IV Capital Markets and Corporate Financing: Recent Developments

Eliot Kalter, Steven Phillips, Manmohan Singh, Mauricio Villafuerte, Rodolfo Luzio, and Marco Espinosa-Vega
Published Date:
June 2004
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Rodolfo Luzio

The development of local securities markets is an important factor driving financial market development and contributing to economic growth. During the 1990s, Chile experienced a remarkable expansion of domestic capital markets. Rapid financial integration, capital accumulation, and economic growth harnessed a virtuous cycle leading to increasing financial deepening.1 Following the Asian crisis, the pace of financial deepening in Chile slowed. This change was linked to a number of interrelated developments, including a deterioration of the external environment, a substantial slowdown of real domestic growth, and a downward shift in domestic demand, especially for investment expenditure.2 Net capital inflows from abroad were much reduced after 1998, a shift that appears to reflect lower demand at least as much as reduced supply of capital.3 Since 2000, a sharp drop in domestic interest rates has led to a pickup in domestic corporate bond issuance.

The recent resurgence of domestic bond financing has underscored the role of domestic capital markets as providing alternative and flexible sources of financing for the corporate sector. Given the prevailing low domestic interest rate environment, domestic corporate firms have taken advantage of a burgeoning domestic bond market to reduce their foreign exposure and reliance on bank financing. Institutional investors, led by pension funds, have also increased their demand for fixed-income paper following the lackluster return from equities in recent years.

This section reviews the development of domestic capital markets and corporate sector financing in Chile in recent years. The purpose is to describe the main factors contributing to financial deepening and to draw on the policy challenges to promote domestic capital markets as stable sources of funding for the corporate sector. In doing so, the section addresses the following set of questions:

  • What have been the main factors underpinning the growth of domestic capital markets in the 1990s?
  • What are the main sources and features of Chilean corporate financing?
  • What are the main characteristics of the investor base and the role of institutional investors?
  • What are the main challenges to promote deeper and more liquid domestic capital markets?

The section underscores the role of macroeconomic policies and structural reforms as the driving factors underpinning the development of local securities markets in the 1990s. Sound monetary and fiscal policies allowed a favorable investment environment, while structural reforms involving privatization and tax policy provided the appropriate conditions for the development of the equity market. Finally, financial sector reforms through early pension fund reform and banking sector regulation assured the sustainability and continuous growth of financial intermediation and sources of funds for firms.

While equity markets saw a rapid expansion in the early 1990s, domestic bank lending remained the leading source of (outside) funding for the corporate sector. The section presents some evidence that firms attempt to “time the market” with their financing sources. Large corporate firms sought to shift from external to domestic financing in the late 1990s, and then progressively moved away from domestic short-term bank borrowing toward long-term bond financing since 2000.4 The sharp drop in domestic interest rates helped reduce the costs of issuing long-term bonds in local currency, thus favoring long-duration debt issuance over short-term bank borrowing. Similarly, given the increase in book-to-market ratios of capital since the late 1990s, equity issuance collapsed in favor of debt financing.

The presence of a well-developed and large institutional investor base has played a fundamental role in supporting the demand for domestic paper. The large presence of pension and insurance companies has provided a stable and growing source of investment funds for the corporate sector. These investors have allowed increased specialization in the investment decision-making process and promoted a sophisticated risk-rating industry. They have also encouraged the development of long-term instruments and contributed to improved corporate governance, transparency, and financial sophistication.

Nonetheless, low liquidity and a high degree of ownership and investor concentration remain important challenges for the development of domestic capital markets. While low liquidity in the equity market provides a disincentive to investor participation, it is also related to the high degree of ownership concentration. The prevalence of dominant economic groups continues to characterize the corporate ownership structure and helps explain the financing structure of corporations. The large presence of these groups has raised questions about the shallowness of equity markets, the protection of minority shareholder rights, and the effectiveness of corporate governance. Recent changes in financial sector regulation and legislation have sought to strengthen corporate governance, improve transparency, and guarantee minority shareholder rights. Changes in capital market legislation have also included tax incentives to promote liquidity in equity markets and have sought to increase firms’ access to capital markets by reducing issuance costs.

Similarly, investor participation has remained concentrated on institutional investors dominated by pension funds and insurance companies. While the presence of these investors has had several positive effects, they have not contributed to higher market liquidity. These investors have favored buy-and-hold investment strategies and skewed the demand for high-quality paper. Recent changes in financial regulation have sought, however, to ease investment restrictions for institutional investors and promote more flexibility in their investment strategies.

