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• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP86T00589R000400500002-7
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 21
• Document Creation Date: January 12, 2017
• Document Release Date: April 25, 2011
• Sequence Number: 2
• Publication Date: December 1, 1985
• Content Type: REPORT

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Directorate of -SeffeL
Intelligence
Chile's Growing Bind:
Financial Solvency Versus
Political Stability
Sciiii
ALA 85-10125
December 1985
385
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Chile's Growing Bind:
Financial Solvency Versus
Political Stability
Directorate of Secret
Intelligence
This paper was prepared b
Office of African and Latin American Analysis. It
was coordinated with the Directorate of
Operations.
Comments and queries are welcome and may be
directed to the Chief, South America Division, ALA,
Secret
ALA 85-10125
December 1985
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Key Judgments
Information available
as of1 November 1985
was used in this report.
Political Stability
Chile's Growing Bind:
Financial Solvency Versus
During the past three years, Chilean President Pinochet has alternated
between two economic policy options as he has sought to reconcile domestic
demands for economic recovery and political liberalization with foreign
creditor pressures for austerity and debt repayment. In early 1984, as the
US Embassy reported, his greater concern over domestic protests led him
to appoint a new economic team favoring expansionist policies that
stimulated a "miniboom" and helped slow the momentum of the opposition
movement. By early this year, in our judgment, he concluded that these
policies and the state of siege imposed in November 1984 had succeeded in
putting his political opponents on the defensive. This and his nervousness
that reduced foreign lending was risking a payments crisis led to an about-
face in early 1985, when Pinochet appointed new economic advisers,
implemented tighter austerity, and concluded an agreement with the IMF.
Now, in our view, Pinochet is again at a crossroads in his economic policy
dilemma. Following a $750 million IMF accord, increased World Bank
lending, and a Paris Club rescheduling last summer, foreign commercial
bankers have syndicated a three-year $1.1 billion loan and have resched-
uled $5.9 billion of 1985-87 maturing debt. The political protest move-
ment, however, is regaining strength at the same time that this complex
loan package is coming together, partly because of the tighter economic
measures that have been introduced to gain creditor support, in our
judgment.
In spite of the renewed financial backing, we and several private-sector
forecasters believe that Chilean economic growth will remain at about 0 to
3 percent over the next year. We foresee cuts in government spending for
1986, a slight rise in unemployment, inflation on the order of 35 percent, a
drop in real wages for the fifth consecutive year, and depressed domestic
savings and investment. Moreover, we expect another $1.7 billion current
account deficit in 1986. This raises the danger that a further slowdown in
the world economy, higher interest rates, delays in loan disbursement, or
resurgent capital flight could produce a foreign debt payments crisis with
little warning.
We believe this shaky financial position has potentially important political
implications. Our past research has shown that in less developed countries
political instability historically has been sparked more often by specific
government economic policies-such as spending cutbacks, retraction of
iii Secret
ALA 85-10125
December 1985
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subsidies, wage restraints-that hurt large or influential groups than by
general economic hardship as such. We believe this is primarily because
such policies provide a rallying point for opposition political forces. We
expect, that, in the case of Chile, the likelihood of more austere policies
next year will again provide a focus for opposition activity. We judge that
both moderate opposition forces and the radical left will attempt to exploit
this public antipathy, and, as a result, Pinochet may face a significant rise
in protest activity by mid-1986.
Even if Pinochet-whose manipulative skills are widely recognized-is
able to avoid providing his opponents economically inspired opportunities,
he is far from out of the woods. Recent economic studies by academic
researchers, US econometric services, and the World Bank project contin-
ued external constraints on Chile's economic development over the next
decade. Pinochet is counting on
a future economic upturn to enable him to win uncontested reelection in
the 1989 presidential plebiscite. Consequently, we foresee greater govern-
ment intervention in the economy in the years ahead to promote develop-
ment in hopes of serving Pinochet's political objectives.
There is little prospect that US interests will benefit from economically
related problems in Chile. The regime could join Latin American propo-
nents of a more politicized approach to regional debt if the financial
squeeze tightens. Santiago's drive to increase exports threatens tougher
competition for US producers at home and in third countries, as well as
greater difficulty penetrating the Chilean market. In a worsening political
conflict, moreover, Washington's goal of a peaceful transition to democra-
cy in Chile will be caught between the partisan and increasingly polarized
objectives of Pinochet and his opponents.
