James Stranko Dynamics of Commodity Economies 11.28.

11 Note Equity Strengths Strong external debt position, low debt-to-GDP ratio, and low ratio of debt payment to government revenue Well-managed state-run company managing principal commodity export High copper export price environment and high percentage of total world reserves Establishment of two well-funded sovereign wealth funds that squirrel the copper boom away for leaner years Equity Weaknesses High dependence on a single commodity and lack of serious diversification A hard landing for China would mean a crash for Chile Growing social unrest due to persistent inequality and protests around public education

Summary While we can attribute Chiles brisk economic growth to both a favorable commodity price environment brought on by Chinese demand, strong institutions, sustainable fiscal policy and a commitment to the rule of law have made it into a stable and prosperous society that is putting aside current windfalls for the future. Nonetheless, it remains more heavily dependent on copper than all other exports combined (55% of the total in 2010) and a sudden price drop would have dramatic consequences for the countrys near-term finances. If Chile is to continue on a path to sustainable growth it must embark on a path to diversify exports and reduce government dependence on copper revenues. Even with its challenges, investing in Chile is a stable and solid long-term equity strategy that will continue to outperform economies with similar risk characteristics.

Chile: A commodities-focused rundown Chiles growth model has been one of outward-focused copper production and export. Unlike many of its neighbors that also rely on primary commodities for much of their exports, Chile has largely avoided a boom-bust economic cycle due to a culture of shrewd fiscal management. Still, coppers high global price has weighed heavily on the Chilean peso, and because of the governments

commitment to a freely floating currency the peso has appreciated significantly as the copper price has risen. And although this has not led to a significant slowdown in exports, it has made other Chilean exports in the commodities and manufactured/processed sectors less competitive against global peers. Terms of trade, similarly, rise and fall along with global demand for copper and economic growth in copper-importing powerhouses like China. Chiles growth has been broadly extensive, and although resource reserves remain high the benefits of the growth have not been shared equally throughout society. Investment in the country has mainly centered around the industry and, given the challenges of developing infrastructure in a geography as unusual as Chiles, overall infrastructure quality and availability is high. Nonetheless, serious regional gaps have emerged, and certain areas in the countrys extremes do lack access to the same level of services as the Santiago and central areas. The gaps in access to the benefits of Chiles commodity boom has led to broad unrest, particularly around educational opportunity and the ability of the government to drive innovation in other sectors. The likelihood of further investment in innovation away from the mining/copper sector is low with the current government, but so is broad decommodification. If the uncharacteristic protests continue, or the fallout from the protest worsens, the government could take more immediate action. One other remedy may be to prematurely tap into sovereign wealth funds that are aimed at pension solvency and social and economic stability. This, however, is unlikely due to strong legal restrictions around the management and usage of the funds. Steady and sure are Chiles trademarks The results of Chiles fiscal and political responsibility are clear, with the Chilean economic growth rate averaging 7% year on year from 1986-1998 and then a more moderate 3% from 1998 to 2009. Despite the cooler growth in the past decade, this rate represents the steadiest and strongest growth in the region, with some years reaching the rate of East Asian economic growth. Poverty reduction

has also been drastic, with the poverty rate dropping from 40% in the mid-1990s to less than 13% by 2008. Income inequality over the same period has not seen so drastic a drop, and this remains an area to monitor for developments as student protests continue in Santiago. Nonetheless, both governments increased spending and the wealth stored in the countrys two sovereign wealth funds represent a gain in welfare for the poorer sectors most vulnerable to macroeconomic shocks. From a macroeconomic perspective, Chile serves as a model for other countries in the regionin indicators ranging from good governance to sound fiscal policy to socially responsible economic liberalization. And clearly, Chile is a counterexample in the region to other countries that have proven susceptible to resource populism that creates dependency on a sole export through the income of a state-owned company.

The bottom line Chile has registered extraordinary sustained economic growth in the two decades following its transition to democracy. In a region where cyclical boom and bust periods damage public finances, threaten democratic transition, and inflate the ranks of the poor, Chile has proven itself to be an exceptional case of peaceful growth and democratic consolidation. From a macroeconomic equity investing perspective, Chile will continue to outperform its regional and global peers in similar risk categories as long as demand for copper remains high. Even without strong demand, foreign reserves, low debt levels and borrowing costs, and sovereign wealth funds create a buffer that can sustain spending in a short recession. Things to watch include local issues like social unrest from unequal income distribution and global issues like prolonged economic slowdown affecting copper consumers like housing and technology sectors. An investment in Chile, even with these caveats, offers good return in a safe investor environment that will continue to outperform regional and global peers.