CAPITAL MARKET DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN
A Strategy Proposal
Document prepared by the staff of the Infrastructure and Financial Markets Division
CAPITAL MARKET DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN A Strategy Proposal
Prepared by: Jesse Wright, Martin Chrisney and Antonio Vives Infrastructure and Financial Markets Division
Summary and Recommendations I.
The Problem in Capital Markets
Savings and Capital Markets
The Structure of Capital Markets
The Bank’s Mandate
The Bank’s Experience
The Bank's Strategy
CAPITAL MARKET DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN A Strategy Proposal Summary and Recommendations
Perhaps in no other activity is the pace of innovation as great or the cost of failure so high as in capital markets. When the countries of Latin America and the Caribbean enter the 21st Century, the structure of the Region’s capital markets will be as different as today’s markets differ from those of the 1970s. The worldwide forces of change are rapid advances in information technology, an accelerated pace of financial innovation, greater private sector participation, and the globalization/integration of domestic markets. At the same time, the lessons from recent currency crises, that threatened to spread throughout the Region’s stock and bond markets, point to the consequences of an excessive dependence on foreign portfolio investment, and especially, investments in highly mobile, short-term instruments. It is axiomatic that savings are key to sustainable, long-term growth. In the Region, however, low domestic savings have been the handmaiden of weak capital market development leading to a greater reliance on external debt. One necessary condition for financial savings is a capital market that can provide accessible and economical instruments to encourage savings and lower the costs of financial transactions. Furthermore, as intermediaries of those savings, efficient capital market institutions will improve the allocation funds to alternative productive investments in the corporate and public sectors. Domestic financial systems within the Region differ greatly owing to the separate economic, political and social development paths chosen. For this reason, the Bank’s capital market strategy must recognize these differing stages of financial development and their impact on capital market institutions. Nonetheless, common themes and challenges will face the Region in the coming years. To meet these challenges it is proposed that the Bank adopt a dedicated capital market strategy aimed at (a) raising the level of savings and improving its composition; (b) enhancing the economic efficiency of capital markets, and (c) promoting the harmonization and integration of the Region’s capital markets. The elements of the capital market strategy identified here should serve as a guide to the Bank’s operating departments in the preparation of country and regional strategies. When deemed necessary, a Country Capital Market Development Program should be designed that identifies specific barriers and interventions for a given country. Each country program will have to be coordinated with other multilateral institutions (IMF and World Bank) to ensure consistency and the appropriate macroeconomic framework. Given the rapid pace of change in capital markets, the Bank should establish a Capital Market Studies Program to provide analytical work, support technical assistance, and disseminate information on best practices. The Program can serve as an independent source of support for regional regulatory
and supervisory bodies, governmental authorities and the Committee on Hemispheric Financial Issues.
CAPITAL MARKET DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN A Strategy Proposal I. Introduction The Inter-American Development Bank has been involved in the development of financial markets in Latin America and the Caribbean for a number of years. A major part of this work has focused on banking systems and prudential regulation, and because of the importance of the banking system, this will remain an important part of the Bankâ€™s work. At the same time, the Bank must focus more attention on non-bank financial issues in long-term debt and equity markets (i.e., capital markets) as it seeks to deepen and broaden financial systems. The scope of capital markets includes primary and secondary markets. Both are important to the effective allocation of scarce capital. Commercial and investment banks, which have a comparative advantage in the management of private information and client relationships, fund investments in primary markets. In addition, secondary markets, which trade claims on existing assets, improve the transactional efficiency of capital markets when information is readily available. Moreover, secondary markets are associated with increased savings through an indirect effect of boosting the liquidity of primary markets. To the extent that capital markets are poorly developed, lack liquidity and transparency, domestic investors, correctly perceiving the higher level of risk, will reduce investment in favor of consumption and thereby lower savings. Moreover, riskier markets will cause domestic savings to flow to offshore accounts. Likewise, international investors, seeking to diversify portfolios, will invest in those countries that have developed more liquid and transparent capital markets that offer a variety of investments. This paper highlights the problems facing the Regionâ€™s capital markets and the importance of raising domestic savings in the context of well-functioning capital markets (Section II & III); discusses the conditions, structure and instruments for efficient and complete markets and new products (Sections IV & V); and reviews the Bankâ€™s mandate and recent experience in capital market activities (Sections VI & VII) . Based on this analysis, a strategy and its implementation are proposed to assist the development of Latin American and Caribbean capital markets (Sections VIII & IX). The strategy proposes that the Bank intensify its efforts in this area and take a more comprehensive view of capital market issues in the region and their linkages with those of developed countries. It is proposed that the Bank adopt a dedicated capital market strategy aimed at (a) raising the level of savings and improving its composition (i.e., shifting from real to financial assets and
transforming savings to longer-term, more stable sources); (b) enhancing the economic efficiency of capital markets; and (c) promoting the harmonization and integration of the Regionâ€™s capital markets. The proposed strategy will deal only with the non-bank segment of financial markets, as the Bank is developing concurrently, a complementary Financial Markets Strategy, which will address the special needs and conditions of the banking system and will integrate both strategies.
