Chile’s forex intervention likely to stabilise peso – experts

The Central Bank of Chile is likely to succeed in stabilising the peso’s exchange rate with the massive foreign exchange interventions announced on November 28, but the path ahead may not be smooth, say observers.

Higher copper prices and an undervalued exchange rate will also contribute to tame volatility, says Quinn Markwith, Latin America economist with London-based consultancy Capital Economics.

“While there is likely to be more turbulence ahead for the Chilean peso, the big falls are probably behind us,” says Markwith. “Indeed, with the central bank intervening and copper prices likely to rise, we think it’s more likely than not that the peso will strengthen by the end of 2020, to around 730 per dollar.”

Nonetheless, the underlying political and social unrest fuelling the crisis, and uncertainty around constitutional reforms, may delay stabilisation, adds Felipe Camargo, economist with Oxford Economics.

“We expect the peso will remain undervalued by 9% during the political transition period, and then will gradually converge to our equilibrium estimate,” he says.

The central bank last week announced its largest forex intervention in 20 years, following weeks of rapid exchange rate depreciation. After almost two months of widespread social unrest, and a deep political crisis, the peso fell by 14.2% against the dollar in the five weeks to November 28, hitting a new record low of 830.

That day, the central bank unveiled a six-month programme spanning from December 2, 2019, to May 29, 2020, in which it would sell $20 billion. In the days since the announcement, the peso has risen by 6.8% against the greenback, and now hovers around 795 per dollar.

However, the central bank does not aim to recoup the losses its currency recorded since early October. “The programme will be successful if it helps asset prices adjust without frictions that affect credit availability or uncertainty in the economy,” said the central bank on December 3.

The copper factor

A key factor likely to support the peso is Chile’s solid fiscal position and overall economic fundamentals. The South American country is the world’s largest copper producer. This commodity accounts for approximately 50% of Chile’s total exports. As a result, the peso tends to follow the ups and downs of copper prices.

“We expect that the copper price will recover over the coming quarters due to a tight global supply,” says Markwith. “Our forecast is that it will increase from $5,800 per tonne today to $6,400 per tonne at the end of next year, before rising further to $7,000 per tonne by end-2021.”

We expect the peso will remain undervalued by 9% during the political transition period, and then will gradually converge to our equilibrium estimate

Felipe Camargo, Oxford Economics

All else being equal, higher copper prices should boost the peso, especially when it is already trading below fundamentals. Capital Economics estimates the currency is now 10% weaker in real effective terms in relation with copper prices.

This undervaluation should also lend support to the central bank’s efforts. “While exchange rate interventions by central banks do not always work, they tend to be more effective when used to counter an overshooting exchange rate than to prevent an adjustment warranted by fundamental shifts in the balance of payments,” says Markwith.

As a result, Capital Economics expects the peso to strengthen to finish 2020 at 730 per dollar, before hitting 685 per dollar by the end of 2021.

Political hurdles

Nonetheless, this does not mean the currency is already out of the woods. The political crisis is expected to linger in the months to come, which could unleash new currency shocks. Unrest is being fuelled by deep-rooted social grievances derived from economic inequality, which is also related to racial divisions.

The conservative government of president Sebastián Piñera has agreed to call a referendum on April 2020 to reform the constitution. One of the protesters’ aims is to establish a clearer institutional break with the dictatorship of Augusto Pinochet, who ruled the country from 1973–1990, until Chile returned to democracy. However, the country still lacks consensus about how to deal with its past, and how to tackle inequality.

“The uncertainty over constitutional reforms will likely delay the speed at which the peso reaches a new equilibrium,” says Camargo of Oxford Economics. “Our baseline scenario assumes that uncertainty will continue to exert selling pressure on the peso until the first quarter of 2020.”

In fact, Camargo thinks there is still room for further declines in the exchange rate if President Piñera yields to pressure adopting a looser fiscal policy, and a more interventionist approach in the economy. Oxford Economics forecasts the peso will start 2020 at 810 per dollar, and only gradually return to around 750 in 2021.

These factors may very well compromise the effectiveness of the interventions. Actually, a recent $4 billion swap injection failed to contain the peso’s slide, points out Camargo.

Enough reserves

One of the most striking characteristics of the forex interventions are their hefty size in relation to Chile’s international reserves. Dollar spot sales at $10 billion almost represent 25% of the reserves portfolio, which stood at $40.5 billion in November.

Nonetheless, the central bank argues this does not represent a danger to stability. In fact, because of depreciation, the reserves have increased their value in pesos. This helped to increase the central bank’s holdings to 15% of GDP in 2019 from 13% a year earlier, according to official data.

“The vulnerability or non-vulnerability of the Chilean economy does not rest exclusively on the level of international reserves,” says the central bank. “This depends on many factors, which are still present – a solvent financial system, a low exchange exposure of economic agents, a clear commitment to fiscal responsibility, an adequate level of reserves and sovereign funds, as well as inflation expectations anchored at 3%.”