Fitch affirms Chile's foreign-currency IDR at 'A+'; outlook stable

Fitch Ratings has affirmed Chile's Long-term Foreign- and Local-currency Issuer Default Ratings (IDRs) at 'A+/AA-'. Fitch also affirms Chile's senior unsecured foreign bonds at 'A+'. The Rating Outlook for the Long-term IDRs is Stable. The Country Ceiling has been affirmed at 'AA+' and the short-term foreign currency IDR at 'F1'.

KEY RATING DRIVERS

Chile's ratings are supported by a credible macro policy framework centred on a strong sovereign balance sheet, inflation-targeting regime and flexible exchange rate. Strong governance standards support the stability of these policies. These strengths counterbalance Chile's low per-capita GDP and high commodity dependence relative to peers.

Fitch projects growth will slow to 1.7% from 2.1% in 2015, marking a third year of sluggish activity for Chile's economy. Lower copper prices and Chinese growth have weighed further on the key mining sector. Non-mining activities have had a lacklustre performance as well despite the favourable conditions presented by a weaker peso and cheaper energy, partly reflecting persistent weakness in local confidence. Average growth projected at 1.9% in 2014-2016 is the second-lowest in the 'A' category and also below the median among investment-grade sovereigns with similar degrees of commodity dependence.

Fitch believes the slowdown in growth is largely structural in nature, clouding prospects for per-capita income convergence with the 'A' median. The reform agenda address key bottlenecks in education and social inequity, but potential benefits should materialise over a long horizon and have been overshadowed in the near term by business concerns over the implications on profits and investment prospects. The authorities have put greater emphasis on productivity in 2016, unveiling a state-backed infrastructure investment fund and measures to facilitate financing, cut red tape and boost service exports.

Inflation remains above the official target (3% +/- 1pp) on the lingering effects of peso depreciation, but expectations remain well anchored. The central bank has raised the policy rate by 50bps to 3.5% since October to contain inflationary pressures but has moderated its tightening bias on the weaker economic outlook. Accommodative monetary conditions have supported borrowing in the weak economic context, specifically for mortgages, although low confidence has restrained an overall pick-up in credit.

Chile's external finances continue to show flexibility to the weaker external backdrop. The current account deficit rose to 2% of GDP 2015 from 1.3% in 2014 on lower copper prices late in the year, although this effect is naturally offset in part by lower profit repatriations by foreign mining companies. The reduction in the CAD since 2013 is unusual for a commodity exporter given price moves.

Public finances are under pressure from weak growth and copper prices, although the 2014 tax reform has limited the deterioration. The central government deficit of 2.2% of GDP of 2015 was only slightly above budget and well below an official October projection despite the weak revenue backdrop, reflecting strong gains from the tax reform. Fitch projects the deficit will rise to 2.8% in 2016 due to the impact of weak growth and copper prices, although the deterioration will be limited by a spending cut (0.25% of GDP) announced in February. Fiscal dependence on copper has been reduced considerably, as lower prices and tax reforms since 2010 have lowered its share in revenues to around 5% from 21%.

The authorities are targeting a 0.25pp-of-GDP reduction in the structural deficit per year through 2018 (when a next administration will take office), and Fitch assumes a similar consolidation pace thereafter. The 2pp of GDP in additional revenues expected from the tax reform by 2018 (on top of 1pp since 2014) offer room for progress on both consolidation and social spending priorities. Future progress on higher education spending has been conditioned on the availability of fiscal revenues, supporting fiscal prudence and the credibility of the consolidation strategy. Further cuts to the structural parameters for growth and copper prices may occur and weaken the estimated structural revenues on which future budgets are based, underscoring a need for spending restraint to contain fiscal deficits. Fitch projects the effective deficits will remain moderate at below 3% of GDP during the forecast period.

Chile's strong sovereign balance sheet remains a key credit strength, but a rising public debt burden is eroding fiscal space to confront shocks. General government debt reached 17.5% of GDP in 2015, more than doubling since 2010. Fitch projects a gradual reduction in the primary deficit could stabilise debt at around 27% of GDP by 2019, below the current 'A' median of 45%. Net debt (considering liquid deposits and stabilisation funds) is among the lowest in the 'A' category but is also rising in a sustained manner. The strong local investor base provides scope to support the rising debt stock, and low non-resident holdings of local treasury securities (3% as of 2015) mitigate sensitivity to global interest rate trends.

Despite low approval ratings, the administration has achieved progress on reforms: expanded free higher education coverage, revamped teacher training and salaries, and technical fixes to the 2014 tax reform. A recently approved bill to strengthen labour unions faces an uncertain fate following judicial strike-down of a key provision. Policymakers have tightened campaign finance laws and anti-collusion mechanisms in response to recent corruption cases, in an effort to uphold relatively strong governance standards. The possible content of a pledged constitutional reform is unlikely to be clear for some time, as the outlined process, beginning with public consultation in 2016, would span past the next election in late-2017.

RATING SENSITIVITIES

The main factors that, individually or collectively, could lead to negative rating action are:

--Failure of growth and investment to recover materially;

--Sustained deterioration in public debt dynamics and/or erosion of fiscal policy credibility;

--Increased external vulnerability stemming from higher external indebtedness and/or erosion of external buffers.

The main factors that, individually or collectively, could lead to positive rating action are:

--Improvement in medium-term growth prospects that narrows the per-capita income gap with peers;

--Significant improvements in the country's fiscal and external balance sheets.

KEY ASSUMPTIONS

--Fitch's base case assumes that China's economy slows in a sustainable and orderly manner, and that copper prices do not deviate substantially from current levels;

--The investment plans of Codelco and other private sector companies are sufficient to maintain broadly steady copper production;