II. The Problem in Capital Markets A Recurring Problem: The debt crisis of the 1980s demonstrated the dangers of Latin American governments, banks and businesses carrying excessive amounts of foreign bank debt. The recent currency crisis in Mexico, which threatened to unsettle other Latin American stock and bond markets, points to the consequences of an excessive dependence on foreign portfolio investment, and especially, investments in highly mobile, short-term instruments. Additionally, the continuous withdrawal of the public sector from large infrastructure finance has created a need for private sector capital, the bulk of which should be raised in the local capital markets to match the local currency of most revenues from these projects. The Need to Develop Internal Savings: These examples demonstrate that the availability of foreign capital, while a valuable complement to domestic investment, cannot wholly substitute for domestic savings. The bulk of Latin American economic and social development must undeniably be financed through domestic savings and investment. This places a heavy burden on domestic stock, bond and money markets to efficiently raise domestic savings and channel these into productive investments. The IDBâ€™s Role: The Bank has worked, for a number of years, with the banking systems of member countries to improve their efficiency, prudential oversight and maximize access to financial services by all elements of society. As these financial systems have evolved and become more complex, new markets and financial instruments are assuming increasing importance. Accordingly, the Bankâ€™s assistance (and more recently the IIC and MIF) is adapting and we find ourselves working with new types of financial intermediaries such as leasing companies, stock and bond markets, guarantee funds, pension funds, etc. III. Domestic Savings and Capital Markets Savings, Growth and Capital Markets: It is axiomatic that savings are key to sustainable, long-term growth. Although much attention is focused on international capital flows (or foreign savings), domestic savings are a more important source of investment funding. However, domestic savings in Latin America is low, averaging 18 percent of GDP in a sample of countries, compared with 33 percent in the fast-growing East Asian economies. As a corollary to lower domestic savings, Latin economies have a higher dependence on external debt and commensurately lower domestic stock market capitalization and bank credit (see Table). Savings depends on a host of variables including income levels, population growth and age composition, as well as the return on assets. One of the necessary conditions for financial savings, however, is the development of domestic capital markets. Capital markets provide an accessible and economical variety of financial instruments to encourage savers, largely
- 3 households, to shift from real assets into financial assets. Furthermore, new instruments that lower the risks inherent in securities transactions can encourage longer-term, stable savings as risks are appropriately priced and distributed more widely throughout the market. There are widespread benefits from capital market development. Capital markets direct savings into the most profitable investments available in the economy. By doing so they improve the overall efficiency of the economy. This also permits corporations to expand beyond the limits imposed by self-financing from retained earnings. Money market price â€œsignalsâ€? also gauge the costs of government capital and permit monetary authorities to control liquidity through these markets. The participants in capital markets also enhance the professionalism and independence of these markets and improve corporate governance. Savings, Growth and Capital Markets - 1993 (US$ billi ) Real GDP
Stock Market US$
% GNP 12.5 b/
Latin Total a/
East Asia Total c/
a/ Argentina, Brazil, Chile, Colombia, Mexico and Venezuela. b/ Average. c/ China, Indonesia, Korea, Malaysia, Philippines and Thailand. SOURCE: (See Annex 1)
IV. The Structure of Capital Markets Complete Markets: The objective of every emerging economy is to develop depth and breath in financial markets to meet the needs of the real economy. This would include making a wide range of choices available to investors and issuers of securities in fixed-income and equity markets. Bond issuers, for example, would ideally be able to issue a variety of maturities ranging from overnight to long-term in both variable and fixed rates. Stock markets would provide large and small companies access to individuals' savings directly or through pension, insurance and mutual funds. Money Markets: The market for securities of less than one year includes government and central bank bills, repurchase agreements of government paper reportos), commercial bank certificates of deposit, corporate commercial paper and trade finance instruments such as bankers' acceptances. These markets, in their inter-bank or over-the-counter (OTC) form, have long been used in most Latin countries. A newer phenomenon, however, has been for these instruments to be listed on organized stock exchanges and for central banks to increasingly conduct monetary policy through open market operations in these instruments. The advantages to investors of having highly-rated, short-term paper available as a vehicle for temporary placement of funds are many. Debt Markets: Public entities (finance ministries, central banks and specialized government agencies for housing, agriculture, export and industry), are the most creditworthy borrowers and generally dominate the issue of local currency debt. However, we are seeing an increasing ability to issue corporate obligations beyond one year in local bond markets. The maturity structure
