III Financial Sector Issues in Small Open Economies

Niamh Sheridan, Alfred Schipke, Susan George, and Christian Beddies
Published Date:
January 2004
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There is a growing consensus in the literature20 that the development of a well-functioning financial system generally plays an important and positive role in the promotion of long-run economic growth and economic stability. This consensus has emerged relatively recently from a growing body of literature based on both theoretical considerations as well as empirical evidence that shows a positive correlation between various measures of financial development and economic growth. There is also some empirical evidence that suggests a causal relationship indicating that financial system development is conducive to economic growth. In addition, another wave of research has looked more closely at the channels through which the financial system enhances growth and has identified a number of specific features that seem to have a potential for enhancing economic growth. The goal of this section is to examine if and in what way the Baltics could develop financial systems with a view to promoting increased long-run growth.

During the first ten years of transition, the reallocation of existing resources and the attraction of new investments took place to a large degree through privatizations, foreign direct investments, and internally generated funds. The role of capital markets and even that of the banking system were rather limited in the allocation of savings and investment. Looking ahead, however, there is considerable potential for the financial system to play an important role in the future. In the medium term, it is anticipated that all three states will have a high level of investment and that the respective banking systems, and potentially the capital markets, could play a key role in determining the efficiency of those investments and therefore contribute to maintaining high growth rates. While the empirical literature shows that financial system development and growth go hand-in-hand, it is less clear what—if anything—policymakers in small open economies can do to foster the development of the financial system. The following section addresses a number of issues that are particularly relevant for the Baltic states and for small open economies in general.

Distortions in the Financial System

The least controversial way of fostering development of the financial system is to reduce existing distortions. As a result of the pursuit of sound macroeconomic policies, the elimination of direct controls, and an almost fully privatized banking system (which eliminates government interference in the allocation of credit), the Baltic states do not exhibit financial repression of the sort commonly found in the CIS and developing countries. The lack of developed capital markets and the dominance of bank financing, however, may reflect existing distortions that should be addressed. Distortions in turn can retard the development of the financial system or favor the development of a particular sector, such as banking, at the cost of others. Furthermore, the financial system could have distortions that lead to allocative and/or production inefficiencies.

In the case of the Baltics, the most important distortions are related to the tax treatment of financial instruments. In all three countries, taxation has been uneven across instruments and has tended to favor bank instruments. In Estonia, income earned from bank deposits is tax free, while income on other types of financial instruments is taxed at 26 percent. In Latvia, capital gains are taxed, while interest income from bank deposits held by households is not. Although new personal income tax legislation is being drafted in Lithuania, which would tax all personal income at the same rate, bank deposits would continue to be tax exempt. Moreover, in Lithuania, income from interest and fees related to leasing and factoring activities is subject to value-added tax, resulting in double taxation of this income and therefore placing these forms of financing at a disadvantage relative to bank lending.

The high concentration ratios (C3 and C5) of banks, including leasing and insurance activities especially in Estonia and Lithuania, as well as the size of the spreads between deposit and lending rates, suggest that these countries might be faced—among other things—with a lack of competition and/or an implicit form of taxation.21 The lack of competition, as reflected in the concentration ratios, is of course partly related to the small size of the countries and the presence of scale economies. Here the future integration of the financial system with that of the European Union should, at least partly, increase competition. The size of the spreads between lending and deposit rates could also be a reflection of unremunerated reserve requirements in excess of those in the euro area, representing an implicit form of taxation.22 More recently though, spreads between deposit and lending rates have come down, reflecting among other things a gradual reduction in cash reserve requirements23 and a pickup in competition at the level of small and medium-sized banks, especially in Estonia. In Lithuania, the unremunerated required reserve ratio is now 6 percent (down from 10 percent in 2000).

In order to create a level playing field, the Baltic states should eliminate the existing tax distortions and apply tax rates uniformly. As the Baltic economies prepare for EU accession, the reserve requirements will ultimately have to be lowered for banks operating in the Baltics prior to joining the EMU in order to meet the averages of 2 percent. The timing of the reduction should, however, take into account broader monetary developments.

