Avoiding the China Trap

Chile is blessed with an abundance of natural resources. From its fertile agricultural land to its extensive Pacific coastline and, especially, its vast mineral deposits in the north, this long sliver of South America produces raw materials that countries not so well endowed need to build new cities and feed their populations.

And Chile’s exports are growing. Between 2003 and 2010 exports grew at an average annual rate of 19% and have quadrupled over the last decade to around US$80 billion in 2011. But much of the growth in recent years has been due to rising demand for a single commodity – copper.

Chile’s economy has always leaned heavily on exports of minerals. In the 19th century, nitrates – used in fertilizer and explosives – bankrolled Chile’s emergence as an independent nation. In the 20th century, copper gradually replaced nitrates as Chile’s main export and today it accounts for more than half of the country’s total exports.

But exports of non-mining products like fruit, salmon, wine and furniture have grown thanks to a web of free trade agreements. Since 2000, Chile has signed agreements with key partners including the United States, the European Union, Korea, China and Japan. Today, it has 21 free trade agreements with 58 countries, giving exporters preferential access to nearly two thirds of the world’s population.

This openness is reflected in the diversification of exports and the number of companies exporting to these markets. In 2010, a total 7,447 Chilean firms exported 4,929 products, up from 5,496 firms and 3,503 products in 1993. Of course, not all companies export to all countries, but the United States, which signed a deal in 2003, has been a key market for non-copper products.

This is no accident. The government’s export promotion agency, ProChile, has worked hard to diversify Chile’s exports to the United States and elsewhere, says ProChile’s director, Felix de Vicente.                                                                                                              

Through its network of 55 trade offices in 41 countries – including five in the United States – ProChile monitors international markets and identifies opportunities and threats for exporters.

“This allows our exporters to make the best decisions at the right time and not make mistakes that could be avoidable,” says de Vicente.

And the strategy has worked. From the mid-1990s to 2008, non-copper exports showed steady growth, reaching over US$30 billion. Chile’s exports fell steeply in 2009 due to the global financial crisis but they have recovered strongly in the last year.

“You can see the trade agreements we have signed have had a positive impact on export diversification,” says de Vicente.

Yet, despite Chile’s integration with foreign markets, its export basket has actually become more – not less – concentrated in the last five years, while copper exports have taken off.

This is mainly due to Chinese demand. China’s booming construction industry needs enough copper to build a new city every three or four months. As a result, the Asian dragon has become Chile’s top trading partner – total exports reached US$12.9 billion in the first nine months of 2011, up 7% from the same period of 2010 – with the metal representing nearly 90% of exports.

“Chile is one of the countries in Latin America with the most diversification of markets and the least diversification of products,” says Osvaldo Rosales, director of the trade and integration division at ECLAC. “We’re talking about a re-primarization of the economy.”

Indeed, after a growth spurt in the early 1990s, Chile’s export diversification, as measured by the Herfindahl-Hirschman index, is virtually unchanged since 1994 when Chile scored 0.27 (1.0 represents maximum concentration) compared to 0.26 in 2008. This compares to an average of 0.1 in the G-7 countries and 0.15 in Korea.

Today, Chile’s exports are less diversified than the exports of many Asian countries at a similar level of development and per capita GDP.

“We improved in the 1990s but we have stalled in the last decade,” says Ricardo Ffrench-Davis, an economics professor at the University of Chile.

In his book, Economic Reforms in Chile: From Dictatorship to Democracy Economic Reforms, Ffrench-Davis argues that the main reason for this stagnation is exchange rate volatility.

Squeezed by the peso

Exporters live and die by the exchange rate. It determines how much they receive for every peso spent producing a product or service. But over the last decade predicting the real exchange rate has been a lottery.

“Is it going to be 450 or 650 pesos? What do I base my investment decisions on for the future? It’s very difficult,” says Ffrench-Davis. 

Without a stable exchange rate, investors will not risk investing in innovation which is key to developing new products and services. Although the dollar has strengthened in recent months due to the European debt crisis, the Chilean peso’s appreciation has made it difficult for exporters in non-mining sectors to compete abroad.

Chile is not the only emerging economy in this bind. The experiences of Korea and Brazil since 1999 have shown that currency volatility can be a disincentive to export diversification. “You end up sticking to what you know, which is traditional exports,” points out Ffrench-Davis.

However, a strong currency is not necessarily a death knell for exporters. Countries with rapidly expanding economies and high productivity growth – like Chile in the mid-1990s – tend to have a more rapidly appreciating exchange rate which is compensated by the higher competitiveness of their exports.

“Thanks to higher productivity, exporters can compete abroad while domestic producers that compete with cheaper imports are protected,” says Ffrench-Davis.

But Chile’s productivity has declined in the last decade. Although productivity was expected to edge up around 0.4% in 2011, it is still nowhere near the average annual growth rate of 2.3% reached in the mid-1990s when Chile’s economy was booming. And sluggish productivity growth, combined with a strong peso, makes it difficult for Chilean exporters to compete with other developing economies, especially in Asia.

The future outlook is not much brighter. The current commodities super-cycle, driven by Asian demand for raw materials, could last for another 15 years or more. In addition, interest rates are expected to remain low in the United States and Europe which means capital should continue flowing into emerging markets, putting additional pressure on the exchange rate.

