S&P revises down Chile rating

PRESS RELEASE

S&P GLOBAL

This an abridged version of the S&P release. See the full release.

OVERVIEW

• Prolonged subdued economic growth has hurt Chile's fiscal revenues, contributed to increases in the government's debt burden, and eroded the country's macroeconomic profile.
• These factors have resulted in a modest increase in Chile's vulnerability to external shocks.
• As a result, we are lowering our long-term foreign currency rating on Chile to 'A+' from 'AA-' and our long-term local currency rating to 'AA-' from 'AA'. We are also lowering our short-term foreign currency rating to 'A-1' from 'A-1+' and affirming our 'A-1+' short-term local currency rating.
• The outlook is stable, reflecting our view that gradual fiscal consolidation and a slow but sustained economic recovery will help stabilize Chile's external profile.

RATING ACTION

On July 13, 2017, S&P Global Ratings lowered its long-term foreign currency sovereign credit rating on the Republic of Chile to 'A+' from 'AA-' and its long-term local currency rating to 'AA-' from 'AA'. The outlook on the long-term ratings is stable. At the same time, we lowered our short-term foreign currency rating to 'A-1' from 'A-1+' and affirmed our 'A-1+' short-term local currency rating. In addition, we lowered our transfer and convertibility (T&C) assessment for Chile to 'AA' from 'AA+'.

RATIONALE

The downgrade reflects prolonged subdued economic growth that has hurt fiscal revenues, contributed to increases in the government's debt burden, and eroded the country's macroeconomic profile. This has resulted in a modest increase in Chile's vulnerability to external shocks.

The combination of still-low global copper prices and low domestic business confidence continues to constrain private consumption and investment, limiting the country's GDP growth prospects. We expect the Chilean economy to grow only 1.6% in 2017, unchanged from last year. We expect GDP growth to rise only modestly to 2% in 2018 and to 2.4% in 2019.

The combination of several years of low economic growth--per capita GDP grew only 1.4%, on average, during 2013-2016--and strong political pressure to boost spending on social programs has contributed to a rising government debt burden. We project that net general government debt (we deduct general government assets including government deposits in the central bank and in other financial institutions and external liquid assets) will approach 11% of GDP in 2017 and may reach 15% by the end of 2019 (25.7% and 28.5% of GDP in gross terms in 2017 and 2019, respectively) because of continued modest fiscal deficits. The government's debt burden, although still low compared with most sovereigns, has consistently increased in recent years from almost 0% of GDP in 2012. In a scenario of only gradual fiscal consolidation, we expect general government debt could increase by around 2.9% annually, on average, over the next three years. We also expect interest payments to consume less than 5% of general government revenues during this time.

The deterioration in Chile's financial profile has moderately increased its vulnerability to external shocks. We now project Chile's gross external financing requirements will exceed 100% of current account receipts (CAR) and usable foreign exchange reserves in the next three years.

We expect an improvement in Chile's terms of trade, led by a recovery in copper prices to $5,500/metric ton (mt) in 2017 and $5,500/mt in 2018 from $4,600$/mt in 2016 (see "S&P Global Ratings Updates Its Price Assumptions For Aluminum, Copper, And Iron Ore For 2017-2019," published on April 10, 2017). However, we expect the trade surplus to remain stable at 2% of GDP this year, close to its level in 2016. Following our expectation for a slow recovery of copper prices, we expect copper exports to increase slightly but be negatively affected by the prolonged strike in La Escondida, Chile's largest copper mine. We expect a current account deficit of 1.5% of GDP in 2017, slightly bigger than the 1.4% deficit in 2016. In a scenario of moderate economic growth and gradual copper price recovery, we expect the current account deficit to slightly decline over the next three years to around 1.1% of GDP in 2020. Foreign direct investment, which has accounted for well above half of all capital inflows over the last decade, should fully fund the current account deficit in the next couple of years.

We project that Chile's narrow net external debt will be around 39% of CAR in 2017 and remain relatively stable in the next two years, around 40% of CAR in 2019.