Corporate Governance and Market Structure

In addition to the elimination of market distortions, more and more emphasis is placed on measures that foster good corporate governance and that enhance the infrastructure of the financial system. The basic infrastructure needs for successful financial sector growth include legal protections for creditors and shareholders, sufficient disclosure standards, well-governed institutional investors, and support for private and public institutions. Levine, Loayza, and Beck (2000) and La Porta and others (1998) examined, for example, the relationship between the legal framework and measures of bond and equity market development and show that countries with greater support for creditor rights, contract enforcement, and information disclosure have higher levels of development of both capital markets and financial intermediaries. There is also a fundamental need for efficient trading and settlement systems.

The market infrastructure and corporate governance frameworks in the Baltic countries are fairly modern (Box 3.1). All three countries have seen significant improvements in their institutional and legal frameworks, as new legislation has been introduced to comply with the terms of the acquis communautaire of the European Union. La Porta and others (1999) developed indicators of the quality of shareholder protection as written in laws; these indicators were extended by Pistor (2000) for transition economies. The indicators, which do not reflect enforcement standards, show that the three Baltic states have levels of shareholder protection that are equivalent or even higher than those in industrialized countries, such as Germany.

To what degree, market infrastructure and corporate governance framework actually have an impact on the behavior of market participants depends crucially on implementation and enforcement. There have been continued improvements in the enforcement of legislation in the Baltics. The European Bank for Reconstruction and Development’s Business Environment and Enterprise Performance Survey, conducted in 1999 and 2002, asked firms to evaluate their business environment using several criteria. According to this survey, the Baltics rate high in terms of providing a favorable business environment, relative to many of the other transition economies, with Estonia receiving one of the highest rankings in both years. Lithuania and Latvia saw an improvement in their ratings between surveys. At the same time, though, the EBRD Transition Report notes that even with the “strong anchor” provided by the acquis communautaire, institutional weaknesses remain in regulation, competition policy, the judicial system, and in local government administration, and these should be addressed.

Information, and therefore financial disclosure as well as accounting and auditing standards, play a central role in financial market development. Disclosure is one of the key underpinnings of good corporate governance; accounting provides the financial information required for businesses to operate in a market environment; and audits serve to affirm the reliability of a company’s financial statement. For example, evidence suggests that countries with some basic accounting standards experience higher levels of stock market development than others who lack these standards (Levine and Zervos, 1996). Box 3.1 provides background information on legislation covering these issues in the Baltics; all three countries have enacted new legislation that complies with international standards in both accounting and auditing practices.

Market-Based Versus Bank-Based Financing

The above shows that equity and bond markets in the Baltics are underdeveloped. This is not surprising because in small economies with less-developed financial systems, corporate bond and equity financing is not typically a viable alternative to bank financing. Berglöf and Bolton (2002), for example, suggest that weaknesses in regulatory and contractual enforcement mechanisms in emerging market economies place banks in a better position to protect creditor rights. Typically, small investors refrain from stock market investments for fear of being exploited by insider trading and prefer to use bank deposits as a savings vehicle. In addition, the number of sufficiently large enterprises is inadequate to make corporate issues of debt or equity cost efficient.

Box 3.1.Market Infrastructure and Corporate Governance in the Baltics


Market infrastructure

HEX Tallinn operates the Estonian securities market infrastructure and thus provides a common trading environment for securities listed on the Tallinn and Helsinki exchanges. Companies may apply to be listed in the main (I-list) funds or in the bonds list. All securities must be dematerialized, freely negotiable, and registered with the Estonian central depository, owned by the Tallinn Stock Exchange (TSE). At least 25 percent of the shares must be in public hands. There is also a free market which is a prelist; firms that do not meet the criteria for listing may be permitted to trade in the free market for one year before applying for an official listing. Supervision is the responsibility of the newly created Financial Supervision Authority, which will lead to more effective supervision and enforcement. The State Liability Act 2001, which provided for legal protections for supervisory staff, should bring about further improvements.

Corporate governance

Most financial sector laws in Estonia favor transparency. Estonia has seen significant improvements in the accounting framework—from 1995 all entities were required to comply with Estonia’s Generally Accepted Accounting Principles. New accounting rules came into force in the beginning of 2003.


