DOMESTIC FINANCIAL LIBERALIZATION: THE RECENT EXPERIENCE OF ARGENTINA, BRAZIL AND MEXICO Fernando J. Cardim de Carvalho* Abstract Domestic financial systems were liberalized in the 1990s in every major Latin American economy. Interest rates were freed, direct credit allocation was sharply reduced, protective barriers insulating market segments and institutions were eliminated, and the role of stateowned banks was drastically curtailed at the same time in which entry by foreign financial institutions was stimulated. At the same time, in a parallel process, controls over both capital inflows and outflows were lifted or sharply attenuated, completing the change in balance of payments regulations that had been generally initiated still in the 1980s with trade liberalization initiatives. It was generally expected that financial liberalization would bring about higher savings, higher investments and, thus, higher GDP growth rates. The results, however, have not been so favorable. In this paper, we discuss the experiences of three countries, Argentina, Brazil and Mexico. In Argentina and Mexico, radical steps were taken to promote financial liberalization, while in the case of Brazil, a more hesitant approach was adopted in the period. The paper describes and evaluates the financial liberalization in the three countries since the early 1990s trying to point out the differences in economic performance that can be at least in part attributed to the different strategies promoted by Argentina and Mexico, on one side, and Brazil, on the other. Key words: Financial Repression; Financial Liberalization; Financial Reforms; Argentina; Brazil; Mexico; Latin America; Savings, Investment and Growth; Latin American Financial Systems
*
Professor of Economics, Institute of Economics, Federal University of Rio de Janeiro, Rio de Janeiro, Brazil. Email:
[email protected].
2 I. Introduction Domestic financial systems were liberalized in the 1990s in every major Latin American economy. Interest rates were freed, direct credit allocation was sharply reduced, protective barriers insulating market segments and institutions were eliminated, and the role of stateowned banks was drastically curtailed at the same time in which entry by foreign financial institutions was stimulated. At the same time, in a parallel process, controls over both capital inflows and outflows were lifted or sharply attenuated, completing the change in balance of payments regulations that had been generally initiated still in the 1980s with trade liberalization initiatives. In two of the three largest Latin American economies, Argentina and Brazil, financial liberalization was more directly related to the repeated attempts to bring long-lasting high inflation under control. In the case of Mexico, on the other hand, inflation, although high, seemed to be less of a problem than in Argentina or Brazil. External pressures, especially from multilateral financial institutions were instrumental in starting the process. However, once initiated, in many cases moving on with liberalization counted on some measure of domestic political support. At the roots of this movement we find varied factors, such as a reaction against political authoritarianism (particularly military authoritarianism in the case of Brazil and Argentina), disappointment with the perceived results of past development processes led by activist states and the widespread revulsion against political corruption that was believed to be inherent to the political process in the region. After a period ranging from a decade to a decade and a half of financial liberalization experience, however, the performance of Argentina, Brazil and Mexico is certainly less than bright or at least less bright than anticipated.1 In particular, growth has been maintained below the average of emerging economies besides being rather volatile. Two “schools of thought” have emerged in the debate on the reasons why the liberalization process has been, so far at least, rather disappointing. On the one hand, some analysts proposed that less-than-bright achievements are the consequence of half-hearted and in fact incomplete adherence to the financial liberalization reform program.2 In this view, political opposition precluded the full implementation of the minimum list of reforms and policies needed to allow liberalization of financial (and other) markets to exert its expected positive influence on the performance of the economy. On the other side of the fence we find the critics of liberalization for whom the program could never really work since it was assumed to be based on false ideas and expectations about the potentialities of free markets, particularly financial markets in developing economies.3 A debate like this cannot be settled, of course, just by recourse to “facts”, since it involves political prejudices, value judgments and different concepts of what constitutes success. 1
Cf, for example, Singh et al (2005), p. 63 This has been generally the view defended by the multilateral financial institutions, such as the IMF, e.g. Singh et al (2005), the World Bank, e.g. World Bank (2005) and the IADB. 3 Cf, e.g. the works by Ajit Singh (not to be confused with Anoop Singh quoted in footnotes 2 and 3) listed in the references. 2
3 Some analysts may consider some “facts” essential while for others the same facts may be entirely irrelevant. In fact, even the meaning of the expression financial liberalization may be uncertain, with different authors understanding it in different ways. As it so often happens in political debates, even if on economic matters, values and preferences matter but so does semantics. Therefore, the first task to be met in a study like this is the clarification of the concept of financial liberalization that will be used so one can build an appropriate benchmark to evaluate its achievements. The literature on financial liberalization and its effects is by now abundant. Few of the works in the field, however, seem to be entirely satisfactory even to their authors, because of the inability of most of them to reach definite results and evaluations. One frequently found difficulty resides in properly dating the process. In fact, this is one aspect of a more general difficulty, that of properly measuring the implementation of a given political strategy. How committed governments really were to liberalization? How far were legal provisions effectively enforced? A reform process does not necessarily begin when a government formally decides so. How prepared was the government bureaucracy to implement a liberalization strategy? How did it deal with opposition? All of these are important questions to address in an evaluation of the success or failure of any political strategy. There are strong arguments to support the application of some comparative method to assess the results of liberalization. Analyzing sets of countries reduces the risk of being swayed by idiosyncratic factors operating in any given country. Nevertheless, studies of large groups of countries can hardly address the type of concerns listed in the preceding paragraph. This paper focus on the recent experience of only three countries, to be able to catch those of their idiosyncrasies that may be relevant to an evaluation of the impacts of financial liberalization, but trying to show, at the same time, that all three countries followed paths that were similar in many important respects. Even in terms of timing there is a tight parallelism between the three experiences, reducing the importance of possibly different environmental factors in shaping each national process. This parallelism will probably explain the degree of similarity between the results of the three experiences. The paper develops as follows. Section II is directed at the clarification of terms just mentioned, trying to define financial liberalization. The modern theoretical underpinning of this concept was developed in the debates about a related concept, that of financial repression, meaning by that the imposition of constraints over the behavior of financial markets and institutions that ended up thwarting its path toward inefficient outcomes. Accordingly, section II offers a summary of the two theories of financial repression and its effects, usually referred to as the Shaw/McKinnon approach. Section III describes the process of financial liberalization as it unfolded in the three countries discussed in the paper, presenting the sequence of policies and the basic context within which they were adopted. Section IV is, again, rather descriptive, presenting data about the variables that are relevant both to measure how far the liberalization process has advanced in the three countries and to evaluate its performance. The variables examined will be those defined as relevant in the models discussed in section II, to avoid overburdening the concept of liberalization.
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Section V will rely on the preceding two sections to proceed to an evaluation of the actual experience of the three countries with financial liberalization trying to address the central debate mentioned above on whether the apparently poor results of financial liberalization in the three countries is due to the incompleteness of its implementation or, in contrast, to any intrinsic flaw in the strategy itself. Financial repression models were developed in opposition to Keynesian models predominant at the time. Accordingly, the evaluation will be made by contrasting the predictions of each family of models. Section VI will then conclude the paper by presenting its main results. II. Financial Repression and Financial Liberalization Financial liberalization as a political slogan came to include any kind of pro-free market reforms, being frequently presented as virtually undistinguishable from liberalization in general. In this wide sense, it is sometimes used to support criticism directed at the way even successful developed capitalist economies work. An example is the constant upbraiding of Germany for its inability to reform corporate governance giving stronger voice to shareholders against stakeholders. Other European countries, such as France, or Asian countries, like Japan, are also frequently charged of maintaining excessive levels of state intervention in the economy or of constraining the free operation of markets through restrictive regulations. In other words, financial liberalization, in the political debate, is often understood as the move toward the Anglo-Saxon model of capitalism where the operation of markets is as fully insulated as possible from extra-economic influences of any kind. For the purposes of this paper, however, this sense of the expression is too wide to be analytically useful. It simply cannot be used to identify a limited set of specific reforms that define a checklist to evaluate concrete cases of financial liberalization. A much more useful meaning, because of its greater precision, can be extracted from the academic debates basically initiated with the models of financial repression proposed by Shaw and McKinnon. According to a very influential interpreter of these models, financial repression involves a cause-and-effect relationship whereby state intervention in financial markets lead to economic stagnation: “Their [Shaw and McKinnon´s] central argument is that financial repression – indiscriminate ‘distortions of financial prices including interest rates and foreign-exchange rates’ – reduces ‘the real rate of growth and the real size of the financial system relative to nonfinancial magnitudes. In all cases this strategy has stopped or gravely retarded the development process.’” (Fry, 1995, p. 20, quoting Shaw) Financial repression thus involves distortionary government intervention in the operation of financial markets, most conspicuously through fixing interest rates at levels that are not equilibrium thereby preventing interest rates from clearing the savings and investments markets. More specifically, interest rates are kept artificially low inducing savers to reduce desired savings, thus rationing resources to investors.
