A Strategy For All Seasons

Mexico's surprise peso devaluation in December sent powerful jolts through Latin America. The fragility of Argentina's economy was soon revealed, and some experts began worrying that all the nations that have opened up to free-market reforms would find themselves in trouble. But Chile, the long, thin country at the bottom of the continent, is buoyant with steadily increasing foreign reserves, falling inflation, and domestic savings that have reached East Asian proportions. "It's like having a nice house in a bad neighborhood," jokes Roberto de Andraca, the chairman of steel conglomerate CAP.

Chileans can be forgiven a little smugness. While recessions batter Mexico and Argentina, the country that started the region's market experiment two decades ago is racking up impressive gains. Gross domestic product will grow by an estimated 6% this year--as it has done, on average, for the past five years. Inflation has dropped to 8.3% annually from 27% in 1990, and Chile's trade surplus is widening. While a panicky capital flight forced drastic belt-tightening by Argentina to avoid devaluation of its peso, Chile's currency has climbed 7% against the dollar since Dec. 19 (charts, page 86E-10).

"HOUSE IN ORDER." That success is increasingly attributed to the "Chilean model." Although Chile's U.S.-educated technocrats started with University of Chicago-style radical reforms, they soon suffered a boom-and-bust in the early 1980s. In response, they gravitated to a distinctive hybrid system that guards against "hot money" flows from abroad while generating and channeling Chile's capital. As a result, the country is attracting big-ticket direct investments, while its own companies are spreading their wings regionally. "This country has put its house in order and now can take advantage of the very large markets around it," says Paolo Fresco, vice-chairman of General Electric Co., which expects to double its 1994 Chilean sales, to $220 million, this year.

The combination of robust domestic performance and do-it-yourself regional integration means that Chile can probably sustain its success even if its bid to join the North American Free Trade Agreement stalls. Ministerial-level talks with the U.S., Canada, and Mexico on joining the NAFTA club are scheduled to start on June 7. Chile also can--and likely will--cut trade deals with Mercosur, the Southern Cone trade bloc made up of Brazil, Argentina, Uruguay, and Paraguay, and with the European Union. But the seal of economic good housekeeping represented by admission to NAFTA could remain elusive.

In Santiago, however, few seem to worry. That's because Chile's economy is being lifted by a powerful tide of direct investments generated mostly within Chile. Total investments in Chile rose to 28% of GDP last year, mainly financed by domestic savings that equaled 25.4% of GDP. Chile "has done a spectacular job of increasing domestic savings" with measures from privatizing pensions to taxing corporate dividends more than profits, says Mexican Finance Secretary Guillermo Ortiz. "These are lessons that have to be examined very carefully, not only by Mexico but by many other countries."

One of Chile's lessons seems to be that Latin nations have to be careful about dismantling all restrictions on capital flows, a notion at odds with orthodox free-market theory. Chile has shielded itself against the shocks that afflicted Mexico and Argentina by keeping a tight rein on hot money. To avoid repeating the painful bust of the 1980s, the Chileans stipulate that foreign investments must be kept in Chile for at least a year and 30% of foreign credits must be deposited with the central bank for a year interest-free. Those are strong deterrents to short-term investors--and a key difference from the strategies of Mexico and Argentina.

In another departure from free-market orthodoxy, Chile's central bank intervenes in currency markets to keep the peso's exchange rate competitive against a basket of the dollar, the German mark, and the yen. This "managed float" helps keep Chilean exports--from forest products to manufactured goods--competitive in its main markets: the U.S., the European Union, and Japan. By contrast, Argentina's fixed peso-dollar parity and Mexico's attempt to keep its peso within an exchange rate "band" resulted in overvaluation of their currencies and huge trade deficits.

Of course, Chile also is benefiting from sheer luck--high prices for commodity exports from fish meal to steel and wood pulp. For copper, which accounts for 37% of Chile's exports, the London market price has climbed to around $1.25 per pound, up from an average 87 cents in 1993.

BIGGER ROLE. But the surge in copper earnings is also a result of fast-rising production--the payoff from Chile's epening of copper mining to foreign investment in stages since the mid-1970s and its creation of a stable business environment. State-owned companies still control nearly half the output of the copper industry, but they were overtaken last year by production coming onstream from massive investments in new mines by companies such as Australia's BHP, Britain's RTZ, and Japan's Mitsubishi. By 2000, such private investments will push Chilean output to 4.1 million tons--40% of the world's total--up from 2.6 million tons this year.