Market infrastructure

The capital market consists of the Riga Stock Exchange (RSE), also operated by HEX, which trades securities on three tiers and through brokerages, investment companies, private pension funds, and the central depository. Settlement of securities trades takes place according to DVP (T+3) (simultaneous, irrevocable, and final), while cash transactions are settled through the central bank. Companies on the official list must make at least 25 percent of their shares freely tradable. Regulation and supervision of capital market activities are vested in a newly established (July 2001) unified agency, the Financial and Capital Market Commission. Latvia’s legal framework is based on civil law. The primary legislation for listed companies is the new Commercial Code of January 2002.

Corporate governance

While the legislative and regulatory frameworks dealing with corporate governance practices have undergone significant change, compliance and enforcement remain areas that need improvement. To foster good corporate governance, a key priority is the strengthening of the judiciary. Disclosure, an important ingredient to sound corporate governance, is of a high standard. All companies on the official (top-tier) list of the RSE, as well as commercial banks and insurance companies (but not brokers), must prepare their financial statements in accordance with international accounting standards (IAS) and have their audits prepared by an approved auditor (typically an international audit firm). Second-tier firms and firms on the free list may prepare their financial statements in accordance with Latvian accounting and auditing legislation. The financial statements of virtually all listed companies, however, are reportedly prepared in accordance with IAS and are audited by sworn auditors following IAS.


Market infrastructure

The market comprises the National Stock Exchange of Lithuania (NSEL), which trades securities on three tiers and through the central depository and brokers. The legal framework for establishing private pension funds has been put in place, but no pension fund is operative as yet. Clearing and settlement is based on the DVP (T+3) principle and linked to the Bank of Lithuania’s payments system. Supervision and regulation is conducted by the Lithuanian Securities Commission. The civil code, effective as of July 2001, provides the basis for private and commercial law.

Corporate governance

Lithuania’s corporate governance structure reflects primarily several historical events, such as the mode of privatization and imminent EU accession. New accounting legislation, which came into force in 2002, should significantly improve the quality of company disclosure. Banks are required to have all annual financial statements audited by international audit companies in accordance with IAS requirements.

There is quite an extensive literature that assesses the merits of market-based versus bank-based financing models. The debate is based on two competing theoretical views. One view is that bank-based systems are better placed to mobilize savings; identify sound investment projects; and exert corporate control, particularly at the early stages of development. The market-based view argues that markets are better suited to allocate capital, provide risk-management tools, and mitigate the problems of concentration in the banking system. Empirical research on the issue has centered on the United Kingdom and the United States as classical cases of market-based financial systems, and on Germany and Japan as bank-based systems. As pointed out by Levine (2002), however, this makes it difficult to draw conclusions for countries that are dissimilar in important ways to these industrial country models. In his paper, Levine constructs a data set for a broad range of countries with different financial structures and growth rates. The results suggest that neither polar view is supported as being particularly conducive to growth. The analysis does support the so-called “financial services view,” which is a hybrid case between bank-based and market-based finance. In essence, the key to growth is the overall development of the financial system; a sound legal framework, including contract enforcement; and investor protection. As such, this research suggests that it does not matter whether financing of private sector activity is dominated by banks or by capital markets, as long as they operate efficiently and under the auspices of a nondistortionary regulatory framework.24

So what should governments do? The authorities can play a pivotal role in providing the necessary infrastructure that supports the development of competitive markets. The basic infrastructure includes strong legal rights for creditors and shareholders, sufficient disclosure standards and high-quality information, well-governed institutional investors, and support for private and public institutions (see Claessens, Djankov and Klingebiel, 2001), as well as efficient trading and settlement systems. In general, the quest to minimize debt-servicing costs under the constraints of a level playing field requires the existence of competitive markets (Fry, 1997); but above all, macroeconomic stability—including fiscal discipline and price stability—are key determinants of sound financial sector development.

By coordinating fiscal and monetary policies, the authorities can provide the basic framework for private sector activity. As a result, an economy that has a bank-based financial system should not suffer in terms of development. It is clear, however, that overreliance on bank credit as a means of financing exposes an economy to the risk of failure in the banking system (IOSCO, 2002). A banking crisis may have more pronounced effects on overall economic activity because firms would find themselves credit constrained and unable to pursue investment projects, which would exacerbate the adverse demand effects. A functioning corporate debt market could serve as a substitute to bank financing, thus mitigating the potential adverse effects of a credit crunch. As pointed out, for example, by (Greenspan (2000), the availability of alternative forms of finance helped mitigate the U.S. credit crunch of the late 1980s.25

