Financial Sector ReformFinancial Sector Reform

Sergio Schmukler

Rethinking Structural Reform ConferenceFederal Reserve Bank of Atlanta

Inter-American Development BankOctober 2003

Discussion on Discussion on Bekaert, Harvey and Lundblad Bekaert, Harvey and Lundblad

Galindo and MiccoGalindo and Micco

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Discussion OutlineDiscussion Outline1. Reform agenda: logic and scope

Broader than these papersBroader than financial sector reforms

2. Outcomes for Latin America: mixed or disappointingExtensive to other regionsNot as predicted by these papers

3. If reforms did disappoint, why?Policy alternatives to these papers’ recommendations

4. Liberalization papers

5. Creditor rights paper

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1. Reform Agenda: Logic1. Reform Agenda: LogicGenerate more and cheaper financing

BANKS(fragile and inefficient)

CAPITAL MARKETS

FIRMS

Increased competition

Cheaper financing

INVESTORS

Higher returns

Wider set of instruments

More financing

GOVERNMENT

Supervision and regulation

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•Depository and clearing•Trading platforms

•Pension funds•Mutual funds•Insurance companies

1. Reform Agenda: Logic1. Reform Agenda: LogicSweeping reforms throughout financial sector

CAPITAL MARKETS SUPPLY

•Financial liberalization

DEMAND

•Privatization•Tax incentives

Long-term financing and specialization

Lower transaction costs

Improve exchange infrastructure

Foreign capital

available

Increase liquidity

•Supervisory agency•Investor protection

Mitigate information and agency problems

More retail investment

Promote stocks dissemination

More discipline and efficiency

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1. Reform Agenda: Actions1. Reform Agenda: ActionsFinancial liberalization increasing since late-1980s

Countries included are Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. The value 1 means repression, 2 partial liberalization, and 3 full liberalization. Figures correspond to end-of-month values.Source: Kaminsky and Schmukler 2002

Latin America: Indices of Financial Liberalization by Sector

More liberalization

0.5

1.0

1.5

2.0

2.5

3.0

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Domestic Financial Sector Capital Account Stock Market

Less liberalization

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1. Reform Agenda: Actions1. Reform Agenda: ActionsOther reforms implemented in the early-1990s

The figure shows the percentage of countries (from a group of 16 countries) that had implemented reforms before 1990, in 1990-1995, and in 1996-2001. Countries included are Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, Guatemala, Honduras, Jamaica, Mexico, Panama, Paraguay, Peru, Uruguay, Venezuela.Sources: Bhattacharya and Daouk 2000, ICRG, and local data

Percentage of Latin American Countries that Implemented Reforms

3125

13

69 69

25

69

25

69

6

100

81

Creation of currentsupervisory agency

Establishment ofinsider trading laws

Enforcement ofinsider trading laws

Improvement in Law and Order index

Before 1990 1990-1995 1996-2001

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1. Reform Agenda: Actions1. Reform Agenda: ActionsReforms occurred mostly after liberalization

The table shows the percentage of coutries that had implemented reforms before partial and full liberalization. Countries included are Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.Sources: Bhattacharya and Daouk 2000, Kaminsky and Schmukler 2001, and ICRG

Sequencing: Financial Liberalization and Institutional Reforms

Law and OrderInsider Trading Laws -

ExistenceInsider Trading Laws -

Enforcement

Partial Liberalization 0.0 14.3 0.0

Full Liberalization 28.6 71.4 14.3

Probabilities of Liberalization Conditional on

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2. But Results Not as Expected2. But Results Not as Expected

(Reforms are good according to these papers)

Equity marketsVisible growth (market cap), but not as in OECDRising concentration and delistingMigration to international equity markets

Small relative to bond markets

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2. But Results Not as Expected2. But Results Not as ExpectedBond markets

Dominated by government paperDollarizationShort durationCurrency and maturity mismatches