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Contents
Key Judgments
The Financial Turning Point
Effects of Policy Shift
3
Pinochet's Tough Adjustments
3
Bankers' Support Regained
4
The Knife's Edge
5
Longer Term Economic Prospects
11
Implications for the United States
12
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FALKLAND ISLANDS
(ISLAS MALVINAS)
(administered by U.K.,
claimed by Argentina)
Boundary representation is
not necessarily authoritative.
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Chile's Growing Bind:
Financial Solvency Versus
Political Stability
Until 1981, the Pinochet government's thorough-
going, free market economic reforms generated a
boom that helped avoid discontent over continuing
tight political control and made Santiago a low risk
for foreign creditors. However, a 14-percent contrac-
tion in the Chilean economy in 1982,' caused by world
recession and the spillover of the Latin debt crisis,
provoked several incidents of domestic unrest that
year. This downturn, in our view, was the primary
impetus for the political protest movement that began
soon thereafter. According to the US Embassy 0
President Pinochet-concerned
that opposition forces were capitalizing on economic
hardship-ignored potential financial problems in
1984 and decided early in the year to stimulate the
economy.
The resulting "miniboom" mitigated economic dis-
tress, at least for the middle class, but, within a short
period of time, created a major financial bind. Indeed,
according to US Embassy and financial reporting, by
late in the year, bankers became reluctant to supply
Santiago with sufficient new money to support contin-
ued growth, which the regime believed was essential
in order to deny its opponents the political initiative.
Pinched by a shortage of investment funds and pushed
to conserve foreign exchange, Pinochet now faces the
same tough economic choices confronting most of
Latin America's civilian leaders. The way he responds
to the external pressures for debt repayment and the
internal pressures for economic growth will not only
determine the country's economic future, but may
also affect the strength of the political protest move-
ment and the government's international economic
and political standing.
In early 1984, a declining standard of living and the
lessons from a year of domestic unrest led Pinochet to
adopt more growth-oriented policies in an effort to
alleviate discontent. Democratic opposition forces
called for reducing unemployment through increased
state spending, according to press reports. Diplomatic
reporting indicated that Chilean businesses were
pressing for debt relief and faster economic growth.
Within the government, as well, pressure was building
for more expansionist measures.
then Interior Minister Jarpa advised
Pinochet that growth-oriented policies were needed to
reduce the popular grievances that were fueling politi-
cal protests. after
a large antiregime demonstration in March 1984,
Pinochet finally decided to heed this advice and
replace his strict free market advisers with a team
favoring state-directed economic expansionism. F_
In its first public address, the new economic team-
made up of Economy Minister Collados and Finance
Minister Escobar-pledged to increase public spend-
ing and state enterprise investment to spur a strong
economic recovery. Collados immediately increased
outlays for housing, mining, and infrastructure im-
provements to reduce unemployment, according to
press reporting. In May, financial statistics showed
that the economic team eased domestic credit by
injecting liquidity into a banking sector crippled by
bad debts. Moreover, the US Embassy reported that,
throughout the summer, the government also provided
new subsidies and higher domestic price supports to
promote domestic manufacturing, agricultural pro-
duction, and export growth. These fiscal stimulants
sparked rapid recovery-averaging over 7 percent in
the second and third quarters of the year-according
to Chilean Government statistics.
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According to a review of academic studies, the Chil-
ean Government's direct role in managing the econo-
my grew steadily between World War II and the
election of President Allende in 1970. Various admin-
istrations used price, interest rates, credit, and wage
controls to manage an economy dependent on copper
and subject to wild fluctuations caused by changes in
international metal prices. Strong copper markets-
accounting for over 80 percent of export revenues
during most of the postwar period, according to trade
statistics provided the state with tax revenue to
fund domestic investment and to grant wage hikes.
High import tariffs and quotas sheltered public and
private corporations from international competition.
To reduce the economy's vulnerability to declines in
copper prices, the government promoted the growth of
state corporations, which may have controlled as
much as 39 percent of domestic production, according
to academic research.
Allende attempted to consolidate this trend by com-
pletely socializing the economy in the early 1970s.
His ambitious efforts to nationalize private indus-
try-including the nation's copper mines, mainly
owned by US companies-bankrupted the national
treasury. External aid ebbed to a trickle, foreign
investors fled, and access to Western credit dried up.
Allende's economic team-short offunds-resorted
to printing money, which boosted inflation to over
1,000 percent in 1973. With the economy internation-
ally bankrupt and the country in political turmoil,
the military seized control of the government in
September 1973.