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In Fry’s view, financial repression, given its expected negative impacts on growth, might not actually be the result of a strategic decision by governments. As he argued, “many developing countries appear to have slipped into financial repression inadvertently.” (id.) According to Fry, governments in these countries may have been motivated by two main goals: 1. to provide the state with financial resources under conditions of poor taxing capacity; 2. to direct the operation of financial markets toward the support of development policies. In the language proposed by this tradition, the attempts to reach these goals should be more appropriately designated as financial restriction than as financial repression.4 The latter would seem to be a rather unintended development of the former. In other words, governments would not seek to willingly distort financial or any other markets. They would, in contrast, try to use financial markets to support development policies. The two goals define, in fact, the main instruments of financial repression. The need to provide the state with the resources it could not obtain through taxation would simultaneously explain measures like excessively high reserve requirements on banks, the obligation of banks to absorb public securities at low interest rates, etc, and the imposition of ceilings on interest rates. Disintermediation would be contained by precluding the emergence rise of private securities markets through transactions taxes and other similar restrictions. The expected result of these policies would be to allow the government to raise funds through seigniorage without appealing to inflation taxes. But the government should not be the only beneficiary of financial restriction: “Selective or sectoral credit policies are common components of financial restriction. The techniques employed to reduce the costs of financing government deficits can also be used to encourage private investment in what the government regards as priority activities. Interest rates on loans for such approved investment are subsidized. Selective credit policies necessitate financial restriction since financial channels would otherwise develop expressly for rerouting subsidized credit to uses with highest private returns. For selective credit policies to work at all, financial markets must be kept segmented and restricted.” (Fry, 1995, p. 21). Of course, an alternative way to guarantee that credit would be directed toward “approved investments” could be the creation of state-owned financial institutions, which were also frequently present in the experiences of financially-repressed countries. Financial repression is, thus, conceived to be something like an acute phase of a more common disease. It would happen when governments ended up generalizing ad hoc controls on the financial system to prevent it from reacting to financial restriction through the creation of alternative ways of doing their preferred deals. 4
“Financial restriction encourages financial institutions and financial instruments from which government can expropriate significant seigniorage; it discourages others.” (Fry, 1995, pp. 20/1) Financial restriction should not be confused with financial restraint, proposed, for instance, in Greenwald and Stiglitz (2003) which refers to imposing caps on interest rates that prevent adverse selection and moral hazard under asymmetric information.
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The deleterious effects of financial restriction, and, even more seriously, of course, of financial repression were of two orders. First, a more traditional, Wicksellian analysis of the savings and investment process, suggested that lower-than-equilibrium interest rates would induce individuals to save less (and firms to try to invest more) than if the interest rate was free to reach its market-clearing level. Investments would thus be rationed by the lack of savings. In addition, lower-than-equilibrium interest rates would not discriminate between those investment projects that offer profitability barely reaching the interest rate and more productive investments, thus allowing inferior projects to be implemented instead of more productive ones. The other set of negative impacts of financial repression related to distortions in financial asset prices (allied to practices such as imposing constraints on the development of securities markets and/or directing credit either by forcing private intermediaries to support approved investments or by creating public financial institutions to do it), which could constitute fatal obstacles to the development of efficient structures of financial intermediation that could properly allocate resources among borrowers of different characteristics. Four main initiatives should constitute the backbone of a financial liberalization process: 1. the elimination of all ceilings to interest rates, allowing them to be determined by the free operation of markets; 2. the elimination of the obstacles created to prevent the development of securities markets, allowing full institutional innovation and differentiation; 3. the elimination the obligations of financial institutions to finance the government (either through excessive reserve requirements or mandatory purchases of public debt securities); and 4. the elimination of public financial institutions, either by shutting them down or by their privatization.5 Predictions of this model are equally clear: the liberation of interest rates should increase savings and investments (the latter by eliminating rationing); the other three measures should lead to differentiation in financial markets with the flourishing of new market segments, emergence of new institutions and introduction of new financial instruments. Capping it all, one would expect growth to accelerate. This unambiguous listing of the expected results of financial liberalization, however, did not resist empirical testing. Most of the predictions of the financial repression theory were either falsified or found weak corroboration by the data. The adverse outcomes of empirical testing, on the other hand, led to a reexamination of the concept. In fact, it was the first set of predictions, by which freeing interest rates should lead to increased savings and, therefore, to increased investments that were most sharply questioned.6 Two different sets of questions were raised. The first is purely theoretical and 5
Caprio et al (2001, p. 10), summarizes the policy program in two main measures: 1. eliminating controls on interest rates and other prices, as well as reducing administrative credit controls; and 2. privatizing state intermediaries, reducing at the same time restrictions on area of operations for financial institutions. 6 Cf Bandiera et al (1998). This ambiguity was also considered by Banco de Mexico (2002).
7 amounts to a criticism of the Wicksellian framework in which the savings function was originally conceived. The second is empirical in nature and relies on the difficulties of isolating the effects of freeing interest rates from other reforms that usually accompany it in concrete processes of financial liberalization. The theoretical criticism raises the point that raising interest rates affects savings decisions through substitution, income and wealth effects. While the traditional Wicksellian framework considers exclusively the substitution effect, that which should impart a positive relationship between savings and the interest rate, income and wealth effects could impact savings negatively. A priori, therefore, one could not predict how savings would react to a rise in the interest rate without knowing the sizes of the three effects. It may be interesting to notice that Keynes, when first proposing his propensity to consume function, in fact, pointed out precisely to the possibility of this ambiguity, raising, however, some arguments to defend the view that income effects should dominate substitution effects.7 In addition, some authors point to the role of liquidity constraints under financial repression to argue that financial liberalization may push up consumption rather than savings. If relevant groups of consumers had been credit-rationed during the financial repression era (if, for instance, government directed credit to selected productive sectors at the expense of financing consumption), financial liberalization may lead to an increase in consumer credit, even if the interest rate rises, and savings will fall. Of course, these effects could not exist in a rational expectations equilibrium and it is not clear how could they fit in a Wicksellian approach to capital theory, which does not rely on any special assumption about the behavior of credit.8 The empirical criticism of the thesis that increasing interest rates will increase savings relates to the fact that financial liberalization in the more precise sense defined in this section rarely comes alone. In fact, it has usually been part of a package that may include, depending on the country being studied, trade liberalization and the opening of the capital account.9 Moreover, which is particularly significant in the cases of Argentina and Brazil, financial liberalization may be an element of a price stabilization strategy. If the inflation momentum is actually broken, motives and behaviors are dramatically changed in the poststabilization period when compared to the inflationary times. Empirical testing of the relationship between aggregate savings and interest rates under these conditions may be very tricky, given all the variables that have to be controlled. The 7
“It has long been recognized, however, that the total effect of changes in the rate of interest on the readiness to spend on present consumption is complex and uncertain, being dependent on conflicting tendencies, since some of the subjective motives towards savings will be more easily satisfied if the rate of interest rises, whilst others will be weakened.” (Keynes, 1964, p. 93). 8 The interest rate that equates savings and investment is the natural rate of interest, defined, according to Wicksell, as the rate of interest that would prevail in a non-monetary economy. When credit is introduced, it affects the market rate of interest, an entirely different variable. Therefore, the existence of credit or any of its characteristics should not affect the relationship between savings and the natural rate of interest. 9 As Eichengreen and Mussa (1998) pointed out, “capital account liberalization has gone hand in hand with domestic economic and financial liberalization.” (p. 9) According to Stallings and Studart (2003), “the two usually go together in practice as components of a more generalized move toward greater reliance on the market.” (pp. 23/4)
8 classical example is given by the Mexican experience in the early 1990s, where higher interest rates attracted foreign capital that actually financed the expansion of private and public consumption.10 For these reasons, an agnostic attitude has prevailed in the literature on financial liberalization with respect to the relation between savings and the interest rate. Generally, it is accepted that no definite prediction can be made about this relationship either in terms of sign or in terms of intensity. Things seem to be better with respect to the second strand of the literature, although, again, some doubts have been raised about the predictions made by authors like Shaw. The first part of the argument seems to be reasonably robust, even if somewhat tautological: financial liberalization should lead to a diversification of markets, institutions and services. In fact, the argument is perhaps tautological because financial liberalization in this sense is precisely the permission for new markets to emerge, new institutions to enter the sector and new products to be created, particularly in the segment of securities markets. But in fact financial liberalization is more than that, involving also the elimination or attenuation of directed credit and the reduction of influence, or outright privatization, of financial institutions owned by governments. Some authors also include in the roster the fall of reserve requirements on bank deposits and the use of open market instruments to practice monetary policy, although one can argue that these elements have actually little to do with financial repression. In relation to these characteristics, the predictions of the financial repression/financial liberalization approach are unambiguous: liberalization should lead to larger and more diversified financial markets. However, in the financial repression/financial liberalization model, it is also predicted that growing and more diversified financial sectors should not only increase investments (by allowing the accommodation of borrowers with different characteristics) but also to allocate resources between investment projects in a more efficient manner. Thus, it is predicted that investments should not only increase but also be more productive, thereby increasing the rate of growth of the economy. It is widely recognized that it may be very difficult to examine how much more efficient investments would be as a result of financial liberalization. For that reason, few studies actually tackle this difficulty. One example is Galindo (2007), that tries to examine how much profitable investments are after liberalization when one factors out changes in the structure of capital of an economy that may occur. Using a sample of twelve developing countries that implemented financial liberalization, they find evidence that profitability has in fact improved. Most researchers, however, refrain from examining this question, pointing out the difficulties, empirical and conceptual, that surround such an endeavor. On the other hand, financial repression theory did not make definite predictions about the stability of liberalized financial systems. Of course, this may be just an aspect of a generally biased view against state institutions, which are assumed to take riskier paths than the ones followed by private banks. The explanation for this difference of behavior would 10
On the Mexican experience in the early 1990s, see Dornbusch and Werner (1994).