This section is organized as follows. First, it provides an overview of the development of capital markets in the 1990s, noting the factors that contributed to financial deepening. It then describes the corporate sector’s increasing reliance on domestic capital markets in the post-Asian crisis period and seeks to explain how firms attempt to “time the market” with their financing sources. Next, it describes the role of institutional investors as key sources of stability and growth. Then the main challenges for the development of local securities are discussed, including recent financial policy reform initiatives to promote financial deepening. The last section concludes.

Domestic Capital Market Development and Foreign Financing

The domestic capital market in Chile underwent a dramatic transformation in the 1990s, marked by large external capital inflows. In fact, since the late 1980s, Chile has experienced a remarkable process of financial deepening. By end-2002, the ratio of total financial assets to GDP was 225 percent, more than three times the ratio prevailing in 1985. By 2002, the stock market capitalization was still the largest single financial market asset, amounting to 75 percent of GDP, while the bank lending portfolio accounted for 70 percent of GDP. Also significant, central bank bonds, which account for three-quarters of total public sector liabilities, represented 30 percent of GDP, while nonfinancial private sector bonds topped 10 percent by end-2002 (Table 4.1).

Table 4.1.Financial Assets–Outstanding Stocks(In percent of GDP)
Corporate SectorFinancial SectorPublic Sector
Stock market capitalizationOutstanding bondsBank creditMortgage bondsTime depositsCentral bankpaperCentral governmentPublic enterprises
Sources: Central Bank of Chile: Bloomberg; Superintendence of Securities and Insurance: and Superintend en cy of Pension Fund Administrators.
Sources: Central Bank of Chile: Bloomberg; Superintendence of Securities and Insurance: and Superintend en cy of Pension Fund Administrators.

From an international perspective, Chile’s financial asset accumulation is also remarkable. After controlling for per capita income and output growth, Chile shows a high degree of financial deepening. The results from regressions of the average market capitalization-to-GDP and total asset-to-GDP ratios during the 1990s on per capita income in 1997 and the average growth of per capita income for a sample of 48 countries places Chile significantly above the expected averages (Figure 4.1).5

Figure 4.1.Level of Financial Development for a Sample of Countries

Source: Beck, Demirgüç-Kunt, and Levine (2001).

Note: Fitted values result from regression on average per capita GDP growth from 1990 to 1997 and log of per capita income for 1997.

International financial integration represented one of the key catalysts driving the rapid deepening of domestic markets. Asset accumulation accelerated rapidly in the 1990s, while capital flows poured in before experiencing a slowdown at the end of the decade. During the 1990s, foreign direct investment represented the main source of foreign capital flows. By 2002, Chile’s liabilities from foreign direct investment had reached 68 percent of GDP, representing about 54 percent of all gross foreign liabilities. Foreign bank loans also became a major source of financing for the private sector. The stock of foreign loans amounted to 41 percent of GDP, accounting for one-third of all gross foreign liabilities (Figure 4.2).

Figure 4.2.International Investment Position

(In billions of U.S. dollars)

Source: IMF, International Financial Statistics.

Compared with other emerging market countries, Chile’s international investment position underscores the openness of the capital account and the degree of financial integration. By end-2001, Chile’s total foreign liabilities had reached 122 percent of GDP, the highest level among the selected group of countries shown in Figure 4.3. Nonetheless, the stock of foreign direct investment in Chile was also the largest as a ratio to GDP, and represented more than half of foreign liabilities. Similarly, Chile’s asset position was also the largest at 80 percent of GDP among the group of countries considered. Foreign direct investment abroad accounted for a quarter of Chilean assets abroad and was, by a significant margin, the largest share of GDP from the sample.

Figure 4.3.Selected Countries: International Investment Position, 2001

(In percent of GDP)

Source: IMF, International Financial Statistics.

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).

Composition of Central Bank Paper

(In percent of total)

Source: Central Bank of Chile.

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.

Financial Sector Reforms

Financial sector reforms have been key factors allowing the development of financial markets in the 1990s. Following the crisis in the 1980s, the authorities implemented far-reaching reforms to the banking, pension, and insurance sectors, coupled with an aggressive privatization program and modernization of the securities market regulations. These reforms supported by stringent regulation and supervision of financial institutions worked to reduce the risks of boom-bust financial cycles.

The comprehensive banking sector reform implemented in 1986 supported the stability and strong profitability of the sector while allowing moderate credit growth during the 1990s.7 The reform under-scored the need for rigid regulation and strict supervision of banking activities, drawing its lessons from the experience of the collapse of the banking system in the early 1980s. The framework implemented a partial deposit insurance system to allow for market discipline, established strict monitoring of loan provisioning, centralized debtor risk information, provided strict limitations to related lending, and imposed portfolio restrictions to limit exposure to exchange rate, interest rate, and credit risks.