Nevertheless, the Baltics should not actively pursue policies that would favor one form of financing over the other. Economic growth has been impressive in recent years, and empirical evidence presented by Levine (2002) supports the view that either system can work, as long as the infrastructure for sound financial sector development is in place. Thus, the authorities should continue to enhance the general financial architecture in their respective economies to ensure that financial intermediaries operate on a level playing field, including the removal of any remaining distortions. Given that the financial systems of the Baltics are primarily bank based, it is crucial that supervisory frameworks are kept in line with international best practices. In addition, the significant foreign participation in the Baltic banking systems requires ongoing cooperation and information sharing with foreign and domestic supervisors. The Baltic banking systems have benefited from foreign entry, which has contributed to the financial strength of banking institutions, but it has also led to a degree of concentration that may result in some banks being considered too big to fail.

While the risks associated with a strong reliance on bank financing and concentration cannot be eliminated, the above-mentioned measures can help to discover problems early on and therefore mitigate potential adverse effects. Furthermore, as the transition process nears the completion and with EU accession within reach, market-based financing can be expected to gain in importance because equity and bonds can be issued in a more cost-efficient manner.

Development of Regional Markets

Given the relatively small size of capital markets in the Baltics, should these economies actively attempt to foster the deepening of regional integration? Markets in transition economies, including the Baltics, are relatively small by international standards, and are likely to remain so; most will not achieve minimum economies-of-scale. As also pointed out by Claessens, Djankov, and Klingebiel (2001), however, the fact that there is limited scope for domestic stock market development does not automatically imply that transition economies will lack access to the services offered by stock exchanges. First, cross-border trade in financial services, harmonization of international practices for raising global capital and trading, and stronger technological links make it much easier for any large corporation to list its stock and raise capital in the market that offers the best conditions. Second, EU integration will drive the process of financial market development in Central and Eastern Europe and the Baltics.26

In addition, some scale efficiencies may be reached through the integration of capital markets at the regional level. This is what the Baltic states have started to do. To some degree, financial laws have already been harmonized with those of the European Union. A cross-Baltic cooperation between the stock exchanges exists, and the HEX Group (Helsinki Stock Exchange) became the majority shareholder in Tallinn in 2001 and in the Riga Stock Exchange in 2002, providing a common trading platform. Although the Lithuania stock exchange has not formed a regional alliance as yet and the government continues to own the exchange and the central securities depository, it is negotiating with both the HEX Group and the Warsaw Stock Exchange about a potential sale. Therefore, closer cooperation among the Baltic countries and further integration with other Western European stock exchanges will help facilitate broadening of the market. As a result, Baltic companies may more easily attract portfolio investments.27

It seems appropriate that the Baltic states pursue a dual strategy. On the one hand, there is further integration among the Baltic stock exchanges and to some degree among them and the exchanges of the Nordic countries. On the other hand, the Baltics are fostering integration with EU capital markets.

Active Government Policy to Develop a Bond Market

The impetus for the growth of underdeveloped debt markets in many transition economies has come primarily from the public sector. A typical side effect of the transition process was that governments faced increased expenditure needs. The resulting rise in financing requirements was therefore an obvious reason for developing a market for government debt because deficits could be financed in a way that did not create base money. An interesting question in this regard is to what extent can the development of a government debt market help facilitate the development of a market for corporate debt. Potential positive spillover effects could be the provision of a market infrastructure that can be used for private sector debt or, more importantly, the creation of a benchmark for corporate debt. Under such circumstances, should governments issue debt above and beyond their financing needs to create this benchmark? It is interesting to examine what the experience of other countries reveals in this regard.28

The existence of a government debt market has some far-reaching implications. Central banks, for example, have multiple interests in the development of a government debt market. First, government securities provide a financing vehicle that is noninflationary and therefore facilitates the implementation of monetary policy more generally.29 In addition, as the transition process is accompanied by sizable capital inflows, the availability of domestic debt instruments facilitates the sterilization of such flows, thus enhancing the monetary authority’s ability to effectively conduct monetary management.30 A well-functioning money market is essential for smooth liquidity management because monetary policy implementation relies increasingly on indirect instruments.31 From a financial sector perspective, the development of sound government debt markets has the potential to improve the functioning of financial markets more generally—i.e., financial markets can be enhanced by creating market rates that reflect the opportunity cost of funds at each maturity (see BIS, 2002).

