• Situation of the financial system
• Risks, vulnerabilities and mitigators
• Thematic chapter: the foreign exchange market in chile

Since our last Report, the global economy has continued to recover from the shock caused by the Covid-19 pandemic, thanks to two factors: progress in the management of the sanitary situation and effective economic containment policies. These policies were key to preventing the crisis from spreading to the financial markets. However, the increase in the sovereign debt and the greater exposure of the monetary authorities to the financial sector have reduced their capacity to cushion shocks in the future. In the main economies of the world, and also in Chile, the magnitude of the impulses has contributed to the economic recovery in the short term, and both users and suppliers of credit have remained resilient, with abundant liquidity availability, in a particularly challenging context. However, the persistent boost to local demand and structural changes in the capital market resulting from forced liquidations of institutional investors’ assets, have had a significant impact on asset prices. This has been compounded by the deterioration of public finances and increased uncertainty. Thus, the rise in long-term interest rates, the depreciation of the peso and the fall in stock prices have been at the extremes of international movements. This has begun to be reflected in a deterioration of the financial conditions affecting domestic agents, such as the Treasury’s financing cost, mortgage rates and terms, and the valuation of pension funds. The non-financial corporate and household sectors have seen significant cumulative amounts of capital outflows and an increased preference for dollar-denominated assets. The main risk to local financial stability comes from new forced asset liquidations that continue to erode the intermediation of resources and the greater uncertainty that this implies. These developments restrict the capacity of the financial system, firms, and households to withstand corrections and/or disruptive events, which have become more likely to occur, both in the country and abroad. In the latter case, of particular note are the risks of reversal in risk perceptions, difficulties in supply chains and concerns about the Chinese real-estate sector. At home, there are concerns about the possibility of a credit contraction in the face of greater risk perceptions, as well as the vulnerability of more leveraged sectors that may be affected by a deterioration of their markets.

SITUATION OF THE FINANCIAL SYSTEM

Since the May Report, the financial outlook continues to be favorable in the developed economies, with still positive growth expectations, while inflation has gained strength. Extraordinary measures of fiscal, financial, and monetary policy have remained in place globally, helping to improve prospects for activity and sustaining commodity prices. However, greater global liquidity increases the probability of reversals in global financial conditions due to changes in risk appetite regarding emerging economies, or the need for greater-than-expected interest rate adjustments in the face of rising inflationary pressures. In addition, major disruptions in the energy supply chain in Europe and China, as well as worries about China’s real estate sector, could affect international trade and revive concerns about global corporate leverage.

Locally, fiscal and monetary support programs played an important role in curbing the negative effects of the Covid-19 crisis and accelerated the recovery of economic activity, avoiding massive corporate bankruptcies and keeping household defaults contained. The substantial stimulus measures, while allowing many companies to stay in business, has helped the economy to recover faster, based on buoyant private consumption, which has strengthened the financial position of companies. Similarly, fiscal support for households increased their liquidity and made it possible to compensate for falls in income, helping to keep delinquency rates in check. These elements have averted a deterioration of the banks’ portfolios, which has helped to maintain the resilience of local credit suppliers.

However, financial conditions have worsened as a result of uncertainty and massive asset liquidations by institutional investors that are reducing the depth and adjustment capacity of the capital market. Stimulus measures aimed at households, such as successive withdrawals of pension savings and annuity advances, while providing additional liquidity, have also hit hard the capital market due to forced asset liquidations. Both the exchange rate and local interest rates have shown strong corrections compared to other economies, accompanied by increased volatility of various asset prices. Thus, since the last Report, long-term interest rates have risen by more than 250 basis points (bp), while the local currency has depreciated 17%.

The withdrawals of pension savings have had the immediate effect of reducing the size of pension funds by close to 18% of GDP, which primarily impacts the fixed-income market. The reduction in the size of the intermediated funds directly affects the provision of long-term financing, which combines with other factors that have caused a deterioration in financial conditions, such as reduced fiscal savings. Moreover, because of the high uncertainty, the demand for dollar assets has soared and capital outflows have intensified after rising since the social outbreak. These elements have eroded national savings, thus increases the country’s dependence on external financial markets.

The strong fiscal impulse deployed since the middle of 2020 has narrowed the scope to implement further mitigating policies in case of future adverse events. The current environment is particularly challenging for public finances, as the aforementioned policies directly affect the fixed-income market, the main source of domestic currency financing for the government. In particular, the lower demand for sovereign bonds occurs in a context of a lower public savings base and, therefore, greater financing needs. Going forward, there is still the need for a trajectory of converging sovereign debt and rebuilding of buffers.

