Here we are again in Chile, cringing at the latest spike in the oil price, worrying about its impact on inflation, monetary policy, confidence and economic growth. It seems 2008 is still fresh in our minds, not solely for Lehman Brothers and the ensuing economic and financial crisis, but also for the extraordinary impact that higher oil prices had not only on inflation but on broader economic activity.
In 2008, Chile experienced annual inflation of 7%, peaking at 10% in October, just prior to the global economic meltdown. Oil explained more than a third of this. Efforts to hike rates by the Central Bank (400 basis points since mid-2006) weren’t enough to curb inflationary pressures and Chile faced a stagflation scenario. From an inflation standpoint, Chile was essentially saved by crisis conditions, which curbed inflation, while the economy was subsequently able to recover on heavy counter cyclical stimulus and related tailwinds (President Piñera’s agenda and earthquake reconstruction).
It should be no secret that oil has the single largest impact on the economy of any item in Chile’s CPI basket. Chile imports more than 90% of its fuel needs, but more importantly, policy decisions related to energy, electricity and transport have increased the economy’s overall exposure to oil. A stabilization fund helps smooth the curves, but pricing impacts are felt quickly. Although oil and related fuels directly account for less than 5% of the CPI basket, the figure rises to as much as 30% when including indirect impacts on other elements such as transport and electricity prices. Furthermore, secondary effects ultimately start to take hold, creating a vicious cycle given that Chile’s economy is highly indexed to inflation (prices for many goods and services are expressed in the inflation indexed Unidad Fomento, or UF). Some would also argue that high oil prices also affect food prices via biofuel substitution (food represents 18% of Chile’s CPI basket), as was the case in 2008.
Curiously, in this latest spike, oil prices have yet to cause a major increase in inflation (12-month CPI holding just above 4% for the first three months of the year), largely due to offsetting factors, such as lower prices for natural gas and holiday packages. An impending 25% cut in electricity prices should help the April figure (however, an increase of 17% in May will mostly offset this). Meanwhile, although the peso is highly correlated to the price ratio of copper to oil, high copper prices (along with a weak dollar) have kept the peso strong. This has meant cheaper oil in peso terms (WTI up 6% year-to-date but flat in pesos). As a result, the economy continues to chug along with the Monthly Indicator of Economic Activity (IMACEC), a GDP proxy, up 5.5% in January compared to the same month a year earlier, while the Central Bank remains on hold.
The market has only recently started to reflect oil price risk with consensus 2012 fiscal year inflation expectations climbing to 3.5% in March, up from 3.1% a month earlier. The risks continue to be skewed to the upside. Oil prices are still facing pressure from geopolitical noise, most notably related to Iran where further sanctions look doubtful to deter the country’s nuclear ambitions. In the meantime, copper prices have held up but are facing risks related to China demand as the economy slows. Meanwhile, the US economy has improved, helping the US dollar and curbing the peso’s rally in recent weeks.
In the event that inflation continues to accelerate, it will likely prompt the Central Bank to hike rates, which ultimately has implications for confidence levels that are already starting to decline. Inflation has a particularly harsh impact on domestic consumption, which has recently been the key driver of economic growth, thus increasing the risk to consensus GDP growth forecasts (which have crept up to 4.4% from a 4.0% low in January).
On the bright side, as Chile experiences ever more frequent oil related inflation spikes, it will induce more proactive measures by the government to reduce overall exposure. Chile’s Achilles heel may still need major surgery, but taping it up would be a good start.
Brian P. Chase is Portfolio Manager, Head of Andean Equities, at Itau Asset Management