Sound Macroeconomic Policies

The resumption of large external inflows in the early 1990s posed a major challenge for policy-makers to create a policy framework to reduce the risks of an external credit boom-bust cycle. Through a balanced policy framework, the Chilean authorities sought to harness financial stability to promote financial market development. They responded by implementing conservative monetary and exchange rate policies supported by strong fiscal performance and only a selective and gradual capital account liberalization.

On monetary policy, the framework until the late 1990s aimed at achieving a gradual reduction in inflation while smoothing currency appreciation and building up a significant foreign position. The central bank built on its anti-inflationary credibility by continuously meeting its preannounced inflation target. It also managed foreign exchange fluctuations within a reference band and sought to smooth currency appreciation. These policies aimed at avoiding an overvaluation of the currency and allowing conditions for sustained capital inflows in the context of gradual disinflation.

As a by-product of its sterilization and reserve accumulation policy in the 1990s, the central bank became the largest debt issuer and pursued sound debt management (Box 4.1). It actively sought to build a local benchmark yield curve based on an indexed unit of account, the Unidades de Fomento (UF), linked to the consumer price index (CPI). The development of a UF-denominated benchmark yield curve was one of the key factors contributing to the expansion of money markets and private sector fixed-income securities. In addition to nurturing the short end of the curve, the central bank sought to lengthen the duration of its domestic liabilities by issuing long-term paper. By the end of the decade, with the convergence of interest rates to international rates, the bank sought to move away from CPI indexation toward the nominalization of its key monetary instruments and debt issuance at the short end of the yield curve.

To help contain domestic inflationary pressure, in particular in the early 1990s, the authorities also sought to restrict capital flows by adopting a gradual capital account liberalization. The gradual approach sought to differentiate between different types of capital inflows and promote foreign direct investment. On the one hand, the deregulation of foreign direct investment became a key priority complementing a liberal tax foreign investment law with a gradual easing of limitations on repatriation of profits and capital. On the other hand, other capital flows, including portfolio inflows, were subject to an unremunerated reserve requirement, an implicit tax on capital based on the investment duration. The objective of this requirement was to reduce the country’s exposure to volatile flows and to extend the duration of capital inflows.⁶

On fiscal policy, the authorities sought to preserve strong fiscal surpluses to ease the government’s debt burden. By 1998, the central government’s public debt had fallen to 12.5 percent of GDP from more than 40 percent of GDP a decade earlier. The increased financing needs in the late 1990s led the government to seek finance abroad and set an external benchmark for domestic private issuers.

The government’s external debt management has sought to build an external benchmark in a position of financial strength in order to improve external financing conditions to the private sector. In the aftermath of the Asian crisis, the authorities perceived an inadequate assessment of the fundamentals underlying Chilean corporate debt and sought to increase foreign investor research on the country’s fundamentals. The sovereign benchmark has helped improve the pricing of external corporate bonds, though issuance of such bonds has not picked up.

Box 4.1.

Establishing Debt Benchmarks in Chile: The Role of the Public Sector

Public debt management has been receiving increased attention in Chile, including with regard to promoting development of financial markets. While the total stock of public debt owed to the domestic private sector has not been rising significantly—it has been broadly stable at around 30 percent of GDP for some time—it is substantial enough for its management to be of consequence, for both the public and private sectors.

To date, the management of public domestic debt has been a task for Chile’s central bank, since nearly all such debt is found on its balance sheet. As of end-2002, the central government still had essentially no debt to the domestic private sector, though the Ministry of Finance has indicated that it is considering a domestic bond issue.¹

In September 2002, the central bank began a program of modernization of its debt management procedures, with these objectives:

• Increasing the liquidity, and facilitating the internationalization, of the domestic fixed-income market;

• Deepening the process of “nominalization” of Chilean financial markets, encouraging the private sector to continue shifting away from use of inflation-indexed instruments;

• Prompting greater capital market efficiency, including development of markets for private debt and hedging instruments.

The bank considered that these moves would serve its broader objectives of deepening and modernizing capital markets and enhancing the economy’s integration with Chile’s main trading partners.

The specific actions that the central bank took include:

• Following international standards in the design of its debt issues, using “bullet” amortization, and interest paid twice a year;

• Increasing the stock of instruments that would serve as references or benchmarks for debt markets, with a view to establishing a yield curve based on liquid markets for low-risk instruments at various maturities.² Following international standards for liquidity, a minimum size for each issue would be US$300 million; and

• Increasing both the relative share and average maturity of its (nominal) peso debt issues, beginning with a new five-year maturity (previously, the longest maturity of peso issues had been only two years).

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Composition of Central Bank Paper

(In percent of total)

Source: Central Bank of Chile.

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These steps build on earlier actions by the central bank that has shifted its liability structure away from inflation-indexed debt in favor of dollar-indexed debt.³ The greater use of longer-term debt denominated in the domestic currency in particular is widely considered essential in the maturation of emerging market economies and, in particular, reducing their vulnerability to external financial crisis. In that vein, the eventual goal would be to persuade international investors to hold peso-denominated instruments issued by the private sector. Establishing benchmarks, and otherwise promoting the development of the domestic market for such instruments, is seen as a step in that direction.

The bank expects that the reform of its debt structure, by generating a rising volume of intermediation, will allow the market to create new hedging markets for specific risks.