9 be that private institutions risk their own money, while public institutions would risk taxpayers’ money. Nevertheless, besides being a simplistic theoretical view11, empirical observation has shown that one very general feature observed in liberalization processes is increased financial fragility, eventually leading to financial crises, caused by the increased competitive pressure put on existing financial institutions. The losses caused by these crises may even end up wiping out the benefits of liberalization.12 Be that as it may, this strand of financial repression theory does make definite predictions as to the expected results of liberalization. In sum, if one puts aside the relation between interest rates and savings, the literature on the expected effects of domestic financial liberalization (even though many analysts argue that it cannot always be separated from capital account liberalization) advances three definite predictions: the financial sector should grow and diversify; investments should increase; and economic growth should accelerate. The study of the three countries, below, will focus on these three predictions besides examining the behavior of aggregate savings. III. The Financial Liberalization Process in Argentina, Brazil and Mexico: Policies All three countries promoted financial liberalization as an element of a double-pronged strategy designed to fight inflation and resume the process of growth that had mostly stalled in the mid-1970s. Argentina, Brazil and Mexico had experimented with state-led import substitution industrialization in the post-war period, with different degrees of success. As it was frequently the case with this style of industrialization, financial repression was a pervasive phenomenon. In fact, authors like Fry, discussed above, seemed to be directly inspired by the Latin American experience when conceiving the notion of financial repression. Another common feature of Latin American import-substitution industrialization experiences was the acceleration of inflation. Although Mexico had never experienced the high rates of price growth that plagued Argentina and Brazil from the late 1970s on, inflation was high enough in all three countries to begin to exert a discernible negative impact on economic growth. As growth stalled and inflation accelerated in the 1970s, the whole concept of state-led industrialization strategy was thoroughly re-examined under a very unfavorable light. The anti-state bias that emerged was strengthened when state intervention became identified with authoritarian styles of government, particularly in the case of Argentina and Brazil, ruled by military regimes until the 1980s. Finally, the debt crisis of the early 1980s, that hit the three countries particularly hard, led to a protracted renegotiation process in which institutions such as the IMF took active part. International pressure was applied on the three nations to adopt liberalizing reforms in trade, finance, balance of payments and domestic 11
One realize how simplistic such a popular view is by listing all the agent/principal problems in the sector discussed in Greenwald and Stiglitz (2003), chapter 9. 12 There is a rich literature on this point. See, e.g. Demigurç-Kunt and Detragiache (2001), Kaminsky and Schmukler (2003), Gruben et al (1998), Yeiati and Micco (2007) and Wyplosz (2001).
10 policy-making. Although a few initiatives in the direction of liberalization had been adopted before that, it is only from the mid- to late 1980s that a definite liberalization strategy can be identified in all three cases. In the rest of this section, the main policies adopted in each country are listed and briefly explained. i. Argentina Financial liberalization in Argentina proceeded in roughly two stages. The first took place still under military rule, led by then-Finance Minister Martinez de Oz, and ended up with the debt crisis of 1982. Two important decisions were made in this stage. The first was the passing of the Financial Entities Law, in 1977, whereby financial institutions were allowed to organize themselves as universal banks. At the same time, additional steps were taken to stimulate the formation of larger financial conglomerates. The increasing concentration in the industry should allow financial institutions to take advantage of scale and scope economies that were suspected to exist, leading to an increase in their operational efficiency and to a reduction in the cost of capital. As pointed out by many researchers, domestic financial liberalization was accompanied by capital account liberalization in the Martinez de Oz years. Domestic banks were allowed in 1978 to accept deposits by non-residents denominated in foreign currencies. These deposits had to be kept for a year, though, although this requirement was soon relaxed until its abandonment in 1979. The Martinez de Oz experiment was interrupted by the balance of payments crisis of the early 1980s, amidst a dramatic episode of capital flight and economic disruption. The turmoil that followed, political and economic, led to the creation of a neologism, martinazo, to refer to the combination of crisis and popular reaction that resulted from the policy mix adopted in this first experience with liberalization. Nevertheless, key initiatives, such as the permission to create universal banks, were not reversed. The second stage began almost ten years later, launched by President Carlos Menem, as the process of Argentine debt renegotiation was concluded and the control of high inflation became the sole concern of macroeconomic policy-making. One should remember that the term of office of Menem’s predecessor, Raul Alfonsin, had been abbreviated, and Menem’s inauguration advanced about six months, on account of popular discontent with the hyperinflation process triggered in 1988/9. Financial liberalization now began with the passing of an Economic Emergency Law, in August 1989, conferring to foreign direct investment the same legal status and privileges given to domestic investment. In the same month, another law was passed, the State Reform Act, setting rules for the privatization of state-owned enterprises, including national and provincial banks. The Act also defined incentives to foreign participation in the acquisition of those firms. Some liberalization policies adopted early in Menem’s first term in office, were subsequently modified to adapt to the Convertibility Program adopted in 1991 by Finance Minister Domingo Cavallo. Thus, in March 1991 the Argentine Central Bank defined
11 regulations for deposit acceptance and lending in US dollars in Argentine banks, modifying the terms of the permission already given in July 1989. The practically complete liberalization of the exchange market decided in April 1991, also modified terms set earlier, in December 1989. A central government decree dated November 1991 eliminated taxes and other restrictions on securities transactions. The Central Bank was given independence in September 1992. Within the framework of the Convertibility Plan, that had created a currency board in Argentina, the monetary authority lost any possibility of acting as lender of last resort, which would create a serious crisis management problem in 1995, under the contagion of the tequila crisis. Another important step in the process of legal reform was taken in 1994 when national treatment was extended to foreign financial institutions operating in Argentina. The tequila crisis of 1995 showed dramatically some of the weaknesses of the financial structure that had been created so far. The currency board regime that defined the Cavallo Plan transformed the bout of capital flight from Argentina in 1995 into a domestic liquidity crisis, sharply increasing bank fragility. Unable to count on the Central Bank to provide emergency liquidity, the Finance Ministry acted to create a facility to fund the purchase of problem banks by healthy banks in March 1995. Three months later, in May, a deposit guarantee fund was created, funded by banks themselves. Most importantly, the Finance Minister negotiated with international banks the creation of stand by lending facilities the government could draw upon to act as a lender of last resort when new episodes of capital flight eventually took place. Finally, still in 1995, Argentina adhered to the 1988 Basle Accord, and its 1996 market-risk amendment. By the mid-1990s, thus, Argentina had basically completed a program of financial liberalization with all the key characteristics proposed in the literature. The strategy was implemented with single-minded determination, as it is illustrated by the complete opening of the domestic banking sector to foreign banks or by the privatization process in which the government got rid of practically everything with the sole important exception of Banco de la Nación, the sale of which was announced by President Menem, who could not, however, complete it before the end of his term. Argentina’s recovery from the tequila crisis was relatively rapid and painless. However, the impact of the Russian crisis of 1998 and, even more importantly, of the balance of payments crisis and exchange regime change in Brazil, in 1999, was much harder and led the country to a recession that the rigidity of the Convertibility Plan transformed into a fullfledged depression in 2001. Although many, or even most, of the legal changes adopted in the 1990s were not actually reversed afterwards, proceeding with, or even maintaining, financial liberalization ceased to be an objective of government. ii. Brazil
12 Financial liberalization in Brazil was pursued with less determination than in Argentina (or in Mexico, as it will be seen). Starting from a similar diagnosis about the cumulative dysfunctionality of state intervention and of financial repression, the Brazilian authorities took some of the crucial steps in the standard liberalization process with a more pragmatic inclination. Legal and regulatory reform began in 1988 when the Central Bank formally recognized a de facto situation in the Brazilian financial structure that had gradually taken place in the 1970s and 1980s. Brazil had adopted a segmented financial structure, similar to the one defined by the Glass-Steagal Act in the US, in the mid-1960s. Loopholes in the law, however, allowed the formation of the financial conglomerates that were legalized in 1988 when the Central Bank passed a resolution allowing the formation of universal banks. Quickly after the resolution was adopted, practically all banks in the country had been reclassified to multiple banks (the local denomination for universal banks). A second important feature of the reform was the removal of ceilings on interest rates. Finally, the same set of measures broke the special connection that existed between the Central Bank and Banco do Brasil, a commercial bank controlled by the Federal Government. Before the Central Bank was created in 1964, Banco do Brasil performed some of the functions of a monetary authority. Transitional arrangements after 1964 preserved some of those functions for Banco do Brasil, particularly those that gave this institution the power to create means of payment independently of the Central Bank. These arrangements (known in Brazil by the name conta movimento) were dismantled in 1988, allowing the Central Bank to assume full powers over monetary policy.13 Brazil already had by this time an active stock exchange, a market for public debt securities and an incipient market for private debt securities, notably debentures. Other types of securities had existed in the past, but their markets disappeared with the acceleration of inflation starting in the mid-1970s. Debentures were better adapted to the volatile environment of a high-inflation economy because of the possibility, set in the contract, of periodical renegotiation of their terms. Even today, almost fifteen years after price stabilization was finally achieved, debentures are still practically the only type of private debt security to find a market in Brazil. An important step in the financial liberalization process was the permission for foreign investors to invest in domestic stock markets, also adopted in 1988, although under some restrictions that were gradually removed in the following years. Finally, it is also worth mentioning the creation of the Comissão de Valores Mobiliários (CVM), a supervisor for capital markets, with a mission similar to that of the Securities Exchange Commission in the United States. 13
In fact, the Central Bank would only fully take over these power in the mid-1990s, when banks owned by the states were privatized or transformed into development agencies. Until then, a variation of the too-big-tofail mechanism operated in Brazil giving these banks the power to freely create means of payment. These banks would create credit, usually in favor of state governments, independently of the volume of reserves they maintained and then would ask the Central Bank to validate their initiatives by advancing them the appropriate volume of reserves. The monetary authority had no choice but to accommodate the requests, not because they were systemically important, but because it was considered to be politically impossible to refuse extending its support to state governments.