All this sends a depressing message to exporters.

“It means the exchange rate will remain low unless there is a temporary crisis such as the one we are experiencing now,” says ECLAC’s Rosales. “Obviously, this is not the best situation to encourage an entrepreneurial climate in Chile.”

Incentives for innovation

New Zealand, Australia and Canada – all countries with natural resource-based economies – have shown that incentives for innovation, better education and training, world-class infrastructure and technology clusters are needed to create successful export industries.

“These incentives have not been present in Chile’s policies, which explains the stagnation in export diversification,” says Rosales.

The Innovation for Competitiveness Fund (FIC), created in 2005 by former President Ricardo Lagos on the basis of a royalty tax on mining, has increased funding for R&D projects, but more needs to be done to support innovators, says Rosales.

In this regard, Chile’s close commercial relationship with the United States is an important advantage, notes ProChile’s Felix de Vicente.

“We have much to learn from the United States in this area if we want Chile to become a pole of innovation in Latin America,” he says. “The experiences obtained from successful cases like Silicon Valley are very beneficial for us.”

Taking a good idea to market can be painstakingly slow in Chile, but US experience in this area can help Chilean innovators to take the next step.

For example, the Go to Market competition, developed by Chile’s economic development agency CORFO, gives Chilean researchers the chance to apply for a four-week training course at the Stanford Research Institute in Silicon Valley.

CORFO is also working to bring international scientific expertise and financing to Chile. In September, the German biotechnology firm Fraunhofer opened its first South American office in Santiago with funding from CORFO. Australia’s national science agency, CSIRO, also has an agreement with state mining company Codelco to establish joint research and development projects.

 “If we can do this in the mining sector, why not other sectors?” says Rosales. “We need to establish more technology centers, research alliances with other countries, and a critical mass of trained professionals.”

But this will not happen if left to market forces alone. Another Latin American country, Costa Rica, has shown that state support is crucial. Since Intel’s decision to establish a manufacturing facility there in 1996, the country has benefitted from a surge in foreign investment and employment but it has not stopped there.

Costa Rica’s government has acted as an intermediary to help small firms meet standards and become suppliers to US companies. CORFO aims to implement a similar program in Chile in 2012 but it must work faster, admits Hernán Cheyre, CORFO’s executive vice-president.

“The main thing we can do is to build bridges for small and medium size companies to reach new markets,” he says.

Distance to market

Chile is in the same time zone as the eastern United States but its geographical isolation is a comparative disadvantage. The higher cost of transporting goods to key markets makes Chilean products less competitive and the small size of the internal market is also a drawback.

“Economies of scale matter, and we are very small,” says Rosales. “But being small allows you to be more flexible and being isolated is an incentive to improve efficiency.”

If Chile is to become a gateway to the Asia-Pacific region – the Singapore of South America – as the government intends, it needs to invest more in infrastructure, says Rosales.

Chile’s national airline LAN established its regional hub in Lima to be closer to key markets like the United States and Brazil, but Chile could become an important regional maritime hub by improving the efficiency of its ports.

The Valparaiso and San Antonio ports process about 70 containers per hour, according to an ECLAC report, which is more efficient than all other South American ports but still less efficient than Chinese ports that process double that amount.

Moreover, post-Panamax vessels are currently too big for Chilean ports but Chile could build the first port on Latin America’s Pacific coast capable of servicing these vessels. “It would be a great competitive advantage for Chile,” notes Rosales.

Chile also needs to improve its road and rail connections with Brazil, Argentina and Uruguay, not just to give Chilean exporters access to ports on the Atlantic coast but also to facilitate intra-industry trade.

International connections

A great challenge for Chile is how to use its network of trade agreements to strengthen the internationalization of its small and medium-size companies.

One reason for Asia’s success in the last 30 years has been the growth in intra-industry trade, preceding in many cases the signing of trade agreements. This type of trade not only generates partnerships between companies, it also foments innovation, but the protectionist tendencies of some countries in South America are an obstacle to integration, says Rosales.

Apart from the automobile industry in Brazil and Argentina, there are few industries that use components supplied by different countries in the region. According to Rosales, this needs to change for Chilean exporters to move up international value chains but it requires political will and does not depend entirely on Chile.

Developing partnerships with companies in countries like the United States and India that can also help Chilean companies upgrade their technological capacity and add value to exports.

India represents only about 1% of Chile’s total exports, but Indian companies are more globalized and better positioned than their Chinese counterparts. This means they could make ideal partners for Chilean companies, especially in the area of offshoring, which is a growing export industry.

But in order to communicate with Indians, Chileans need to speak English better. While Costa Rica has promoted English-language training and reformed its education system to meet the needs of investors, only around 3% of Chileans speak English fluently. “It’s a big gap,” admits CORFO’s Cheyre.

There is clearly room for Chile to improve but the current debt crisis in Europe and North America is a window of opportunity. While other countries struggle with crippling debts, Chile has its fiscal accounts in order and plenty of access to capital. Crucially, it is also an attractive foreign investment destination with a stable and growing economy.

Chile has done the job of opening markets but now it needs to develop its international connections so exporters can reach further and run faster. It’s not too late to escape the China trap, but diversifying exports takes innovation, bridges and partners like the United States.

Julian Dowling is the Editor of bUSiness CHILE