A further benefit of the new debt issues has been the information about inflation expectations now conveyed by interest rate differentials between inflation-indexed and nonindexed debt. On the new five-year issues, such differentials have stayed close to the bank’s inflation objective (i.e., to the midpoint of the 2–4 percent target bank).

The size of the central bank balance sheet creates the opportunity to create a considerable range of benchmarks—not only at different maturities, but also in different currency denominations/indexations. Looking forward, the supply of total public domestic debt is not expected to grow very significantly via fiscal deficits, given the government’s commitment to fiscal discipline.⁴ Still, simply on the basis of existing central bank debt—on the order of US$20 billion, to be compared to the above-mentioned US$300 million standard for minimum issue size—it is clear that the central bank has the opportunity to provide a considerable range of benchmarks. Of course, at the margin bench-marking in any one instrument type reduces the scope for benchmarking in others.

Going forward, the bank’s announced policy is to hold constant the share of dollar-indexed instruments in its debt liabilities.⁵ Central bank debt is now divided (in increasingly equal shares) between inflation-indexed peso debt, dollar-indexed peso debt, and nominal peso debt, as shown in the figure. Although the rise in the share of dollar-indexed debt since 1997 may appear as an upward trend, in fact it occurred in three discrete episodes (in 1998, 2001, and 2002), in which the bank’s motivation was foreign exchange market intervention rather than benchmarking.

In the last few years, the central bank has reduced the share of inflation-indexed (UF) instruments in its liabilities significantly, by roughly half. This decline has come at the shorter maturities; indeed, all of the central bank’s debt having maturity greater than five years continues to be in UF form. This pattern reflects the central bank’s deliberate policy of promoting “nominalization” of private balance sheets in general, at the same time recognizing that a market preference for inflation protection will likely persist in long-maturity market segments (e.g., mortgages and pension savings). Looking forward, the 0–5 year market will be increasingly nominalized while the longer-term issues, from 5 to 20 (and possibly more) years, will be in UF.

The central bank’s strategy thus entails the eventual loss of the traditional shorter-term UF benchmarks. Such a change naturally involves some costs, at least during a period of transition. One such area may be the interest rate swap (IRS) market, which is not yet fully developed in Chile. The IRS market is relatively illiquid, as the end of short-dated UF issuance has made the market less complete in the 0–2 year segment, and the UF curve does not provide a continuous reference point to price IRS contracts.⁶ Looking forward, further progression of the nominalization process will allow the market to price IRS off the curve for nominal peso debt.

Aspects of the Chilean Market for Foreign Exchange Hedging Instruments

The Chilean market for foreign exchange hedging instruments primarily uses the spot and the NDF (nondeliverable forward) markets.

The market for foreign exchange hedging is fairly liquid, with transactions in the spot and NDF market reportedly reaching daily volumes of US$ 1.4 billion. Most contracts are valued at US$3–5 million, and monthly demand for corporate hedges tends to be about US$4–6 billion. The usual tenor for foreign exchange hedge contracts is between 90 days and two years with ample liquidity; corporates typically roll over their hedges for a longer duration. Cross-currency swaps are available for up to five years, with typical fixing at 30-day intervals.

In recent years, a significant outside stimulus to the private hedging market has been the central bank’s net issuance of dollar-indexed debt. The bulk of this injection was in the second half of 2001, when the stock of such debt rose to more than 7 percent of GDP, from about 2 percent of GDP in the previous year; a further increase, to 9 percent of GDP, occurred in 2002. Both increases were part of periods of exceptional intervention to support the Chilean peso. Looking forward, the bank’s announced policy is to hold steady the share of dollar-indexed instruments in its total debt liabilities.

Prepared by Manmohan Singh. ¹ Domestic debt of the public enterprises is limited mainly to a few recent issues, including by CODELCO and Metro. Subnational governments have no financial debt. ² For the time being, the bank is concentrating its new issues at original maturities of two and five years, for both nominal peso and dollar-indexed debt. For inflation-indexed debt, the bank is issuing at maturities of 5, 10, and 20 years. ³ The greater issuance of peso-denominated debt is part of the bank’s “nominalization” strategy, begun in 2001, when the bank switched its operational target from an inflation-indexed interest rate to a simple nominal interest rate. ⁴ The (temporary) deficits permitted under the structural balance rule tend to be moderate in size. Debt issues by the public enterprise sector might play a greater role, though in the past most such debt financing has been from external sources. ⁵ Although as always the bank reserves the right to foreign exchange intervention if it identifies exceptional circumstances. ⁶ A further indication of illiquidity in the shorter-term UF market is that UF interest rates are not quite as far below nominal peso rates as indicators of inflation expectations would predict. For example, in June 2002, one- and two-year yields on inflation-indexed instruments were only about 240 basis points below yields on nominal peso issues with corresponding maturities. Surveys of inflation forecasts, however, suggested somewhat higher expected inflation rates, closer to 3 percent.

Main Characteristics of Financing Flows

Domestic bank credit remains the primary source of corporates’ outside funding, but domestic bond markets have become increasingly important. Domestic corporate bond issuance before 1998 represented less than 1 percent of total corporate debt issuance. Yet, by 2001, the annual issuance had reached a quarter of total debt financing. Meanwhile, domestic commercial bank credit to the corporate sector saw a sharp increase from 1995 to 1999. During the period, it doubled in nominal terms and came to account for more than half of total corporate financing (Table 4.2).

Table 4.2.