To cope with the economic chaos, Pinochet turned to
a group of orthodox, free market economists-many
groomed at the University of Chicago-then known
as the "Chicago Boys." They revitalized private
markets by eliminating controls on prices, interest
rates, and foreign exchange. They slashed state subsi-
dies, cut spending and borrowing, and sold most
nationalized firms to private investors. They also
dismantled barriers to foreign investment, reduced
tariffs, and eliminated trade controls. Foreign lenders
and investors rushed to Chile, igniting a boom in
1976 that lasted until 1981. The results were impres-
sive-according to government statistics, economic
growth increased at an annual rate of over 6 percent,
as inflation fell from nearly 175 percent to under 10
percent. However, international financial data show
that Chile's debt tripled to over $15 billion, pushing
debt service to an unsustainable 92 percent of ex-
ports.
According to Embassy reporting, Chile's free market
search for its international comparative advantage
led to a surge in commodity production, while ineffi-
cient manufacturing industries languished. Produc-
tion of agricultural staples and textiles nearly died in
the face of more efficient foreign competition, while
exports offishmeal, lumber, and fruits rocketed.
Copper as a percentage of exports fell from 80 percent
to 47 percent by 1983. The policy, however, left Chile
dependent on world market prices and foreignfinanc-
ing.
The experiment went awry when Santiago allowed
the peso to become overvalued in an apparent attempt
to suppress inflation. This encouraged Chileans to
borrow heavily overseas and to import cheap luxury
goods. When the international debt crisis hit, finan-
cialfows to Chile ceased. According to financial
observers at the time, bankers were surprised to find
that Chilean firms, having squandered their loans
through purchasing nonproductive corporations and
ill-considered investments, were bankrupt. The net
effect of the funding cutoff, coupled with a world
recession, was the 14 percent plunge in GDP in 1982.
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Effects of Policy Shift
While it is not possible to document a clear cause and
effect relationship, we believe the shift in economic
policies was a factor in the reduced level of protest
activity in the first half of 1984. The regime's appar-
ent responsiveness to the plight of the populace-
rather than any immediate results from the new
measures-seemed to undercut the ability of opposi-
tion forces to mobilize popular participation in protest
activity. Lack of support from labor and the middle
class in particular thwarted efforts by Pinochet's
opponents to stage a national strike. The government
shrewdly tailored some relief measures, such as pro-
viding subsidies for refinancing middle-class, busi-
ness, and trucker loans, while boosting investments by
state corporations to generate work for union and
unskilled labor, according to US Embassy reports.
however, the switch to growth-oriented policies raised
foreign bankers' apprehensions in late 1984 about
debt servicing prospects, as Chile's current account
position deteriorated throughout the year. Central
Bank data indicated that the growing economy helped
spur imports, while low copper prices kept export
revenue down. This shrank the trade surplus in the
first half of 1984 to $390 million-far below Central
Bank economic projections-and left Chile without a
trade surplus in the second half. Instead of making
appropriate economic adjustments, the US Embassy
noted, Santiago resorted to heavy short-term borrow-
resolve against new lending,
Santiago also began pressing its creditors for an
additional $500 million in longer term loans by
trading on its past reputation as a sound credit risk.
Bankers not only turned down the request, but,
according to the US Embassy, the bank advisory
committee representing Chile's commercial lenders
threatened in August to withhold nearly $200 million
in promised loans. Moreover, a resurgence of protest
activity in September contributed to stiffened creditor
When the government imposed a
future access to credit.
state of siege in November 1984, bankers threatened
not to reschedule Chile's 1985-87 debt and to cut its
Pinochet's Tough Adjustments
Over the following few months, we believe two factors
led Pinochet to shift economic policy again:
? His concern that reduced foreign lending would
provoke a payments crisis.
? His belief that stern political measures had put his
opponents on the defensive, reducing their ability to
exploit economic issues.
Thus, in February 1985, he installed a new economic
team, including new Finance Minister Buchi, that
promised a return to strict free market policies. The
financial press reported that the government delayed
cost-of-living increases for pensioners, froze salaries
for public employees, cut overall government spending
by 10 percent, and reduced its direct financial assis-
tance to private banks.
To further bolster creditor confidence, Chile pushed
to improve its international financial position. In
February the government reached preliminary agree-
ment with the IMF for a three-year, $750 million
extended fund facility. After a major earthquake
struck Santiago and the principal port at Valparaiso
last March, the Fund announced it was raising the
budget deficit target to permit public spending for
reconstruction. Meanwhile, according to the US Em-
bassy and press reporting, the economic team pushed
a wide range of promotional measures and incentives
which they hoped in time would spur export growth,
thus earning additional foreign exchange to pay the
debt.2 In March and June, Chile devalued the peso,
improving its export competitiveness, and press re-
ports indicate that another devaluation is likely soon.
