With the Mexican and Argentine financial crises fresh in their minds, policymakers are acutely aware that capital inflows are transitory.52 The experiences of the crises of the 1980s and the recent banking difficulties of 1994–95 have demonstrated that a sound precrisis banking system and experienced and skilled bank supervisors are important to the prompt success of crisis recovery programs. Therefore, in assessing the ability of Latin American countries to deal with future adverse shocks leading to capital flight, it is necessary to consider the long-term challenges to the franchise value of banks in these markets.
Two of the policymakers’ major concerns, which have been confirmed by events in Mexico and Argentina, are associated with the expansion of domestic credit that follows large, unsterilized capital in-flows. The first is that the inflows may lead to an unsustainable appreciation in the real exchange rate. The second is that the expanded bank loans may not be sound enough to stand a reversal of the inflows. A financial crisis may then follow a reversal of the capital inflows. This section focuses on the latter concern, and issues related to the sustainability of the exchange rate regime are addressed in Section VI.
Before the Mexican financial crisis at the end of 1994, the authorities in several countries resorted to a policy of sterilization to ameliorate the impact of a possible reversal of the capital inflows. Sterilization was used as a tool to control the domestic credit expansion effects of capital inflows. The degree to which a country sterilizes can be measured by the ratio of foreign reserves to the supply of money. This measure captures the intent of sterilization, which is to control the growth of credit by controlling the growth of the supply of money as foreign currency assets are purchased by the central bank.53 A historical series on the ratio of foreign reserve assets to a narrow definition of money supply—currency plus transaction deposits—covering the period of capital inflows is presented in Chart 13 for the sample coun-tries.54 The chart shows Chile to be the most aggressive sterilizer between 1990 and 1993, followed by Colombia and Peru. Mexico shows a very erratic pattern of sterilization, and Argentina, showing a downward trend in the ratio, can be characterized as the least active sterilizer.
The evidence for the sample countries analyzed in this paper suggests that the experience with sterilization during the period of capital inflows of the early 1990s has been mixed. For example, in 1992, Chile, which was an active sterilizer, had the highest ratio of deposits to GDP among the five countries in the sample (see Chart 8). In contrast, Argentina, the least active sterilizer, had among the lowest ratios. Since Chile has one of the strongest banking franchises in the group, this indicator suggests that the quality of the banking franchise is a more important determinant of the ratio of deposits to GDP than the sterilization policy chosen by the central bank.
Consistent with the mixed evidence, there is no consensus among policymakers and analysts on whether and under what circumstances sterilization is a useful tool to manage capital inflows. While sup-porters of sterilization stress the risks associated with an expansion of domestic credit, critics of sterilization emphasize the costs and limitations associated with that policy.55 The debate also expands beyond the desirability of sterilization to the benefits and costs associated with different sterilization methods.
Ratio of International Reserves to Narrow Money Supply
Source: International Monetary Fund, International Financial Statistics, various issues.Ratio of International Reserves to Narrow Money Supply
Source: International Monetary Fund, International Financial Statistics, various issues.Ratio of International Reserves to Narrow Money Supply
Source: International Monetary Fund, International Financial Statistics, various issues.Sterilization is carried out through the balance sheet of the central bank. In the classic case of unsterilized intervention, the central bank buys the foreign currency inflow, for example, U.S. dollars, by issuing its own liability to the party selling the dollars.56 If this liability is issued to a domestic commercial bank in the form of a reserve deposit in the central bank, the commercial bank would use this deposit to expand domestic credit until the required or desired ratio of domestic credit to reserve deposits in the central bank is restored. The central bank can conduct sterilization either by increasing reserve requirements on commercial bank liabilities or by issuing liabilities to nonbanks, which do not have the authority or the public confidence to use the central bank liability as a vehicle to expand domestic credit.
What role does the state of the franchise value of the banking system play in the policy decision to sterilize or not and in the choice of alternative sterilization methods? Clearly, if the financial system has strong mechanisms in place to control the quality of credit, some of the dangers of credit expansion would seem to be reduced. First, sound banks would have incentives to evaluate properly the risks associated with extending loans, and, second—and perhaps even more important—central banks would stand ready to deal with financial difficulties by using emergency loan assistance as an incentive for banks to establish credible loan workout programs.57
Turning to the choice of sterilization method, the discussions in Sections II and III highlight the tradeoff of carrying out a sterilization policy through the imposition of high reserve requirements on bank deposits: although high reserve requirements are effective in preventing the expansion of domestic credit, they reduce bankers’ opportunity to learn how to build a strong banking franchise by preventing them from making loans. Based on their experiences in the 1980s, policymakers have begun to recognize the dangers of forcing the banks to bear the burden of a sterilization policy through high reserve requirements. An important question is whether these costs of a sterilization program can be avoided; that is, can the central bank find a way to sterilize without inhibiting the development of the franchise value of the banking system?