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The liberalization of private financial activities in Brazil didn’t touch, however, some of the points that are considered essential in the literature. Directed credit did not disappear. In fact, there are many forms by which credit is directed to priority sectors. Private banks, for instance, still have to use a minor fraction of their deposits to finance agricultural activities. The bulk of directed credit is supplied, however, by public financial institutions. The most important financial institutions owned by state and local governments were privatized in the 1990s. The federal institutions, however, were preserved and, if anything, strengthened in the same period. The Federal Savings Bank (Caixa Econômica Federal) directs credit mostly at low-income housing and urban infra-structure. Banco do Brasil directs a large part of its credit to agriculture. Finally, the National Social and Economic Development Bank (BNDES), created in 1952, in the heyday of the import substitution process, is not only still very active but it is, in fact, the most important source of funding for investment in the country. None of these three institutions were seriously considered for privatization, not even in the more conservative administrations of Fernando Collor (1990/1992) and Fernando H. Cardoso (1995/2002).14 Another initiative that is considered an important element of financial liberalization, the reduction or elimination of banks’ reserve requirements, was also ignored in Brazil, despite the strong pressure exerted by banks in the whole period. High reserve requirements on demand deposits are still considered a key instrument in the control of market liquidity and, thus, of inflation so that its elimination is not included even in a longer-term list of future initiatives. A final important point in the process of financial liberalization concerns the opening of domestic banking markets to foreign banks. Again, some opening to foreign institutions took place in the mid-1990s, but only to a limited extent. In the aftermath of the monetary reform that achieved price stabilization in Brazil, the Real Plan15, many banks found themselves in trouble, since sharing inflation tax revenues had been, for a long time, an important source of earnings in the industry. Many of those banks which got in trouble with the dramatic fall in inflation tax revenues after the stabilization plan was launched tried to compensate it by extending credit to private consumers, without having the skills to do so. When, six months after the monetary reform, the federal government was forced by the tequila crisis to sharply increase interest rates and take other drastic steps to curtail aggregate demand, some banks were compromised beyond recovery. The federal government acted quickly to contain the stress, creating a program locally known by its acronym PROER, by which insolvent banks would be split in two: the “good” side would be sold to healthy banks, while the “bad” side would be liquidated by the Central Bank. The sale of the good side to a healthy bank would be financed by a special
14
During the Cardoso administration Banco do Brasil was directed to behave in a private-like fashion and BNDES acted mostly as an investment bank promoting (and financing) the privatization of state-owned enterprises. President Lula, in contrast, has mostly restored the original functions of these institutions. 15 Named after the new currency, the real.
14 line of credit extended by the Central Bank, at favored interest rates, besides enjoying some fiscal privileges too.16 The banking sector in Brazil is led by a small group of public and private banks, and the Central Bank was afraid that the consolidation that had to follow price stabilization could unreasonably increase the degree of concentration in the industry. It was in this context that a few foreign banks were welcomed to the country. No law or regulation was actually changed. In fact, current Brazilian law is still very restrictive as to the permission for foreign banks to enter domestic markets. The foreign banks that were allowed in, had to obtain an individual authorization signed by the President of Brazil. Once allowed to enter, foreign banks receive national treatment, that is, they enjoy the same privileges as domestic banks. Entry, however, is still strictly controlled. Given the depth of the post-stabilization stress, many banks were welcomed into the country and their share of the domestic market increased significantly between 1995 and 1998, when the stress was controlled and after which entry has practically stopped. Afterwards, foreign banks’ market share could only increase because of mergers and acquisitions between banks which are already operating in the country.17 Domestic financial liberalization in Brazil, thus, was not as extensive as in Argentina or Mexico. It was implemented more cautiously than in the other two countries discussed here. An exception to this pattern of behavior, did not relate to domestic liberalization but to capital account liberalization. We do not intend to explore this process in this paper, since it is generally considered a parallel process to domestic financial liberalization, its frequent companion, but raising a different set of problems. Brazilian laws and regulations of capital movements are based on the notion that controlling capital flows is an important instrument of macroeconomic policy. Since the late 1980s, and particularly in the early to mid-1990s, however, the Central Bank has taken steps to remove all types of restrictions to capital flows, even though there remain serious doubts as to its competence to make these decisions. Without proper Congress surveillance, the monetary authority may have abused its legal powers in the matter. Be it as it may, most of the restrictions over capital flows have been removed and the capital account is currently open, de facto, if not de jure. c. Mexico Financial liberalization in Mexico also began in 1988, when a large set of measures were implemented, among which one counts: 1. the permission for universal banks to issue securities the proceeds of which they could use freely, at market interest rates, just maintaining a liquidity reserve ratio of 30% of their value in the form of public instruments; 2. the permission for banks to participate in the auctions of CETES, the government security used to fix interest rates.18
16
On the banking stress of 1995, see Carvalho (1998). On the entry of foreign banks in Brazil in the period, see Carvalho (2000). 18 Banco de México (2002). 17
15 The freedom to use the proceeds of securities issuance was extended in 1989 to the other financing channels of banks, which implied, in practice, the abolition of interest rate ceilings and controls. Resources obtained by banks were subject to the 30% liquidity reserve ratio until 1991, when the requirement was eliminated. As happened in other cases, this was not the first time an attempt at financial liberalization was made. In the 1970s, a limited set of liberalizing reforms was implemented. These reforms were unsuccessful, though, maybe because they were introduced in a very volatile environment, while large deficits emerged both in the fiscal budget and in the balance of payments. The crisis that ensued led to the nationalization of banks in 1982.19 The nationalized banks were fragmented, in an attempt to promote functional specialization, and non-depository institutions were gradually sold by the State. In 1989, new reforms were passed, eliminating credit allocation controls and reserve requirements other than the liquidity reserve ratio. Other measures adopted in 1988 and 1989 included: 1. development banks were shut down or had their role drastically downsized; 2. incentives were given to financial innovation and the diversification of financial products; and 3. relaxation of restrictions on foreign direct and portfolio investment. In 1990, the virtues of specialization were reexamined and the operation of universal banks was again permitted. Two years later, nationalized banks began to be re-privatized, in a process that lasted two years. Only Mexican nationals could take part on the process, with many restrictions still applying to foreign ownership in the banking industry. The financial liberalization process was temporarily interrupted by the tequila crisis of 1994/1995. Newly-privatized banks seemed to have been steered toward a reckless credit expansion path by buyers who paid overpriced values for them in the privatization auctions. According to Hernandez-Murillo (2007), prices paid suggested buyers anticipated earning oligopoly profits given the level of concentration of the Mexican banking sector. Eager to recover their expenses, bankers exposed themselves too much to credit risks leading to the mid-1990s crisis. The depth of the 1994/5 crisis forced the central government to bail out the banking sector, through a de facto nationalization of bank loans. FOBAPROA, the government-led deposit insurance institution, swapped non-performing bank loans (estimated to have reached 52.6% of total loans in December 1996) for public securities.20 As far as bailing out goes, the intervention was successful in maintaining the solvency of the banking system, but at the cost of paralyzing the financing of private activities. Banks maintained their
19
Cf. Gonzáles-Anaya and Marrufo (2001) and Hernandez-Murillo (2007). As the latter paper informs, 58 of the existing 60 banks were nationalized. The only survivors were Citibank and Banco Obrero, owned by trade unions. 20 Cf Hernandez-Murillo (2007).