Pension reform initiated in 1980 shaped the development of capital markets, helping to finance the privatization process in the late 1980s and setting the development of a sophisticated domestic investor base. The transition from a pay-as-you-go to a fully funded system together with the austere fiscal policy allowed a stable accumulation of large funds to be invested in private sector assets. The reform sought to protect the interest of the contributors to the system, and imposed tight regulations and supervision on fund managers. Stringent limits on the types of securities and issuers were imposed, based on risk ratings, portfolio diversification, ownership concentration, and other specific criteria. Over the past decade, pension regulation has sought to gradually liberalize portfolio investment limits while improving supervision and competition.

The privatization of companies in key industries in the mid-1980s was also a key element contributing to equity market development. Newly privatized firms in the telecommunications, energy, and banking sectors became the flagship companies of the local stock market. The rapid increase in the equity values of these companies in the early 1990s favored the development of conglomerates and economic groups controlling the privatized firms.8 A wave of mergers and acquisitions, including the large participation of foreign corporations in the late 1990s, contributed to the increased concentration of capital ownership, a key feature of the capital structure in Chile.

Key changes in securities market legislation have sought to strengthen market infrastructure, improve corporate governance and transparency, and expand the set of institutional investors. Given the large size of the insurance and pension funds, regulatory changes to their portfolio investment necessarily have a significant impact on the local securities markets. In 1994 and 1995, the authorities’ efforts to continue improving capital market regulation paid off with the enactment of the Private Pensions Law, the Securities Market Law, and Mutual Fund and Insurance Companies legislations. These laws liberalized pension fund portfolio limits, improved regulations, and added security assets and large infrastructure projects to the list of eligible instruments for pension fund investment.

More recently, the authorities have sought to promote further the development of the domestic capital market. New legislation, including the Public Tender Offer Law (OPA Law) in 2000 and the reform of the Capital Markets Law in 2001, has focused on harnessing corporate governance and transparency while easing the investment restrictions of institutional investors and reducing capital market access cost to small firms. The OPA Law provides for strong guarantees to minority shareholder rights and conditions to strengthen corporate governance. It also allows more flexibility to investment funds and regulates the participation of pension funds in initial public offerings. The Capital Markets Law focuses on improving the liquidity and depth of financial markets while facilitating the access to capital markets of emerging firms.9

Sources of Corporate Financing

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.

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

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

In 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)
New IssuesAmount IssuedIndebted EntitiesStock OutstandingStock in

Percent of GDP
Source: Superintendency of Securities and Insurance.
Source: Superintendency of Securities and Insurance.

Figure 4.4.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.

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)

Bank Loans



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

Investor Base in Chile

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
Government DebtTime DepositsMortgage BondsCorporate BondsEquity
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)
Sources: Ministry of Finance; Central Bank of Chile; Bloomberg; Superintendency of Securities and Insurance; and Superintendency of Pension Fund Administrators (AFPs).
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
(In millions of U.S. dollars)
Government paper12,81414,84615,98716,62415,61516,33315,11913,058
Financial sector7,5499,14812,28813,33915,56817,19215,77116,427
Of which: mortgage paper5,3026,6737,4767,6727,9818,0867,2836,537
Of which: time deposits1,5521,4353,4744,5015,8236,9806,4637,833
Corporate sector11,00810,45710,2937,8047,6148,1799,56710,070
Of which: stocks8,2047,5147,5574,8814,5104,4073,9153,548
Of which: bonds2,0772,0011,6441,8852,0692,7624,6795,604
Foreign investment601754581,8894,8534,1565,0276,121
(In percent of portfolio)
Government paper39.441.239.339.934.233.931.627.1
Financial sector23.225.430.
Of which: mortgage paper16.318.518.418.417.516.815.213.6
Of which: time deposits4.84.08.510.812.714.513.516.3
Corporate sector33.829.025.318.716.717.020.020.9
Of which: stocks25.220.918.611.
Of which: bonds6.
Foreign investment0.
Sources: Superintendency of Securities and Insurance; and Superintendency of Pension Fund Administrators.
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)
Fixed Income
Short termMedium termEquityMixedOther
Number of funds
Value of funds
Source: Association of Mutual Funds.
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.

Challenges for the Development of Domestic Capital Markets

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
EquityFixed Income
Market capitalization

(In percent

of GDP)

(In percent)

(In billions of

U.S. dollars)

(In percent)
Source: Inter-American Federation of Securities Markets.
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)
Fixed Income
EquityTotalOf which: private sector bonds

(In percent

of stock)

(In percent

of stock)

(In percent

of stock)
Sources: Cifuentes and others (2002); and Inter-American Federation of Securities Markets.
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
Total AssetsMinority shareholders
ConglomeratesIn billions of U.S. dollarsRelative size (In percent)DebtControlling shareholdersIn billions of U.S. dollarsPension funds (In percent)ADRs (In percent)
In billions of U.S. dollarspercent of assetsIn billions of U.S. dollarspercent of assets
Five largest37.754.017.346.010.728.69.527.827.5
Ten largest49.370.022.144.915.230.811.932.028.0
Twenty largest57.582.026.345.717.630.513.726.625.8
All conglomerates63.991.029.846.719.430.414.626.524.4

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.