In view of the higher inflationary pressures, the CBC Board raised the monetary policy interest rate (MPR) by 225bp between July and October. Considering the greater risks for the convergence of inflation to the 3% target over the policy horizon, the Board brought forward the withdrawal of the monetary stimulus and anticipated that the convergence of the MPR to its neutral level would occur sooner than expected in the September Monetary Policy Report. However, the MPR still remains in expansionary territory and the expected control of inflation has reduced long-term rates by about 70bp since the last hike.

Despite the deteriorating local financing conditions, companies have not experienced significant problems in their financial situation. Fiscal, financial, and monetary support measures, as well as the economic recovery and the adaptation of businesses, have contributed to the rebound in sales, the normalization of debt levels, and a decline in corporate defaults. Since the last Report, corporate debt decreased, down to 117% of GDP in the second quarter of this year, due to the recovery of activity and less dynamic credit, associated with a lower financing demand. Thus, after increasing after the onset of the sanitary emergency, aggregate leverage returned to close to where it was at the end of 2019. By the second quarter of this year, companies reporting their financial statements had improved their profitability and liquidity position, while moderating their indebtedness at the margin. Meanwhile, bank-financed firms increased their leverage driven by Fogape loans, a dynamic that has been partially reversed with the increase in sales, maintaining default indicators low and stable.

Changes in financial conditions and market capitalization, and the greater uncertainty surrounding investments have resulted in a significant increase in dividend distributions by companies, combining the effect of higher profits and lower corporate savings. This increase occurs in a context of more available resources in 2021 compared to 2020, as a result of an increase in the profits of the bigger companies in the economy and, in some cases, greater resources associated with the sale of assets. In addition, there will be an increase in the proportion of profits paid before or during the current year. It should be noted that this increase occurs in a context of falling stock market returns, which is usually related to lower growth prospects for the corporate sector. In turn, the increase in dividend payout could be associated with a lower volume of investment projects in the pipeline, given a perception of greater uncertainty in the medium term.

Households remain highly liquid and have seen a reduction in their financing needs and have kept short-term defaults under control, although their long-term assets have been eroded. The deployment of support measures has eased the pressures on household finances that had been building up since early 2020. Thus, since the previous FSR, liquidity continued to increase due to the withdrawals of pension savings and the expansion of fiscal transfers. This has resulted in greater holdings of more liquid assets and a moderation in household debt, which stood at around 49% of GDP in the second quarter of this year and has remained stable ever since. Withdrawals of pension savings have had as a counterpart an important reduction in household savings, which went from 9.9% to 5.6% of GDP in the last year. Since the May Report, households have maintained their financial burden to labor income ratio stable and have used part of their available liquidity to repay their debts, although not as intensely as they did after the first withdrawal. In combination with the above, voluntary renegotiation of installments helped to alleviate the financial burden and bring delinquency levels to historic lows.

Stress tests show that the banking sector remains resilient and very solvent, beyond challenges for long-term financing, which have implied credit restrictions. Meanwhile, aggregate profitability, after some declines, stabilized early this year, in a context of forward-looking indicators pointing to higher credit risk. The banking sector’s stress tests indicate that the system remains solvent, and its indicators are slightly improving over last year, even in the face of scenarios of severe deterioration in pandemic indicators and financial conditions. This is partly due to the precautionary behavior of the banking system and the creation of an appropriate level of provisions. In addition, in order to move towards compliance with regulatory limits, in accordance with Basel III standards, various entities announced extraordinary capitalizations, including the recently enacted US$1.5 billion capitalization for Banco Estado.

However, recent structural changes to the local financial market compromise the usual intermediation of funds in which banks participate, especially at longer terms, as well as the banks’ capacity to provide foreign exchange hedging services. In the short term, this has already translated into tightened conditions for long-term loans to individuals and businesses. The mortgage credit market provides an example, as the terms and the fraction of down payment have returned to their levels of 20 years ago. A further worsening of the financial system would exacerbate this situation, affecting the payment and funding capacity of the government, households, and firms, as well as the solvency of the banking system.