Box 3.2.Developing Markets for Debt: Some Country Experiences

A number of countries have actively developed government securities markets to create benchmarks and develop market infrastructure and thereby facilitate the formation of corporate debt markets (see for example Fry, 1997; and Bank for International Settlements, 2002). For example, the Asian countries had to rethink market strategies in the aftermath of the Asian crisis. Many believe that the crisis was caused in part by companies’ overreliance on the banking system. Companies often resorted to highly volatile short-term funding, often in foreign currency, which left them vulnerable. Domestic savings would have been sufficient to finance company operations, however, had debt markets existed that could have channeled some of these savings into domestic investment.

  • The Hong Kong Monetary Authority, which operates in an environment similar to that of the Baltics (Currency Board Arrangement, small open economy, etc.), has developed a government debt market, including the provision of an efficient clearing and settlement system, despite the fact that the government does not need the funds raised to finance itself. This, however, requires strong fiscal discipline to avoid moral hazard in the sense that the extra funds could be used for extra spending.
  • In Jamaica a reference rate was established that could be used for pricing in the markets for commercial paper, certificates of deposit, interbank claims, and other repo markets. This was one of the benefits of the creation of a government debt market in Jamaica.
  • In Malaysia the infrastructure and procedures established for the government debt market served as models for private sector debt markets.
  • In Mexico brokerage houses started operations in government securities and then expanded their activities using the same techniques and facilities to develop markets for private debt.
  • Chile and Israel have used indexation as a means of sustaining financial markets in the face of ongoing inflation. Mexico also developed markets for indexed bonds under inflationary conditions. It is important to note though that indexation can only be a short-term fix to assist other stabilization measures, most notably fiscal adjustment. In the long run, indexation erodes the government’s revenue through inflation. In addition, indexation may spill over to other labor markets, thus having adverse effects.
  • Chile also switched from a pay-as-you-go pension system. In addition, the legal and regulatory frame-works related to the nonbank sector and capital markets were beefed up. Due to the long history of fiscal surpluses, the Chilean government has seldom issued debt. They did, however, issue foreign debt instruments to facilitate a sovereign rating (sovereign risk benchmark). For that purpose, US$500 million was issued in 2000 and US$650 million was issued in 2001. The central bank is primarily issuing domestic government bonds in the local market for monetary management and to establish a benchmark yield curve.
  • The Monetary Authority of Singapore (MAS) actively pursued the development of a liquid bond market. Like Greenspan (2000), the MAS took the view that an overdependence on the banking system has the potential to exacerbate problems for borrowers in a crisis situation, with the Asian crisis being a good example. To make available to investors a broader range of financial assets of varying credit risk and maturities, the following steps were taken to develop the Singapore dollar bond market: building and extending a benchmark yield curve through issuing government securities—a 10-year maturity in 1998 and a 15-year maturity in 2001; increasing the size of the issues per tranche; and establishing a repo facility to support primary dealers because repo markets are important to support secondary market activity.

Overall, the creation of a sound government debt market supports the formation of private sector debt markets. Government securities yields may be used as reference rates for corporate bond issues, pricing in the markets for commercial paper, etc. In addition, the infrastructure and the procedures established for the government debt market may be used as a model for private sector debt markets. Box 3.2 highlights some specific country experiences in which government debt markets served as a vehicle for developing corporate debt markets.

So far, the discussion has focused on the potential positive spillover effects of government debt markets and not so much on the potential benefits of private sector debt markets. As pointed out, above, it may be unwise to rely solely on one form of financing, such as bank financing. If a crisis dries up that avenue of financing, an alternative financing channel, such as debt instruments, can mitigate the problem. Also, in the absence of debt markets firms have to finance the acquisition of long-term assets through short-term funding. By doing so, they either incur sizable mis-matches (with respect to either currency or maturity), or they may find that overall investment policies are biased toward short-term projects, which may hamper growth prospects (BIS, 2002). Finally, an important factor in judging alternative means of financing relates to the cost of funds. Since banks charge administrative fees that range from loan origination fees to charges for information processing and monitoring, an efficient corporate bond market helps firms to lower their financing costs and provides competitive pressure for banks to lower their charges.