The first part of this section considers alternative policy options to sterilize. The second part discusses how the state of the banking franchise might affect authorities’ policy choice of whether and how to sterilize. The third part considers some recent empirical evidence on the relationship between the quality of the bank franchise and the quality of capital flows through the equity market. Finally, the last part turns to another challenge that banking systems in some Latin American countries are currently facing: the securitization of financial instruments. Specifically, this part analyzes how the recent developments in domestic capital markets and the increased access to world capital markets affect the franchise value of Latin American banking systems.
Sterilization and Franchise Value of Banking System
In carrying out a sterilization policy using reserve requirements on bank deposits, the central bank con-strains the expansion of bank credit following a capital inflow by directing banks to hold a high portion of the funds collected through the issuance of deposits in the form of reserves held as vault cash or deposits at the central bank rather than as loans. If the reserve ratios against deposits specified by the central bank are a binding requirement, this ratio must be greater than that which banks would voluntarily hold at the interest rate the central bank offers on reserve deposits that banks hold with the central bank.58
If banks are subject to a binding reserve requirement, the spread between the interest earned on loans and the interest paid on deposits will be greater than in the absence of the requirement. This will act as a tax on bank intermediation, reducing both the quantity of deposits and the quantity of loans relative to the situation in which the banks are not subject to reserve requirements. Thus, the policy will directly affect the quantity of credit. Because it is the purpose of a sterilization policy to reduce domestic credit, this aspect of a high reserve requirement is beneficial to the overall policy objective.59 As indicated in Section III, however, reserve requirements induce both central bankers and commercial bankers to accept lax credit standards.
Is there a way that the central bank can achieve the perceived benefits of credit reduction while preventing a deterioration in the franchise value of the banks through a binding reserve requirement policy? For example, are the deleterious effects of the above policy reduced if the central bank sterilizes through a voluntary rather than a required reserve program? If the banks are to hold reserves voluntarily, they must be compensated through interest payment on reserve balances held with the central bank.60 The reserve tax would no longer be a tax because, by definition, reserves pay whatever it takes for banks to voluntarily hold them. Thus, the central bank would have to pay an interest rate on bank reserve deposits that would result in the same amount of domestic credit that is created under the reserve requirement policy. Since, by assumption, the amount of domestic credit is the same as before, the interest rate on loans is the same as under the reserve requirement policy. Depositors, however, obtain a higher yield because the banks now earn interest on reserve deposits at the central bank.61 Hence, the tax cost of the sterilization policy is shifted from depositors to the central bank.
Central banks also have the option of duplicating the above policy results by issuing central bank liabilities paying market rates of return that are not held in the banking system, as in Chile and Colombia. Instead of imposing reserve “requirements” on banks that pay market rates of return, the central bank could issue an equivalent amount of liabilities to nonbanks to equal the amount of liabilities it had originally held in the form of reserve deposits of banks.
The central bank liabilities issued to nonbanks would compete with bank deposits for investor funds—as some investors would shift from bank deposits to the liabilities of the central bank. This would increase bank funding costs and loan rates and would reduce bank credit.62 Hence, the central bank can choose a quantity of liabilities issued to the nonbank public that reduces bank credit to the same level as that achieved through a policy of either imposing reserve requirements or paying interest on reserves.
When the central bank chooses a policy that relies on investors’ voluntarily holding its liabilities, the interest rate it must pay depends on how investors—whether banks or the general public—evaluate the risk of lending to the central bank. If the central bank holds foreign reserve assets, such as U.S. dollar treasury bills or bank deposits earning an almost risk-free interest rate, it would run losses if investors believed that liabilities issued by the domestic central bank were riskier than liabilities issued by the U.S. government or U.S. chartered banks.63
The central bank could cover these losses in several ways. First, it might attempt to roll the losses over by issuing additional liabilities. This policy would be unsustainable, however, if the central bank continued paying market interest rates on its liabilities; it would only lead to higher and higher liability costs. Alternatively, the central bank might have access to subsidized funding from the government budget, but this approach would only transfer losses from the central bank to the fiscal authority. If this source of funding were closed, the central bank would have to fund its losses on bank reserve deposits through its seigniorage earnings on currency issue, which does not pay interest. If these earnings were the central bank’s only source of revenue, the losses the central bank could absorb would be limited by its willingness to tolerate inflation.
If the central bank must minimize its losses and control inflation, its options are few: it must limit its role of direct lending to domestic borrowers to demonstrate to the market that it is serious about controlling inflation, and it must strengthen its supervisory procedures to control bank risks before a banking crisis occurs. It follows, therefore, that only central banks with strong franchises should risk paying interest on liabilities.