RISKS, VULNERABILITIES AND MITIGATORS

Globally, despite progress in handling the sanitary situation, vulnerabilities associated with increased liquidity, risk appetite and the search for returns have continued to accumulate. In a context where uncertainty persists about the unfolding of the pandemic, high global liquidity has favored the rebound of economies. Yet, it has had the collateral effects of greater search for and valuation of riskier financial assets, and increased corporate and government borrowing. This combined with the prospect of accelerated withdrawals of monetary stimulus in several economies, or other events, could reduce the capacity to refinance debts held by these agents and abruptly increase their risk premiums. This is especially relevant among the more leveraged and still vulnerable agents. A case in point is the financial problems in the Chinese real-estate sector, which could cast doubts on the international corporate sector, disrupt global financial conditions, and affect trade with emerging or commodity-exporting countries.

Forced liquidations of assets that continue to structurally weaken the domestic capital market and limit its capacity to face corrections and/or disruptive events are the main risks to local financial stability. The massive and indiscriminate withdrawals of pension savings and annuity advances, initially justified by the need to contain the impact of the crisis, although they increased the short-term liquidity of households and firms, have fueled demand further, pushing the economy to grow beyond its potential. They also caused structural damage to the capital market, whose short-term effects are already beginning to be felt. This damage, together with the deterioration of domestic savings, will cause impacts in the medium and long term that would be exacerbated if measures of this kind would be repeated.

Going forward, new forced liquidations of financial assets would increase uncertainty and would further reduce the capacity of the fixed-income market to provide financing and cushion external shocks. This would further increase the cost of financing and impose greater restrictions on access to mortgage credit for individuals, investment funds for companies and government funding. These elements, in turn, would result in slower long-term growth. Furthermore, the derivatives market would become shallower, which would restrict foreign exchange risk management mechanisms for companies. All these elements would make the Chilean economy more vulnerable to external fluctuations and changes in global financing conditions.

It is worth noting that, despite stable and low delinquency indicators, increased defaults by the more vulnerable credit users are expected in the face of stress scenarios. Although default remains at record-lows among households and businesses, there are sectors that remain financially weaker because of the pandemic, especially those firms that rescheduled their debt repayments and were not granted Fogape credit. A further economic downturn would increase their probability of future default and make it more difficult for them to access financing. Likewise, new risk factors appear for credit users, associated with increases in interest rates and higher inflation. For both businesses and individuals, the combined effect of these factors increases the risk of default in stressed scenarios, beyond what could be generated by a further weakening of the activity scenario.

In effect, the increase in additional provisions on the banks’ side reflects an increase in portfolio default expectations. In turn, higher indebtedness could reduce the Treasury’s capacity to mitigate adverse shocks and could impair the perception of sovereign risk, further increasing the cost of financing for local agents. Moreover, there is also a foreign exchange risk for credit users and the Treasury itself, in the face of a potentially growing mismatch and the aforementioned weakening of the local hedging market.

The broad spectrum of possible scenarios, originated by the current and potential deterioration of the capital market and a more challenging international context, finds the Chilean economy more vulnerable and with less economic policy room to mitigate them. In the context of a sanitary situation that could relapse and affect the economy, as has occurred in other jurisdictions, mitigation measures have less room for action than they had when the pandemic began. While the level of sovereign debt remains relatively contained, there has been a significant increase in the pace of borrowing and growing requirements for various types of spending. A weaker fiscal policy could affect the perception of risk in our economy and further increase credit costs. In addition, monetary policy is in a phase of stimulus withdrawal, a sharp currency depreciation, and a shrinking capital market with reduced capacity to cope with economic fluctuations.

All this results in less room for applying palliative policies in the event of deteriorating expectations, structural changes in the financial system, or new disruptive events. Although tools have been added, such as the possibility of buying Treasury bonds --in exceptional cases that pose a threat to the stability of payments-- and the increase in international reserves, it should be noted that the measures applied by the CBC are designed to contain short-term volatility and not to reverse structural changes.

THEMATIC CHAPTER: THE FOREIGN EXCHANGE MARKET IN CHILE

The thematic chapter of this FSR deals with the foreign exchange market in Chile, stressing how important it is for it to be efficient and competitive given the current floating exchange rate regime, and providing an overview of possible future changes in its structure and operation. The analysis covers the structure and participants of the local market, as well as trading, clearing and settlement mechanisms. It also analyzes the outcomes of the interaction of these factors in terms of metrics such as the complexity of traded instruments, market liquidity, and users’ costs, among others. The functioning of the forex market under proper conditions of safety and competition, as well as with instruments that adjust to the needs of its participants, is of the utmost importance in a floating exchange rate regime. Therefore, the CBC has recently carried out several initiatives to promote the cross-border use of the Chilean peso and the development of infrastructures to mitigate the risks associated with these transactions. In the medium term, this may produce significant changes in the functioning of the foreign exchange market.