The decision to develop a bond market, however, needs to take into account the effects on the banking system. A common worry is that bond markets could take business away from banks. While this may be a concern for bank supervisors, corporations would be less vulnerable to weaknesses in the banking system. Although the evidence suggests that the growth of bond markets does lead to slower growth in the banking system, there is no evidence that bond markets actually take away business from banks. In fact, banks play a key role in, and derive profits from, the development of bond markets because they usually act as issuers, holders, dealers, and so forth. In fact, once banks have reached prudential lending limits to single customers they may serve as underwriters. A bond market therefore may enhance the health of banks by improving both market discipline and revenues, even though banks may face a deterioration in the quality of their loan portfolios.

Since there are differences in bond ratings—and therefore differences in costs depending on the company that issues the bonds—higher-rated companies may find it more attractive to issue bonds, particularly in view of the potentially lower costs. This, however, may leave banks with lower-quality loans on their books as they lose higher-rated clients. Finally, it is not necessarily the case that the bond market can serve as a substitute for bank lending in a crisis. True, the concentration of intermediation functions solely in banks that are typically highly leveraged gives rise to potential vulnerabilities. To the extent that bank lending and bond issues are correlated (e.g., a deterioration in general confidence in the wake of a banking crisis), a decline in lending may be accompanied by a decline in bond issues. Empirical evidence from both OECD countries and emerging market economies suggests that bank lending and bond issues are indeed correlated.32

Should the Baltics promote the development of government debt markets more actively, given the positive spillover effects on private debt markets? As pointed out, above, Latvia has issued longer-term government debt beyond its financing needs to foster long-term financing in domestic currency instruments. While this has contributed to the establishment of a benchmark yield curve through the extension of maturity profiles of government securities and the provision of a sound infrastructure, the policy seems to have extended bank loan maturities rather than boost private bond issues. Therefore, given that it is not certain whether such government actions are sufficient to foster the development of corporate debt markets, the Baltic states should first and foremost focus on the elimination of existing distortions (e.g., those that favor bank growth over capital market development) and consider measures that would improve corporate governance even further.33

All three Baltic states decided to reform their pension systems in the mid-1990s. Although the primary objective of the reforms is to address the long-term sustainability of the pension systems in the context of adverse demographic developments, experiences from other countries show that the “privatization” of social security systems has a potentially large impact on the development of capital markets. All three countries decided to move from a purely pay-as-you-go system to a three-pillar pension system. The first pillar of the new system is a scaled-down and slightly modified version of the former pay-as-you-go system. The second pillar is a mandatory34 but fully funded system of privately managed pension accounts. Finally, the third pillar provides tax incentives for those who make additional voluntary contributions to a pension fund.

From the point of view of capital market developments, the most important component of the Baltic pension reform is the creation of the second pillar, that is, the creation of a mandatory (once opted into) but fully funded system. The relatively low level of income in these economies implies that despite tax deductibility households are unlikely to increase substantially their voluntary savings under the third pillar. The creation of the second pillar, however, will increase the need for appropriate investment vehicles. If that need is fulfilled domestically, pension reform should lead to the creation of more diverse financial market instruments, more liquidity, and an overall deepening of financial markets. This in turn should improve competitiveness and, therefore, contribute to a better allocation of scarce savings, as well as improved risk diversification. The empirical evidence suggests that most pension funds in other countries have traditionally preferred domestic assets. For example, in 1991 only 7 percent of the assets of the world’s 300 largest pension funds was invested abroad.35 Despite the fact that during the 1990s the degree of international diversification increased, regulators and pension fund managers continue to prefer domestic assets. If the objective is to foster the development of a domestic capital market, policymakers may, of course, limit the ability of fund managers to invest abroad. In addition to the argument that such a regulatory restriction is necessary to foster the development of a domestic capital market, such restrictions on foreign investments are potentially useful as well for reducing capital flight in the initial stages of capital market development and decreasing the volatility of capital flows.

Most empirical studies analyze the case of Chile to determine the impact of pension reforms on the development of financial markets, given that Chile began the reform of its pension system in the early 1980s. Initially, Chile’s pension funds were highly regulated and limited to government securities. Holzman (1996) constructs a number of indicators in order to capture the implications of the pension reform for the development of the financial system and shows that the privatization of the social security system was associated with a substantial improvement in these indicators.36 By the end of the 1990s, Chile’s pension funds had become the most important institutional investors in the country, amounting to about 45 percent of GDP.