Private Sector Financing Issuance

(In millions of U.S. dollars)

Sources: Capital One; Superintendency of Securities and Insurance; and Central Bank of Chile.

¹In 1999, external bank borrowing by Enersis alone accounted for US$3.5 billion.

Table 4.2.

Private Sector Financing Issuance

(In millions of U.S. dollars)

	Domestic			External
	Equity	Bonds	Banks	Equity	Bonds	Banks
1995	223	69	4,419	224	500	1.606
1996	619	133	5,382	297	2,020	3,688
1997	121	83	6,671	67	1,800	5,295
1998	71	798	6,820	—	1,063	3,600
1999	—	745	6,522	—	760	6,1811
2000	—	1,252	6,221	—	300	4,764
2001	—	2,739	5,545	—	886	2,074
2002	—	1,732	5,068	—	40	1,061

Sources: Capital One; Superintendency of Securities and Insurance; and Central Bank of Chile.

¹In 1999, external bank borrowing by Enersis alone accounted for US$3.5 billion.

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Table 4.2.

Private Sector Financing Issuance

(In millions of U.S. dollars)

	Domestic			External
	Equity	Bonds	Banks	Equity	Bonds	Banks
1995	223	69	4,419	224	500	1.606
1996	619	133	5,382	297	2,020	3,688
1997	121	83	6,671	67	1,800	5,295
1998	71	798	6,820	—	1,063	3,600
1999	—	745	6,522	—	760	6,1811
2000	—	1,252	6,221	—	300	4,764
2001	—	2,739	5,545	—	886	2,074
2002	—	1,732	5,068	—	40	1,061

Sources: Capital One; Superintendency of Securities and Insurance; and Central Bank of Chile.

¹In 1999, external bank borrowing by Enersis alone accounted for US$3.5 billion.

In contrast to the increasing domestic debt financing, the corporate sector’s external debt financing has seen a pronounced drop since 1997. From 1995 through 1997, external borrowing amounted to almost 50 percent of total corporate sector financing. In contrast, by 2002, the share of external borrowing represented less than 20 percent. External bond financing declined the most as the three-year moving average of bond issuance in 2002 was more than two-thirds down from its 1999 level. The retrenchment of foreign bank financing was also significant, as the three-year moving average dropped by half in the same period.¹⁰

Equity financing was the main casualty of the emerging market financial turmoil of the late 1990s. New American Depository Receipt (ADR) placements dried up completely after 1998 from a peak of US$755 million in 1994. Similarly, after 1997, there were no new initial public offerings in the local stock market. This is not surprising, given the sharply rising cost of capital in the late 1990s. Using the book-to-market ratio as a rough proxy for the cost of capital, the cost of issuing equity in 1998–2001 was twice that of the 1992–95 period. The fact that ex post dividend yields were not significantly different between these two periods would suggest that investors were demanding higher risk premia, and discounting share prices accordingly.

The surge in domestic bond market issuance is not a phenomenon unique to Chile, as most emerging market countries experienced a similar expansion (Table 4.3). In fact, domestic issuance for the sample of emerging market countries considered in Figure 4.4 grew almost tenfold from 1997 to 2001, making it the single most important source of financing in 2001 for these countries. However, the pattern of corporate funding showed important regional differences. While domestic bank lending in Asia and Eastern Europe remained the largest source of corporate finance during the period, Latin America experienced a sharp bank retrenchment in 2001 compensated by a large domestic bond issuance. In the case of Chile, however, the financially strong domestic banks continued to issue new loans, albeit at a much lower rate, even as external bank lending fell.

Table 4.3.

Domestic Corporate Bond Market

(In billions of Chilean pesos)

Source: Superintendency of Securities and Insurance.

Table 4.3.

Domestic Corporate Bond Market

(In billions of Chilean pesos)

	New Issues		Amount Issued		Indebted Entities		Stock Outstanding		Stock in Percent of GDP
	Private	Public	Private	Public	Private	Public	Private	Public	Private	Public
1995	5	0	28	0	44	2	900	81	3.1	0.3
1996	4	1	57	17	45	2	888	95	2.8	0.3
1997	6	1	36	9	41	1	778	59	2.2	0.2
1998	6	1	377	5	40	1	1,003	65	2.7	0.2
1999	12	1	393	5	43	1	1,287	71	3.5	0.2
2000	20	1	717	12	43	1	2,013	73	5.0	0.2
2001	36	4	1,793	108	62	2	3,832	203	8.8	0.5
2002	35	5	1,245	175	66	4	4,851	463	10.6	1.0

Source: Superintendency of Securities and Insurance.

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Table 4.3.

Domestic Corporate Bond Market

(In billions of Chilean pesos)

	New Issues		Amount Issued		Indebted Entities		Stock Outstanding		Stock in Percent of GDP
	Private	Public	Private	Public	Private	Public	Private	Public	Private	Public
1995	5	0	28	0	44	2	900	81	3.1	0.3
1996	4	1	57	17	45	2	888	95	2.8	0.3
1997	6	1	36	9	41	1	778	59	2.2	0.2
1998	6	1	377	5	40	1	1,003	65	2.7	0.2
1999	12	1	393	5	43	1	1,287	71	3.5	0.2
2000	20	1	717	12	43	1	2,013	73	5.0	0.2
2001	36	4	1,793	108	62	2	3,832	203	8.8	0.5
2002	35	5	1,245	175	66	4	4,851	463	10.6	1.0

Source: Superintendency of Securities and Insurance.