Strength of the Franchise and the Impact of Sterilization
The strength of the banking franchise affects the costs and benefits of a sterilization policy in more ways than just the direct costs to the central bank, however. This subsection considers the costs and benefits of sterilization under four different scenarios—where both the central bank and the banks have a strong franchise, where the central bank is strong but the banks are weak, where the banks are strong but the central bank is weak, and where both the central bank and the banks have a weak franchise value.
If both the banks and the central bank have strong franchises, bank credit decisions are basically sound, and the central bank is well equipped to restore confidence in banks if a systemic crisis occurs. If the central bank should choose to engage in some sterilization to build up a war chest relative to domestic credit to use in the event of a systemic crisis, it can do so at relatively low cost. There would, however, seem to be little need to engage in sterilization to limit domestic credit growth resulting from capital inflows because bankers will not take undue risks. If the capital inflow exceeds the availability of safe domestic loans, domestic savers will be induced to reduce their supply of domestic savings. For example, if bankers believe that there is an excess supply of capital that cannot be invested at an expected return commensurate with the risk, they have two alternatives: they can invest the excess funds in foreign assets or they can reduce the interest rate paid on deposits, which reduces loanable funds in the domestic market. In either case, the domestic supply of savings declines, and the expected return on loans increases for a given level of risk.
If the central bank has a strong franchise, but the banks are weak, the central bank must be concerned about overexpansion of bank credit. If it chooses a policy of sterilization, it can do so at relatively low cost because investors perceive that central bank credit decisions both in normal times and in a systemic crisis will be sound. The central bank must, however, design policies that build the franchise value of banks. To this end, it is probably preferable for the central bank to sterilize by issuing liabilities directly to the public to give investors a safe haven from risky banks rather than imposing high reserve requirements, which, as shown by the experience of the 1980s, does not encourage bankers to improve the franchise value.
If the banks are strong and the central bank is weak, resources should be kept out of the hands of the central bank. Bank credit expansion is a lesser risk than the accumulation of foreign reserve assets on the central bank’s balance sheet that can be used later to expand central bank domestic credit. Even without sterilization, however, a capital inflow has the potential to increase the balance sheet of the central bank as long as the resulting foreign currency in-flow is purchased by the central bank.64 In this case, dollarization—by which residents are freely permitted to hold dollar-denominated deposits—may help to safeguard the franchise value of banks. If low reserve requirements on foreign currency deposits are imposed, a significant proportion of the capital in-flow will not end up on the balance sheet of the central bank.
If the franchise values of both the banks and the central bank are weak, policy options are very few. It is certainly wise to control the expansion of bank credit, but it is unwise to put resources under the control of the central bank. Whether policymakers in this situation choose sterilization or not, the most important policy objective is to begin building the franchise. The place to begin is probably with central bank policies on supervision and lending because this is most directly in the control of policymakers.
Capital Inflow Challenge and Franchise Value of Banks: Some Empirical Evidence
Capital can flow into an economy through channels other than directly through the banking system.65 For example, in many Latin American countries, equity markets have attracted the interest of foreign and domestic investors in the early 1990s. The fact that investors have alternatives to banks is also a source of concern for policymakers in countries receiving large inflows of capital. After all, even if regulators know that banks are making sound credit decisions, they may not have knowledge about how firms are using funds that they have raised in the stock market.66 If an adverse shock occurs, the authorities may face pressures to protect the real value of share prices. These concerns have sometimes added to arguments advanced by those supporting sterilization policies. This subsection examines the relationship between the quality of the bank franchise and the quality of capital flows through the equity market to determine whether the banking franchise affects how funds raised in the equity market are invested.
In Section II, it was argued that the banking franchise plays a very important role in Latin American economies because banks monitor and control borrower liquidity. In the highly uncertain economic environment of a developing economy, a good bank ensures that its borrowing customers invest their funds in projects with immediate cash-flow benefits. Banks have tools at their disposal, such as the ability to demand immediate payment of principal rather than to roll over a loan, that give them power to force borrowers to abandon unprofitable activities. To use these tools, banks analyze short-term cash-flow data and the day-to-day activities of the firm. In sharp contrast to bank loans, equity contracts en-courage firms to invest in projects that do not have immediate cash-flow benefits because they permit corporations to raise funds at a low cost relative to current earnings. Equity contracts do not require the repayment of principal; nor do they require the bor-rower to promise the investor a fixed stream of interest or dividend payments.