Chile has been following a fiscal rule for its annual budgets since 2001, targeting an underlying structural balance over the course of a business cycle. This policy has helped boost the predictability of fiscal policy and anchor investor confidence. However, since 2013, the combination of subdued economic growth and political demands for higher government spending on social policies has contributed to several years of persistent fiscal deficits, in contrast with a fiscal surplus of 2.3% of GDP, on average, during 2003-2012. The effective actual general government fiscal deficit deteriorated to 2.7% of GDP in 2016 from 2.1% in 2015. We expect that the general government fiscal deficit will widen to 3.1% of GDP in 2017 and slowly decrease in the following years to 2.5% in 2019.

Our base case is that Chile will continue to operate under some form of rules-based fiscal policy, likely incurring modest structural fiscal deficits in the coming years. At the same time, we believe that Chile's fiscal rule will continue serving as a political anchor to contain demands for more government spending. The government is not likely to raise taxes in the coming two years, following the controversy associated with its recent tax reform. Hence, if copper prices stay low and global GDP growth remains subdued, the burden of potential fiscal adjustment is likely to fall on spending.

We view Chile's commitment to anchor fiscal and monetary policies within a transparent framework of rules as a strength to the credit rating. Chile's long track record of sound macroeconomic policies implemented by different political coalitions has contributed to its prosperity and high level of human development. We estimate Chile's GDP per capita at $14,200 in 2017. We expect per capita growth to average 1% in the next three years, down from an average of 3% in 2010-2015. Chile has near full literacy and its poverty rate is below 12%.

We expect broad continuity and predictability in economic policy after national elections in November of this year. We think Chile will maintain the distinctive pillars of its market economy (fiscal and monetary rules, openness to trade and investment, and judicial security and predictability) while strengthening social policies, mainly in education, health, and pensions.

Chile enjoys monetary flexibility thanks to a credible monetary policy that has targeted inflation while maintaining a flexible exchange rate. The transmission mechanism of monetary policy is likely to remain effective. Inflation has remained in the single digits for many years and is likely to be 2.7% this year, down from 3.8% in 2016. Long-term inflation expectations remain within the central bank's target range of 3% plus or minus 1%. The Chilean financial system is deeper than that of almost all Latin American countries. Domestic credit to the private sector and nonfinancial public sector will likely reach 87% of GDP in 2017, and total banking system assets are expected to reach 127% of GDP.

We believe that contingent liabilities are limited. The government estimates that its guarantees amounted to 1.6% of GDP as of March 2017, mainly internal debt guarantees to the national railway and metro (Empresa de los Ferrocarriles del Estado and Metro), followed by guarantees on education loans. While gross general government debt is estimated at 25.7% of GDP at the end of 2017, gross public debt is estimated around 34% of GDP (net public debt at 18% of GDP). The government occasionally provides limited capital injections to its mining company, Codelco, as well as to ENAP, a government-owned energy company. On the whole, the public-sector enterprises do not pose a substantial contingent liability for the sovereign.

OUTLOOK

The stable outlook reflects our expectation of broad continuity in economic policy after national elections later this year. It also reflects our expectation of a gradual decrease in Chile's general government fiscal deficit in a context of moderately higher economic growth and low inflation. At the same time, we expect moderate current account deficits will stabilize Chile's external profile.

We could revise the outlook to negative from stable in the next two years if economic growth is lower than our expectations, resulting in larger-than-expected fiscal deficits and contributing to annual increases in general government debt beyond our projections. Similarly, we could revise the outlook to negative in the event of an unexpected weakening of Chile's commitment to prudent fiscal and monetary policies that could lower business confidence, resulting in further erosion of the sovereign's financial profile.

Conversely, a sustained recovery in GDP growth along with prudent fiscal and monetary policies would gradually strengthen Chile's economic base while facilitating fiscal consolidation. That, together with continued diversification of the economy that strengthens economic resilience, could gradually reduce external vulnerabilities and lead us to revise the outlook to positive in the next two years.