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

2. A few lessonsA few lessons Conceptual issuesConceptual issues Agenda A bit of historyA bit of history Financial sector structureFinancial sector structure Moving forwardMoving forward

3. A few lessonsA few lessons Conceptual issuesConceptual issues Agenda A bit of historyA bit of history Financial sector structureFinancial sector structure Moving forwardMoving forward

4. Indexation can be thought of as a compromiseIndexation 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 biasMay enhance credibility, for it removes one source of inflationary bias Indexation is not a substitute for fiscal responsibilityIndexation is not a substitute for fiscal responsibility “Pillar A” for developing a long term debt market if there is no reputation (“Pillar B”: demand or financial saving)“Pillar A” for developing a long term debt market if there is no reputation (“Pillar B”: demand or financial saving)

5. A bit of historyA bit of history Conceptual issuesConceptual issues Agenda A few lessonsA few lessons Financial sector structureFinancial sector structure Moving forwardMoving forward

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. UF and Real Exchange Rate (index, average 1990=100) Dollars / UF RER 40 50 60 70 80 90 100 110 120 130 140 778287929702

8. Gross and Net Consolidated Public Debt (% of GDP) Net 0 20 40 60 80 89909192939495969798990001 02 0 10 20 30 40 50 Gross (Gross) (Net)

9. Conceptual issuesConceptual issues Agenda A bit of historyA bit of history Financial sector structureFinancial sector structure A few lessonsA few lessons Moving forwardMoving forward

10. Domestic Public Debt Structure in 2002 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

11. Bank Lending to the Private Sector (% of GDP) 30 35 40 45 50 55 60 65 9192939495969798990001 02(Nov.)

12. Bank Lending Structure (% of GDP) 0 10 20 30 40 50 60 99000102 UF > one year pesos > one year pesos < one year UF < one year

13. Stock of Corporate Bonds in Domestic Market (% of GDP) 0 2 4 6 8 10 12 14 93949596979899000102

14. Corporate UF Debt Placements (total amount and average term) 0 5 10 15 20 25 30 35 92939495969798990001

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

16. Institutional Investors Assets (% GDP) 0 10 20 30 40 50 60 70 80 90 19941995199619971998199920002001 Pension Funds Insurance C. Mutual Funds

17. A few lessonsA few lessons Conceptual issuesConceptual issues Agenda A bit of historyA bit of history Financial sector structureFinancial sector structure Moving forwardMoving forward

18. Missing part: risk sharing from foreigners UF is not easily accepted internationally –inflation accounting risk –lack of successful experiences –some money illusion (like higher carry) Nominalization and internationalization of the PesoNominalization 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 investorsUse strong anti-inflation credibility to attract investors

19. 2 and 5 Year Expected Inflation (%) Five years survey Two years 1.5 2.0 2.5 3.0 3.5 4.0 4.5 MarAprMayJunJulAugSepOctNov

20. A few lessonsA few lessons Conceptual issuesConceptual issues Agenda A bit of historyA bit of history Financial sector structureFinancial sector structure Moving forwardMoving forward

21. CPI indexation is way for redemption. Avoid FX denominated domestic financial system.CPI indexation is way for redemption. Avoid FX denominated domestic financial system. But it’s not easy to replicate. It needs...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) Has some negative collateral effects: prevalent indexation in other marketsHas some negative collateral effects: prevalent indexation in other markets Imperfect substitute of full redemption: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?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