16 profitability by not lending, just by earning interest on the public securities swapped for their non-performing loans.21 To react against this situation, a new step was taken: the complete elimination of restrictions on foreign ownership of domestic banks. The expectation of the authorities was that foreign banks could revive the sector with better operational practices, higher skills in the provision of credit and other services, better risk management systems, etc. According to Hernandez-Murillo (2007), by the end of 2006, foreign banks controlled more than 80% of total bank assets, a market share that is much higher than one finds in any other major economy in the region. The liberalization process was not confined to the banking sector. As Tornell et al. (2003) point out, constraints on the issuance of commercial papers and corporate bonds were also removed in the period, and the ban on the issuance of indexed bonds was lifted. Securities markets still have to become, however, a significant source of finance for firms. The remaining concerns with financial reform seem to be focused on the apparatus of financial regulation and supervision that failed so completely in preventing the banking crisis of 1994/5. In 1998, FOBAPROA was replaced by another deposit insurance institution, IBAP, charged to protect small depositors but to reduce the protection given to large depositors, in order to stimulate the latter to impose some discipline on banks. In 1999, new rules were passed defining procedures for risk measurement and assessment by banks. These new procedures were strengthened in 2003, in anticipation of the Basel II Accord.22 d. Summary The three countries advanced far in the financial liberalization process from the late 1980s to the present. As in other experiences, these countries experienced periods of stress and crisis that were not enough, however, to lead them to reverse the liberalizing reforms. On the other hand, in the 2000s, governments at least in Argentina and Brazil do not seem to share the same enthusiasm for continuing down the same road. Of the three cases, certainly Argentina and Mexico were the countries where the process was pursued more intensely and consistently at least until the beginning of the new millennium. Brazil has maintained a more ambiguous position, particularly in respect to opening domestic financial markets to foreign institutions. In common, the three countries share the consideration of liberalization as an element of an overall macrostabilization strategy, the permission for universal banks to operate, the freeing of interest rates, and attempts to stimulate securities markets. Another common trait to the three experiences is the opening of the capital account in parallel with domestic liberalization. How far were the expectations of the promoters of financial liberalization processes actually met?
21 22
Cf. Tornell et al (2003). Idem.
17 IV Recent Performance of the Three Economies By the end of the 1990s, the bulk of liberal reforms had already been implemented in Argentina, Brazil and Mexico. The last big step in this process, giving permission to foreign institutions to operate in domestic banking markets was taken in the aftermath of the Mexican crisis of 1995. Although financial liberalization had been initiated in the late 1980s in the three countries, many authors still insisted, about ten years later, that it was too early to evaluate the success of the experience. As already pointed out, many would probably still question such initiative today because of what they see as the incomplete nature of the liberal reform wave.23 These analysts would argue that what critics see as intrinsic inadequacies of liberalization should in fact be seen as results of liberalization processes prematurely aborted by the lack of political will to pursue such reforms to the end. We will return to this debate in the next section. In this section we want to present recent data about the macroeconomic performance of the three countries and the performance of the sectors and markets of the economy that should benefit from financial liberalization. Available information gathered by institutions such as CEPAL and the IMF allows us to use information related to at least the mid-2000s. These data are particularly important because they are collected and divulged according to similar criteria, minimizing the problem of national idiosyncrasies in the denomination and elaboration of quantitative information. When advisable, however, we complement these data with information generated by other institutions. Data related to the 2000s are particularly interesting for this discussion because, in contrast to the 1990s, a decade of strong turbulence, especially in its second half, the 2000s have been unusually smooth, at least until the pressures associated with the subprime mortgage crisis emerged in the US in mid-2007. Financial liberalization in Latin America, as it is well known, was strongly associated with the opening of the capital account, which made the countries of the region strongly sensitive to shocks generated in the international financial system. In fact, Argentina, Brazil and Mexico did suffer the contagion effects of policy changes in the US (such as the hike in interest rates in 1994) and of crises in other emerging economies, such as the Asian crises of 1997 and the Russian crisis of 1998. These processes generated strong pressures on the three economies examined in this paper, certainly complicating, if not compromising, the evaluation of the results of financial liberalization. In the 2000s, so far, comparable disturbances have not been generated, making evaluations of domestic developments in the three countries potentially more meaningful. We will group the information according to the predictions made by the financial repression theory about the expected effects of liberalization. Despite the misgivings of many analysts with respect to the macroeconomic impact of liberalization on the savings 23
This is the gist of the argument presented by multilateral institutions such as the World Bank. See, for instance, The World Bank (2005).
18 rate, on investment and on growth, we begin with these and other relevant macroeconomic variables searching to detect possible positive or negative impacts of financial liberalization. Next, we turn to predictions that are specific to financial markets, which are the expansion effect and the efficiency effect. The expansion effect relates to the prediction that liberalization should be followed by an increase in bank credit and by the growth of securities markets. The efficiency effect will be taken here in a restricted sense, which is how far can the expansion of financial markets be related to real investment and the level of activity. This section is devoted mainly to the examination of available quantitative information. In section V, when evaluating the whole process we will try to get a more qualitative perspective on the liberalization process. i. Macroeconomic Performance As observed in section II, in the classical Shaw/McKinnon model of financial liberalization, one should expect that freeing interest rates, simultaneously with the removal of credit controls and the like, should increase aggregate savings. Higher amounts of savings, on the other hand, would allow the financing of a higher volume of investments, eliminating rationing. As a result of the increase investments, the economy should grow more quickly. As also discussed in section II, most analysts, including a large fraction of those favorable to financial liberalization (or at least favorable to eliminating financial repression, which is not necessarily the same thing), seemed to be skeptical about this effect. Table 1 brings data on the three variables, aggregate domestic savings, investments and growth of GDP for Argentina, Brazil and Mexico from 1994 to 2005. Domestic savings ratios were very volatile in all three countries in the period, ranging from a little above 16% to over 26% in Argentina, from 18.6% to almost 26% in Brazil and from 16.9% to 25.8% in Mexico. Argentina and Brazil, however, exhibit a different pattern than Mexico. In the former cases, the domestic savings ratio seems to be increasing at the final years of the period after oscillating around levels below 20% in the late 1990s. Mexico, on the other hand, does not exhibit any obvious trend: the highest saving rates were actually reached still in the late 1990s, in the aftermath of the 1995 crisis. They then fell precipitously in the beginning of the new decade just to recover slightly in 2004 and 2005. One could be tempted to attribute the visible increase of the savings ratio in Argentina and Brazil to a belated effect of financial liberalization. A much more immediate explanation for the observed behavior, however, should be found in tables 3 and 4, where data on real exchange rates and on the current account of the balance of payments are reported. In fact, in the early 2000s, both countries changed dramatically their exchange rate policies, leading to significant real devaluations that caused net exports to rise sharply. The two countries became net exporters of savings. In the case of Brazil, clearly the change in the savings ratio does not have any relation to the behavior of interest rates that actually declined or remained stable in the same period, as it is shown in table 5. In the case of Argentina, it may be worth remembering that, from 2002 on, even if most of the liberal reforms of the 1990s were not in fact rolled back, the government’s policy stance assumed a clearly antiliberal bias.
19
Be that as it may, increased domestic savings is not sufficient by itself to promote faster growth. For that to happen it is necessary that savings are used to finance higher investments. Investment ratios in all three countries however, do not seem to have changed their past trends. Most of the time, investment rates remained low, at or below 20% of GDP. In the case of Argentina, on observes in 2004 and 2005 some recovery from the exceptionally low rates of investment reached in the deep crisis of 2001/2, but even in this case, the high rates of growth exhibited by that country seems to rely mostly in increasing capacity utilization than in capacity creation.24 Finally, GDP growth has been characteristically volatile in the three economies around low rates most of the time. The exception, again, has been Argentina in its “non-liberal” post2002-crisis. TABLE 1 Table 2 shows that macroeconomic policies adopted since the 1990s have been successful in dealing with the one-time major concern in Latin America that is the behavior of prices. Inflation has fallen dramatically in all three countries, and more recent information confirms this trend, with the possible exception of Argentina, where some uncertainty about inflation has been recently revived. In contrast, macropolicies have been much less effective in fighting unemployment, which remains high even when one disconsiders the years when the economies suffered exceptionally strong adverse shocks. TABLE 2 Table 3 illustrates one important element not of financial liberalization per se, but of the policy environment that is judged to be appropriate to allow liberalization to exert its expected virtuous influences. All three countries, but most visibly in the case of Argentina and Mexico, have taken measures directed at reducing fiscal imbalances In the case of Argentina, certainly helped by the reduction in interest expenditures resulting from its debt renegotiation, a modest surplus has been achieved from 2003 to 2005. Mexico, on the other hand, has practically reached a balanced budget in 2005 (which continued in 2006). Brazil may be the odd man out in this respect, when budget deficits began to grow again in 2005 after falling for three years. TABLE 3 The behavior of real effective exchange rates in the three countries in the period 1997 to 2005 is shown in table 4. Again, volatility is a common trace between the three experiences. In the case of Argentina one can see an almost uninterrupted process of real appreciation of the peso until the 2002 crisis a small but suggestive piece of illustration of the difficulties in sustaining the regime of fixed exchange rates adopted with the Convertibility Plan of 1991. After the crisis the volatility of the real exchange rate was 24
Although more recent evidence points to the possibility of an increase in the rate of investments in Argentina.
