Chile was once the toast of Latin America. Thanks to its innovative reforms that led the region in selling off bankrupt state enterprises to domestic and foreign investors, the Chilean economy and the local stock market were in a continuous boom. Unemployment was minimal. Politicians heatedly debated each other over who was more centrist. And given the slightest provocation, Chileans would explain what other emerging markets should be doing to achieve similar levels of contentment and capital flows.

But after years of smugness, there is a healthy sense of impatience and dissatisfaction in the country. Last year’s recession – a 1.1% drop in GDP that was small by regional standards, but was the first economic contraction in Chile in almost a generation – has something to do with the changed attitude. So does the continuing drama of General Augusto Pinochet, who recently returned to Chile after a 17-month detention in Britain. The former dictator fought off extradition to Spain, but now faces possible prosecution on human rights violations at home for the more than 3,000 people who were killed or disappeared under his rule between 1973 and 1990.

Yet another key factor is the widespread realization within the business community and the government that the rest of Latin America has equaled, indeed in some cases surpassed Chile in terms of economic liberalization, and that the country needs dramatic measures to regain its status as a magnet for global capital markets.

“It’s a lot harder to be in the vanguard when everybody else has undertaken reforms,” says President Ricardo Lagos, the socialist who was elected in December. “But I am convinced Chile can, and will, regain its leadership.”

That’s the kind of resolve that Lagos’s centrist Christian Democratic predecessor, Eduardo Frei, demonstrably lacked. Frei proved a timid president, more interested in avoiding controversies and conflicts than tackling urgent economic and political issues. Though Lagos’s left wing label ruffles conservatives, they, like most Chileans, are eager for a more activist president. Lagos, who is an admirer of Britain’s Tony Blair, would like to prove that a socialist government can bring about capitalist prosperity. “We are aiming to achieve the investment and economic growth necessary for a fairer the distribution of wealth,” says Lagos.

Finance Minister Nicolás Eyzaguirre vows to end “the isolation of the Chilean economy from international capital flows.” Thus far, the most important step in this direction has been the elimination of the one-year restriction on foreign investments and the suspension of the infamous encaje, which required foreign investors to keep up to 35% of their investment in a non-interest-bearing cash account with the central bank.

Soon to follow will be other key measures, including the end of a 15% capital gains tax paid by foreign investors and less red tape. Meanwhile, new legislation aims to protect minority shareholders, including foreigners, and permit businesses to offer stock options to their executives and allow management to repurchase company shares to help lift their prices. “Our stock market is deep, but not liquid,” says Eyzaguirre.

Chile’s stock market capitalization is equivalent to just under 70% of the GDP, by far the highest proportion in Latin America. Yet a good day of trading on Santiago’s stock exchange involves a meager $20 million in transactions. Housed in a Victorian-style building, the bolsa is open only three hours a day, with a score of traders milling about its circular, wood-parquet pit, chatting and smoking more than shouting out buy-and-sell orders. “I took my 15-year-old son, Diego, who knows all about electronic trading, and he asked me whether this was a museum,” recalls Jorge Errázuriz, managing director of Celfin, a leading Chilean investment bank.

Ezyaguirre predicts that the new reforms will lead to a renaissance of Chile’s capital markets within a couple of years. But financial analysts and investors insist much more dramatic action will be needed to get Chilean equities noticed on Wall Street the way they used to be. “The Chileans made major reforms 20 years ago and they have been living off their image ever since,” says Arturo Porzecanski, chief economist for Latin America at ING Barings in New York. “They have to create some new, exciting vision of the country as more than just a producer of copper, fruit and lumber.”

“I know there are a lot of impatient people out there,” Carlos Massad, governor of the central bank of Chile, told Wall Street analysts on a recent visit to New York. “But we will do it at our own pace.” Back in Santiago, though, there are some pretty radical notions being bandied about by prominent, impatient people in the financial community.

“Maybe we should get rid of the central bank and dollarize the economy,” says Celfin’s Errázuriz. “That would draw Wall Street’s attention.” Henry Rudnick, president of, an online Chilean brokerage, suggests that financial institutions operating abroad be allowed to openly peddle mutual funds, pension fund management, and even mortgages in Chile. “This sort of real competition won’t wipe out local financial institutions. On the contrary, it will make them more efficient and stronger,” says Rudnick. “These are the kinds of issues that are being discussed today in the local investment community.”


