John H. Welch

The New Face of Latin America: Financial Flows, Markets and Institutions in the 1990s

The gains and difficulties Latin American countries face from financial market development and liberalisation have received much attention in current economic literature. Nevertheless, significant issues have received little or no attention, even though the success of these efforts depends upon them. The purpose of this article is to explore the benefits from open and developed-two words that are not necessarily synonymous financial and capital markets in Latin America and possible important obstacles which will be faced in the remainder of the I990S. Despite the importance of financial liberalisation, trade liberalisation is the central policy of any liberalisation effort. Moreover, the usual arguments favouring financial liberalisation stem only from the benefits of this policy in itself.1 The usual conclusion is that trade liberalisation leads to capital account liberalisation. It is not fully appreciated that financial liberalisation and privatisation are not only complements, but necessary complements to trade liberalisation. One could write a number of volumes developing this proposition rigorously. Since this is beyond the scope of this article, however, I will leave the motivation for the proposition at an intuitive level; in a liberalised environment, domestic

Financial Growth and Economic Development

An increased separation between saving and investment decisions, i.e. large increases in financial assets relative to tangible assets, is seen by many economists1 to be a necessary if not sufficient condition for the self-sustained growth of an economy. Over the last three decades extensive theoretical and empirical research has focused on the relationship of financial development and economic development.

Privatization in Mexico and Chile: Comments on Bazdresch and Elizondo and Meller

The papers by Carlos Bazdresch and Elizondo and Patricia Meller on the privatization programs in Mexico and Chile present succinctly the most advanced privatization programs in Latin America. Bazdresch and Elizondo’s paper locates the Mexican push for privatization in the more general context of a liberalization program. They conclude--I think correctlythat privatization should be viewed as a policy instrument-perhaps not even the most important instrument-at policymakers’ disposal when liberalizing an economy. Certainly in Mexico and in Chile trade liberalization took center-stage in the economic structural reforms undertaken in each country. Patricia Meller’s paper concentrates more on the avenues through which the Chilean authorities privatized state-owned enterprises and why these were important to the failure of the first wave of reprivatization in the 1970s and the success of the more recent reprivatizations since 1985. The distinguishing characteristic of the second wave of privatization was the goal of diffusion of ownership through “peoples capitalism” to avoid the formation of “grupos” which were widely seen as one of the ingredients in the collapse of the first wave. The paper also tries to measure the implicit subsidies involved in the divestitures. Although I have some questions about these calculations, I will not discuss them here. Bather, I would like to unify my discussion of the two papers by following Bazdresch and Elizondo’s suggestion in first identifying the importance of privatization in economic reform. One benefit from privatization is that divestiture essentially changes the objective function of the owners from one that may incorporate noneconomic objectives to one of profit maximizing.’ But the fact that the objective function changes or becomes clear does not necessarily mean that managers will act according to the new owners’ wishes.* For privatization to play the central role in reform, however, the form of ownership and the market for ownership must effectively discipline management behavior compared to

Development with Inflationary Finance: 1945–63

The period 1945–63 in Brazil is sometimes referred to as the period of easy import substitution. Until 1961, when the ability to industrialise through import substitution industrialisation had ended, industrialisation was financed to a large extent through inflation. Domestic firms were protected by selective exchange controls and the ‘law of similars’ which allowed high tariff barriers to be erected on competing products.1 In general, firms financed long-term investment with the inflated retained earnings from protection, while financing working capital through short-term bank credit.2 Industrialisation proceeded by initially developing consumer durable production. The short-term and medium-term financial system grew up around consumer durables where commercial banks discounted the accounts receivable or ‘duplicatas’ of firms needing working capital. This system was complemented by the appearance of the bills of exchange (letras de cambio) market. Vertical integration was promoted by the generous application of the law of similars, the encouragement of multinational corporations to operate in Brazil, and direct government production in heavy industries such as steel, petroleum, transportation, and public utilities.3