20 greatly diminished by a conscious policy of exchange rate management directed at keeping the profitability of exports. In Brazil, a crawling peg exchange rate regime was abandoned as a result of the balance of payments crisis of 1998/9 and replaced by a floating exchange rate regime. As policy interest rates were raised in 1999 to control the inflationary impact of the change in exchange rate regimes, real exchange rates were contained by excess inflows of capital. The relative normalization of the situation in 2001 allowed a dramatic real devaluation to take place that ultimately induced the radical change operated in the current account beginning in 2002, shown in table 3. The combined impact of a mostly pure floating exchange rate regime and a high policy interest rate however, in contrast with the Argentinean experience, ended up gradually eroding the advantages created by the initial devaluation. Finally, during the period under discussion, Mexico experienced more limited volatility ending the period with a lower real exchange rate than it began. Again, referring to the information contained in table 3, the relatively small real devaluation of the period 2003 to 2005 induced some improvement in Mexico’s current account but not enough to eliminate the deficit, as it happened in Argentina and Brazil. TABLE 4 Table 5 reports the behavior of nominal deposit and loan interest rates. Perhaps the more intriguing fact shown in the table is that in the whole period interest rates were much higher in Brazil than in Argentina and Mexico. Higher interest rates prevail in Brazil in comparison to the other countries no matter their macroeconomic situation. Except for 2002, when Argentina was rapidly sliding into a deep recession that cost it more than 10% of its GDP, deposit and lending rates were higher in Brazil when its inflation was higher than in the two other countries, but also when it was lower. They were higher compared to a post-crisis not-so-liberal Argentina, but it was also higher than liberalized Mexico. As observed in section II, the financial repression model predicted that interest rates should increase with financial liberalization because caps on interest rates would be eliminated. Afterwards, however, interest rates should decrease as the financial system became more efficient and the cost of capital reduced. 25 It is exceedingly complex to examine this point, particularly in the case of Argentina and Brazil where financial liberalization was promoted amid attempts at price stabilization, so that interest rates before liberalization would also be the interest rates before price stabilization. The interpretation of interest rate behavior under high inflation regimes is very difficult, seriously compromising the comparison between pre- and post- stabilization interest rates. Be that as it may, although interest rates remain very high in the three countries even with their inflation rates remaining relatively low, it is certainly not evident why they are so much higher in Brazil. On the other hand, the data does not give clear support to the expectation that interest rates would decline with the continuation of liberalization. Interest rates in Argentina were already rising under the convertibility regime and the liberal rules. They fell steeply only after the 2002 crisis, when the context was already biased against 25
Honohan (2001), p. 92, observed that interest rates in developing countries did rise after liberalization. He also states that interest rate volatility too rose in the period.
21 liberal strategies. In the case of Brazil, as in the case of Mexico, interest rates seemed to fall more intensely in the end of the 1990s. In the 2000s they began to oscillate around still relatively high levels. A complementary puzzle is the size of the spread suggested by the comparison between deposit and lending rates in Brazil. The comparison has to be considered very carefully, since those rates are averages and do not necessarily show actual spreads charged by specific classes of financial institutions. Again, after all the required qualifications are made, the fact still remains that the difference between rates paid on liabilities and charged for loans in Brazil is exceptionally large, when contrasted to the values observed in Argentina and Mexico.26 TABLE 5 In sum, at the macroeconomic level, there is little discernible impact of financial liberalization on the operation of the three economies discussed here. This is not, of course, a formal rigorous examination of the effects of financial liberalization. It may very well be possible that the expected benefits of liberalization could not emerge because of other surviving imbalances or because of policy mistakes or, still, by the lack of real commitment of authorities to the financial reform program, even though this may be a hard point to argue since most of the liberalization measures were adopted willingly by governments in the three countries. In fact, as we saw, and will discuss in more depth in section V, the predictions of financial repression theory with respect to the macroeconomic effects of liberalization were questioned on theoretical grounds even by supporters of liberal reforms. II. The Banking Sector More definite predictions were made with respect to the operation of liberalized financial systems. In particular, the financial repression theory predicted that the financial system would expand and diversify as a result of the removal of restrictions on competition and the reduction of the role of the state in the sector. In fact, all three countries implemented processes of privatization of state-owned financial institutions, although in the case of Brazil federal banks were not put for sale, even under the liberal administration of Fernando H. Cardoso. The Brazilian federal government still owns big and influential financial institutions, including the largest commercial bank, Banco do Brasil. It also owns the largest savings bank, Caixa Econômica Federal, and a very active development bank, Banco Nacional de Desenvolvimento Econômico e Social. As a result, directed credit remained much more important in Brazil than in Argentina or Mexico, that in effect dismantled developments banks and privatized a large number of state-owned banks (although Argentina also preserved Banco de la Nación, the local equivalent of Banco do Brasil).
26
In fact, actual spreads seem to have remained high also in México, although not as high as in Brazil. Montes-Negret and Landa (2001) attribute the size of spreads in Mexico to the oligopolistic nature of the banking sector.
22 Information in table 6 seems, at first sight, to weaken the liberal argument that liberalization would stimulate the financial sector to expand. Although an increasing trend in the domestic supply of credit (amid some oscillation) can be detected in the case of Brazil, it is much less visible in the case of Argentina (amid strong volatility). In the case of Mexico, simply there is no expansion at all to be detected. The domestic-credit/credit-tothe-private-sector ratio is generally low, especially in the cases of Argentina and Mexico. TABLE 6 Nevertheless, financial repression theory finds some solace in the contrast between the information of total domestic credit supply and credit offered to the private sector. This contrast, in all three countries, suggests a strong crowding out effect, with the public sector absorbing a major fraction of available Bank lending capacity. In fact, this has less to do with financial repression per se, which emphasizes the role of the state in supplying and allocating credit, than with the type of stabilization and crisis management policies employed in the period to deal with inflation and balance of payments problems. In the case of Argentina, high inflation and hyperinflation27 had inflicted heavy damages to the banking industry, which induced a flight from peso-denominated financial assets toward US dollar-denominated investments. After price stabilization, the banking industry had to start from an exceedingly low level of operations. Dealing with public securities remained an attractive option for banks, particularly after the 2001 crisis. A similar, albeit less strong, inflation process happened in Brazil. The banking system, however, was much stronger in the aftermath of price stabilization than in Argentina28, ready to expand credit to the private sector. The macroeconomic policy strategies adopted by successive Brazilian federal administrations, however, led to a rapid increase in the supply of public securities offering unbeatable combinations of rates of interest and hedge against all major risks. Finally, in the case of Mexico, after the banking debacle of 1994, the government switched nonperforming assets in the balance sheet of banks for public securities, which allowed Mexican banks to expand and become profitable without having to expose themselves to the risks of lending to private borrowers. Thus, financial repression theorist could feel at least partially vindicated since it is very reasonable to assume that credit to the private sector could have expanded in the period if banks did not have the alternative of profitably investing in public securities. The support for the liberal thesis, however, has to be qualified by the acknowledgement that the phenomenon described in table 6 resulted not from any surviving pro-state bias but from the reliance on very conventional macroeconomic policies to fight turbulences generated by balance of payments and financial problems. Banking systems seem to be generally safer in recent years, as shown both in table 7 and table 8. After the banking crisis of 2002, Argentina changed the terms of its adherence to the 1988 Basle accord, reducing the minimum risk-weighted regulatory capital coefficient back to 8%. Brazilian and Mexican banks kept capital coefficients well above the minimum 27 28
On the distinction between high inflation and hyperinflation, see Carvalho (1991). Cf Carvalho (1998).