Chile also is allowing foreign interests to play a much bigger role in the sensitive telecommunications field. Last year, the government agreed to allow foreign companies to compete for shares of Chile's long-distance phone market. A price war touched off by entrants such as the U.S.'s BellSouth and Bell Atlantic has benefited Chilean users by driving rates down sharply in recent months. And at least eight foreign companies, including MCI Communications Corp. and Sprint Corp., are eyeing newly opening cable and personal-communications markets.

Helping attract such investments is the political stability Chile has regained since the stormy days of Marxist President Salvador Allende in the 1970s. With a century-long democratic tradition, Chile made a smooth transition back to democracy in 1990 after 17 years of rule by military strongman Augusto Pinochet, Allende's successor. "What has changed has been the political and business climate," says John W. Lill, president of the Chilean subsidiary of Toronto-based American Barrick Resources Corp. The company is investing $500 million between now and 2000 in Chilean mining.

The probusiness climate owes much to a broad, four-party governing coalition led by President Eduardo Frei's middle-of-the-road Christian Democratic Party. "Democracy and the market are on everyone's agenda," says Andres Velasco, a fellow at Harvard University's John F. Kennedy School of Government and former Finance Ministry chief of staff. "In some sense, no matter who governs, basic policies are not going to change very much."

It's not surprising that the Chilean model is beginning to create homegrown multinationals. One pioneer is Madeco, a conglomerate with 1994 sales of $390 million worth of copper and aluminum products ranging from aluminum-foil potato-chip bags to high-voltage cables. To broaden its base, Madeco has made a string of acquisitions in Argentina and Peru, partly financed by a $63 million issue of American Depositary Receipts in New York. "Argentina, Peru, and Chile are one big market," says Andres Goijberg, Madeco's head of management analysis.

Supermarket chain Santa Isabel, Chile's second-largest, is also building a broad regional base. It bought two small supermarket chains in Lima in 1993 to carve off a 22% market share just when Peru's economic reforms were taking hold. It is about to open two stores in Paraguay, and it hopes to issue ADRs. "You have to grow or you'll disappear," says Santa Isabel Chairman Eduardo Elberg.

In 1990, CTC, Chile's privatized telecommunications company, was the first Latin American company to issue ADRs. So far, 18 Chilean companies have sold them--a total of $1.7 billion last year alone--mostly to finance cross-border investments. And at home, investors are able to tap Chilean capital markets that were swelled by domestic savings totaling $13.2 billion last year, out of the country's $52 billion GDP.

HARD-WON. One source is the pension-fund system, which is run by 18 private management companies. With assets currently worth $22 billion, the funds pour $170 million a month into Chilean financial markets. These markets are able to sell Chilean corporate bonds with maturities up to 30 years and to finance home buyers with 30-year mortgages, unheard-of in other Latin countries.

Such gains have been hard-won. Although many Chileans who opposed Pinochet's ironfisted rule now acknowledge that he was right to force the economy open, few forget the pain of his restructuring, which threw 22% of the workforce out of jobs. Nearly one-third of Chileans continue to live in poverty, earning less than $100 a month. Spreading the wealth a bit will be crucial to Chile's long-term success. "Our biggest challenge is to integrate Chileans who are outside the system," says Economy Minister Alvaro Garca.

He sees sustained growth as the answer. To keep growing at 6% to 7% annually, he estimates, Chile needs to invest 30% of GDP--not a big leap from last year's 28%. If that happens, Chile will be on its way to joining the ranks of the developed nations, with or without NAFTA.

How the Chilean Model Works


-- Taxing corporate dividends more than profits

-- Encouraging pension savings in privately managed funds

-- Running a government budget surplus and paying down public debt


-- Requiring foreign investors to keep capital in Chile for one year

-- Requiring deposits of 30% of foreign loans at the central bank at no interest for one year


-- Managing the peso's exchange rate to keep it price-competitive against a basket of the dollar, German mark, and yen

-- Rebating the 18% value-added tax to exporters