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Emerging Market Economies: Private Sector Issuance

(In billions of US. dollars)

Source: Capital One.Note: Emerging market economies: Argentina, Brazil, Chile, China, the Czech Republic, Hong Kong SAR, Hungary, Korea, Malaysia, Mexico, Poland, Singapore, and Thailand.

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Features of Chilean Corporate Debt

Despite the central bank’s nominalization of the key reference interest rate in 2001 and its recent efforts to create a peso-denominated yield curve benchmark, CPI-based indexation in Chile remains pervasive in domestic financial markets. More than 90 percent of fixed-income securities issued from 2000 to 2001 were UF-denominated (i.e., indexed to the CPI), while about half of bank loans were also CPI linked. On the other hand, indexation to the U.S. dollar for domestic fixed-income securities remains low, underscoring the role of local markets as a financing alternative to shield from increasing foreign exchange volatility.

Another prominent feature of Chile’s securities markets is the long duration of the instruments. The average duration of corporate bonds was seven years in 2002 with maturities ranging up to 30 years. The long maturities of bonds reflect the predominant role of pension funds and insurance companies. Given the long duration of pension and life insurance liabilities, these investors represent a readily available source of demand for securities with maturities of 20 or more years. In contrast, as shown in Table 4.4, the average maturity of commercial bank loans was less than two years (partly as a consequence of regulations limiting banks’ maturity mismatch).

Table 4.4.

Private Debt and Issuance Characteristics

(Average maturity; in years)

Sources: Superintendency of Securities and Insurance; Superintendency of Banks and Financial Institutions; and Capital One

Table 4.4.

Private Debt and Issuance Characteristics

(Average maturity; in years)

	Commercial Bank Loans	Domestic Bonds	External Bonds	External Loans
1997	1.2	13.8	33.0	6.3
1998	1.1	17.7	9.5	4.0
1999	1.3	12.1	8.6	2.8
2000	1.6	13.6	10.0	6.1
2001	1.8	14.3	15.1	3.5

Sources: Superintendency of Securities and Insurance; Superintendency of Banks and Financial Institutions; and Capital One

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Table 4.4.

Private Debt and Issuance Characteristics

(Average maturity; in years)

	Commercial Bank Loans	Domestic Bonds	External Bonds	External Loans
1997	1.2	13.8	33.0	6.3
1998	1.1	17.7	9.5	4.0
1999	1.3	12.1	8.6	2.8
2000	1.6	13.6	10.0	6.1
2001	1.8	14.3	15.1	3.5

Sources: Superintendency of Securities and Insurance; Superintendency of Banks and Financial Institutions; and Capital One

The Dominant Role of Contractual Savings Institutions

The large presence of pension funds and insurance companies in the financial system in Chile stems from the enormous growth of these industries since the financial sector reforms in the 1980s. Total assets held by these two industries reached 75 percent of GDP in 2002 with the pension fund assets representing 58 percent of GDP. Excluding equity assets, pension funds and securities firms accounted for almost half of total financial assets outstanding in 2002. At end-2002, pension funds held 39 percent of government bonds, 50 percent of mortgage bonds, 37 percent of corporate bonds, and 35 percent of time deposits (Table 4.5).

Table 4.5.

Share of Pension Funds in Financial Markets and Size of Markets

Sources: Ministry of Finance; Central Bank of Chile; Bloomberg; Superintendency of Securities and Insurance; and Superintendency of Pension Fund Administrators (AFPs).

Table 4.5.

Share of Pension Funds in Financial Markets and Size of Markets

	Government Debt		Time Deposits		Mortgage Bonds		Corporate Bonds		Equity
	Size (In billions of U.S. dollars)	AFP (Percent share)	Size (In billions of U.S. dollars)	AFP (Percent share)	Size (In billions of U.S. dollars)	AFP (Percent share)	Size (In billions of U.S. dollars)	AFP (Percent share)	Size (In billions of U.S. dollars)	AFP (Percent share)
1995	25.8	38.9	15.4	8.8	6.1	65.4	2.2	60.3	71.2	10.5
1996	27.1	42.7	18.7	6.2	7.5	65.3	2.1	61.4	65.8	10.5
1997	29.9	40.8	22.3	14.7	9.3	56.0	1.8	57.2	71.8	9.7
1998	28.0	45.4	24.7	17.2	9.0	57.1	2.1	55.3	51.8	8.7
1999	27.3	44.0	24.2	23.1	9.2	56.6	2.4	53.8	68.3	6.0
2000	27.9	46.0	24.4	27.6	9.1	56.6	3.5	41.3	59.7	6.7
2001	27.0	45.9	22.2	28.0	8.6	53.4	5.8	37.3	56.4	6.2
2002	27.3	39.4	22.0	34.6	8.0	49.8	6.8	37.5	48.6	6.7

Sources: Ministry of Finance; Central Bank of Chile; Bloomberg; Superintendency of Securities and Insurance; and Superintendency of Pension Fund Administrators (AFPs).

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Table 4.5.