- 4 (yield curve), however, generally does not extend beyond two or three years, and the central problem for both government and corporate borrowers is to push out maturities as far as is possible. This is not easy. Bondholders are exposed to inflationary policies, inadequate information due to poor accounting systems, lack of credit review agencies or a legal system that is unable to enforce foreclosure judgements in a commercially meaningful time period. Equity Markets: Organized stock exchanges in emerging economies have been slow to develop because of the traditional reluctance of closely-held firms to divulge information to the public or an unwillingness to dilute voting power and control of the firm. For these reasons, closely-held private placements have historically been more important. However this is changing as a larger number of shareholders are looking to secondary markets to provide an exit mechanism in which to divest. Moreover, stock markets attract a different kind of investor than bond markets. Risk capital that seeks a higher return through ownership is willing to accept more uncertain returns than bondholders and thus is an important adjunct to fixed-income markets. Institutional Money Managers: Insurance companies, mutual funds and pension funds achieve important economies of scale through pooling small savings, diversifying investments and monitoring market information. Institutional investors are also able to do this at a lower transaction cost. Institutional investors raise the level of professionalism within markets through requiring better information and increased transparency. Institutions are the largest pool of savings and investment, in emerging as well as mature economies. Efforts to mobilize savings in emerging markets therefore cannot ignore their dominant role. But in fact, severe restrictions are sometimes placed on their investment policies. For example, it is not uncommon to find public pension funds restricted to investing in government debt sometimes paying less than market rates. Restrictions placed on purchases of common stock, corporate debt or real estate keep rates of return to the funds low and deprive the domestic capital market of the largest source of investment and liquidity. Financial Infrastructure: Capital market participants nearly unanimously agree that they should not engage in underwriting, trading or asset management activities in the absence of a secure legal and regulatory environment. Foreign investment funds usually cannot go into a market that lacks adequate legislation and oversight. Even so, capital market activities in some countries continue to operate under antiquated civil or commercial codes that did not anticipate many of todayâ€™s markets or financial instruments. Similarly, many organized exchanges operate as self-regulatory organizations (SROs) that may not meet internationally recognized norms for transparency and disclosure. OTC trading activity sometimes does not take place within rules promulgated by a trade associationâ€™s "master agreements" or a similar legal framework. Although exchanges perform a self-regulatory function, most developed financial systems additionally have a securities exchange commission-type institution (comision nacional de valores, CNV) that provides an additional layer of oversight. Investors look to these organizations to safeguard the markets through establishing minimum standards of capitalization, registration of securities and market participants, timely and material disclosure and effective enforcement. The timely disclosure of material information is a key ingredient generally lacking in emerging
- 5 markets. The problem is deep-seated as it generally results from an inadequacy of local accounting conventions or an ethos of secrecy pervading the markets. In addition, there is a lack of credit rating agencies that render objective judgements on increasingly complex financial instruments and markets. In addition to the legal and regulatory framework, the financial infrastructure should include a non-bank payments system for the organized exchanges. Commonly called clearance and settlement within a central securities depository, these clearing houses depend importantly on legislation enabling their establishment and on the clarification of legal concepts such as netting and the treatment of guarantees in bankruptcy for their effective operation. Swift and effective enforcement of the securities laws and regulations is