'According to Embassy) I Santiago has promot-
ed its minerals, lumber, fruit, and fish products in new markets by
increasing export credit and staging promotions at trade fairs.
Additionally, the government is considering new tax and investment
incentives to encourage added processing that will raise export
values. The US Embassy also reports that Santiago is proposing
legislation to provide direct incentives to export industries-includ-
ing a 10-percent export rebate scheme, increased export financing,
and a new export insurance facility. Further, PROCHILE-the
government export promotion agency-has been restructured to
develop programs to help small producers penetrate overseas
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Bankers' Support Regained
The change in the economic team delayed the com-
plex debt financing package for several months. =
bankers were
still nervous about lending to Chile, offering only
$300 million in new money-a fraction of the $2
billion originally requested for 1985 financing needs.
Meanwhile, the US Embassy reported that Chile's
dwindling trade surplus-hurt by falling commodity
prices-forced Financial Minister Buchi to draw
down reserves to keep debt servicing current.
At this point, several factors led bankers to renew
financial support for Santiago,
On the economic side was
Chile's worsening payments position and Pinochet's
positive free market shifts. On the political side was
the President's decision last June to lift the state of
siege, reflecting both international political pressures
and, in our judgment, Pinochet's view that protest
activity was containable. After Santiago relented in
its opposition to multilateral development bank bor-
rowing, the World Bank approved a $300 million
cofinancing loan with private bankers and granted
several project loans. Meanwhile, Chile's IMF pro-
gram was cemented in July, setting the stage for a
Paris Club agreement to reschedule $170 million of
public debt. Commercial bankers began syndicating a
three-year $1.1 billion loan, while rescheduling $5.9
billion of 1985-87 maturing debt.
The Economic and Political Cost
Santiago's moves to set the stage for new lending
aggravated domestic economic stagnation, according
to US Embassy reporting. Tight foreign exchange and
the uncertain domestic climate have inhibited domes-
tic investments. Government statistics show economic
growth neared zero in the second and third quarters of
1985, and unemployment oscillated around 14 per-
cent. Additionally, the government's cancellation of
cost-of-living increases and other belt-tightening mea-
sures caused real wages to fall 8 percent by August
over the same period last year.
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within the government.'
As in 1983, we believe this economic stagnation is
again causing general domestic dissatisfaction and
greater middle-class support for an accelerated transi-
tion to civilian rule. Pinochet's cutbacks in social
spending and financial relief programs, the eroding
living standards, and an uncertain business environ-
ment have left the government vulnerable to opposi-
tion forces. In August, the leaders of the democratic
opposition finally hit upon a device for channeling
growing middle-class frustrations over economic hard-
ship and political deprivation-the so-called National
Accord. This platform, agreed to by 11 opposition
groups ranging from center right to center left, is the
first broadly supported formula for transition to civil-
ian rule that also has some appeal for moderates
Public opinion polls, US Embassy reporting,
make clear that dissatisfaction also is
latest protest activity.
growing among the lower classes, especially in the
slum neighborhoods surrounding Santiago and other
major cities. The Communist Party has doubled its
membership by recruiting large numbers of unem-
ployed workers and students, according to the US
Embassy. Until recently, organized labor-divided by
Pinochet's efforts to depoliticize and downgrade union
influence-has not been responsive to Communist
appeals for a general strike. Nevertheless, we believe
the mood among the rank and file may be shifting as
union members have taken a more active role in the
The Knife's Edge
We believe this three-year process of economic and
political pushing and pulling has left the competing
forces in Chile, as well as interested international
players, each at its own crossroads. The government is
again confronted with the challenge of formulating
economic policies that will deprive its opponents of
exploitable economic issues without forfeiting its in-
ternational creditworthiness. The opposition political
forces potentially have another opportunity to rally
popular opinion and put the regime further on the
defensive. International creditors are calculating how
much more money to risk in hopes of recovering
existing loans. Interested foreign observers are con-
cerned about finding a way to encourage responsible
political forces in Chile to work out their own peaceful
transition to democracy.