Share of Pension Funds in Financial Markets and Size of Markets

	Government Debt		Time Deposits		Mortgage Bonds		Corporate Bonds		Equity
	Size (In billions of U.S. dollars)	AFP (Percent share)	Size (In billions of U.S. dollars)	AFP (Percent share)	Size (In billions of U.S. dollars)	AFP (Percent share)	Size (In billions of U.S. dollars)	AFP (Percent share)	Size (In billions of U.S. dollars)	AFP (Percent share)
1995	25.8	38.9	15.4	8.8	6.1	65.4	2.2	60.3	71.2	10.5
1996	27.1	42.7	18.7	6.2	7.5	65.3	2.1	61.4	65.8	10.5
1997	29.9	40.8	22.3	14.7	9.3	56.0	1.8	57.2	71.8	9.7
1998	28.0	45.4	24.7	17.2	9.0	57.1	2.1	55.3	51.8	8.7
1999	27.3	44.0	24.2	23.1	9.2	56.6	2.4	53.8	68.3	6.0
2000	27.9	46.0	24.4	27.6	9.1	56.6	3.5	41.3	59.7	6.7
2001	27.0	45.9	22.2	28.0	8.6	53.4	5.8	37.3	56.4	6.2
2002	27.3	39.4	22.0	34.6	8.0	49.8	6.8	37.5	48.6	6.7

Sources: Ministry of Finance; Central Bank of Chile; Bloomberg; Superintendency of Securities and Insurance; and Superintendency of Pension Fund Administrators (AFPs).

This dominant role has helped shape the composition of corporate bond market issuance. The growth of contractual savings has led to a reallocation of savings toward long-term assets to match the long-term maturity of liabilities. This preference for long-term assets has contributed to an increased demand for public and private sector long-term bonds. Correspondingly, corporate firms have responded by issuing bonds in two tranches, one of 8–10 years targeted to pension funds and the other of 20 years or more targeted to insurance companies. Similarly, pension funds and insurance companies induced the development of mortgage bonds with long maturities.

While contributing to the growth of financial markets in Chile during the 1990s, pension and life insurance sectors have been subject to restrictions regarding the composition of their portfolios. As shown in Table 4.6, pension funds and insurance companies have continued to hold a significant share of their assets in public debt—in particular, central bank paper—and bank-intermediated instruments. At end-2001, they held only 20 percent of their portfolio in corporate sector securities. Until the mid-1990s, pension funds could not invest abroad. Since 1995, this restriction has been progressively eased, and, in response, investment in foreign assets has grown considerably, reaching 13 percent of their total portfolio in 2002. More recently, the ceiling on foreign investment by pension funds was raised to 25 percent of pension funds’ portfolio.

Table 4.6.

Pension Fund Administrators and Insurance Industry Investment Portfolio

Sources: Superintendency of Securities and Insurance; and Superintendency of Pension Fund Administrators.

Table 4.6.

Pension Fund Administrators and Insurance Industry Investment Portfolio

		1995	1996	1997	1998	1999	2000	2001	2002
		(In millions of U.S. dollars)
Total		32,539	36,007	40,722	41,629	45,703	48,176	47,830	48,198
Government paper		12,814	14,846	15,987	16,624	15,615	16,333	15,119	13,058
Financial sector		7,549	9,148	12,288	13,339	15,568	17,192	15,771	16,427
	Of which: mortgage paper	5,302	6,673	7,476	7,672	7,981	8,086	7,283	6,537
	Of which: time deposits	1,552	1,435	3,474	4,501	5,823	6,980	6,463	7,833
Corporate sector		11,008	10,457	10,293	7,804	7,614	8,179	9,567	10,070
	Of which: stocks	8,204	7,514	7,557	4,881	4,510	4,407	3,915	3,548
	Of which: bonds	2,077	2,001	1,644	1,885	2,069	2,762	4,679	5,604
Foreign investment		60	175	458	1,889	4,853	4,156	5,027	6,121
Other		1,108	1,381	1,697	1,974	2,053	2,317	2,346	2,522
		(In percent of portfolio)
Total		100.0	100.0	100.0	100.0	100.0	100.0	100.0	100.0
Government paper		39.4	41.2	39.3	39.9	34.2	33.9	31.6	27.1
Financial sector		23.2	25.4	30.2	32.0	34.1	35.7	33.0	34.1
	Of which: mortgage paper	16.3	18.5	18.4	18.4	17.5	16.8	15.2	13.6
	Of which: time deposits	4.8	4.0	8.5	10.8	12.7	14.5	13.5	16.3
Corporate sector		33.8	29.0	25.3	18.7	16.7	17.0	20.0	20.9
	Of which: stocks	25.2	20.9	18.6	11.7	9.9	9.1	8.2	7.4
	Of which: bonds	6.4	5.6	4.0	4.5	4.5	5.7	9.8	11.6
Foreign investment		0.2	0.5	1.1	4.5	10.6	8.6	10.5	12.7
Other		3.4	3.8	4.2	4.7	4.5	4.8	4.9	5.2

Sources: Superintendency of Securities and Insurance; and Superintendency of Pension Fund Administrators.

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Table 4.6.