In Section III, evidence was presented that, in economies where central bank policies encouraged banks to perform their role of monitoring firms’ cash flow, that is, in those countries with a relatively strong franchise value of banks, the adjustment to large capital outflows associated with the debt crisis, while difficult, did not lead to the extreme levels of inflation that occurred where the banking franchise was weakest. In weak franchise markets, inflation was used as a device to spread the cost of credit problems throughout the economy because neither central banks nor commercial banks had the means to resolve credit problems by working with troubled borrowers to resolve their cash-flow problems. Because equity contracts do not encourage investors to monitor cash flow, investments made through these contracts create many of the same risks as loans made by banks with weak franchises: lenders have no means of resolving cash-flow problems in the event of renewed capital flight.
This potential weakness of the equity contract creates a monitoring role for short-term lenders. although corporations can raise funds through equity contracts, even in markets like the United States, they rarely have the freedom to depend completely on equity contracts to fund their investment projects. Other lenders, whether bondholders, commercial paper holders, or banks, issue contracts that require borrowers to pay principal and interest on a timely basis. In Latin America, these other lenders are primarily banks. Thus, it is important to investigate whether, in those markets where the banking franchise is relatively strong, banks play an important role in maintaining the liquidity of firms even when they issue equity contracts.
If banks monitor and manage corporate liquidity, firms will not be able to disregard the demand for current cash flow, even though they rely heavily on equity markets. Banks will insist that borrowers meet stringent payment schedules, or they will resort to bankruptcy procedures. In contrast, where the franchise is weak, loan covenants will not be en-forced, and firms’ investment decisions will be determined largely by the demands of equity investors for capital gains rather than by current cash flow.67 As a result, in an economic downturn, firms that must satisfy the demands of strong franchise banks will be in a position to cut costs to absorb the shock of reduced revenues, whereas firms monitored by weak franchise banks will not. For example, in strong bank franchise markets, a larger portion of firms’ costs will be variable than in weak franchise markets. Hence, corporate profit streams should be more volatile in weak franchise markets, which should lead to greater volatility in stock prices.
Price-earnings ratios should also, on average, be higher in weak franchise markets because expected future earnings should be high relative to current earnings. Of course, stock market variability should also make price-earnings ratios more variable in weak franchise markets than in strong ones.
Evidence on stock market volatility, covering the period of capital inflows, is presented in Charts 14 and 15. Volatility is measured in terms of local market indexes in local currency and in U.S. dollars. All of these measures indicate that, through the end of 1994, on average variability has been highest—albeit declining—in Argentina, Colombia, and Peru and lowest in Chile and Mexico. This pattern fits investor perceptions of the franchise ranking of the banking systems in the early 1990s, as measured by the deposit-to-GDP ratios (see Section III). Investors in Chile and Mexico perceive these banking franchises to be stronger than those in Argentina and Peru.
Data on price earnings ratios in the two relatively weak franchise systems are not available over the en-tire period, so inferences from this evidence cannot be as conclusive as the volatility evidence. Nevertheless, as indicated in Chart 16, Argentine price-earnings ratios have been, on average, substantially higher than those of Chile and Mexico. Colombian price-earnings ratios have also been, on average, above those of the two countries where the franchise is perceived to be strong. Price-earnings ratios for Peru are available only for the third and fourth quarters of 1993 and are not presented in a chart. However, for the third quarter of 1993, the Peruvian price-earnings ratio was 34.95, compared with 39.27 for Argentina, 18.05 for Colombia, 16.89 for Chile, and 14.11 for Mexico. In the fourth quarter, the price-earnings ratio was 39.19 for Peru, 24.47 for Argentina, 24.90 for Colombia, 20.04 for Chile, and 19.70 for Mexico. Thus, the meager evidence available for Peru suggests that price-earnings ratios are also higher in that market than in the strong franchise markets.
Thus, it appears that the quality of the bank franchise affects how funds are invested outside the banking system. Where the franchise is strong, firms invest in projects that place more priority on current cash flow than where the franchise is weak. To the extent that an environment in which firm cash flow—and hence economic value—is uncertain, speculators may be attracted to that market. A strong banking franchise may therefore reduce speculative capital in-flows that enter outside the banking system.68
Capital Market Threat to Banking Franchise Value
In addition to the policy dilemma imposed by sterilization, before the financial crisis at the end of 1994, the banking systems in several Latin American countries had started to face a challenge well known in major industrial countries: the securitization of many financial instruments that heretofore had appeared mostly on bank balance sheets. In Latin America, capital markets alternatives to bank loans had begun to be available on a fairly wide scale, most notably the corporate bond market in Chile, money markets in Mexico, and equity markets in a number of other countries. By and large, the most internationally well-known firms were able to raise capital in the U.S. and Euromarkets. This raised concerns that the franchise value of the banking system may have weakened in Latin America.