The US Embassy reports that the regime, for its part,
now intends to assuage rising discontent over the
economy by expanding the domestic money supply-a
move reminiscent of state-directed growth policies in
1984. We believe that this option is preferred because
by July, according to US Embassy reporting, Santia-
go already was bumping up against the public-sector 25X1
fiscal deficit target set with the IMF for 1985, leaving
little room for increased government spending in the 25X1
second half. Based on Chile's recent experience, we
believe increased monetary expansion will produce an 25X1
initial spurt of growth and inflation, increasing import
demand. Unless Santiago receives waivers from the
IMF on its monetary targets, however, we judge it
will remain vulnerable to a suspension of multilateral
and commercial loan disbursements at the same time
its foreign financing requirements begin rising.
Although negotiations with foreign banks have been 25X1
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the turn of the year,
Chile will not receive the full complement of 25X1
funds right away. As it is, we estimate the current
account deficit will reach $1.8 billion for 1985. To
meet this gap, Santiago has drawn down reserves to
remain current on its payments until bank funds are
made available. Because of this, Chile is near finan-
cial insolvency, having already drawn down over 80
percent of its $1 billion net foreign exchange reserve
cushion, according to US Embassy reporting. Foreign
exchange reserves also have been eroded, according to
press reports, by a decline in the repatriation of profits
by Chilean firms and by increased capital flight
stemming from growing nervousness over the political
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The Impact of the National Accord
on Chile's Political Situation
The Accord. In late August, 11 leading parties, acting
in concert with Cardinal Fresno, composed their main
differences and formulated moderate proposals to the
government for a transition to civilian rule. They
overcame the major sticking point-whether to en-
dorse Communist participation in the political pro-
cess-by proposing all totalitarian parties be banned
by court action. Numerous other parties and special
interest groups have since endorsed the accord.=
Pinochet rejected the accord and insists on sticking to
the drawn-out timetable for a transition to civilian
rule contained in the 1980 Constitution. In a major
speech in mid-September, he accused the accord's
proponents of wanting only to gain power and of being
soft on Communism.
abdication of power once responsible civilians are
ready to assume it. Key civilians in the government
reportedly also favor a more accommodating stance.
The Moderates' Strategy. The Embassy notes that
the alliance among the moderates is fragile and that
it may yet collapse over interpretation of key provi-
sions. At this point, however, the moderates appear
united in their readiness to be flexible; they have
publicly stated that virtually everything in the accord
is negotiable. They seem especially anxious to avoid
supporting antiregime violence because this would
leave them open to charges of collaborating with the
Communists and give the government a pretext for
ignoring the accord.
Pinochet, nevertheless, is concerned,
The US Embassy believes that some Army generals
will accept modifications of the 1980 Constitution
and that sentiment may be growing for the military's
We concur with several estimates by private-sector
forecasters that Chilean economic growth will remain
low-about 0 to 3 percent-over the next year and
probably beyond. In our judgment, cuts in govern-
ment spending will boost unemployment slightly
above 14 percent, while real wages will probably drop
in 1986 for the fifth year in a row as labor settlements
fail to keep pace with Chile's high inflation. Despite a
tightening of fiscal policy, the momentum of price
increases, coupled with more rapid money supply
growth, is likely to push inflation up to about 35
percent. World Bank assessments contend that Chile
cannot return to robust growth without increasing
domestic savings. These have tended to dry up during
Moderate leaders nevertheless believe that concrete
measures, such as legalization of political parties, are
needed to avoid greater political radicalization of the
country, according to press To
demonstrate that the accord enjoys broad national
support, the parties are pressing ahead with a peti-
tion-signing campaign that concentrates on the mid-
dle class. They are counting on Cardinal Fresno's
continuing involvement and are probably heartened
periods of high inflation because of Santiago's unwill-
ingness to maintain sufficiently high real interest
rates, leaving most banks with a dearth of investment
funds and heightening the risk of business failures.
Based on US Embassy reporting and on assessments
by US econometric forecasting services, we project
Chile-assuming no pickup in domestic unrest-is
again headed for a $1.7 billion current account deficit
in 1986, principally because of depressed commodity
export prices. A slowdown in the world economy, a
spurt in imports, higher interest rates, delays in loan
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that he will resume an active role
as mediator once the signature campaign gains mo-
mentum.
The Communists'Position. The Communists under-
scored their strength in urban slums by organizing
widespread violent demonstrations in September and
by conducting another demonstration in early No-
vember. Party leaders appear to be weighing the risks
of proceeding without cooperation from the moder-
ates, while the regime is determined to crack down on
protests. Meanwhile, the US Embassy reports that
the bombings that blacked out most of the country in
both September and November demonstrate the in-
creased capabilities of leftist terrorists.