Rave Reviews
What is surprising is that such discussions are taking place under a socialist president, Lagos, who narrowly defeated the conservative candidate, Joaquín Lavín, clearly favored by the business community. The legal battle against Pinochet, as well as a host of other political issues such as the new president’s commitment to repeal the Constitution imposed by the former dictator, to act on environmental issues, and to restore full civilian control over the armed forces, also provide fodder for conservative opponents of the new government. “I think that even the [right-wing] opposition in Congress is ready to accept the reforms I am proposing,” says Lagos, who insists his political goals won’t take a backseat to his economic program.

And yet, Lagos is enjoying a honeymoon with the business and financial communities – at least for now. Besides the president’s moves to open the capital markets, they are impressed by his determination to resist social spending increases, despite a still high 8% jobless rate, and to achieve a 1% budget surplus by next year. “When the economic pie increases, then labor unions should be in a position to claim a part of the benefits,” says Lagos.

On the government’s side, there are good reasons to act quickly to lift capital controls. While an economic recovery is clearly underway, Chile expects to receive this year only about half the $9 billion in foreign direct investment that entered in 1999, much of which went for purchases of large energy companies by Spanish corporations. The Chilean economy is probably solid enough to expand by 5% to 6% this year. But to resume the 7% to 8% annual growth levels of the past, it will need additional sources of capital. Meanwhile, as US interest rates have risen, the global competition for capital has intensified. So Chile’s moves to liberalize foreign investment rules and attract portfolio investment could hardly be better timed.

“If I had one question to ask Finance Minister Eyzaguirre, it would be, ‘How can you bring more Chilean companies to the capital markets?’” says Felipe Larraín, an economist who recently returned to Santiago after a long stint as a Harvard professor. The Chilean business world, he points out, is essentially divided between those 26 companies that are listed as ADRs on the New York Stock Exchange, which qualifies them to raise capital at cheaper rates, and the vast majority of other companies that are either family firms or listed on the somnolent Santiago bolsa.

One reason for the bolsa’s slugishness is that so many stocks are controlled by private pension fund management companies that rarely make large sales or purchases of Chilean equities. In 1981, Chile pioneered a system of private pension management companies – the Administradoras de Fondos de Pensiones, or AFPs – which became a model for the rest of Latin America (and recently, in more modest form, part of George W. Bush’s presidential campaign platform for reforming the social security system in the United States). By investing part of employee salaries into stocks, bonds, and treasury notes, the AFPs offered Chilean workers the eventual possibility of an economically viable retirement. More immediately, the AFPs emerged as the first, true domestic institutional investors in Latin America, helping to finance the privatization of Chilean industry and creating a corporate bond market. The AFPs also became by far the largest investors on the Chilean stock market. Today, the AFPs administer $37 billion in pension funds, equivalent to half the country’s gross domestic product.

Local Limitations
But as has been the case with so many Chilean reforms, the AFPs have lost some of their luster, though there are efforts to reinvigorate them. Under current law, the AFPs can invest up to 10% of their funds in foreign blue-chip stocks and another 6% in foreign triple-A bonds. The restrictions meant that the AFPs largely missed out on Wall Street’s biggest, longest bull run, while the Chilean market turned sluggish. And the results were evident in the private pension funds’ returns for Chile’s future retirees. Between 1981 and 1994, the system’s annual compound return was an impressive 14% in dollar terms. But if the period is stretched from 1981 to 1999, the average annual return plummets to 11%.

“We are asking the government to allow us to invest up to half of our funds abroad,” says Axel Christensen, investment manager at Cuprum, one of the best-run AFPs. “When our economy or markets drop, we should have the option to look for markets abroad with higher yields.” In fact, legislation setting higher limits on AFP investments abroad will probably pass before the end of the year.

But serious doubts remain about the investment talents of the AFPs. For example, at Cuprum, which is the fifth largest AFP, the investment team consists of only a dozen employees, who handle a portfolio of $6 billion. Usually, they make investment decisions only when their board of directors meets every two weeks. Without personnel to analyze or trade US securities, Cuprum hires the best-known American mutual funds to make their investments. “For now, we go with the biggest,” says Christensen. “Nobody gets fired for hiring Merrill Lynch or Goldman Sachs to invest their money.”

Perhaps as AFPs increase their foreign investments and diversify their money managers abroad, their returns will rise to the salad days of the mid-1980s to mid-1990s. But the private pension system has other problems. Over the last decade, the number of AFPs has shrunk to eight from 18, and the management fees charged to contributors are high – equivalent to more than 2.5 % of an employee’s gross salary. Meanwhile, outdated government regulations, which were originally meant to reduce risks in the private pension fund system, require an AFP not to exceed by more than a couple of percentage points the industry-wide average of profitability. In effect, if Cuprum earned too much on its investments by comparison to its peers, it would be penalized by having to set aside the “excess earnings” into its reserves. “So, we’re always looking over the shoulders of our competitors to see where they are investing,” says Christensen. “That’s why all AFP portfolios look so much alike. It’s a herd mentality.”