Figure 4.5.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.

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.

Concluding Remarks

This section has identified important challenges for the development of Chile’s domestic capital markets. In particular, low liquidity in equity and bond markets as well as a high degree of ownership concentration remain important impediments. Given the structure of the domestic investor base, the dominant presence of pension funds and insurance companies with buy-and-hold investment strategies helps explain the reduced liquidity. More importantly, the high ownership concentration remains an important feature determining the corporate finance structure and characteristics of capital markets.

Recent changes in financial regulation and legislation, however, have sought to address concerns on the relative depth of capital markets and effectiveness of corporate governance while improving capital market regulation. The OPA Law in 2000 aimed to increase the protection of minority shareholders’ rights and tightened corporate governance standards. The Capital Market Reform I enacted in 2001 included tax and regulatory measures to promote market liquidity, improve firms’ market access to finance, and encourage voluntary savings to increase the depth of capital markets. The creation of a multifund pension system is also helping to increase investment diversification. The most recent legislative proposal advancing the second stage of capital market reforms seeks to foster the development of the local venture capital industry as well as tighten market regulation.

Policymakers have thus been actively working to improve financial market infrastructure, tightening corporate governance standards and market regulation. As demonstrated by the recent reforms, the authorities have underscored the role of bridging missing markets, promoting liquidity and transparency, and providing incentives to widen access to investment resources. At least two important broad challenges remain: the internationalization of the investor base and the optimal portfolio allocation of pension and insurance companies while guaranteeing their investment safety.

Higher participation of foreign investors in domestic markets would foster market development, increase investment resources, and allow higher risk diversification. The presence of international investors would help promote the development of new financial instruments and could increase market resilience to external shocks by reducing the balance sheet effects of currency mismatch for domestic companies. While there is no magic policy to ensure foreign investor participation, developed countries’ experiences underscore the importance of continuously improving financial market infrastructure and safeguarding investors’ rights.

The optimal portfolio allocation of contractual savings, bearing the trade-off between investment efficiency and safety, remains a major policy challenge. Recent changes in regulations have progressively eased investment restrictions of pension and insurance companies and are helping improve the efficiency of domestic capital markets. The difficult policy question ultimately leans on the role of contractual savings in promoting capital market development while preserving the safety of these investments.


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See Eyzaguirre and Lefort (1999) for an overview of these developments.


See Caballero (2002) for an account of the impact of external shocks on domestic output and the effect of lower external savings on domestic investment. In particular, he notes the financial squeeze on small and medium-sized enterprises.


Only for 1998 is it clear that Chilean firms faced restricted access to debt financing, as evidenced by a jump in secondary market bond spreads. Subsequently, such evidence shows that Chilean firms—or at least the large companies that have borrowed externally in the past—have enjoyed ready access to external finance on favorable terms.


Caballero (2002) also provides evidence on the shift of large corporate firms toward domestic bank financing at the expense of small and medium-sized companies. He underscores the perverse economic implications of the crowding-out effect on such companies, which were severely constrained on the financial side.


See Demirgüç-Kunt and Levine (2001) for the data source.


The role and cost-benefit of the capital restrictions in Chile during the 1990s has been a topic of intense debate. See Forbes (2002) and Gallego and Hernandez (2003) for the latest analysis on the costs of these restrictions on firms.


See Section V for a more detailed account of developments in the banking sector.


See Walker and Lefort (2002) for a more detailed discussion on the formation of economic groups in Chile.


For more detailed analysis of these reforms, see Cifuentes and others (2002).


Note that more than half of the foreign bank borrowing in 1999 was accounted for by the US$3.5 billion external loan to Enersis to finance its investments in Argentina and Brazil, as well as in Chile.


Agosin and Pasten (2003) provide a detailed account of the much discussed Chispas case involving the tender offer for Enersis, Chile’s electricity flagship company, by Endesa Spain.


Cross-listed firms go through the mechanics of standardizing accounting practices and information disclosure on a regular and timely basis.


The paper shows the Herfindahl index for both the pension fund and banking industry increasing since 1995.


The non-free-float shares include shareholdings by the government and affiliated entities, corporate treasurers, banks, principal officers, and board members of firms, including shares owned by individuals or families that are related to the company.

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