23 required, given the profile of their assets. One should be careful when interpreting these data as prima facie evidence that liberalized banking systems are less fragile than repressed systems. As shown in table 6, the banking systems in the three countries are heavily dependent on public securities which usually have zero risk for risk-weighting regulatory purposes. If, or when, banks in those countries begin to expand its operation with private borrowers current regulatory capital can quickly become insufficient to fulfill the supervisors’ demands. TABLE 7 Explainable in part by the same arguments just raised, nonperforming loans have been kept low (excepting, of course, the crisis period in Argentina) and provisioning strong, as it is shown in table 8, which in part does reflect the increasing concern in the region with the adoption of more modern methods of risk assessment and management. TABLE 8 Finally, if one again excludes Argentina because of the profound effects of the 2002 banking crisis, which still must influence the performance of the sector, in Brazil and Mexico banks remain a profitable industry, as it is exhibited in table 9. Again, according to financial repression theory, one should expect falling rates of return in the industry as a result of deregulation, removal of protective barriers and entry of foreign banks. Nevertheless, the result, so far, seems to be the opposite, with bank profitability actually rising in the period. TABLE 9 iii. Securities Markets Bank activities were expected to expand after liberalization as a result of increased competitive pressures coming from new institutions. But new financial markets should also emerge to take advantage of the profit opportunities created by liberalization. In particular, securities markets should expand in those segments where banks have no competitive advantage. Securities markets have expanded of late in the region. Capital account liberalization measures allowing foreign investors to buy stock in local exchanges in the late 1980s and early 1990s were essential to expand trade and create liquidity. Of course, price stabilization also contributed decisively to make stock trading attractive to investors. The grave turbulences of the 1990s prevented, however, these markets to flourish, which seems to have began in the 2000s. Largely because of foreign capital inflows, which accelerated their pace in the 2000s, stock prices have risen strongly so far in this decade, as it is exhibited in table 10. TABLE 10
24 The rise of capital inflows to domestic securities markets combined with the improvement in country-risk evaluations shown in table 11 to make these markets an increasingly attractive source of resources at least for those large firms which could have access to them. Although securities markets are still very small by any measure, table 12 shows for the Brazilian case, they recently began to reach more significant dimensions which could lead them, if not interrupted by any major disturbance, to become a relevant source of resources for the private sector in the near future. It is important to note, in any case, that table 12 is only informing the relative size of new securities issuance in Brazil, not the actual use of that source of capital by investing firms. It only shows that new issues of stocks and of debt securities could soon become a relevant source of finance for investment by Brazilian firms, if the trend continues in the future. TABLE 11 TABLE 12 Currently, the reality, however, is that securities markets are still really relevant in the three countries only for trading with public securities. Its importance may be gauged by the difference between total domestic credit and credit to the private sector in table 6, since banks and associated institutions are the main holders of public debt securities. The eventual development of private securities markets depends directly on eventual changes in macroeconomic policy that may reduce the stock of public debt and reduce the attractiveness of public securities to investors. The good news, of course, is that a private securities market would need mostly the same kind of infra-structure already created to trade public securities, be it in terms of payments systems or of legal structures. The existence of a large market of public debt also helps the development of private securities markets in providing the necessary benchmarks for the definition of yield curves for private securities. V Discussion Financial liberalization was proposed by liberal-minded economists to developing countries as a more efficient way of mobilizing and allocating financial services than what was then called financial repression. Efficiency, however, has multiple meanings whether we are dealing with individual agents or institutions, with specific industries or with whole economies. To individual agents or institutions what matters, of course, is which alternative is more profitable or, which in given circumstances should lead to the same result, which is less costly. In this sense, building monopoly positions, for instance, or growing to be “too big to fail” can be very efficient from the point of view of an individual institution. When we consider collectives, like an industry or the whole economy, for that matter, things become more difficult because measurement criteria have to be defined relying, perhaps, inevitably, on some arbitrary choice of targets. Financial repression theory was fundamentally a macroeconomic theory. It dealt mostly with aggregates, such as savings, investments and GDP. Its most important predictions
25 related to savings ratios, investment ratios, and economic growth. In a nutshell, financial repression theory predicted that freely-moving interest rates would go up, stimulating consumers to save more, lifting the financial constraint on investment, and therefore pushing growth rates up. In addition, privatization of state-owned banks, ending directed credit and removal of protective barriers should allow the financial system to diversify and expand, improving the allocation of financial resources in support of the worthiest investment projects. Again, the final effect should be the acceleration of economic growth. If growth acceleration is the ultimate criterion of success, one should not be surprised by the feeling of disappointment that has surrounded the experience so far in Latin America. As acknowledged by the World Bank: “Certainly the reforms produced some gains. But the growth benefits of the financial and nonfinancial reforms in the 1990s were less than expected.” (World Bank, 2005, p. 207) Growth has not accelerated in Argentina, Brazil and Mexico, nor have the savings ratio and the investment ratio exhibited any significant change in the period examined in this paper. Of course, there are two possible explanations for the failure of financial liberalization to promote faster growth: liberalization may have been overwhelmed by other, countervailing, factors that neutralized its benefits; or the assumptions on which the theory of financial repression relied may simply be wrong. Supporters of financial liberalization tend to emphasize the continuing meddling of the economy by the government, crowding out private borrowers, for instance, or refusing to eliminate, rather than just attenuate, direct credit allocations.29 On the other hand, at least in the first years after liberalization had began, in the 1990s, it could also be argued that continued turbulence in the international economy had prevented the economies which had implemented reforms to reap the fruits of their efforts. As times passes, even if one accepts them, the two arguments lose some of their force. First, because, in contrast to the 1990s, the 2000s have been, so far, almost extraordinarily benign: growing international trade and the absence of international financial crises allowed the better prepared developed economies to accelerate growth. As Rodrik (2007) has observed, the economies that better enjoyed the new opportunities were not the ones who followed the financial liberalization model. In the case of the three countries studied in this paper, only Argentina seemed to have taken this opportunity, accelerating growth to rates that not only allowed the country to recover lost terrain but in fact to grow beyond it.30 The Argentine success, of course, does not strengthen the case of liberal reformers. As to the complaint that, even after liberalization, government meddling in the financial sector remained high, it may just boil down to an acknowledgment that abstract models of 29
Cf. World Bank (2005), p. 215. In fact, growth continues at high rates. According to the last Boletin de Estabilidad Financiera published by the Banco Central de la Republica Argentina in the second semester of 2007, the annualized rate of growth of the Argentine economy in the first semester was 8.4%.
30
26 free financial markets may be too far from the real world to generate meaningful predictions. One could reasonably make the case that Brazil did not take the liberal reforms to heart as expected by financial repression theorists. Direct credit is still very important in the Brazilian economy, as it can be seen in table 13. Most of direct credit is in fact allocated by the federal development bank (BNDES), which was never even cogitated as a candidate to privatization. Private financial institutions in Brazil do complain against unfair competition in the markets for long-term finance, even though these same institutions never manifested even the most remote interest in exploring the same segment. TABLE 13 The same criticism, however, cannot be taken at face value in the case of Argentina, until the 2002 crisis, or Mexico in the period covered in this paper. In fact, both countries changed radically their financial systems, without the reservations maintained in the case of Brazil. All restrictions to the entry of foreign banks were removed. Privatization swept the bank industry. Direct credit was virtually eliminated in Argentina and reduced to a small niche of the market (allocation to small firms) in Mexico. To a large extent the remaining presence of the state in these two cases was due mostly to the attempt to manage banking and balance of payments crises with the fewer policy instruments that governments were left with after liberalization. Argentina, in fact, ended up suffering a deep crisis in 2002 and Mexico was classified as an underperformer even by analysts who supported liberalization.31 From the late 1980s to the late 1990s, all three economies went through a wide process of liberal reforms that, deep as it was, could not shape them at the image of the rarefied model of free markets assumed in the financial repression literature. One ignores real-world constraints at one’s own peril. The kind of radical transformation that is proposed in works like World Bank (2005) could only be achieved in semi-totalitarian regimes, such as Pinochet’s after the 1973 coup. Even then, the radical reforms implemented by the military led to a deep banking crisis a few years later. Of course, Caprio et al (2001) are right to note that “few lament the demise of financial repression” that, for them “was associated with the rise of populism, nationalism, and statism.” (pp. 3, 4) The World Bank utilizes an even more colorful language: “The financial repression that prevailed in developing and transition countries in the 1970s and 1980s reflected a mix of state-led development, nationalism, populism, politics and corruption.” (World Bank, 2005, p. 207)32 Even if one does not consider financial repression theory to be supported by solid empirical evidence and its predictions to be, in large part, wrong33, it is reasonable to acknowledge 31
Cf Tornell et al. (2003). These authors argue that liberalization was a disappointment in Mexico because of the failure to reform the judiciary to ensure greater contract enforceability. 32 It should not be surprising then that “[t]he World Bank has actively supported financial liberalization in developing and transition economies”, Caprio et al (2001), p. 10, fn. 9. 33 In fact, as already seen in section II, a large number of analysts would take the prediction that savings should increase with the removal of interest rates controls with many reservations, even at the theoretical
27 that at least some degree of financial liberalization could be justified in the conditions under which the three countries actually operated in the late 1980s. Perhaps most important among those conditions was the perception that many of the domestic controls had become dysfunctional. In particular, interest rate controls could be circumvented more or less easily by the requirement that borrowers had to keep some minimum balance in their accounts to qualify for a loan or by the demand that the client buy other services that were more profitable to banks. Most of these demands were actually banned by supervisors but were applied anyway since borrowers frequently did not have any choice but to accept them to get loans. The literature on the three cases studied in the paper mentions that in many cases regulations got to be so complicated that enforcement became very difficult. In addition, some controls or credit allocation mechanisms could become long obsolete before policymakers could make a decision to change them. In sum, even supporters of activist developmental states could accept the possibility that financial systems could be overregulated to the point of loss of efficiency at certain times. On the other hand, the most extreme expectations of the achievements of financial liberalization were fed by approaches that relied on the efficient market hypothesis. This hypothesis neglects the relevance of market imperfections, some of which may have such importance in the case of developing countries as to impose limits on the degree of financial liberalization that one may want to reach. By far, the most relevant market imperfection to be considered in the present context is the existence of positive externalities involved in some investment projects that can only be properly recognized and accounted for by public development banks. Developing economies are usually characterized by the existence of gaps in their productive structure. Some investment projects may be strategic in the sense that they induce other investments, by private investors and privately financed, that may close those gaps. The original project may contribute to make other investment projects viable, which is a positive externality that is not considered in the calculations of the rate of return and of ability to pay back loans made by private suppliers of credit. As it is the case with any type of externality, social returns are different from private returns, but it is the latter that counts in a liberalized system. In mature economies these externalities may not be that relevant, although they certainly survive in sectors such as public utilities, for instance. In developing countries, the identification and financial support of investment projects that may induce other investments may be an essential element of a successful development strategy.34 In the case of Mexico, governments since the mid-1990s seem to have decided to bet on the integration of its economy with the US economy. No matter how successful this strategy level. On the other hand, asymmetric information models would also qualify the second prediction, related to the superior efficiency of free financial markets. Cf. Stiglitz and Greenwald (2003) and Honohan and Stiglitz (2001) who defend the implementation of a financial restraint strategy in opposition both to financial repression and to financial liberalization. 34 One should confuse these externalities with accelerator effects, which may be very important but act through variations in income and demand. The effects emphasized here relate to productive chains where the investment in some strategic points may induce investments in the remainder of the chain.