Given all the inefficiencies in the AFPs, some critics charge that proposed reforms aren’t enough, and that the private pension system should be flung open to competition. “Why not allow some foreign investment bank to come in and say to a blue-collar worker or an office employee, ‘You know, I can administer your private pension contributions for a lower management fee and maybe get you a better return than your AFP,’” says Rudnick, the online stockbroker.

Banking, the other pillar of the Chilean financial system, is also suffering from symptoms of sclerosis after years of acclaim. By comparison with most of the rest of Latin America, the performance of Chile’s banking system remains enviable. For instance, during last year’s recession, past-due loans as a percentage of the banks’ total portfolios rose from their previous 1% to a still healthy 1.9%. “[That] is a level that any other country would like in years of economic expansion,” says José García-Cantera, managing director of Latin American equity research at Salomon Smith Barney.


With economic recovery underway in Chile, bank loans will grow by about 9% this year, and the system’s profitability is also rising. Already, Chile is the Latin American country with the highest banking penetration and the lowest net interest margin – less than 4% – making for some fairly satisfied clients, both in corporate and retail lending. But Chilean banks still display a relatively low ratio of non-financial income, such as fees and commissions, to their total income (about 23% for the whole system compared to the 40% levels of first-world financial systems).

And even as the lifting of capital controls invites more foreign investment into local bank stocks, bankers are worried that institutional investors and Wall Street portfolio managers will become skeptical about the profitability of Chilean banks unless they diversify their income away from loans. Some bankers claim they are shackled by government regulations that are more focused on risk than on stimulating development of the banking system. “In Chile, banks can do only what the laws state,” says Lionel Olavarría, CEO of Banco de Credito e Inversiones (BCI), the fourth largest bank. “If the laws don’t specify an activity, then banks cannot do it.”


Until new legislation is passed, banks cannot become financial holding companies, and thus generate income from stock brokering, insurance and private pension fund management, besides their core lending business. Regulators also are hampering the development of Internet business. “We would love to get more into business-to-business e-commerce acting as intermediaries between suppliers and buyers,” says Olavarría. “But it’s important that no regulations exist that put us at a disadvantage with banks elsewhere in the world, because in this Internet era in which transactions and information take place at such great speed, even the flimsiest red tape can create insuperable obstacles for us to compete for new business.”


The government is taking some steps toward allowing banks to expand beyond their traditional activities. By the end of June, banks will have been required to submit a “self-evaluation” of their credit and financial risks, exposure abroad, quality of their management, technological advances, strategic planning, and overall transparency-presumably as a first step in permitting the strongest banks to diversify into new financial sectors. “We want a banking system [in which] the risks will be priced by the market, not by government regulations,” says Central Bank Governor Massad.

But for now, the government’s attention seems too focused on concerns over banking concentration. The reason was last year’s takeover of Banco Santiago by Spain’s newly merged Banco Santander Central Hispano, leaving the Spanish bank with more than the legal limit of a 20% share of Chilean banking, a benchmark created by the government and Congress to foster competition and benefit consumers. But critics ask why banks should be any different than any other businesses that have been allowed to grow with no limits while consumers have been protected by opening up the country to foreign competition. “Let the market determine how much banking concentration there should be,” argues Olavarría. “We should worry more about stimulating competition than creating barriers.”

Demonstrating the caution and sobriety of a central banker, Massad says the barriers will be removed, “gradually and carefully.” But Finance Minister Eyzaguirre, sounding more impatient, says the government’s goal is that “Chile will be a developed country by 2010,” thanks in part to a new commitment to “market-friendly regulations.” He even allows himself a display of humor, suggesting a slogan for the new era: “Capitalism and socialism united will never be defeated.”

A Socialist Leader Champions Capitalist Prosperity
President Ricardo Lagos is Chile’s first socialist head of state since Salvador Allende was killed in the 1973 military coup led by Gen. Augusto Pinochet. No doubt, the memories of the left-right polarization of the Allende era contributed to the unexpectedly close presidential race that Lagos won last December. But in his few months in office, the energetic, 62-year-old president has demonstrated an enthusiasm for tackling problems that civilian Chilean leaders have avoided dealing with for a decade. This accounts for the “Lagos effect” – a sharp rise in his popularity, even in the conservative business community. But critics say he is battling on too many fronts, rather than concentrating on one or two major political and economic goals. Recently, at La Moneda, the austere, 19th-century presidential palace in downtown Santiago, President Lagos sat down for an interview with LatinFinance to answer some basic questions about his policies.