To a large extent, the present crisis has severely curtailed the access of Latin American countries to international capital markets and has hampered the further development of several domestic securities markets. Notwithstanding recent developments, however, the significant changes in domestic capital markets that occurred in the early 1990s cannot be ignored, and the question still remains as to whether, once current banking difficulties are resolved, domestic securities markets will pose a permanent threat to the franchise value of banks. This section evaluates such a potential threat.
Price Earnings Ratios
(First quarter to first quarter)
Source: International Finance Corporation, Emerging Markets Database.Price Earnings Ratios
(First quarter to first quarter)
Source: International Finance Corporation, Emerging Markets Database.Price Earnings Ratios
(First quarter to first quarter)
Source: International Finance Corporation, Emerging Markets Database.As suggested by the evidence in the previous subsection as well as by the discussion on the nature of the bank franchise value in Section II, a strong banking franchise can improve the performance of bond and equity markets because banks are in a better position than equity holders to monitor corporate liquidity; thus, a capital market and a strong banking system can be complementary rather than competitive.
In highly developed capital markets, such as the United States, short-term money market instruments, primarily the commercial paper market, have replaced bank loans as the primary source of short-term credit to corporations. Despite this development, banks continue to play the role of liquidity monitor. Commercial paper issuers obtain a credit line from banks to ensure investors that they can meet their commitments to deliver interest and principal on time. In addition, if there should be an operational problem during the issuance of commercial paper, the corporation can draw on its credit line until the problem is cleared up. These credit lines are not credit guarantees; they can be, and are, canceled on very short notice. It is the cancellation of a commercial bank credit line that signals to other investors that the borrower’s credit quality has deteriorated. Thus, the threat of a line cancellation gives banks tremendous power over a borrower’s business, even though the bank no longer makes a loan.
Given the importance of the banking franchise, even in highly developed financial markets, what competitive threat do capital markets pose to the franchise value of banks? Because capital market development creates alternative sources of funds that are available to corporations, it leads to a reduction in the role of bank loans in corporate finance. The spread between the interest rate on loans to corporations and bank funding costs declines, and bank profits decline. Under normal circumstances, profitability would be restored through shrinkage of the banking industry both through mergers and through a decline in the percentage of financial instruments supplied by banks. A scaled-down banking system would then continue to play its important role in maintaining borrower liquidity.69
It is very difficult, however, for policymakers to scale down the banking system. Because of the important role that banks play in maintaining liquidity in financial markets and in providing accounts used as the means of payment, they are usually implicitly or explicitly insured by the government, either through direct deposit insurance or through access to central bank credit. This insurance is often not priced appropriately, preventing bank deposit costs from fully reflecting the risks that banks take. Consequently, bankers who operate banks that should exit with this shift have an incentive to maintain their profitability by taking increased risks (see Weisbrod, Lee, and Rojas-Suárez, 1992). The gains from using the insurance subsidy to generate profits increase as competition from capital market instruments causes spreads on safe credits to decline. Thus, at some point even banks with formerly strong franchises will be tempted to take risks (see Weisbrod, Lee, and Rojas-Suárez, 1992). The recent banking crisis in the industrial world—Japan, the United States, and Scandinavia—indicates the difficulty of timing regulatory actions to prevent the increase in bank risk.
In Latin America, therefore, the main issue in evaluating the capital market impact on the franchise is whether the spread that banks can earn by holding short-term loans to corporations on their balance sheets has fallen to the point where banks seek alter-native, risky investments. The spread available to banks holding corporate loans can be approximated by comparing the cost to corporations of borrowing in the short-term money market with the marginal cost to banks of funding corporate loans. Banks’ marginal funding costs are the costs that banks face in raising liabilities in the money markets, such as the wholesale market for certificates of deposit and the interbank market. If this spread is relatively high, banks can still make money by lending to large corporations, and the balance sheet franchise is relatively safe.