Summary and Concluding Remarks: Towards a New Financial Reform in Brazil

The objective of this study has been to provide a systematic analysis of the post-war Brazilian experience with financial and capital market development. The introduction motivates the study and outlines a macroeconomic chronology which serves as a backdrop throughout. Chapter 1 reviews a number of different theories concerning the importance of financial development and different policy prescriptions to attain this goal. Chapter 2 looks at the pre-reform financial system during the heyday of import substitution industrialisation (ISI) from 1945 to 1964. The same chapter argues that the lack of functioning financial and capital markets contributed to the exhaustion of ISI policies. It also pinpoints the areas where market and institutional failures led to serious problems in the intermediation process. Chapter 3 analyses the original objectives to the reformers in 1964–7, the structure of financial markets which resulted from the reforms, and the structure of the decision process of financial policy. The remaining chapters of the study investigate the longer-term ramifications of the reforms. Chapter 4 shows that the objectives of creating vigorous markets for equities took much longer than expected and had limited success. Chapter 5 analyses the implications of creating inflation-indexed debt instruments. Finally, Chapter 6 examines the changing balance sheet structure of Brazilian firms and financial institutions in addition to gauging the efficiency of the intermediation process in Brazil.

The Indexation of Financial Assets

The military government that took power in 1964 concentrated initially on reducing the inflation rate. This was attempted through ‘gradualist’ policies which were thought more appropriate for a fragile economy that could not absorb a ‘shock treatment’ stabilisation programme.1 Admitting that inflation would not fall instantaneously to low levels, the Castello Branco administration, specifically Minister of Finance Octavio Gouveia de Bulhoes and Minister of Planning Roberto de Oliveira Campos, concentrated on minimising distortions which had been caused by inflation, especially in financial markets.2 The main innovation was the creation of indexed bonds, Adjustable Obligations of the National Treasury (ORTNs), which were followed by other indexed assets. As Table 5.1 shows, indexed financial assets came to dominate financial markets over the period 1964–85 increasing from 4.7% of non-indexed assets in 1965 to around two times the size of non-indexed assets in 1985.

The Reforms of 1964–5

The financial reforms initiated in 1964 had three basic objectives: (1) improve allocative efficiency of capital markets, (2) design an institutional structure which would allow the implementation of selective credit policy, and (3) establish institutions that would facilitate inflation stabilisation. In many instances, these objectives were not mutually compatible. For example, creating strong primary and secondary markets for equities is difficult in the face of restrictive monetary policy. Further, selective credit programmes made, at times, anti-inflationary monetary programming difficult, if not politically impossible. In other cases, the initial measures did not achieve the original objectives and stronger measures were implemented. This chapter outlines the initial objectives of the reformers, the initial reforms, and the resulting structure of the financial system.

The Development of Equities Markets: 1964–85

Creating robust primary and secondary markets for stocks and bonds was the dominant objective of the reforms of 1964–7. The reasoning behind the reforms and the initial attempts at reform were outlined in Chapters 2 and 3. The economic crisis of 1963–4 saw firms become extremely illiquid. Policy makers felt that firms relied too heavily on (marginal) borrowing to finance any increase in productive activity. The fact that firms valued assets on a historical basis, as opposed to a market basis, combined with inflation to decapitalise them. This resulted in inadequate provisions for depreciation showing up as ‘illusory profits’.1 The small market for equities, comprised of both the stock exchanges and the almost non-existent ‘over-the-counter’ market (mercado de balcao), was seen as a barrier to the stronger capitalisation of domestic firms through stock issue. Further, the closed nature of firms and their reluctance to dilute control made the issue of common stock extremely rare, thus stunting the development of a primary issues market.2

Commercial Banks, Investment Banks, Conglomeration, and the Financial Structure of Firms

Commercial banks historically have been the key institutions in the Brazilian financial system. They were affected directly by the following developments in different degrees over the last twenty years: (1) the institution of formal financial indexation to the inflation rate and the subsequent strengthening of the secondary market for ‘pre-fixed indexed’ assets — LTNs, certificates of deposits, bills of exchange, etc. — and ‘post-fixed indexed’ assets — mainly ORTNs — in the so-called ‘open market’; (2) competition from non-bank intermediaries; (3) the ability to contract foreign loans through Central Bank Resolution 63; and (4) the explicit promotion by the Brazilian government of financial conglomeration. It should be noted that the importance of non-bank competition vis-a-vis commercial banks was dampened by the process of conglomeration because commercial banks are usually the central institution in a financial conglomerate. The typical financial conglomerate in Brazil is centred on a commercial bank; other members are an investment bank, a ‘financeira’, a broker and dealer.1