necessary to maintain the integrity of financial markets. This will require that the regulatory authorities have access to electronic audit trails of organized exchanges, as well as bank and other financial records of OTC transactions. The integration of private capital markets throughout the world will also require an increasing degree of cooperation among the world’s regulatory authorities. Ideal capital markets, as described above, do not develop in a vacuum and their growth is facilitated or diminished by the quality of macroeconomic policy. Fixed-rate lending or bond holding, for example, will not develop in an inflationary environment and foreign participation in a market can be enhanced or discouraged by exchange rate policy. Tax policy will also exert an important influence on savings and investment behavior. For these reasons, the Bank’s capital markets strategy must always be viewed within the context of the country’s overall economic policy program.
V. New Products Securitization is a relatively recent financial technique that is gaining in popularity. Securitization allows a comparatively riskier firm access to capital markets or to lower financing costs by segregating higher quality receivables or assets from the risky firm. The default rate of the receivables or the quality of the assets should be known or measurable. The assets are placed in a trust or other legal structure that is bankruptcy remote from the parent firm, called a special purpose vehicle (SPV), it issues securities collateralized by the assets or receivables. Since the SPV contains only comparatively high quality assets or receivables legally separate from the parent, its credit rating will likely be higher than the parent firm permitting it to issue securities at a lower cost. Securitization can also be used to make a firm’s balance sheet more liquid by turning long-term assets such as mortgages (collateralized mortgage obligation, CMO), bank loans or physical inventories (warehouse receipts) into cash through securitizing these assets. The firm or financial institution is then free to originate more mortgages or loans or purchase more inventory to grow its business. Securitization, moreover, is also finding its way into infrastructure and project finance where the
- 6 cash flow from the project (i.e. electricity tariffs, oil revenues, etc.) can be securitized and the proceeds used to finance project development. A claim on the cash flow generated by the project, as opposed to a claim on the physical asset as in a bond financing, may be less risky and thus a more attractive financing option.
Guarantees: Latin America as in other developing areas of the world has not been immune to unstable political conditions and unwarranted regulatory change. Sovereign and regulatory risks frequently pose the greatest threat to a projectâ€™s viability, particularly infrastructure projects with extended payback periods, and therefore are the most feared by investors. The Bank, because of its knowledge of the country and long-standing relationship with member governments, may be uniquely qualified to raise the confidence level of private investors through providing performance guarantees of government and regulatory actions. Project Finance is closely related to securitization and guarantees and can involve the simultaneous use of all three financing techniques. As in securitization, project finance does not look to the general balance sheet or total cash flow of the firm for repayment, but rather to the specific project that will give rise to the cash flow. Firms can undertake very large projects through syndication of the funding and sharing of risks among a number of creditors or investors. Project finance lends itself to a wide variety of financing techniques, many of which depend on the ability to raise money in the local capital markets and to hedge local currency receipts and outlays. Derivatives and Risk Management: Notwithstanding the adverse publicity surrounding derivatives recently, these instruments perform a valuable economic function and their continued use will grow in Latin America. Properly used, derivatives facilitate the transfer of price risks of commodities, foreign exchange and interest rates to investors willing to accept these risk for a fee or profit. This allows businessmen or bankers to concentrate on their core business through hedging exposure to these uncontrollable external factors. Derivatives have been used extensively in Latin America principally for commodity swaps and price hedging. Coffee, sugar, copper and oil are only a few of the physical commodities whose prices have been fixed through forward sales. In addition, financial transactions such as stock indices, currency and interest rate swaps or hedges are becoming more common. This is a proper use of derivatives where business risk is reduced when businesses and banks layoff their price risks on those better able to manage these risks. Similarly, some Latin countries are instructing their ministries of agriculture to experiment with pilot programs that use derivatives to hedge agricultural price risks in return for a gradual phasing out of crop price subsidies. The financing of some infrastructure projects can be made more secure if futures contracts are used to fix the prices of inputs and outputs. In addition, some countries already have extensive over-the-counter derivatives markets and are establishing derivative contracts on local stock and commodity exchanges. However, there have been disquieting press reports of some Latin American financial institutions