Although arguments can be made in favor of pension funds from investing abroad, there are also a number of arguments that can be made for limiting investments in domestic instruments. These arguments are particularly applicable to small open economies such as the Baltic states. If the pension reform takes place at a time when the domestic capital market is still almost nonexistent or substantially underdeveloped, and therefore unable to absorb the additional savings, the pension reform could put substantial pressure on asset prices and lead to financial instability.37 Furthermore, limiting investments abroad could lead to too much risk taking and result in moral hazard. If funds can only be invested domestically, there may be an implicit assumption that the government is willing to bail out the sector, and thereby encourage excessive risk taking.38

Despite the fact that the three Baltic states share many similarities—especially in terms of size, openness, and proximity to established European capital markets—they have implemented pension reform at different paces. The second pillar in Estonia and Latvia became operational in 2002. Lithuania’s second pillar system, however, will not become operational before 2004. The three countries also differ substantially in terms of pension fund regulation (Table 3.1).

Table 3.1.Pension Reform
Establishment of second pillarApril 2001July 2001January 2004
third pillarJanuary 2000July 1998January 2000
Contributions to second pillar6 percent22 percent35.5 percent4
Mandatory domestic investmentsNone5None670 percent
Source: Estonian, Latvian, and Lithuanian authorities

Based on legislation passed by Parliament in December 2002

4 percent from social security contributions; 2 percent additional contributions from payroll

Scaled increase to 10 percent in 2010 from 2 percent during the period 2001–06

Scaled increase to 5.5 percent from 2007 onward from 2.5 percent in 2004.

No investment restrictions with respect to euro area.

Until 2003, investments had to be in domestic instruments, i.e., government securities and banks’ time deposits. With respect to the third pillar, 15 percent of pension funds may be invested abroad.

Source: Estonian, Latvian, and Lithuanian authorities

Based on legislation passed by Parliament in December 2002

4 percent from social security contributions; 2 percent additional contributions from payroll

Scaled increase to 10 percent in 2010 from 2 percent during the period 2001–06

Scaled increase to 5.5 percent from 2007 onward from 2.5 percent in 2004.

No investment restrictions with respect to euro area.

Until 2003, investments had to be in domestic instruments, i.e., government securities and banks’ time deposits. With respect to the third pillar, 15 percent of pension funds may be invested abroad.

Until 2003, Latvia placed the toughest restrictions on foreign investments; during the first 18 months of operation, investments were limited to domestic assets—either in the form of government securities, time deposits in domestic banks, mortgages, or deposit certificates. From the beginning of 2003 onward there are formally no limits on investments in foreign assets, however, a 70 percent currency-matching rule effectively continues to restrict foreign investments.39

On the other side of the spectrum lies Estonia, which imposes no restrictions on whether the funds are invested domestically or abroad, as long as the investments take place in the euro area.40 According to Lithuania’s legislation, passed in December 2002, its second pillar system would fall in between. The different approaches reflect the differing strategies of the Baltic countries. The strategy of the Estonian authorities has been to foster integration with European capital markets. Because its fiscal position generally has been stronger than those of the other two Baltic states—with very low levels of government debt and a budget position that is close to being balanced—government financing has been less of a concern than in the other two countries.

Because of some restrictions on foreign investment, pension reform is likely to provide the greatest boost to Latvia’s domestic capital market, followed by that of Lithuania (Figure 3.1). But contribution rates will be increased only gradually in Lithuania and Latvia; therefore, the overall second pillar contributions—and hence the accumulation of assets—will be substantially below those of Estonia during the first couple of years. Preliminary estimates suggest that in 2006 the stock of assets in Latvia will amount to about 50 percent of those in Estonia. Given that Lithuania’s second pillar pension reform will not start before 2004, its stock of assets will be even less, amounting to 50 percent of those in Latvia. Since Estonia’s investment regulation is the most liberal among the Baltic states, the government runs close to a balanced budget, and Estonian corporations have tended to borrow abroad, pension reform is likely to have a limited impact on the development of its domestic bond market.

Figure 3.1.Pension Reform and Capital Markets, 2002–06

(Stock of funds in percent of GDP)

Sources: Country authorities; IMF staff estimates.

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