Pension Fund Administrators and Insurance Industry Investment Portfolio

		1995	1996	1997	1998	1999	2000	2001	2002
		(In millions of U.S. dollars)
Total		32,539	36,007	40,722	41,629	45,703	48,176	47,830	48,198
Government paper		12,814	14,846	15,987	16,624	15,615	16,333	15,119	13,058
Financial sector		7,549	9,148	12,288	13,339	15,568	17,192	15,771	16,427
	Of which: mortgage paper	5,302	6,673	7,476	7,672	7,981	8,086	7,283	6,537
	Of which: time deposits	1,552	1,435	3,474	4,501	5,823	6,980	6,463	7,833
Corporate sector		11,008	10,457	10,293	7,804	7,614	8,179	9,567	10,070
	Of which: stocks	8,204	7,514	7,557	4,881	4,510	4,407	3,915	3,548
	Of which: bonds	2,077	2,001	1,644	1,885	2,069	2,762	4,679	5,604
Foreign investment		60	175	458	1,889	4,853	4,156	5,027	6,121
Other		1,108	1,381	1,697	1,974	2,053	2,317	2,346	2,522
		(In percent of portfolio)
Total		100.0	100.0	100.0	100.0	100.0	100.0	100.0	100.0
Government paper		39.4	41.2	39.3	39.9	34.2	33.9	31.6	27.1
Financial sector		23.2	25.4	30.2	32.0	34.1	35.7	33.0	34.1
	Of which: mortgage paper	16.3	18.5	18.4	18.4	17.5	16.8	15.2	13.6
	Of which: time deposits	4.8	4.0	8.5	10.8	12.7	14.5	13.5	16.3
Corporate sector		33.8	29.0	25.3	18.7	16.7	17.0	20.0	20.9
	Of which: stocks	25.2	20.9	18.6	11.7	9.9	9.1	8.2	7.4
	Of which: bonds	6.4	5.6	4.0	4.5	4.5	5.7	9.8	11.6
Foreign investment		0.2	0.5	1.1	4.5	10.6	8.6	10.5	12.7
Other		3.4	3.8	4.2	4.7	4.5	4.8	4.9	5.2

Sources: Superintendency of Securities and Insurance; and Superintendency of Pension Fund Administrators.

From early on, the authorities imposed a tight regulation on the type of assets the funds could invest in with the paramount rationale of preserving safety. This regulation has taken the form of maximum limits on holdings of particular classes of instruments. More recent regulatory changes have introduced greater flexibility on the range of instruments allowed; funds initially had been largely restricted to government securities, financial sector securities, and high-grade corporate securities.

Key elements of pension regulation and incentives have also led to the concentration of the fund industry. The combination of the “one fund per Pension Fund Administrators (AFP)” system and the minimum/maximum relative profitability rules (prior to the regulatory changes in 2002), resulted in AFPs having extremely similar portfolio. As evidenced in the literature,¹¹ the dispersion of returns among competing pension funds had been very small, favoring a consolidation process that saw the number of pension funds drop from 21 in 1994 to 8 in 1998.

The creation of the multifund system in 2002 is helping to increase investment diversification. Prior to the regulatory changes in 2002, AFPs were only allowed to invest up to 37 percent of their portfolio in shares and were limited to a maximum of 7 percent of an issuer’s equity. Since September 2002, AFPs have been allowed to offer five different investment funds (named A through E) with different risk profiles, and investment limits. The restrictions on equity holdings now range from up to 70 percent in Fund A to no equity investment in Fund E. Limits on holdings of individual stocks also vary according to the related ownership of the issuer, liquidity, ownership concentration, and risk classification.

The low participation of pension funds in the equity market also reflects the changing investment conditions in the 1990s. The drop in pension funds’ investment in local equity follows from the large tender offers by foreign companies that took over control of large local firms.¹² Similarly, the low return on equity investment in the late 1990s also explains the reduced appetite of pension funds.

While the presence of AFPs has been a key factor contributing to the development of the corporate bond market, pension funds also face important limitations in this market. They can subscribe to a maximum of 20 percent of any bond issue that has to be conducted through open purchases, thus restricting their participation in other placements. As in the case of equity holdings, AFPs are not allowed to invest in bonds rated below investment grade. As a result, market access by potential issuers becomes a yes-no matter, based on whether the risk assessment on the quality of the supplied asset is above investment grade. In this regard, given the dominant market presence of the pension funds and insurance companies, market demand is skewed toward high-quality issuers.

Nonetheless, the presence of these institutional investors also has important positive externalities. Walker and Lefort (2002) find evidence that pension reform facilitates the accumulation of “institutional capital” through an adaptive legal framework and increased specialization in the investment decision-making process. The presence of these investors also promotes transparency and integrity through the mandatory risk-taking process and strengthening of corporate governance by promoting minority share-holder interests.

Other Investors

Despite their small size, mutual funds and retail investors also play an important role in capital markets by increasing liquidity, especially at the short range of the bond market. In particular, mutual funds have seen an important rise in their portfolio holdings from less than 4 percent of GDP in 1995 to more than 10 percent in 2002. Table 4.7 shows that mutual fund investment is largely concentrated on the short-term end of fixed-income liabilities. More significantly, the diversity of the funds has contributed to market liquidity at the short-term range of the fixed-income market, especially for central bank paper.

Table 4.7.

Mutual Fund Investment, December 2002

(In millions of U.S. dollars, unless otherwise indicated)

Source: Association of Mutual Funds.

Table 4.7.

Mutual Fund Investment, December 2002

(In millions of U.S. dollars, unless otherwise indicated)

		Fixed Income
		Short term	Medium term	Equity	Mixed	Other
Number of funds
	National	55	34	27	7	8
	International	13	32	57	40	1
Value of funds
	National	3,524	2	81	165	36
	International	469	1	56	66	5

Source: Association of Mutual Funds.