- 7 using the derivatives markets, especially the large Brady Bond market, to assume large speculative positions. In the case of commercial banks, operating under guaranteed deposit schemes, this is imprudent behavior that exposes the banking system to moral hazard. Risk management systems that measure, monitor and report derivatives risk on a real time basis to top management and shareholders are likely to be inadequate or non-existent in most Latin American banks and companies. Moreover, the regulatory authorities in these countries have yet to catch up to these recent financial developments and may be unaware of the extent of risks the banking system and corporate sectors are running. VI. The Bank’s Mandate Bank’s Mandate: In the Eighth Replenishment, the Bank recognized the key role of domestic savings and investment and will continue to assist its members’ efforts to reform and modernize their financial sectors. Moreover, the Heads of State of the Republics of the Americas, in their most recent Summit, endorsed the principals of open, transparent and integrated capital markets. The Bank Group Enjoys An Important Comparative Advantage: In many respects, the Bank Group is uniquely qualified to provide loans and technical assistance in the area of capital markets development. As a development bank owned by its membership, there is a degree of trust and common purpose that does not normally exist in an "arms-length" commercial transaction. This allows both parties to work in areas that would be considered too sensitive for a normal commercial venture. This is especially true in the area of capital markets development and reform which have wide implications for the economy and society. VII. The Bank’s Experience The Bank, in more than three decades of lending activity, has been actively involved in financial market development (see Annex 2). There have been two particularly productive periods of financial markets activity for the Bank, with the first period beginning in the mid-to-late 1970s and the second period beginning in 1990. Annex 2 at the end of this paper reviews all non-bank capital markets activity by the IDB since 1990 within Investment, Financial, and Global MultiSector Loans. In addition, selected Pre-investment and Multilateral Investment Fund operations were reviewed. The Bank’s capital markets activity can broadly be categorized into operations dealing with prudential/supervisory concerns and those operations that dealt with capital market institutions or financial instruments. The former would include: national securities legislation; securities supervisory agencies; financial disclosure; oversight and enforcement; and, payments systems or clearance and settlement. The second type of activity involves: money and debt markets; equity markets; commodity exchanges; institutional savings; and risk management. The Bank’s prudential/supervisory activity can be summarized as follows: The Bank has worked with 18 countries to modernize and improve their national securities legislation and in some cases to help draft new legislation; in six countries we have provided institutional strengthening
- 8 for the comisiones nacionales de valores; in five countries the Bank assisted in improving financial disclosure which generally consisted of creating guidelines for auditing, risk classification and investor disclosure standards; the Bank worked with four countries to define regulatory oversight; and finally, the Bank Group has worked with fourteen stock exchanges in eleven countries to improve or install central securities depositories in each country. Within the realm of capital markets institutions and financial instruments, the Bank Group has: worked in five countries to issue disclosure guidelines for debt issues by private corporations and incentives for the development of a long-term debt market; the Bank Group has also assisted 16 countries’ stock exchanges to develop or improve internal rules and regulations and brokers’ access to new financing techniques; in two countries the Bank has assisted with efforts to amend tax legislation to encourage commodity market development. The Bank Group is currently moving forward with cash market development in four countries; in ten countries, the Bank has assisted in the preparation of guidelines for insurance companies and pension funds to invest in equities and provided technical assistance in the drafting of insurance legislation; and finally, the Bank has helped two countries with risk management through the creation of a risk rating system for publicly offered securities. In addition, there are a number of operations in the pipeline that should be approved before