Long a beacon of economic stability in South America, Chile has been buffeted lately by the global rise in inflation. Can a key element of its monetary policy help it weather the storm?

Waves crashing into lighthouse

Alejandra Daroch , Domingo Russi and Jaime Carey Astaburuaga

September 30, 2022 12:00 AM

One of the most important macroeconomic factors worldwide, inflation is constantly under the microscope: analyzed and discussed by economists, politicians and business leaders. In the last few months, however, rates of inflation around the globe have drawn more attention than usual due to the alarming increases many countries have experienced. A number of events have triggered these jumps, one of the most important of which is Russia’s invasion of Ukraine.

Latin America has not been spared. A recent report from the United Nations, “Repercussions in Latin America and the Caribbean of the Russo-Ukrainian War: How to Face This New Crisis?”, predicts that regional inflation in Latin America will increase from 6.6% in 2018 to 8.1% in 2022.

The Chilean economy in particular has been affected by both global factors and internal events—including, significantly, the uncertainty of the results of its constitutional process, which may conclude with the approval of a new Magna Carta to be voted in a mandatory plebiscite on September 4, 2022. In early August, the National Statistics Institute of Chile reported that the consumer price index (CPI) had increased 8.5% thus far in 2022 and 13.1% over the previous 12 months—the highest increase since 1994.

As annual inflation in Chile continues to rise—due primarily to food and energy prices—use of the inflation index Unidad de Fomento (UF) in a variety of transaction types has become extremely important, unlike previous years in which the UF, due to low inflation, typically had a nonmaterial (or at least less relevant) effect on the economy.

The UF, created in 1967, is determined monthly based on the variation of the CPI during the previous month. It is published daily, in its readjusted value, by the Chilean Central Bank. It generally reflects the prices of domestic goods and services, such as health care, education and real estate. Likewise, it’s used in Chile for almost all mortgage loans, car loans, lease rents and insurance premiums. Conversely, it is not common to see salaries in Chile indexed to the UF. As a result, when the rate of inflation is high (as it is now), the purchasing power of workers is weakened.

In mergers-and-acquisitions transactions, although it’s not the general rule, it’s common to see parties agreeing to establish purchase prices according to UF. Doing M&A deals in UF is intended to account for the risk that the prospective seller may face when the agreement includes a deferred closing of the transaction—in which case inflation may vary substantially between the deal’s execution and closing.

Such a variation could of course have a significant impact on the purchase price. For example, in a recent local asset transaction whose price was agreed to by the parties in UF and the closing occurred three months later, the value of the UF increased and the purchase price increased accordingly by about $20 million in that timeframe.

Regional inflation in Latin America will increase from 6.6% in 2018 to 8.1% in 2022."

Other operations in which UF has become increasingly relevant are local credit agreements and investment instruments. Chilean banks usually resort to UF loans to ensure that the value of the money loaned will be maintained during the term of the loan or credit agreement. Market participants typically prefer UF-indexed or -denominated investment tools as well. It’s important to note that when inflation rates are high, the use of UF in credit agreements and investment instruments will result in an increase of the financial cost.

It’s worth considering that the application of the UF to a specific transaction does not depend only on the voluntary agreement of the parties thereof—it’s already included in several Chilean statutes that relate to corporate matters and foreign investments in Chile, such as the Corporations Law and the Funds Law. The former provides that the subscription price of company shares must be readjusted by UF if there’s a deferred payment of the subscription price—and that shareholders who exercise their withdrawal rights from closed corporations must receive the book value of the UF-readjusted shares. The Funds Law, in turn, establishes that dividends not paid in a timely manner to the partners of the relevant fund must also be adjusted by the UF variance. Accordingly, foreign and domestic investors who seek to invest in Chilean corporations and funds should give special consideration to these statutes, as they directly affect the value of their investments.

In Chile, the use of UF across a variety of transactions will likely continue, as inflation is expected to continue to rise, at least in the short term. Given this, anyone involved must carefully assess whether to enter transactions in UF, especially in times of high inflation. Regardless, Chilean institutions have demonstrated a serious and professional sense of purpose in adopting measures to contend with such economic complexities—the Central Bank has adopted healthy measures such as increasing the monetary policy rate, and we expect that such acts will continue to be adopted with sound technical motives.

Alejandra Daroch is partner of Carey and co-head of the firm’s Corporate / Mergers & Acquisitions / Banking & Finance / Insolvency, Bankruptcy and Restructuring / Capital Markets Groups. Her practice focuses primarily on advising international and local clients in mergers and acquisitions, including negotiated transactions, auction processes, mergers, joint ventures, private equity, securities and debt.

Jaime Carey A. is Carey's managing partner and co-head of the firm's Tax Group. His practice focuses on personal and corporate tax planning, local and international tax consulting, project financing, mergers and acquisitions and foreign investment transactions.

Domingo Russi is an associate at Carey. His practice focuses on corporate and commercial law, mergers and acquisitions, capital markets and general practice.

Headline Image: istock/Milan_Jovic, ISTOCK/VALENTINRUSSANOV

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