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Table 4.7.

Mutual Fund Investment, December 2002

(In millions of U.S. dollars, unless otherwise indicated)

		Fixed Income
		Short term	Medium term	Equity	Mixed	Other
Number of funds
	National	55	34	27	7	8
	International	13	32	57	40	1
Value of funds
	National	3,524	2	81	165	36
	International	469	1	56	66	5

Source: Association of Mutual Funds.

The presence of foreign investors has largely been associated with the development of ADRs in the early and mid-1990s, but has experienced a significant retrenchment ever since. By end-1996, total ADR holdings were significant, at US$6.4 billion. More than 60 percent of firms included in the stock market (IPSA) index were cross-listed as ADRs in the United States. The preference of ADRs by foreign investors was likely related to higher liquidity and better information and disclosure practices.¹³ Nonetheless, despite the suspension of capital controls and elimination of capital gains taxes for foreign investors, the presence of international investors has fallen as reflected by the sharp drop in ADR holdings since 1996.

Equity Market Liquidity

Despite Chile’s high equity market capitalization, equity turnover is low compared with that of other bourses in the region. As shown in Table 4.8, equity turnover in Chile is well below that of other countries in the region even though Chile’s degree of financial development compares favorably to the sample countries.¹⁴ More significant, the equity turnover ratio remains below its peak in 1995 and has continued to decline in recent years (Table 4.9). It is important to note, however, that traded volumes tend to be low when returns are low and when overall economic activity slows down. Hence, the economic slowdown following the Asian crisis could partly explain the lower traded volumes.

Table 4.8.

Latin America: Liquidity in Fixed-Income and Equity Markets

Source: Inter-American Federation of Securities Markets.

Table 4.8.

Latin America: Liquidity in Fixed-Income and Equity Markets

	Equity		Fixed Income
	Market capitalization (In percent of GDP)	Turnover (In percent)	Transactions (In billions of U.S. dollars)	Turnover (In percent)
Argentina	11	28	17	600
Brazil	19	83	109	…
Chile	84	10	62	274
Colombia	13	18	35	…
Mexico	32	47	1	33

Source: Inter-American Federation of Securities Markets.

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Table 4.8.

Latin America: Liquidity in Fixed-Income and Equity Markets

	Equity		Fixed Income
	Market capitalization (In percent of GDP)	Turnover (In percent)	Transactions (In billions of U.S. dollars)	Turnover (In percent)
Argentina	11	28	17	600
Brazil	19	83	109	…
Chile	84	10	62	274
Colombia	13	18	35	…
Mexico	32	47	1	33

Source: Inter-American Federation of Securities Markets.

Table 4.9.

Liquidity in Fixed-Income and Equity Markets

(In millions of U.S. dollars, unless otherwise indicated)

Sources: Cifuentes and others (2002); and Inter-American Federation of Securities Markets.

Table 4.9.

Liquidity in Fixed-Income and Equity Markets

(In millions of U.S. dollars, unless otherwise indicated)

			Fixed Income
	Equity		Total		Of which: private sector bonds
	Transactions	Turnover (In percent of stock)	Transactions	Turnover (In percent of stock)	Transactions	Turnover (In percent of stock)
1996	8,208	11.5	69,513	323.3	1,906	19.8
1997	7,308	11.1	74,817	334.7	2,708	24.4
1998	4,409	6.1	79,627	336.2	4,353	38.9
1999	6,873	13.2	45,520	198.3	2,971	25.4
2000	6,250	9.2	42,483	185.4	4,927	39.0
2001	4,138	6.9	66,536	274.2	4,987	34.5

Sources: Cifuentes and others (2002); and Inter-American Federation of Securities Markets.

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Table 4.9.

Liquidity in Fixed-Income and Equity Markets

(In millions of U.S. dollars, unless otherwise indicated)

			Fixed Income
	Equity		Total		Of which: private sector bonds
	Transactions	Turnover (In percent of stock)	Transactions	Turnover (In percent of stock)	Transactions	Turnover (In percent of stock)
1996	8,208	11.5	69,513	323.3	1,906	19.8
1997	7,308	11.1	74,817	334.7	2,708	24.4
1998	4,409	6.1	79,627	336.2	4,353	38.9
1999	6,873	13.2	45,520	198.3	2,971	25.4
2000	6,250	9.2	42,483	185.4	4,927	39.0
2001	4,138	6.9	66,536	274.2	4,987	34.5

Sources: Cifuentes and others (2002); and Inter-American Federation of Securities Markets.

Taxation could be another factor affecting stock market liquidity. Cifuentes and others (2002) note that the applications of taxes on the secondary markets of ADRs in 1995 could have contributed to the drop in liquidity in domestic markets. Yet, these taxes were temporary, as all controls on capital flows were phased out beginning in 1998 and completely eliminated in 2001. Nonetheless, high marginal income tax rates and capital gains taxes created a bias against the domestic stock market in the case of retail and foreign residents. In this regard, the capital market reform in 2001 eliminated the tax on capital gains for high-turnover stocks and short sales of stocks. Yet despite these changes, equity market liquidity did not experience a significant improvement in 2002.

Fixed-Income Market Liquidity

Liquidity in fixed-income markets is significantly higher than that in equities, but it is largely driven by transactions in central bank paper and mortgage bonds. As shown in Table 4.9, fixed-income transactions also fell noticeably in 1999 and 2000, which could also be explained by lower economic activity. Another potential factor is the changing composition of central bank paper over the past three years as the importance of inflation-indexed bonds fell relative to U.S. dollar-linked and nominal paper.