The only market for which there are published data on commercial paper rates and money market bank funding rates is Mexico. In Mexico, two wholesale funding markets are available to banks: the banker’s acceptance market and the interbank market.70 In early 1994, before the outbreak of the financial crisis, the commercial paper rate was about 13.5 percent, and the banker’s acceptance and inter-bank rates were about 11.5 percent; thus, the spread between the commercial paper market and the banker’s acceptance or interbank markets was about 200 basis points, compared with only a few or no basis points in the United States (Chart 17).71 Consider the following scenario: if the noninterest expense involved in a bank making a large corporate loan is assumed to be 75 basis points, which is high by U.S. standards, the bank is still able to earn a spread of 125 basis points between a loan priced at the commercial paper rate and its marginal cost of funds. If the bank funds this loan with an 8 percent equity-to-loan ratio,72 it will earn a pretax return on equity of 27 percent, which is high even for a market where treasury bill rates are somewhat less than 10 percent.73 Thus, it appears that developments in domestic capital markets have not yet significantly threatened the profitability of Mexican banks.74
Mexico: Interest Rate Spreads on Selected Financial Instruments, March 1991-March 1994
(In basis points)
Source: Banco de Mexico, Indicadores Economicos (November 1991 and March 1994).Mexico: Interest Rate Spreads on Selected Financial Instruments, March 1991-March 1994
(In basis points)
Source: Banco de Mexico, Indicadores Economicos (November 1991 and March 1994).Mexico: Interest Rate Spreads on Selected Financial Instruments, March 1991-March 1994
(In basis points)
Source: Banco de Mexico, Indicadores Economicos (November 1991 and March 1994).Besides Mexico, Chile is the other Latin American country where the issue of competition to banks from domestic capital markets has arisen. Chile is perhaps the only Latin American market that has developed a corporate bond market. As in the case of the Mexican commercial paper, the impact of this market on the bank franchise must be measured in terms of the spread between corporate bond interest rates and the marginal cost of funds facing banks. Unfortunately, this spread cannot be measured as directly as the spread in the commercial paper market in Mexico, but there is strong direct evidence that, if the spread between bond interest rates and the marginal funding costs of banks were available, it would be relatively large.
As a percentage of GDP, the corporate bond market grew rapidly during 1988–91 and has slowed down recently (Table 10). In 1992, corporate bonds, which, equaled about 5.5 percent of GDP, were al-most entirely held by pension funds and insurance companies, with two-thirds of the volume held in pension funds.75 In contrast, pension funds and insurance only held 17 percent of total equities. In 1993, the top five pension funds held 74 percent of the total assets of all pension funds as well as 75 percent of the corporate bonds held by pension funds (Table 11). These figures indicate that the market for corporate bonds is quite narrow and concentrated and imply that the market is relatively illiquid—that is, a single trade probably moves the market price significantly. The illiquidity of the market should tend to keep interest rates on corporate bonds relatively high compared with a more liquid instrument like bank deposits. This would suggest that bank spreads and bank profits are still relatively immune to domestic capital market competition.
Chile: Corporate Bonds Outstanding
Chile: Corporate Bonds Outstanding
| Corporate Bonds (1) | GDP (2) | (1)/(2) | ||
| Year | (Billions of pesos) | (Percent of GDP) | ||
| 1980 | 2.0 | 1,075.3 | 0.18 | |
| 1981 | 3.7 | 1,273.1 | 0.29 | |
| 1982 | 21.1 | 1,239.1 | 1.70 | |
| 1983 | 21.0 | 1,557.8 | 1.35 | |
| 1984 | 20.0 | 1,893.4 | 1.06 | |
| 1985 | 29.1 | 2,576.6 | 1.13 | |
| 1986 | 12.3 | 3,246.1 | 0.38 | |
| 1987 | 32.6 | 4,159.8 | 0.78 | |
| 1988 | 107.8 | 5,411.0 | 1.99 | |
| 1989 | 242.2 | 6,778.4 | 3.57 | |
| 1990 | 411.7 | 8,477.9 | 4.86 | |
| 1991 | 659.9 | 10,939.2 | 6.03 | |
| 1992 | 758.1 | 13,740.0 | 5.52 | |
Chile: Corporate Bonds Outstanding
| Corporate Bonds (1) | GDP (2) | (1)/(2) | ||
| Year | (Billions of pesos) | (Percent of GDP) | ||
| 1980 | 2.0 | 1,075.3 | 0.18 | |
| 1981 | 3.7 | 1,273.1 | 0.29 | |
| 1982 | 21.1 | 1,239.1 | 1.70 | |
| 1983 | 21.0 | 1,557.8 | 1.35 | |
| 1984 | 20.0 | 1,893.4 | 1.06 | |
| 1985 | 29.1 | 2,576.6 | 1.13 | |
| 1986 | 12.3 | 3,246.1 | 0.38 | |
| 1987 | 32.6 | 4,159.8 | 0.78 | |
| 1988 | 107.8 | 5,411.0 | 1.99 | |
| 1989 | 242.2 | 6,778.4 | 3.57 | |
| 1990 | 411.7 | 8,477.9 | 4.86 | |
| 1991 | 659.9 | 10,939.2 | 6.03 | |
| 1992 | 758.1 | 13,740.0 | 5.52 | |
Chile: Pension Fund Assets by Type of Issuing Agency, December 1993
Cuprum, Habitat, Provida, Santa Maria, and Summa.
