Central Bank independence is maintained, Congress approves marginal increases in taxes to higher income brackets and corporations, and legislators tighten bank regulation. Incoming Minister of Finance Mario Marcel emphasizes the importance of fiscal prudence and keeps a lid on government deficits. Pension reform does away with compulsory defined contributions, resulting in a hybrid system. Mining companies are subject to higher taxes but not nationalization. On the external front, global interest rates continue to rise but oil prices stabilize at elevated levels as the war in Ukraine simmers. Copper prices rise further, but inflation and tight monetary policy remain as headwinds to domestic growth. In this environment, we could expect a partial (one-quarter to one-half) decline in the discount of Chilean assets relative to historical levels.
In our optimistic scenario, the Constitutional Convention does not change the status quo significantly, budget plans offer greater emphasis on keeping debt ratios stable or reducing them, and mining regulation is surprisingly benign. On the external front, rates continue to rise but oil prices drop while copper prices continue to climb. Growth is surprisingly high while inflation is surprisingly low. Monetary policy becomes less restrictive. In this scenario we could see a two-thirds decline in valuation discounts.
Under the pessimistic scenario, we assume a paradigm shift in Chilean economic policy. The Constitutional Convention raises questions about the thrust of the Chilean economic model. Government spending results in greater deficits and national debt. Pension funds and mining companies are nationalized. On the external front, interest rates continue to rise as do oil prices, though copper prices also rise. The growth and inflation outlook for Chile worsens. In this scenario, discounts in the valuation of Chilean assets would double or more from current levels.
Without assigning artificially precise probabilities to each scenario, we would see the base case scenario as most likely, with equal balance between the upside and downside scenarios.
Jorge Mariscal is an adjunct professor at Columbia University School of International and Public Affairs and former Chief Investment Officer for Emerging Markets at UBS Wealth Management. Tulio Vera is the chair of the Global Americans International Advisory Council and former Chief Investment Strategist for the JPMorgan Latin America Private Bank.