Outlook. Because Pinochet probably realizes that his
backing within the government and the military is
uncertain and that resuming a state of siege could
hurt Chile's economy by reducing access to new loans
from international financial institutions, he is likely
to temper his actions somewhat. Nevertheless, if
terrorism escalates, he may reimpose the state of
siege, calculating that he can point to growing Com-
munist-led violence, rally armed forces support, un-
dercut the national accord, and ignore international
disbursement, or resurgent capital flight would pre-
cipitate an acute foreign exchange crisis, in our view,
probably causing Santiago to suspend its interest
payments temporarily.
If the experience of the past few years is a guide, the
linkage between political unrest and investor/lender
nervousness suggests that local discontent increases
the risk of Santiago's payments position quickly dete-
riorating. According to projections made by Chile's
bank advisory committee, funding from the IMF,
World Bank, and commercial creditors is in rough
balance with foreign financing requirements through
1986. If capital flight again picks up, we believe the
government would resort to restrictions on foreign
What the National Accord Proposes:
? An immediate end to restrictions on civil liberties.
? Direct presidential and congressional elections,
with no date specified.
? Permitting future amendments to the 1980 Consti-
tution, which is nevertheless implicitly endorsed.
? No witch hunt against members of the armed forces
after they return to the barracks.
? Banning "totalitarian"parties-implicitly the
Communist Party-by later court action.
? Avoidance of violence by its signatories.
It does not call for President Pinochet to step down
before his term ends in 1989.
exchange operations and the freezing of dollar ac-
counts, probably causing bankers to suspend credit-
as they did in January 1983-which would in turn
bring about contraction of the economy.
The prospects of such a financial crunch, in our
opinion, would force Santiago to again tighten the
fiscal policy as well as increase restrictions on the
money supply. We would anticipate additional cuts in
social spending, and we believe state corporations
would reduce their employment-creating investments
to shore up earnings that make up a major share of
government revenues. Earthquake reconstruction ef-
forts and other infrastructure-oriented projects would
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Figure 4
Chile: Selected Economic Indicators, 1983-86
Public Sector Deficit
Percent
-5 1983 84 85, 86a
Gross Foreign Exchange
Reserve
Billion US $
also probably be postponed to hold down import
requirements. According to press reporting, Pinochet
has even suggested that military spending might be
reduced, although this already is comparatively low,
and we judge that further cuts are unlikely.'
Real Wages
Percent
Inflation Rate
Percent
Gross Domestic Investment
As a percentage of GDP
6
Under these kinds of pressures, we believe the govern-
ment would again approach creditors for additional
lending. Based on current reports of continuing
banker nervousness over Chile, however, we doubt
Santiago would find much help. This could lead
Pinochet's spokesmen to request debt relief from the
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The March 1985 earthquake-that left $1.8 billion
in damages-has placed additional demands on Chi-
le's economy, according to US Embassy reporting.
Although Santiago received IMF approval to increase
domestic deficit spending from 3 to 3.5 percent of
GDP, this provides only $90 million for relief The
government freed another $150 million by delaying
pension and employee cost-of-living increases until
next year. Santiago's use of reserves to pay its debt
and its declining trade surplus also have limited
imports of goods necessary for reconstruction. Addi-
tionally, Chilean policymakers are torn between di-
recting investment funds to reconstruction or to the
export industries. Ignoring reconstruction could ag-
gravate domestic unrest, while failure to increase
export-oriented investment would reduce economic
growth and worsen the current account deficit over
the next several years.
bank advisory committee in forms such as capping
interest payments, resulting in negotiations that
would be watched closely by all Latin American
debtors.
Gross interest
payments
Political Repercussions
In some respects, Chile fits the pattern described in 4ili
Gross principal
past CIA research s on the relationship between eco- repayments
nomic problems and political instability. This research noted that specific government economic measures-
spending cutbacks, the retraction of subsidies, wage 0 1983 84 85a 86 a
restraints-that hurt large or influential segments of
the population are more likely to provoke instability
than general economic hardship shaped by the coun-
Figure 5
Chile: Debt and the Servicing Burden,
1983-86
try as a whole. The primary reason seems to be that 25X1
such policies provide a rallying point for opposition
forces. As noted earlier, there have been instances in
Chile since 1983 when tough government-imposed Thus, we believe that the continuing financial bind,
austerity measures clearly helped catalyze protests. the likelihood of tighter government economic policies 25X1
Moreover, in early 1984, when the government-in next year, and eroding living standards will lead to
apparent recognition of the phenomenon-granted increased discontent among a wide variety of groups.
additional relief for miners and other key groups, Based on US Embassy reporting, we see an increasing
support for the protest movement waned.
