BY DIANA FARRELL
AND SUSAN LUND
Most countries in Latin America have made serious strides toward reforming their economies in the last 15 years, opening their markets to trade and foreign investment, reducing government budget deficits, adopting more flexible currency regimes and reducing inflation. Yet despite these reforms, the financial systems in Latin America remain small relative to the size of the economies. And this reality, we believe, weakens the region’s prospects for sustainable growth.
Altogether, the financial assets of Latin America amounted to just $4.3 trillion at the end of 2006, compared with more than $8 trillion in China. These assets equal 154 percent of gross domestic product for Latin America, compared with 307 percent in China and 250 percent in emerging Asia. Moreover, Latin America is largely cut off from the growing volume of capital flowing around the world.
Of course, Latin America is diverse, and there are bright spots in the financial landscape. Chile has a modern pension system and a sound equity market. Brazil has high-performing banks, while the capitalization of Mexico’s equity market has more than tripled since 2002. But the overall picture is problematic. Although large companies can raise funds in the United States and Europe, small and midsized firms have more restricted access to capital and pay more for it when they can get it. In a recent McKinsey survey (available at www.mckinseyquarterly.com), just 40 percent of business executives in Latin America say they have good access to external financing, compared with 60 percent of executives in other emerging markets.
The situation may brighten. Since 2002, the region’s stock of financial assets has grown at 18 percent annually (adjusted for exchange rate changes), up from just 5 percent in 1995 to 2002. Many countries have significantly reduced inflation and have adopted more flexible exchange rate regimes; both steps are essential to maintaining macroeconomic stability. Foreign investors are taking notice, with inflows into the region’s stock markets and private equity investments both up in 2005.
Is Latin America, then, on the verge of a (long-awaited) breakthrough? Much depends on whether policy makers can continue to reduce public debt while imposing further reforms on financial and legal systems.
One common way to assay the development of a financial system is by measuring its depth – the value of financial assets as a percentage of GDP. For the most part, deeper financial markets bolster growth because they are more liquid and thus better able to withstand shocks, they improve borrowers’ access to capital, and they offer more efficient pricing as well as improved opportunities for hedging risk.
Latin America’s lack of financial depth is seen across both countries and asset classes. The comparison to emerging Asian nations – Thailand, Malaysia, Indonesia, the Philippines and South Korea – is particularly striking, since the regions have similar living standards and education levels. GDP per capita is $8,100 in emerging Asia (measured in terms of purchasing power), compared to $8,800 in Latin America. And both regions average the same amount of schooling.
Chile, with the region’s most developed financial sector, has less financial depth than China – despite having per capita income that is more than twice as high – and is far below the better-developed markets in South Korea and Malaysia. Brazil’s financial depth is on par with the Philippines. Given the size of its economy, Mexico’s financial depth is startling low – only 118 percent of GDP. Venezuela’s financial depth amounts to less than 89 percent of GDP, on par with Romania and Ukraine. (…)
SUSTAINING THE MOMENTUM
To keep sound financial deepening on track, policymakers will have to build on the macroeconomic reforms already in place. The first imperative is to continue reducing the size of government debt. While government debt contributes to financial deepening, it does not do so in a productive way. Most countries have made progress in replacing foreign currency debt with domestic debt, thereby reducing the sort of asset-liability mismatch that creates significant risk of financial crises. But more needs to be done to reduce public spending and the drain on the region’s savings. In addition, countries should foster investor confidence and signal a commitment to keeping inflation under control. One important step in the right direction is to reinforce central bank independence. While Chile and Mexico have made notable progress on this front, other countries lag behind.
Other financial system reforms are also needed, according to McKinsey’s survey of business executives in Latin America. Financing constraints are a top-five issue behind slow growth for these executives; only regulation, economic recession and an increasingly competitive market environment are seen as more important. Among the financial reforms that Latin American executives would like to see, stock market reform is the highest priority, followed by further improvements in pension systems and streamlined corporate bond markets. Reducing the cost of issuing equities and bonds on domestic markets is critical.
Finally, most Latin American economies would benefit from strengthening creditors’ protection in court and expediting bankruptcy proceedings. Although Latin America has liberalized its financial systems over the last 15 years, investor protection and legal contract enforcement are still poor compared with the United States and with high-performing emerging markets. For example, according to the World Bank’s Doing Business survey, it takes an average of 587 days to enforce a debt contract in Latin America and costs more than 20 percent of the value of the debt, compared with 230 days in Korea at a cost of less than 6 percent of the debt. Not surprisingly, the McKinsey survey shows that 39 percent of business leaders view ineffective bankruptcy laws or inefficient courts as a barrier to further financial system development.
The Latin American economies, in short, have come a long way from the bureaucratic rigidity of their post-colonial economies. But, alas, the region has a long way to go.
This column is based on an excerpt from a longer article in the Milken Institute Review, Fourth Quarter 2007. Republished with permission from the authors.