- Tomás Baliño, Charles Enoch, and William Alexander
- Published Date:
- July 1995
The transition to indirect instruments of monetary policy in Chile started as early as 1974, as part of a broad package of economic liberalization measures. The most important reforms in the monetary policy framework took place between 1974 and 1976. However, starting in 1981, the country experienced severe external shocks and entered a major banking crisis, the impact of which lasted until 1987 and the extent of which impaired the ability of the central bank to conduct its monetary policy; it also caused a temporary reversal of some of the initial reform measures. Since 1987, the Central Bank of Chile (CBC) has been able to increase its reliance on indirect instruments again, although massive inflows of capital since the early 1990s have been putting heavy pressure on it. During that period, the central bank has continuously refined its open market operations and supplemented them with other instruments and measures, particularly reserve requirements.
Motivation for Reform
Chile’s economy of the early 1970s was characterized by weak or negative growth and domestic and external imbalances. In 1973, the annual inflation rate was approximately 500 percent, and the fiscal deficit reached 21 percent of GDP. Monetary policy operated through interest rate ceilings, quantitative credit controls, directed credits, and a system of reserve requirements. Real interest rates were negative.
The pre-1974 financial sector in Chile consisted of 20 government-owned commercial banks, 1 foreign-owned commercial bank, and a limited number of nonbank financial institutions. The activities of the financial sector were highly regulated and restricted.
Process of Reform
Chile is often presented as an example of a successful stabilization program that combined financial and external trade liberalization and deep structural reforms, including in the monetary area. Beginning in the mid-1970s, the Chilean authorities focused their stabilization efforts on reducing the fiscal deficit and conducting a tight monetary policy; the latter pushed real interest rates upward. The fiscal situation improved gradually until it showed a surplus in 1979, and public sector savings increased drastically. On the other hand, as inflation did not abate as fast as expected, the government turned to the use of the exchange rate as the anchor of its stabilization program: the inflation rate declined from 212 percent in 1976 to 20 percent in 1981. Chile initiated a program of privatization, including in the banking sector, cut tariffs uniformly, and opened its current and capital accounts between 1976 and 1982. A variety of measures had been adopted to prepare the introduction and full implementation of indirect monetary control in 1976. Interest rate decontrol began in 1974 with the liberalization of short-term money market rates. In 1975, commercial bank interest rates were freed. Reform of monetary control procedures started in 1975 with a gradual reduction of subsidized and selective credits, the removal of quantitative credit controls, and a reform of the central bank’s discount window.
The new policy framework, in full operation since 1976, was based on auctions of central bank credit and treasury bills, supplemented by a redesigned discount window and reserve requirements. Initially, the level of the latter was high (75 percent on sight deposits and 47 percent on time deposits). In 1975, the central bank started remunerating these reserves. In 1977, the reserve requirement was lowered to 10 percent on sight deposits and 4 percent on time deposits. Subsequently, the reserve requirement was unified, and remuneration was phased out in 1978.
Among the measures adopted in this period were the privatization of most commercial banks, the lowering of the barriers to entry for domestic banks and financial institutions as well as for branches of foreign banks, the easing of restrictions on the scope of activities, and the free access of domestic banks to borrow abroad. Steps to strengthen the supervisory, regulatory, and legal systems included raising the minimum capital requirements and the penalties for noncompliance, restricting the concentration of bank ownership, and increasing reporting requirements.
Notwithstanding these reforms, fundamental weaknesses in the prudential system remained, particularly with regard to the establishment of adequate standards for credit provisioning and the enforcement of regulations. In the face of severe external shocks, which included high international interest rates, a sharp drop in copper prices, and increases in oil prices, these weaknesses contributed to the major banking crisis that began in 1981. The crisis brought about a reversal of some of the reform measures and significantly impaired the ability of the central bank to conduct its monetary policy.1
The postreform period can be divided into two subperiods: (1) the period from 1981 to 1987, which was marked by the banking crisis, severe external shocks, and the related setbacks in the ability of the CBC to implement monetary policy under the new indirect instruments framework; and (2) the period after 1987, which was marked by a new economic stabilization program and a regained soundness of the country’s financial system, which in turn enabled the central bank to apply and develop its indirect monetary policy framework.
Despite the measures that had been taken at the time of liberalization, the banking sector remained vulnerable and eventually had a crisis that the government had to address in the early 1980s, The supervisory and regulatory framework still showed several weaknesses, the most important one being the lack of a precise definition of the limit on loans to a single borrower (or interrelated borrowers). During the privatization process, several commercial banks were purchased by large conglomerates. As a result, this high concentration of ownership, together with the lack of regulation on bank loans to interrelated entities, led to a concentration of bank lending to a small number of groups. In addition, depositors had little incentive to monitor the riskiness of banks because they expected the government to rescue them in case of crisis.
