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Redemption Through Indexation: The Chilean Experience

Redemption Through Indexation: The Chilean Experience. Rodrigo Valdés Central Bank of Chile IADB Conference - November 2002. Agenda. Conceptual issues. A bit of history. Financial sector structure. Moving forward. A few lessons. Agenda. Conceptual issues. A bit of history.

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Redemption Through Indexation: The Chilean Experience

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  1. Redemption Through Indexation: The Chilean Experience Rodrigo Valdés Central Bank of Chile IADB Conference - November 2002

  2. Agenda • Conceptual issues • A bit of history • Financial sector structure • Moving forward • A few lessons

  3. Agenda • Conceptual issues • A bit of history • Financial sector structure • Moving forward • A few lessons

  4. Indexation can be thought of as a compromise • protects against nominal surprises (like FX denominated debt) • but allows for some flexibility (less than domestic currency denominated debt, more than FX denominated) • May enhance credibility, for it removes one source of inflationary bias • “Pillar A” for developing a long term debt market if there is no reputation (“Pillar B”: demand or financial saving) • Indexation is not a substitute for fiscal responsibility

  5. Agenda • Conceptual issues • Financial sector structure • Moving forward • A few lessons • A bit of history

  6. 1960’s • Financially repressed system (caps to interest rates) • CAR and UF (indexing unit) created to offer positive real interest rates. Originally quarterly adjustments (with inflation) • 1972-76 • Average annual inflation reached 312% • 1977 • UF adjustments become daily with the daily-equivalent of last months’ CPI inflation • Many UF denominated financial transactions allowed

  7. 140 130 120 Dollars / UF 110 100 90 80 70 60 RER 50 40 77 82 87 92 97 02 UF and Real Exchange Rate(index, average 1990=100)

  8. (Gross) (Net) 80 50 Net 40 60 30 40 20 20 10 Gross 0 0 02 89 90 91 92 93 94 95 96 97 98 99 00 01 Gross and Net Consolidated Public Debt (% of GDP)

  9. Agenda • Conceptual issues • A bit of history • Moving forward • A few lessons • Financial sector structure

  10. UF denominated • 17% of GDP • Average maturity: 4.3 years • Interest rates: 3.2 for BCU-5 and 4.8 for BCU-20 Peso denominated • 8% of GDP • Average maturity: 0.5 year • Interest rates: 4.4 for BCP-2 and 6.3 for BCP-5 Dollar indexed • 8% of GDP • Average maturity: 1.8 years • Interest rates: 3.2 for BCD-2 and 4.6 for BCD-5 Domestic Public Debt Structure in 2002

  11. 65 60 55 50 45 40 35 30 02 (Nov.) 91 92 93 94 95 96 97 98 99 00 01 Bank Lending to the Private Sector(% of GDP)

  12. 60 50 UF < one year 40 pesos < one year pesos > one year 30 20 UF > one year 10 0 99 00 01 02 Bank Lending Structure(% of GDP)

  13. 14 12 10 8 6 4 2 0 93 94 95 96 97 98 99 00 01 02 Stock of Corporate Bonds in Domestic Market(% of GDP)

  14. 35 30 25 20 15 10 5 0 92 93 94 95 96 97 98 99 00 01 Corporate UF Debt Placements (total amount and average term)

  15. Typical Mortgage Contract in Chile • 20 year loan for 75% of property value (5 to 25 years) • UF indexed • Monthly • Interest rate in 2002Q3 = 6.5% • Financing: institutional investors and banks • Intermediaries: banks (give warranty and administer) • Prepayment allowed at contracted interest rate

  16. Mutual Funds 90 80 70 60 Insurance C. 50 40 30 20 10 Pension Funds 0 1994 1995 1996 1997 1998 1999 2000 2001 Institutional Investors Assets (% GDP)

  17. Agenda • Conceptual issues • A bit of history • Financial sector structure • A few lessons • Moving forward

  18. UF is not easily accepted internationally • inflation accounting risk • lack of successful experiences • some money illusion (like higher carry) • Missing part: risk sharing from foreigners • Nominalization and internationalization of the Peso • monetary policy interest rate (overnight) a year ago • short-end of the yield curve (5 years) • full capital account opening and friendlier tax environment for capital movements • Use strong anti-inflation credibility to attract investors

  19. 4.5 4.0 Five years 3.5 survey 3.0 2.5 2.0 Two years 1.5 Mar Apr May Jun Jul Aug Sep Oct Nov 2 and 5 Year Expected Inflation (%)

  20. Agenda • Conceptual issues • A bit of history • Financial sector structure • Moving forward • A few lessons

  21. But it’s not easy to replicate. It needs... • a long time to get used to it (35 years in Chile!) • high inflation experience to value it • demand side (institutional investors) • CPI indexation is way for redemption. Avoid FX denominated domestic financial system. • Has some negative collateral effects: prevalent indexation in other markets • Imperfect substitute of full redemption: • there is no risk sharing with the rest of the world • but it is a way to start • Challenge: issue sovereign debt in pesos to foreigners. Big question mark: corporate debt?

  22. Redemption Through Indexation: The Chilean Experience Rodrigo Valdés Central Bank of Chile IADB Conference - November 2002

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