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Chile Invoking Ghost of Friedman Kills CPI Linkers

November 19, 2012

Chile Invoking Ghost of Friedman Kills CPI Linkers

Milton Friedman, foreground, gives a speech at the 1976 Nobel Prize ceremony. Source: PBS via Bloomberg

Chile’s success in stamping out inflation is punishing investors in the nation’s $51.7 billion government bond market, where more than 70 percent of the outstanding debt is linked to consumer prices.

So-called linkers have returned 3.8 percent this year, compared with the emerging-market average of 12.6 percent, according to data compiled by Barclays Plc. Chile’s central bank has kept its benchmark borrowing rate at 5 percent for 10 months even though traders anticipate annual inflation will slow to 1.8 percent in February, below the country’s 3 percent target.

While the central bank has turned Chile into the highest- rated country in Latin America and allows the government to sell bonds at the lowest yield in the region’s history, Citigroup Inc. recommends investors avoid bonds tied to the consumer price index. The securities are underperforming because policy makers refuse to reduce borrowing costs, a legacy of hyperinflation that dictator Augusto Pinochet ended after seeking help from Nobel Prize-winning economist Milton Friedman in 1975.

“Chile had a very long history of inflation and it really had very serious problems,” said Claudio Loser, a former Western Hemisphere director at the International Monetary Fund. He served as the IMF’s Chile director in the mid-1980s and has a doctorate in economics from the University of Chicago, where Friedman taught. “Whenever there is a problem with inflation in this inflation-targeting system, they adjust policies very quickly. There is little patience for high inflation.”

World Beater

No other emerging-market central bank with below-target inflation has resisted cutting interest rates or easing bank reserve requirements this long, data compiled by Bloomberg show.

Banco Central de Chile declined in an e-mailed statement to comment on its monetary policy.

Chile’s Aa3 grade from Moody’s Investors Service, the same as Japan and South Korea and five levels higher than Brazil, has helped the nation obtain Latin America’s lowest market interest rates. The government sold 10-year dollar bonds last month at a yield of 2.38 percent, or 3.19 percentage points below JPMorgan Chase & Co.’s EMBI Global Index of Latin American sovereign debt. The peso is the world’s second-best performing currency this year with a 7.7 percent gain against the dollar.

Citigroup and Bice Inversiones are telling clients the central bank’s effort to quash inflation means CPI-linked bonds will keep underperforming.

Real Rates

Annual cost-of-living increases in Chile, South America’s fifth-largest economy, slowed to 2.9 percent in October from 3.7 percent a year earlier. After adjusting for inflation, the nation’s real interest rate rose to 2.1 percent last month, the highest in the Americas, according to data compiled by Bloomberg.

The yield on the government’s fixed-rate bonds due in January 2022 has risen 12 basis points, or 0.12 percentage point, since the end of August to 5.42 percent. Yields on similar-maturity inflation-linked notes climbed 22 basis points to 2.44 percent in the same period.

“You can’t go too much against the central bank,” Dirk Willer, a strategist at Citigroup in New York, said in a telephone interview. “Inflation is fully under control.”

Chile’s central bank lowered its interest rate by a quarter-point in January to 5 percent and has kept it unchanged since. By contrast, policy makers in Brazil have cut borrowing costs by the most of any major central bank tracked by Bloomberg in the same period. The 3.75 percentage point reduction chopped Brazil’s rate to a record low 7.25 percent, even as consumer price increases have exceeded the government’s target.

Pump Priming

Central banks in the U.S. and Europe are also suppressing interest rates to support economic growth. The Federal Reserve has carried out three rounds of asset purchases, known as quantitative easing, since reducing its target rate for overnight loans between banks to a range of zero to 0.25 percent in December 2008. The European Central Bank announced an unlimited lending program in December.

Speculation the measures will cause consumer prices to increase has prompted investors to pile into inflation-linked debt from developing countries. Brazilian linkers have returned 23.8 percent this year, according to Barclays.

Average inflation in 15 of the largest developing economies accelerated to a seven-month high of 4.3 percent in September, according to data compiled by Bloomberg. The data exclude Argentina. It slowed to 4.1 percent in October.

In Chile, traders in the forwards market for unidades de fomento, the nation’s inflation-linked accounting unit, expect consumer prices to rise 0.01 percent in the three months through January and annual inflation to remain below the central bank’s 3 percent target in 13 of the 18 months through April 2014.