The buy-and-hold investment bias of institutional investors together with increased concentration in the pension and insurance industries could also help explain the low liquidity in bond markets. As shown earlier, these investors play a dominant role in the bond market. The process of pension fund and insurance company consolidation coincided with the drop in bond transactions. Cifuentes and others (2002) show the relationship between rising measures of concentration in the pension fund and banking industry with the downturn in transactions.¹⁵

More recently, however, corporate bond market transactions have seen a large increase as bond financing has grown rapidly. The low interest rates and recent legal changes have favored this development. In particular, the capital market reform in 2001 has introduced greater flexibility in accessing capital markets and has introduced the possibility of issuing commercial paper for short-term financing by limiting the application of stamp taxes. Relaxation of portfolio limits for mutual and investment funds have also increased activity at the short-term range of corporate bonds.

High Ownership Concentration

The high degree of ownership concentration remains a main feature determining the structure of corporate finance and characteristics of capital markets given its implications for corporate governance and minority shareholder protection (Table 4.10). Recent studies by Lefort and Walker (2000) and Agosin and Pasten (2003) note the prevalence of economic groups, which account for 91 percent of total assets of nonfinancial firms registered in the Superintendency of Securities and Insurance (SVS). Lefort and Walker show that firms affiliated to conglomerates obtain a higher proportion of outside finance and get significantly more long-term debt financing than nonaffiliated firms. They find that controlling shareholders tend to have more equity than strictly needed for control, suggesting that the inside cost of finance for the conglomerates is lower than the cost of outside financing.

Table 4.10.

Chile: Ownership Concentration, 1998

Source: Lefort and Walker (2000).

Table 4.10.

Chile: Ownership Concentration, 1998

					Equity
	Total Assets						Minority shareholders
Conglomerates	In billions of U.S. dollars	Relative size (In percent)	Debt		Controlling shareholders		In billions of U.S. dollars	Pension funds (In percent)	ADRs (In percent)
			In billions of U.S. dollars	percent of assets	In billions of U.S. dollars	percent of assets
Five largest	37.7	54.0	17.3	46.0	10.7	28.6	9.5	27.8	27.5
Ten largest	49.3	70.0	22.1	44.9	15.2	30.8	11.9	32.0	28.0
Twenty largest	57.5	82.0	26.3	45.7	17.6	30.5	13.7	26.6	25.8
All conglomerates	63.9	91.0	29.8	46.7	19.4	30.4	14.6	26.5	24.4
Nonaffiliated	6.1	9.0	2.5	42.7	3.2	53.6
Total	70.0	100.0	32.5	46.4	22.6	32.4

Source: Lefort and Walker (2000).

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Table 4.10.

Chile: Ownership Concentration, 1998

					Equity
	Total Assets						Minority shareholders
Conglomerates	In billions of U.S. dollars	Relative size (In percent)	Debt		Controlling shareholders		In billions of U.S. dollars	Pension funds (In percent)	ADRs (In percent)
			In billions of U.S. dollars	percent of assets	In billions of U.S. dollars	percent of assets
Five largest	37.7	54.0	17.3	46.0	10.7	28.6	9.5	27.8	27.5
Ten largest	49.3	70.0	22.1	44.9	15.2	30.8	11.9	32.0	28.0
Twenty largest	57.5	82.0	26.3	45.7	17.6	30.5	13.7	26.6	25.8
All conglomerates	63.9	91.0	29.8	46.7	19.4	30.4	14.6	26.5	24.4
Nonaffiliated	6.1	9.0	2.5	42.7	3.2	53.6
Total	70.0	100.0	32.5	46.4	22.6	32.4

Source: Lefort and Walker (2000).

Compared with other emerging market countries, the investor concentration in equity markets in Chile remains noteworthy and could explain the low participation of international investors. Figure 4.5 uses a measure of “free float” of outstanding equity, which is the proportion of the outstanding equity market available for purchase in the open market by international investors.¹⁶ Chile’s free-float measure is among the lowest when compared with other emerging market countries.

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Selected Countries: Free-Float Measure¹

(In percent of outstanding equity)

Sources: Morgan Stanley’s Composite Index; and Bloomberg.¹ The proportion of outstanding equity market available for purchase in the open market by international investors.

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The high degree of ownership concentration raises questions about the relative depth of the capital markets and the effectiveness of corporate governance. Agosin and Pasten (2003) argue, however, that the existence of well-developed institutional investors has provided an important counterweight to controlling investors. These investors have played an important role of monitoring controllers and limiting rent seeking. While the low turnover of equity reflects the degree of ownership concentration, these institutional investors could be a factor to increase transparency in corporate governance.

The new OPA Law enacted in 2000 has been an important step to strengthen corporate governance. The new framework for public tender offers aims at increasing protection of minority shareholders’ rights and reducing rent extraction from controllers. It requires public tender offers to be made open to all shareholders for shares of a large or controlling percentage of a company’s shares. The law also attempts to minimize insider agency problems through independent auditing committees with ample powers of oversight over corporate activities. In addition to attempting to improve corporate governance and promoting minority shareholders’ rights, the new law has also sought to affect financial deepening by allowing more flexibility to investment funds and regulating the participation of pension funds in public tender offers.