the end of 1995. These loans also deal with national securities legislation, CNVs, stock exchanges, pension and insurance systems etc. The countries include: Barbados, Dominican Republic, El Salvador, Honduras, Mexico, Panama, Uruguay and Venezuela. VIII. The Bank’s Strategy In less than five years, Latin America and the Bank will enter the 21st Century. Given the rapid rate of development, the structure of the Region's financial markets will be as different in the year 2000 as today's markets differ from the 1970s. The Region's capital markets will be carried along by the same forces that are driving change in the rest of the world such as rapid advances in information technology, an accelerated pace of financial innovation, and the globalization/integration of domestic markets. Owing to the separate economic, political, and social development paths countries of the Region have chosen, their domestic financial systems differ greatly. Moreover, within the realm of economic policy, markedly different fiscal, monetary, and tax policies prevail as well as differing degrees of reliance on private markets. The Bank’s capital market strategy must recognize these differing stages of financial development and their impact on capital market institutions. The Bank should adopt a capital market strategy to achieve the broad goals of (a) raising the level of savings and improving its composition (i.e., shifting from real to financial assets and transforming savings to longer-term, more stable sources); (b) enhancing the economic efficiency of capital markets; and, (c) promoting the harmonization and integration of the Region’s capital markets. In pursuit of these goals the Bank should stimulate its borrowing member countries to pursue five
- 9 strategic objectives in the financial sector: 1. 2. 3. 4. 5.
To maximize access to financial services by all elements of society; To promote new and varied sources of long-term domestic savings; To develop modern financial infrastructure and innovative instruments to channel domestic savings into private investment; To attain maximum efficiency through promoting competition among the providers of financial services leading to a lower cost of intermediation; and, To improve the prudential regulation and supervision of the financial system and the enforcement of its laws.
To achieve these objectives, activities should concentrate on the following areas: (a) national securities laws, (b) regulatory norms and practice, and (c) financial or commercial practices within each market and their implications for the development and integration of the Region’s capital markets. Highlighted below are activities in support of these strategic objectives. Regulatory Infrastructure 1.
Securities legislation is the basic foundation for a capital market. Those countries without a national securities act should enact one or update existing statutes. The Bank Group in the past has offered technical assistance to countries in the form of expert review of securities laws. In some cases, the addition or improvement of clauses dealing with the establishment and operation of futures and options exchanges, clearance and settlement, netting and similar legal concepts have been recommended.
Establishment of a comision nacional de valores (CNV) should be a high priority in those countries that presently do not have a securities regulator as well as the institutional strengthening of existing CNV’s. The Bank and the U.S. Securities and Exchange Commission have signed a Memorandum of Understanding (MOU) for the SEC to provide technical cooperation to member countries’ CNVs. The Bank has also had preliminary discussions with the U.S. Commodity Futures Trading Commission (CFTC) and the U.S. Federal Reserve Board toward similar MOUs. Regulatory Operations
Adequate financial disclosure is crucial for investors to make informed investment decisions. This requires internationally recognized accounting standards (commonly called, Generally Accepted Accounting Principles, GAAP) and credit rating agencies. The critical document for informing investors is the information memorandum or prospectuses. The most demanding standard is that all material information is divulged to the investor at the time of offering and investors subsequently must be informed on a timely basis of all material changes in the company’s status. Efforts are needed to encourage CNVs and the private sector to move toward this information standard within each market and eventually to harmonize these standards across the Region.
- 10 4.
The growth of OTC markets and organized exchanges mean that broker/dealers, securities issuers, investment companies, and investment funds (mutual funds) will proliferate. This puts an added burden upon CNVs to maintain adequate oversight and enforcement over the operations of securities markets and market professionals. CNVs should establish minimum standards and registration systems for market professionals, securities issuers and investment companies. In addition, the Bank Group can provide assistance with the installation of automated audit and registration systems within CNVs.