Chile: Pension Fund Assets by Type of Issuing Agency, December 1993
| Issuing Agency | Five Largest Funds1 |
| Total government institutions | 75.2 |
| Central Bank of Chile | 75.2 |
| Treasury | 71.6 |
| Other | 82.9 |
| Financial institutions | 69.3 |
| Enterprises | 75.2 |
| Investment in foreign entities | 88.4 |
| Other | 57.7 |
| Total assets | 74.0 |
Cuprum, Habitat, Provida, Santa Maria, and Summa.
Chile: Pension Fund Assets by Type of Issuing Agency, December 1993
| Issuing Agency | Five Largest Funds1 |
| Total government institutions | 75.2 |
| Central Bank of Chile | 75.2 |
| Treasury | 71.6 |
| Other | 82.9 |
| Financial institutions | 69.3 |
| Enterprises | 75.2 |
| Investment in foreign entities | 88.4 |
| Other | 57.7 |
| Total assets | 74.0 |
Cuprum, Habitat, Provida, Santa Maria, and Summa.
A possible further threat to the franchise value of the banking system in Latin America is large corporate access to the capital markets of the United States and Europe. For example, before the 1994 crisis, large, well-known firms with stable revenue bases, such as utilities, raised equity funds in the U.S. market through ADRs, which trade on the major stock exchanges.76 In addition, some firms is-sued medium-term notes, which are instruments similar to bonds but are not subject to the disclosure requirements of bonds, in the U.S. market. Despite their name, these instruments have varying maturi-ties, sometimes quite long.77
While access to U.S. markets for new funds is quite limited under current conditions, access at some future date cannot be ruled out. How much of a threat does U.S. market access pose to the franchise value of banks in Latin America? Since ADRs are similar to equity instruments, a strong domestic banking franchise is an important complement to access to the U.S. domestic market as it is to access to domestic equity markets. The threat posed by access to the medium-term note market is best evaluated by considering why Latin American firms are not significant users of U.S. short-term money markets, such as the commercial paper market, unless they have a dollar-denominated cash flow. U.S. money markets are highly liquid, and large U.S. corporations use money market instruments rather than bank loans when cash outflows do not quite match cash inflows. It might seem relatively simple for a Latin American telephone company, for example, to issue commercial paper in the U.S. market and to engage in a currency swap to cover its cash outflow in its local market. In this way, it would seem to be able to lock in a low borrowing cost from a highly liquid market.
This transaction, however, is not as simple as it might first appear. A currency swap, like any futures contract, is priced according to the relative nominal interest rates between two markets. The currency in which nominal interest rates are higher will trade at a discount at maturity of that contract relative to the currency where nominal interest rates are lower. Swap contracts are usually priced off money market interest rates, such as the interbank rate. In Latin America, because money markets are relatively illiquid, banks may not be willing to price a contract off the interbank rate. If, for example, in Mexico, a peso-dollar swap contract were priced off the Mexican commercial paper rate rather than off the inter-bank rate, the discount on pesos at maturity of the contract would be relatively large because the commercial paper rate is higher than the interbank rate. This would erode a large portion of the gain to raising short-term funds in the dollar market.78
In Chile, the corporate bond market is a medium-term market, which might seem to provide an interest rate that can be used to price currency swaps for firms that issue medium-term notes in the United States. Again, the partial evidence presented above indicates that, like the Mexican commercial paper market, this market is illiquid, implying that Chilean medium-term interest rates include a liquidity premium, which reduces the cost advantage of raising funds in the more liquid U.S. market.
Based on the evidence of how fixed-income and equity markets in Latin America operate, it seems that a strong threat to the banking franchise from capital markets is some years away. The most liquid capital markets in the region are equity markets; even where fixed-income markets are operational—namely, the commercial paper market in Mexico and the corporate bond market in Chile—spreads are high relative to bank costs and the paper is held by a few investors. The growth of equity markets, however, poses some dangers for policymakers worried about unstable capital inflows.
Comprehensive analyses of the recent episodes of capital inflows in Latin America are included in Calvo, Leiderman, and Reinhart (1993a, 1993b), Corbo and Hernandez (1993), and Claessens and Gooptu (1993).
If the central bank controls growth by imposing high reserve requirements on deposits, the growth of the narrow money supply relative to foreign currency assets on the balance sheet of the central bank is controlled directly. If the central bank issues liabilities to the nonbank public, that is, it sterilizes through open market operations, it controls the growth of the money supply indirectly because it does not create bank reserve deposits around which banks can increase their issuance of transaction accounts.
An indicator of sterilization is constructed by using the ratio of foreign reserve assets to Ml rather than to the monetary base because the latter ratio would be affected by how the sterilization policy is carried out. If sterilization is carried out through imposition of high reserve requirements, which are part of the monetary base, the ratio would be biased downward compared with a situation in which the policy is carried out through the issuance directly to the public of central bank liabilities that are not part of the monetary base. The choice of an indicator of sterilization using M1 or any other monetary aggregate in the denominator, however, seems arbitrary.