‘More Hawkish’

“Most of the market thinks that the Chilean central bank is more hawkish than the rest,” Felipe Hernandez, an economist at Royal Bank of Scotland Group Plc, said by telephone from Stamford, Connecticut. Chilean policy makers “believe the cost of waiting and then having to make bigger cuts is less than the cost of cutting less, sooner, and being wrong.”

Friedman helped to shape that hawkish view. In 1956, Chile’s Catholic University signed a deal to send scholarship winners to study economics at the University of Chicago, where Friedman taught alongside Friedrich Hayek, an Austrian-born economist who won the Nobel Prize two decades later.

The graduates then returned to teach economics in Santiago, earning the moniker “Chicago Boys.” They recommended slashing government spending, ending price controls and increasing trade to tame inflation that surpassed 700 percent in 1974.

Allende Coup

Almost two years after taking office in a coup that ousted President Salvador Allende, Pinochet sought advice from a visiting Friedman in March 1975 as inflation persisted above 350 percent. Pinochet stacked his cabinet with Chicago Boys and their disciples in the late 1970s and early 1980s.

The inflation rate fell below 100 percent by 1977 and has remained below 10 percent since 1994. Chile will post the slowest inflation in Latin America this year, according to the Washington-based IMF.

Pinochet regime’s conferred independence on the central bank on Dec. 9, 1989, five days before the first democratic elections in two decades. A year later, the central bank was the second in the world to introduce an inflation target.

The country has posted budget surpluses in 15 of the 22 years since the return of democracy. In 2001, Chile introduced a rule that forces it to save during boom years. It has been the region’s only net creditor since 2005, according to the IMF.

‘Friedman’s Theory’

Last year, Chile’s debt was equal to 11.2 percent of its gross domestic product, the lowest of any country in Latin America or Eastern Europe, IMF data show.

“Friedman’s theory was that an excess of money was always the cause of inflation,” Rolf Luders, who studied under Friedman at Chicago and became Pinochet’s finance minister in 1982, said in a telephone interview from Santiago. “The principal contribution of the Chicago Boys to the reduction of inflation was to reduce Chile’s fiscal deficits, which slowed inflation from the very high rates of 1973 and 1974 and paved the way for later success.”

The Chicago school remains influential in Chile. Two government ministers, Cristian Larroulet and Joaquin Lavin, studied economics at the University of Chicago, as did Deputy Finance Minister Julio Dittborn.

Alonso Cervera, a Latin America economist at Credit Suisse Group AG, says that Chile’s central bank is right to hold off on cutting rates because economic growth remains strong.

Economic Growth

Gross domestic product expanded by 5.7 percent in the third quarter from a year earlier, beating analysts’ estimates for the second straight quarter. The economy is benefiting from an unemployment rate that has dropped by almost half since August 2009 and from rising real wages. The price of copper, which accounts for more than half of Chile’s exports, is beating its 10-year average this year at $3.52 a pound.

“Inflation is under control but it is a very dynamic economy,” Cervera said in a telephone interview from Mexico City. “There is no case to be made for lowering rates in Chile. The question is whether they shouldn’t be raising rates.”

Yields on Chile’s 10-year dollar bonds due in 2022 were little changed at 2.34 percent while the two-year swap rate increased one basis point to 5.01 percent at 9:22 a.m. in Santiago.

The cost of protecting Chilean bonds against default for five years rose three basis points to 84 basis points, data compiled by Bloomberg show. Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower fails to adhere to its debt agreements.

Peso Boost

The peso appreciated 0.6 percent to 482.1 per dollar.

Traders have pared their estimates for inflation over the next three months for five straight weeks. Three-month breakeven inflation, a measure of expectations for future price increases, fell to 1.63 percent on Nov. 16 from 1.7 percent a week earlier and 4.79 percent at the end of August. Breakeven rates also indicate that traders expect inflation to undershoot the 3 percent target for the next five years.

“There is a risk that in the next couple of months it could go lower,” Mauro Roca, a strategist at Deutsche Bank AG in New York, said in a telephone interview. “The short-term inflation scenario is particularly benign. It’s because of the central bank’s credibility and inflation expectations that are anchored around the target.”

To contact the reporter on this story: Sebastian Boyd in Santiago at sboyd9@bloomberg.net

To contact the editors responsible for this story: David Papadopoulos at papadopoulos@bloomberg.net; Michael Tsang at mtsang1@bloomberg.net.


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