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Table 1
Chile: Balance of Payments
3.8
3.7 3.8 4.0
-2.8 -
3.4 -3.3 -3.5
Net services -2.1 -
and transfers
2.3 -2.3 -2.3
Net interest -1.7 -
2.0 -1.9 -2.0
Net other -0.4 -
0.3 -0.4 -0.3
Capital account 0.4
2.0 1.6 1.8
Long-term inflows 1.1
1.0 1.3 1.7
Principal -0.9 -
repayments
1.7 -2.0 -2.1
New borrowing 2.0
2.7 3.3 3.8
Short-term debt -0.8
1.0 0.2 0.0
Direct investment 0.1
0.1 0.1 0.0
pool of individuals who could be brought to rally
against unpopular government policy moves:
? There are increasing numbers of urban poor and
unemployed youth who are potential recruits for
radical leftist parties and terrorist groups.
? Among the middle class there is increasing disen-
chantment with economic policies that depress in-
come and employment prospects and limit credit
availability.
? As far as Chilean youth are concerned, as employ-
ment prospects for university students are becoming
bleaker, more of them are becoming radicalized.
In our judgment, over the next year, there will be a
sustained effort by both moderate opposition groups
and the radical left to exploit any government mis-
steps and capitalize on economically spawned social
discontent. Democratic political forces are more likely
to seek middle-class support for peaceful social mobi-
lization activity, while the far left probably will
engage in more frequent terrorism. In the absence of
steady economic growth or government concessions,
by late 1986 Pinochet may face a significant rise in
protest activity, assuming opposition forces continue
to present a relatively united front against the regime.
An Alternative Scenario
We believe there is a slight chance that President
Pinochet-whose manipulative skills are widely rec-
ognized by observers of the Chilean scene-could take
steps to deprive his opponents of the opportunity to
use the economic lever against him. Instead of replen-
ishing foreign exchange reserves, as called for in its
IMF program, Chile could direct loan disbursements
toward new job-creating investments of $500-800
million and press official and commercial creditors for
more lending. This would require waivers from the
IMF on performance targets to avert a suspension of
loan disbursements.
Pinochet could also use new funds, at least in the short
term, to ease discontent by injecting new spending on
a wide front:
? Direct debt relief for middle-class mortgagers and
small businesses.
? Cost-of-living increases for government workers and
wage hikes for nonpublic workers.
? Expanded public works and social help programs.
? Increased construction projects by government cor-
porations to reduce unemployment.
? Financial relief and government shipping contracts
for truckers.
? Subsidies and import protection for domestic
manufacturers.
? Expanded agricultural price supports.
Most of these "social subsidies" would be unsustain-
able into 1987, in our judgment, without strong and
continuing international support or a dramatic
strengthening of commodity prices. As far as interna-
tional lenders are concerned, we doubt they would be
willing to see funding diverted into social programs
that would only end up increasing Chile's financial
needs.
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Table 2
Comparison of Projections for
Leading Economic Indicators
Data
Resources,
Inc.
Wharton Chase Central
Econometric Econometrics Bank of
Forecasting Chile
Inc.
Gross domestic
investment
(as percent of GDP)
Current account
deficit
protect industries such as textiles.
Indicators that Pinochet was seriously thinking about
the "social subsidies" option would include:
? Replacement of free market members of the eco-
nomic team with more state-oriented advisers.
? An expanded policy formulation role for the Social
and Economic Council.
? Increased Chilean backing for initiatives by the
Cartagena Group of Latin debtors.
? Government proposals for new import regulations to
Longer Term Economic Prospects
Even if Pinochet is able to neutralize the economy as
an issue next year, he is far from out of the woods.
Recent economic studies by academic researchers, US
econometric services, and the World Bank indicate
that external constraints will continue to impede
Chile's economic development for the rest of the
decade. Despite the rescheduling of 1985-87 debt,
these sources project that Santiago will have difficulty
meeting its debt service burden because of heavy
dependence on copper exports.
IPinochet is count-
ing on a future economic upturn to enable him to win
uncontested reelection in the 1989 presidential plebi-
scite. Consequently, we believe the odds of Pinochet's
becoming disillusioned with his current economic
stabilization policies and turning to state-directed
growth to serve his political objectives will only
increase over time.