As capital markets become increasingly integrated the possibilities for cross-border malfeasance increase, necessitating a higher degree of inter-country cooperation between CNVâ€™s in their enforcement efforts. Capital Market Development
6. Local currency debt and equity markets are needed. The goal is to promote the issuance and transaction of longer term securities (i.e. to extend the yield curve) for public and private debt and to encourage the growth of organized stock exchanges. Exchanges, especially the smaller ones in the Region, generally lack adequate trading systems, clearance and settlement mechanisms and depositories. The Bank, in the past, has worked to make the banking systemsâ€™ payments mechanism safer, and should continue its work with the clearing systems of organized exchanges. 7.
A number of countries are in the process of establishing cash markets and commodity exchanges for agricultural goods. As governments decrease their intervention in agricultural pricing and commodity merchandising, the private sector must take up this role. Cash commodity markets, with well defined contract standards, provide an alternative marketing outlet offering transparent price discovery for farmers. Commodity exchanges with futures and options on futures have been used for more than a hundred years in the major Latin markets. They allow primary producers and processors to hedge their commodity price risk. On a limited basis, these products may be useful in smaller markets.
The development and democratization of capital markets is greatly enhanced via the activities of domestic institutional investors. Given their liability structure, insurance companies and pension funds are natural long term investors. Mutual funds, venture capital funds and other institutional investors are also important longterm investors. Recognizing the importance of institutional savings, the Bank has worked in the development, modernization and often in the privatization of social security and pension systems in a variety of member countries. Significant effort has been made and should continue in legislative reform and regulatory oversight of pension systems and especially in the area of opening up investment opportunities in those asset classes needed by social security, pension, insurance, trust banks and mutual funds.
Capital markets are complementary to traditional financial intermediaries (such as deposit banks) and should not be viewed as a substitute for a well functioning banking system. Each market serves a particular need and there are important synergies between them. For
- 11 example, securities markets often use the banking system to clear payments while the banking system benefits from the price information generated by securities trading. The competition between the two markets also serves to lower transaction costs and increase allocative efficiency. The Bankâ€™s strategy for supporting banking systems will be addressed in a complementary strategy statement for financial markets.
10. Capital controls affect the flow of foreign funds and have an important effect on the development of domestic capital markets. Regulations affecting the types of investment instruments available, distinctions between residents and non-residents, minimum holding period, tax withholding and other policies affect the amount and composition of foreign capital are examples of capital controls. These controls should be carefully reviewed, within the context of macroeconomic objectives, so that their impact on capital markets is known. Capital Market Deepening 11. Local currency financing exposes banks and businesses to price risks that cannot be hedged in international futures markets. For this reason, the domestic financial system will generally need a U.S. dollar/local currency futures contract, a local currency short-term interest rate product and an index on the local stock exchange. In addition, access to offshore hedging opportunities should be available to control the risks of international transactions. This will permit the growth of risk management by exporters/importers, banks and institutional money managers. The increasing use of derivative products in Latin America will also challenge regulatory authorities and top management of banks and businesses to inform themselves of the risk inherent in these products and how they will manage these risks. 12. Commodity securitization may be a mechanism for countering the traditional scarcity of credit going to the agricultural sector. This type of instrument can help farmers and processors to improve the liquidity of their assets and enhance cash flow and should be a part of a total rural finance package offered by the Bank. There are numerous problems, however, associated with the use of commodity securitization. A warehouse receipt or bono de prenda representing a claim on a physical commodity in storage must be commercially and legally secure. A commercially secure instrument would require a system of standards and grading for the commodity and approval and inspection of warehouses. In addition, legal security would involve perfecting claims and bankable property rights. The Bank Group has a long history of involvement in these areas, and should continue this activity. IX. Strategy Implementation The Bank Group is in a unique position and has an array of programs that can be used to support capital market development. The Bankâ€™s activities should focus on local and regional activities that support the goals of the Capital Market Strategy.
