President Allende pays little attention to monetary policies. Price distortions and galloping inflation encourage an informal economy, reducing tax revenue. The government owns most banks and maintains a repressive domestic capital market. Prices soar, real wages drop, investment falls. The government's finances spiral out of control. Chile maintains six official foreign exchange rates.
Pinochet collapses the multiple exchange rate regime into three rates. He institutes a "crawling peg" system of four monthly devaluations, different in each segment to achieve exchange rate unification. Banks are sold back to the private sector, restrictions on banking are relaxed, and interest rates are freed. International capital movements, however, are still strictly controlled.
With very little supervision from monetary authorities, many banks accumulate bad loans. Inflation remains high, often reaching into the triple digits. The Central Bank puts in place a system of daily devaluations indexed to domestic inflation, then abandons it when it fails to bring inflation below 30 percent.
Pinochet's regime lifts some restrictions on medium- and long-term capital movements. A massive inflow of foreign capital follows, adding to Chile's existing debt. The adoption of a fixed exchange rate policy results in acute overvaluation of the Chilean peso, a loss in international competitiveness, and a financial crisis in 1981.
Many banks fail as a result of their bad debt and general financial turmoil. Pinochet nationalizes the financial sector to avoid a further banking crisis. Subsidy schemes favoring debtors lead to Central Bank losses and a deficit in the public sector's finances. A macroeconomic program devalues the peso.
A group of Chilean economists puts together an adjustment program with the help of the International Monetary Fund and the World Bank. Periodic small devaluations follow an initial exchange rate adjustment. Banks are privatized and recapitalized. By 1988, Chile reaches macroeconomic stability.
Congress approves a legislative proposal aimed at reforming the tax system through a broadened tax base, an increase in corporate income tax, and an increase in the value-added tax. Foreign financial flows increase. The financial sector is stable and dynamic.
President Frei's administration aims to achieve economic growth, low inflation, and stable foreign exchange rates. Increases in foreign reserves, national savings, and investments enable Chile to prepay some of its external debt. The Central Bank maintains a competitive real exchange rate.
Inflationary pressure leads the Central Bank to raise interest rates to 14 percent. Economic turmoil in Asia and Brazil, falling copper prices, and a slowdown in investment contribute to an increase in unpopular measures to curb inflation and avoid recession. Because of strict capital controls enacted in the '80s and '90s, Chile is somewhat protected from the volatility of short-term capital flows.
Strong macroeconomic management, reliance on long-term rather than short-term capital inflows, and sound financial institutions help Chile's economy rebound. With inflation at a 60-year low, the Central Bank relaxes its monetary stance. Interest rates decline. The peso is allowed to float freely in international markets and withstands market pressures despite crises in Argentina and Brazil.
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