28 may turn out to be, this alternative is not open to Argentina or Brazil. In these countries, the idea that development could just be left to the markets, entertained during the 1990s, was for all practical purposes abandoned in the 2000s. In the case of Brazil, the role of BNDES has been strengthened while in Argentina development banks are being recreated after being dismantled in the 1990s. Is this trend in Argentina and Brazil temporary? Will private financial markets eventually replace public development banks in financing development? The answer may be yes or no depending on how one assesses the costs and benefits of the operation of different financial structures in mature economies.35 In the short to medium term, however, the more likely choice is some intermediate system where financial markets may freely set asset prices and interest rates, but the state recuperates or maintains some strong presence in the financing of investment. In fact, even in the case of Brazil, where bank credit has expanded more rapidly and capital markets have reached a larger dimension very few transactions have been directed at financing productive investments.36 In fact, the much quicker growth of financial transactions than of productive investments has been a trend in practically every major financial system. Financial operations are supporting merger and acquisitions operations, where existing assets just change hands, or piling layers over layers of securities, with new financial assets being backed by other financial assets, in a process that feeds largely on itself.37
VI Conclusion Financial liberalization processes in Argentina, Brazil and Mexico are presently in a kind of hiatus, even because most of the major reforms that define them have already been made. Mexico seems to maintain a liberal bias, the 2002 crisis seemed to have fed an anti-liberal bias in Argentina, and Brazil remains, as in the past, in the middle, trying to combine free financial markets with strong state activities in the financing of investment. Financial liberalization reforms were left incomplete, but in the main they were not reversed. In the three countries, concerns about the banking sector seem to be more focused on the need to modernize the regulatory and supervisory apparatuses, particularly with the incoming implementation of the new Basel accord, than in proceeding with privatization processes and the other “classical” measures proposed by financial repression theorists. Progress with price stabilization and in reaching fiscal balance may hold some good perspectives for the continuation of the expansion of financial markets, particularly those 35
Singh (2003), Singh and Zammit (2006) and Singh and Glen (2005), for instance, believe that bank-based systems with strong government presence may remain as a characteristic feature of efficient financial systems (in contrast with market-based systems like the one in the United States) even after maturity is reached. 36 The remarkable increase in the value of new issuance of debentures in Brazil, for instance, in 2005 was largely absorbed by leasing institutions to finance working capital. Cf. Sant’Anna (2006). 37 Keynes, in A Treatise on Money, had already advanced the notion of two relatively autonomous circuits he called financial circulation and industrial circulation, the first related to transactions with financial assets, the second with goods and services. In these terms, recent years have witnessed a quick expansion of financial circulation, with, however, a relatively lesser impact on the actual purchase of investment goods. Cf. Keynes (1971), chapter 15.
29 for private debt securities through the fall in the stock of public debt. In contrast, the increasing dependence of local markets on foreign capital inflows may have made stock exchanges and other securities markets too vulnerable to reversals in capital flows. Under these conditions, the wisest strategy may remain the one that maintains the incentives to the expansion and diversification of financial markets but still keeps in the hands of the public sector instruments powerful enough to allow it to support investments even in contexts of financial turbulence. References Banco de Mexico, Direction of International Affairs, Implications of financial liberalization for the promotion and allocation of domestic saving: the case of Mexico, 9th APEC Finance Ministers’ Process, 2002. Bandiera, O., Caprio, G., Honohan, P. and Schiantarelli, F., Does financial reform raise or reduce savings?, 1998. Caprio, G., Hanson, J., and Honohan, P., Introduction and overview: the case for liberalization and some drawbacks”, in Caprio et al (2001). Caprio, G., Honohan, P. and Stiglitz, J. (eds), Financial Liberalization. How Far, How Fast?, New York: Oxford University Press, 2001. Carvalho, F., “A post Keynesian approach to inflation, high inflation and hyperinflation, in P. Davidson and J. Kregel (eds), Economic Problems of the 1990s, Cheltenham: Edward Elgar, 1991. Carvalho, F., “The Real stabilization plan and the banking sector in Brazil”, Banca Nazionale del Lavoro Quarterly Review, 51 (206), Sept 1998. Carvalho, F., “New competitive strategies of foreign banks in large emerging economies: the case of Brazil”, Banca Nazionale del Lavoro Quarterly Review, 53 (213), June 2000. Demirguç-Kunt, A., and Detragiache, E., Financial liberalization and financial fragility, in Caprio et al (2001). Dornbusch, R., and Werner, A., “Mexico: stabilization, reform and no growth”, Brookings Papers on Economic Activity, 1, pp. 253-315, 1994. Eichengreen, B. and Mussa, M., Capital account liberalization. Theoretical and Practical Aspects, IMF Occasional Paper 172, 1998. Fry, M., Money, Interest, and Banking in Economic Development, Baltimore: The Johns Hopkins Press, 2nd edition, 1995.
30 Galindo, A., Sciantarellu, F., and Weiss, A., “Does financial liberalization improve the allocation of investment? Micro-evidence from developing countries”, Journal of Development Economics, 83, 2007. Gonzales-Anaya, J. and Marrufo, G., Financial market performance in Mexico, 2001. Greenwald, B. and Stiglitz, J., Towards a New Paradigm in Monetary Economics, Cambridge: Cambridge University Press, 2003. Gruben, W., Koo, J. and Moore, R., When does financial liberalization make banks risky? An empirical examination of Argentina, Canada and Mexico, 1998. Hernandez-Murillo, R., “Experiments in financial liberalization: the Mexican banking sector”, FRB of St Louis Review, Sept/Oct 2007. Honohan, P., How interest rates changed under liberalization. A statistical review, in Caprio et al (2001). Honohan, P. and Stilgitz, J., Robust financial restraint, in Caprio et al (2001). Kaminsky, G., and Schmukler, S., Short-run pain, long-run gain: the effects of financial liberalization, NBER, June 2003. Keynes, J.M., The General Theory of Employment, Interest and Money, New York: Harcourt, Brace, Jovanovitch, 1964. Keynes, J.M., A Treatise on Money, vol. 1, London: The MacMillan Press for the Royal Economic Society, 1971. Montes-Negret, F., and Landa, L., Interest rate spreads in Mexico during liberalization, in Caprio et al (2001). Rodrik, D., The false promise of financial liberalization, Global Policy Forum, Jan 22, 2007. Sant’Anna, A., “Crescimento de debentures financia capital de giro”, BNDES, Visão do Desenvolvimento, 5, 20/07/2007. Singh, A., Corporate governance, corporate finance and stock markets in emerging countries, 2003. Singh, A., and Glen, J., Shareholder value maximization, stock market and new technology: should the US corporate model be the universal standard?, 2005 Singh, A., and Zammit, A., Corporate governance, crony capitalism and economic scrises: should the US business model replace the Asian way of ‘doing business’?, 2006.
31 Singh, A., Belaisch, A., Collyns, C., de Masi, P., Krieger, R., Meredith, G., and Rennhack, R., Stabilization and reform in Latin America: A macroeconomic perspective on the experience since the early1990s, Washington: IMF, 2005. Stallings, B. and Studart, R., Finance for Development. Latin America in Comparative Perspective, Washington: The Brookings Institution, 2003 The World Bank, Economic Growth in the 1990s. Learninf from a Decade of Reform, Washington: The World Bank, 2005. Tornell, A., Westerman, F. and Martinez, L. Liberalization, growth and financial crises. Lessons from Mexico and the developing world, 2003. Wyplosz, C., How risky is financial liberalization in the developing countries?, G 24 Discussion Paper 14, Sept 2001. Yeiati, E. and Micco, A., “Concentration and foreign penetration in Latin American banking sectors: impact on competition and risk”, Journal of Banking and Finance, 31, 2007.