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The Capital Market Strategy outlined above is intended to serve as a guide for the MIF, the Regional Departments and the Integration and Regional Programs Department in the preparation of country and regional strategies and in the design and preparation of specific operations for capital markets development. These operations should be designed with the goals and strategic objectives in mind. Priorities: The priority assigned to the twelve activities discussed above, depend of course on the particular stage of a countryâ€™s capital market development. The four areas of activities above are listed in order of priority and it is expected that operations will be proposed for Bank financing in the more advanced areas only when it can be shown that the level of development in Regulatory Infrastructure and Operations is satisfactory. For instance, work on disclosure guidelines or regulatory oversight and enforcement should necessarily wait until a securities law and regulatory agency have been organized to define these activities. Similarily, the introduction of sophisticated financial products makes little or no sense if basic capital market institutions are not well-developed or do not exist. Operations that work concurrently on several of the priorities listed will have to be carefully sequenced and articulated. Lending and Technical Assistance: In the past, the Bank has used Investment Sector Loans, Global Multisector Loans, Technical Cooperation Agreements and the Multilateral Investment Fund (MIF) to assist and effect reform in the capital markets (see Annex 2). These programs provide an important foundation and should continue to be applied on a country basis through the Regional Departments or on a regional basis through the Integration and Regional Programs Department and the MIF.
Capital Market Development Program: The interrelation of all the elements involved in a well-functioning capital market requires a global approach to avoid the pitfalls of a piecemeal aproach. Therefore, in those countries where capital market development is a priority, a fullfledged Country Capital Market Development Program may have to be developed. The Program will review the conditions prevailing in those markets, analyze the barriers to their development and propose specific interventions. The operational departments of the Bank are responsible for the preparation of these strategies, with technical support from the central departments. In addition, since the evolution of capital markets is intimately related to the overall macroeconomic framework, each country strategy will need to be coordinated with the actions of the IMF and World Bank. Capital Markets Studies Program: Given the complexities and rapid change in capital markets, the Bank will need to develop and transfer know-how. For these purposes, the Bank should also develop a Capital Market Studies Program to produce analytical work, support technical assistance, and disseminate information on best practices to improve capital market efficiency in the Region. The Program will provide a focal point for the Bankâ€™s know-how and technical expertise on regional capital market issues and can serve as an independent source of support to regional regulatory and supervisory bodies, governmental authorities and the Committee on Hemispheric Financial Issues.
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The Capital Market Studies Program should support international and regional bodies, like the International Organization of Securities Commissions (IOSCO) and the Council of Securities Regulators of the Americas (COSRA), and promote their efforts to coordinate and integrate securities regulatory commissions. As well the Capital Markets Studies Program would convoke international conferences to bring Latin American government officials, bankers, investors, and corporate end-users of capital markets together with their counterparts in developed financial markets.
X. Conclusion Clearly, capital market development is a complex and long-term process. In this document, only some of the basic principles are highlighted, while the examples are illustrative and do not exhaust all the technical issues regarding capital market instruments or institutions. The approach suggested here is to pursue the broad goals of promoting saving, capital market efficiency, and regional integration through capital market development within the Bankâ€™s lending and technical assistance programs. These activities should be complemented by efforts at the regional level to improve the integration of markets in coordination with regional institutions and governments. As well, the Bank should promote these efforts by providing a forum for discussion of these topics and designing a program of studies to support them.
Savings, Growth and Capital Markets - 1993 (US$ billions) Real GDP
Argentina Brazil Chile Colombia Mexico Venezuela
252.3 426.7 42.1 48.6 326.2 58.3
Latin Total a/
East Asia Total c/
6.1 1.0 6.4 4.2 3.0 3.8
15.5 20.4 21.2 16.5 17.4 15.7
36.9 189.3 68.2 14.0 130.2 4.1
14.6 44.4 161.8 28.9 39.9 7.1
60.9 426.6 26.6 9.6 140.6 11.9
24.1 100.0 63.1 19.8 43.1 20.5
43.7 18.7 0.3 0.9 46.7 21.2
17.3 4.4 0.7 1.8 14.3 36.4
a/ Argentina, Brazil, Chile, Colombia, Mexico and Venezuela. b/ Average. c/ China, Indonesia, Korea, Malaysia, Philippines and Thailand.
SOURCE: World Bank, International Monetary Fund.