LF: What does it mean to be a socialist president in this era of global capitalism?
Lagos: It means we have learned the hard way that there is no quicker path to achieving social benefits than embracing a market economy. I think our society at large understands that there are certain basic rights that should be guaranteed to all, such as education and health benefits, especially as per capita income increases. And this sort of consensus is important because a country suffering from internal divisions and social conflicts cannot compete in the new global economy.

LF: You have announced important political initiatives, such as a plebiscite to reform the constitution inherited from Pinochet. Will such political battles make it more difficult to accomplish the economic reforms you are advocating?
Lagos: I firmly believe in the saying, “It’s the economy, stupid.” I won’t consider my six-year term successful unless Chile grows by 6% to 7% annually. But we have a constitution that does not pass world standards for a democracy – with some senators appointed rather than elected and too large a political role for the armed forces, among other defects. There is a widespread consensus in this country to achieve a truly democratic constitution. So I think that even the opposition in Congress won’t stand in the way of economic reforms for political reasons.

LF: Recently, there has been a debate on whether the balance of foreign capital flows into Latin America has tipped too far in favor of direct investment over portfolio investment. What is your view concerning Chile?
Lagos: Initially, direct foreign investment was very important, and it was linked to the privatization process in the 1970s and 1980s. But now, we are in a second, more complex stage, in which a lot of foreign direct investment is related to the difference in rates of return on investment here and abroad. In North America and Europe, investors think a 10% annual return on a business for say, 20 years, is a good investment. But here in Chile, there are many local entrepreneurs who expect a 20% annual return. So, if a foreigner is willing to buy their business for twice the price they thought it was worth, they will gladly sell. The proof is that most new foreign direct investment has been in existing companies – like telecommunications firms, energy companies, banks. But personally, I am not concerned that foreign direct investment far exceeds portfolio investment in Chile. And I would add that there is no xenophobia towards foreign investment of any kind.

LF: What will it take for Chile to again become a magnet for portfolio investment?
Lagos: We have taken some steps already to eliminate controls over short-term capital flows. For instance, we have just ended the notorious requirement that foreign investments in Chilean equities remain in the country for at least a year, and we will end the 15% capital gains tax on foreigners who sell their Chilean equities. We are also taking measures to protect the rights of minority shareholders. But beyond that, we want to embrace the New Economy, and make foreigners think of Chile as a place to invest in Internet and other information technology companies.

Poor Cousin No More
Few companies demonstrate the importance of foreign portfolio investment more than Concha y Toro, Chile’s leading winery. A decade ago, Americans considered its wines synonymous with economy-size magnums of simple Cabernet. The image was about the same in Chile, where Concha y Toro had its headquarters in a seedy, working-class district of Santiago – just the neighborhood for the nation’s vino popular.

Nowadays, Concha y Toro sells more bottles of wine than any other foreign winery in the United States. Its wines have steadily progressed in quality to the point where the company has signed a joint-venture agreement with Château Mouton-Rothschild of Bordeaux to produce a super-premium $50 Cabernet, “the first, really great Chilean wine, with a finesse and complexity that matches some of the fine French wines,” brags Eduardo Guilisasti, chief executive officer of Concha y Toro.

Guilisasti has no doubt when and why his company experienced such a dramatic turnaround. In 1994, Concha y Toro listed its shares in ADR form on the New York Stock Exchange, the first winery to be quoted on the Big Board. The $50 million raised by the issue – equivalent to 17% of the company – was plowed into acquiring more land and winery equipment, including new oak barrels and stainless steel fermentation vats. Expert enologists, both Chileans and Europeans, were hired. Concha y Toro wines, which used to be classified crudely as reds and whites, diversified into sophisticated varietals, including Cabernets, Chardonnays, Merlots, Sauvignon Blancs.

Even as they have moved into higher market niches, Concha y Toro wines maintain an excellent price-to-quality ratio that gives them a competitive advantage over comparable American, Australian and European rivals. This has pleased institutional investors and other portfolio managers. So have the returns on their investments. Concha y Toro has achieved a market capitalization of $560 million, and a share of the vintner that was bought a decade ago is worth 18 times more today.

Chile is often criticized for still being too much of a natural resource country, with exports that have added little value over the years. “But if you look at the price differential between grapes and finished premiums, wine is the highest value-added product that Chile exports,” says Guilisasti, who recently moved his headquarters into a modern, glass Santiago skyscraper, appropriately called the World Trade Center.