Can Governments Replace Markets? Lessons from Chile’s Pandemic Credit Interventions

An IMF study on Chile shows that during the COVID-19 capital flow crisis, government-backed credit guarantees and central bank liquidity jointly enabled firms to shift to cheaper domestic borrowing. The findings highlight that well-coordinated public interventions can temporarily substitute private markets during sudden stops.

As global financial markets convulsed during the early months of the COVID-19 pandemic, emerging economies like Chile found themselves abruptly cut off from international capital. In response to this “sudden stop,” Chile’s government launched an aggressive suite of credit support programs designed to keep its firms afloat. A new working paper authored by Miguel Acosta-Henao, Andrés Fernández, Patricia Gomez-Gonzalez, and Ṣebnem Kalemli-Özcan, explores the impact of these interventions. Published by the International Monetary Fund’s Research Department in collaboration with the Central Bank of Chile and Brown University, the study provides a rare, data-rich analysis of how public policy can offset collapsing private financing during moments of acute stress. Through a combination of micro-level firm data and a structural economic model, the paper investigates the efficacy and limits of government actions to replace missing capital flows.

A Sudden Stop and a Swift Policy Reaction

Chile’s financial system was hit hard in early 2020 as foreign investors rapidly withdrew from emerging markets. Cross-border bond flows fell sharply, and the country’s corporate risk premium, measured by the CEMBI spread, more than doubled. Access to international financing dried up, particularly for small and mid-sized firms. Recognizing the danger to its real economy, the Chilean government launched two major initiatives: the Credit Facility Conditional on Lending (FCIC) and the sovereign guarantee program FOGAPE-COVID. The FCIC offered low-interest loans from the Central Bank to commercial banks, provided they increased lending to smaller firms. FOGAPE-COVID, on the other hand, guaranteed up to 85% of new working-capital loans to firms with annual sales below a set threshold, significantly lowering the credit risk for banks.

Together, these policies were worth nearly 20% of GDP, a scale seldom seen in the developing world. Their aim was clear: substitute for the international capital market by redirecting credit flows through domestic institutions. But the real question was whether such a strategy could work in practice, especially without triggering distortions or inefficiencies.

Evidence from a Natural Experiment

The authors took advantage of a unique feature in the design of FOGAPE-COVID: its eligibility criteria were based on firms’ 2019 sales, with a sharp threshold at 1 million UF (a Chilean inflation-indexed unit of account). This created a natural experiment. Firms just below the threshold were eligible for credit guarantees, while those just above were not, despite being similar in every other respect. Using a regression discontinuity design (RDD), the researchers found that eligible firms increased their domestic debt share by 9.4 percentage points relative to their ineligible counterparts.

This shift had macroeconomic significance. Eligible firms made up around 18% of Chile’s gross output, and their increased borrowing in the early months of the crisis accounted for roughly 1% of national GDP. Notably, these firms borrowed more from the same banks that also served ineligible firms, highlighting that the change was not about access but about pricing. In essence, the guarantee program reduced the cost of domestic borrowing enough to drive a decisive shift in firms’ financing mix from foreign to local lenders, and from foreign currency to Chilean pesos.

What Happened to the UIP Premium?

A central mechanism behind this substitution was the reduction of the so-called UIP (Uncovered Interest Parity) premium. Normally, Chilean firms face a 4% premium when borrowing in local currency versus foreign currency, even from domestic lenders. During the crisis, this premium initially widened but then disappeared entirely for firms eligible for FOGAPE. Crucially, this was not due to an appreciation of the peso or improved conditions abroad. Rather, it was driven by a drop in the interest rates offered on domestic loans to eligible firms, thanks to the guarantees. Ineligible firms, meanwhile, continued to face the elevated UIP premium. The authors confirmed this pattern using loan-level data, further establishing the policy’s precision in targeting the firms most in need.

Why Both Policies Were Needed

To understand why these results occurred and to explore what would have happened under different scenarios, the researchers built a small open economy model with heterogeneous firms. In the model, firms differ in how much international collateral they can offer, and thus in their ability to borrow abroad. When a sudden stop hits, larger firms with international collateral shift to domestic debt, while smaller firms face tightening constraints. Absent intervention, the spike in demand for domestic credit raises local interest rates, especially for smaller firms.

The model shows that neither FCIC nor FOGAPE alone could fully restore credit conditions. FCIC provides liquidity to banks but doesn’t reduce their risk aversion. FOGAPE improves access but can increase demand to the point of driving up rates. Only when both policies are deployed in tandem does the system stabilize: banks lend more, interest rates fall, and firms can replace foreign financing with affordable domestic credit. This outcome mirrors what the Chilean data reveals.

Short-Term Fix, Long-Term Lessons

Chile’s experience offers an important lesson for other emerging markets: during moments of extreme capital market stress, well-targeted and complementary policies can allow governments to temporarily substitute for private financing. The FCIC-FOGAPE duo worked because they addressed both sides of the problem, liquidity and risk. But the authors caution against overreliance on such tools. Extended use of guarantees and subsidized lending could create distortions, moral hazard, or strain public finances. Nonetheless, when deployed swiftly and temporarily, these measures can buy time, preserve productive capacity, and soften the blow of external shocks. As global financial cycles become more volatile, this case study provides a compelling roadmap for future crisis responses.