Sterilization conducted through open market operations may lead to central bank losses because the central bank liabilities used for sterilization usually pay higher interest rates than the central bank returns from holding foreign exchange assets (e.g., Calvo, 1991). Moreover, as sterilization through open market operations tends to raise domestic interest rates, capital inflows may increase further.
If the economy is dollarized, a significant component of the foreign currency inflow may remain outside the central bank because the increase in the demand for domestic currency may be less than the inflow.
If the franchise value of the banking system is strong, even the adverse impact on banks of a sudden reversal of the real exchange appreciation would be minimized. Sound banks would take into account the probability of such an occurrence when ex-tending credit to economic agents whose real net income is largely dependent on revenues from the nontradables sector of the economy. Therefore, either credit to the riskier sectors would be limited or the risk would be properly reflected in an accumulation of capital. Indeed, the discussion in Section III made it evident that the methods used by central banks in some Latin American countries played a major role in the extent and duration of the crisis in the 1980s.
Banks hold reserves for settling transactions among individual banks. The demand for reserves depends on the overall liquidity of an economy’s money markets and the lending policies of the central bank. See Garber and Weisbrod (1992), Chap. 13.
Moreover, because reserve requirements tend to lower the interest rate paid on deposits, they would constrain additional inflows of capital.
They would, however, be willing to hold some reserves without being compensated with interest payments because the reserves are necessary for payments clearing purposes.
In contrast to a reserve requirement policy, a policy of paying interest on bank reserves, by raising the yield on bank deposits, may create incentives for further capital inflows.
Like a policy that pays interest rates on reserves, sterilization through open market operations may also attract further inflows of capital.
Central bank losses in Chile and Colombia—two active sterilizers—reached 2.2 percent and 0.8 percent of GDP in 1991, respectively. By 1992, these ratios had declined to 1.1 percent and 0.5 percent of GDP, respectively. However, these losses cannot be fully attributed to sterilization practices.
Unsterilized intervention results in an expansion of the central bank’s balance sheet.
When foreign investors purchase equity, they must exchange a hard currency deposit for a local deposit to pay for their purchase. As a result, the local bank obtains hard currency funds that can result in an expansion in the local banking system.
The role of credit extended through the equity markets in a speculative attack on the exchange rate is discussed in Section VI.
For evidence pn this point from several East Asian economies, see Weisbrod and Lee (1993).
In this regard, it should be noted that Mexico did not experience a rapid increase in stock prices in the months before the crisis. In fact, the Mexican Bolsa Index stood at 2600 on December 1, 1994, the same level as of January 1, 1994.
The function of providing liquidity is still important, but the demand for bank loans to provide liquidity declines as capital markets develop. Capital markets develop because markets are liquid enough to settle payments at the end of the day with securi-ties rather than with “good funds.” This argument is presented in detail in Section II.
Banker’s acceptances were an important funding instrument for banks in 1989 when reserve requirements on deposits reached 100 percent. When these requirements were eliminated, the market for banker’s acceptances shrank substantially, and bank deposits regained their importance as a funding source for banks.
Moreover, the spread between commercial paper and short-term deposits was about 400 basis points in early 1994.
This equity ratio is chosen to conform to the capital guide-lines of the Bank for International Settlements.
This calculation assumes that 92 percent of the loan is funded at the bank’s marginal cost of funds, and the remaining 8 percent of funds is raised in the equity market. Banks earned 13.5 percent on the entire loan, which is the commercial paper rate. They paid 11.5 percent, the banker’s acceptance rate, on 92 percent of the funds used to make the loan, as well as 75 basis points of noninterest expenses on the entire amount of the loan. Based on this revenue stream and the funding and noninterest costs, banks earned about 27 percent on the remaining 8 percent of funds used to make the loan, which represents the equity funding.
It is also noteworthy that during the financial crisis in Mexico, when interest rates on repurchase agreements secured by government paper rose to more than 80 percent, interest rates on bank deposits remained below 60 percent. Of course, only the most secure banks in the system were able to raise bank deposits under these conditions.
For a relative comparison, in the United States, corporate bonds are about 19 percent of GDP.
Foreign firms use ADRs to become listed on a U.S. stock exchange without being subject to the Security and Exchange Commission’s disclosure requirement. To issue ADRs, however, foreign firms must hold a deposit with a U.S. chartered bank to guarantee payment of dividends. Receipts verifying the existence of these deposits are the instruments that are actually traded.
See Crabbe(1993).
During the recent financial crisis in Mexico, a Mexican firm experienced a well-publicized default on its dollar-denominated commercial paper, perhaps damaging other Latin American firms’ access to this market as well.