The combined effects of the banking crisis and the external shocks led to a significant setback in the ability of the CBC to implement its monetary policy and led to a partial reversal in the monetary policy reform process. First, there was a reversal of some interest rate liberalization measures in that the central bank began to post “suggested” deposit rates. Second, with the transfer of large amounts of problem loans to the central bank, the latter became the main provider of liquidity to the banking system. Much of this credit was provided through various subsidy programs. These emergency measures dominated monetary policy actions from 1981 to 1986-87. At the peak of the crisis, in 1983, the authorities abandoned the exchange rate as the nominal anchor of their stabilization program.
The authorities’ strategy for re-establishing a sound financial system consisted in (1) strengthening the regulations governing the banking system, (2) implementing programs to reduce the debt-service burden of the private (nonbank) sector, and (3) recapitalizing the private financial system through central bank purchases of substandard loans and, subsequently, through the sales of shares of the troubled banks to the private sector. These rescue operations and subsidy programs resulted in substantial operating losses for the CBC, which amounted to the equivalent of roughly 10 percent of GDP.
In 1985, Chile adopted a new orthodox stabilization program based on sound fiscal and monetary policies, coupled with an acceleration of structural reforms. These measures contributed to increased savings and investment, and there was sustained and rapid real growth of GDP in the following years. The impact of these measures could be felt as early as 1987. Most subsidy programs were phased out. The use of indirect instruments to conduct monetary policy was gradually resumed.
In October 1989, Congress enacted a new central banking law, providing legal autonomy to the CBC. According to this law, the central bank has a mandate to preserve the stability of the currency and the normal execution of domestic and external payments. To pursue these objectives, the law vested in the central bank the powers to formulate and implement monetary, credit, financial, and foreign exchange policies and to issue regulations on monetary, credit, financial, and foreign exchange matters.
Since 1987, the CBC’s main operational objective has been to set domestic real interest rates at levels consistent with the objectives for economic growth and price stability. (As a result of this policy, there have been considerable variations in the growth rate of liquidity over time.) Sales of the central bank’s indexed instruments (PRCBs) are the main tool of monetary policy, and most financial instruments in Chile are still indexed. On the other hand, the use of treasury bills in the central bank’s operations has gradually disappeared, owing to the improving fiscal position that reduced the need to issue those bills. The central bank’s key interest rate is the rate on its 90-day instruments (the reference rate). This rate is set by the central bank, and the 90-day notes are sold “on tap” to the banks.
A wide range of PRCBs with different maturities has been developed by the central bank during the past few years. Up to 1989, the maximum maturity of the central bank’s open market instruments was 360 days. In April 1989, a new PRCB with a maturity of 10 years was added to the spectrum. In the course of 1992 and 1993, several other maturities, of between 4 and 20 years, were added, with a view to increasing the breadth of the market. In contrast to shorter-term maturities, the market rate for longer-term PRCBs (maturities longer than 90 days) is determined on the basis of bids received by market participants for a preannounced quantity to be auctioned.
Starting in 1990 and reaching a peak in 1992 and 1993, Chile has been experiencing large inflows of capital. These inflows, initially encouraged by the differential between interest rates in Chile and those abroad, have put a heavy burden on the central bank’s monetary policy.2 In an effort to limit currency appreciation and at the same time contain the growth of credit, the central bank stepped up its sales of promissory notes. In addition, in 1990, it increased the commission on swap operations and established a minimum of one year for such operations. Later in the year, the central bank reintroduced partial remuneration of bank reserves (equivalent to the monthly inflation rate in excess of 1.5 percent). In 1992, it increased reserve requirements and imposed an additional requirement of 20 percent on new foreign borrowing, later extended to all foreign exchange deposits at commercial banks and increased to 30 percent. More recently, the central bank has also started short-term transactions in repurchase agreements; pension funds, insurance companies and banks are the main participants in these operations.
The financial sector was first liberalized in some key areas, and quantitative monetary controls were phased out and replaced by new, indirect instruments. However, improvements in banking regulation and supervision were insufficient to avoid a costly financial crisis. In turn, that crisis led the central bank to reintroduce some interest rate controls and to provide direct support to banks in difficulties. Once the country had recovered from the banking crisis and the external shocks and had stabilized its macroeconomic conditions, the central bank resumed full reliance on indirect methods of monetary policy. Since then, the central bank has been continuously refining its open market operations, particularly by improving the auction mechanisms and widening the maturity range of its promissory notes—the latter to facilitate the development of a market for longer-term paper. These improvements were supplemented with revisions in other instruments, particularly reserve requirements, and the introduction of new instruments, particularly foreign currency swaps.
Indirect monetary instruments have also enabled the central bank to cope with the large capital inflows that have occurred since 1990. To sterilize the effects of its purchases of foreign exchange, it has relied heavily on sales of its promissory notes. However, these massive issues, in turn, have led to new operating losses, one of the main problems the central bank has had to cope with during the past decade.