If Pinochet marches down this path, we believe the
state will take a heavy future role in this restructuring
of the economy and in directing credit into areas that 25X1
could fuel domestic expansion. Press reports indicate
that Chilean businessmen are already calling on the
government to develop an economic strategy heavily
oriented toward import substitution and export pro-
motion. Santiago is likely to make sure that the
investment projects it targets receive ample domestic
credit and preferential treatment in obtaining govern-
ment contracts and foreign exchange. At the same
time, we would expect to see some elements of a
"social subsidies" approach: agricultural price sup-
ports, which would reduce dependence on imports;
and increased trade barriers, which would spur
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Chile's Increased Dependence
on Multilateral Lending
Faced with commercial banker resistance to in-
creased lending to support economic growth, the US
Embassy reports that the Chilean economic team is
reversing a decade-old policy and seeking major
loans from multilateral and bilateral financial insti-
tutions. This policy reversal did not come easily,
because cut-
offs in funds from the development banks helped
destabilize the Allende government-a lesson not lost
on Pinochet. Nonetheless, Santiago acquiesced this
year after bankers insisted it apply for multilateral
development bank credits as a precondition to earnest
financial negotiations.
Chile is asking the World Bank for over $350 million
in 1985-$250 million in the form of a structural
adjustment loan plus guarantees for a $300 million
loan cofinanced with commercial bankers. Addition-
ally, Santiago will seek a $250 million structural
adjustment loan in 1986 and, according to US Em-
bassy reporting, over $100 million in various project
credits. The Inter-American Development Bank will
lend Chile over $500 million in 1985-86.
We also foresee Santiago requesting more US AID
funds to address growing economic problems. Chile's
increased emphasis on agriculture and road develop-
ment, set against strained domestic resources, pro-
vides the impetus. Further, Santiago will probably
seek expanded CCC credits, but use these funds for
the purchase of other commodities as Chile becomes
self-sufficient in grain. Taken together, we estimate
multilateral and bilateral sources could lend Chile
over $2 billion in the next three-year period-twice
as much as new bank lending-thereby heightening
Pinochet's dependence on these sources and, conse-
quently, his vulnerability to associated international
political pressures.
growth of domestically produced goods. In addition,
the government would probably push incentives for
export-oriented industries, which are the key to meet-
ing future debt servicing requirements.
We believe that the end result of growing state
intervention and more nationalistic policies will be a
substantially transformed economy. The move away
from free market policies to the use of wider ranging
controls and increased expenditures to guide and
subsidize development will once again, in our view,
lead to stagflation, similar to Chile's economic perfor-
mance between 1930 and 1973. Despite government
efforts to promote exports, Chile's balance of pay-
ments will remain in disequilibrium and vulnerable to
external shocks that would precipitate periodic pay-
ments crises.
Implications for the United States
There is little prospect that US interests will benefit
from economically related problems in Chile. In view
of Santiago's continuing economic troubles, which
have occurred despite its willingness to work with the
IMF, Chile could be cited by other debtors as an
example of the failure of the post-1982 approach to
debt problems. As far as Chile is concerned, we expect
that, given the political situation, the government will
press for more flexibility in resolving its financial
dilemma. This could include more political activism,
ranging from direct appeals for US Government
backing with commercial lenders to more active col-
laboration with other debtors in the Cartagena Group.
We believe the Pinochet government will broach a cap
on interest payments or other forms of debt relief in
the event bankers refuse new loans. Other Latin
debtors could be encouraged to follow suit, pushing
debt rescue programs in new and uncharted direc-
tions.
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Chile's pressing need to increase exports will probably
result in growing bilateral frictions. We believe Santi-
ago will look to its traditional export markets-such
as the United States-in the next three years to
absorb its increased production of copper and fruit,
posing tougher competition for US producers at home
and in third-country markets. Additionally, Chile is
eyeing the potential for its arms industries to earn
foreign exchange through increased exports. Growing
exports by countries like Chile, Argentina, Brazil, and
other Third World providers will help countries, such
as Iran and Iraq, which offer tempting arms markets.'
Moreover, the pressure to sell could easily play into
the hands of gray arms market purchasers who are
willing to pay up front in hard currency.
Finally, a worsening political conflict in Chile would
affect US interest in seeing a peaceful transition to a
democratic government. Moderate opposition forces
would expect the United States, in our view, to press
the regime to adopt an accelerated transition timeta-
ble. Pinochet, on the other hand, would seek US
economic support, but he would not necessarily agree,
in exchange, to hasten the return to civilian rule.
The shift away from strict market-oriented policies
also would damage US commercial interests. Multi-
national corporations will remain vulnerable to tough-
er regulations on their foreign exchange transactions
and investment projects. At the same time, higher
tariffs and import controls will limit the ability of US
exporters to make competitive gains in the Chilean
market.
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