Institutional investorsFast growth but tapped by governments

10

2. But Results Not as Expected2. But Results Not as ExpectedLatin America Equity Market Growth Is Poor

Stock Market CapitalizationPercentage of GDP

0

25

50

75

100

125

150

1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999

Latin American countriesAsian countriesG-7 countries

Countries included are Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. Asian countries: Hong Kong, Indonesia, Korea, Malaysia, Philippines, Taiwan, and Thailand. G-7countries: Canada, France, Germany, Italy, Japan, U.K., and U.S. Figures correspond to end-of-year values.Sources: IFC's Emerging Markets Database, World Federation of Exchanges (FIBV), and The World Bank

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2. But Results Not as Expected2. But Results Not as ExpectedStock Exchanges Affected by Increasing De-listing

Domestic Stock Exchanges: Number of Companies

Source: IFC's Emerging Markets Database

0

100

200

300

400

500

600

Argentina Brazil Chile Colombia Mexico Peru Venezuela

1990 1995 2000

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2. But Results Not as Expected2. But Results Not as ExpectedLarge Companies Migrate to International Markets

Latin American Companies: Value Traded

Countries included are Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. Internationalized companies are defined as companies that cross-list or raise capital in international stock markets at some point in time. Figures correspond to end-of-year values.Sources: The Bank of New York, Euromoney, and IFC's Emerging Markets Database

USD Millions

0

50,000

100,000

150,000

200,000

250,000

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Internationalized companies in international marketInternationalized companies in domestic marketDomestic companies

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2. But Results Not as Expected2. But Results Not as ExpectedEquities Traded Belong to a Handful of Large Firms

PercentageStock Market Concentration (end-2000)

Source: IFC's Emerging Markets Database

0

10

20

30

40

50

60

70

80

Arg

entin

a

Braz

il

Chi

le

Col

ombi

a

Mex

ico

Peru

Ven

ezue

la

Hon

g K

ong

Mal

aysi

a

Thai

land

Japa

n

U.K

.

U.S

.

Share of trading of top ten companies

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2. But Results Not as Expected2. But Results Not as ExpectedPublic Bond Trading Outweighs Equity Trading

Value Traded in Domestic Markets (2000)

The figure shows the value traded through the domestic exchanges. However, in the case of Mexico, repo operations (conducted or not through the exchange) are also considered.Sources: Local data, The Handbook of World Stock, Derivative & Commodity Exchanges 2001, Federacion Iberoamericana de Bolsas de Valores (FIABV), and The World Bank

68

0

2

4

6

8

10

12

14

Argentina Bolivia Colombia Ecuador El Salvador Mexico

Government bonds Equities

Percentage of GDP

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3. If Reforms Did Disappoint, Why?3. If Reforms Did Disappoint, Why?

Wrong sequencingFinancial integration went too fastImperfections in international markets lead to vulnerabilities when domestic sector is not ready Thus, follow right sequencingBut, are there sufficient incentives to reform institutions without the discipline from openness and crisis?

Wait for the fruits of reforms and do more The dividends from reforms have long gestation periodThus, accelerate paceBut, we all know what happens in the long run

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3. If Reforms Did Disappoint, Why?3. If Reforms Did Disappoint, Why?

Wrong expectationsRecommendations based on cross-sectional evidenceReforms did not tackle well some basic issues for EMs

Macro policySystemic risk Domestic and external shocks, e.g. capital flows volatilityInstitutional factors – size, information asymmetries, moral hazard

GlobalizationThus, redesign reform to address the basic issues, and revise expectationsBut, many of these issues are intrinsic to emerging markets and solving them is a daunting task

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4. Liberalization Papers4. Liberalization Papers

Great papers!

Important contributionsWelfare implications relative to previous workGrowth mean and volatilitySolid workAlmost painful to read, “overwhelming force”Incorporated most comments received in the past years, so difficult to discuss

Particularly for the growth mean paper

Volatility paper needs to address the same comments that spur paper already did

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4. Liberalization Papers4. Liberalization PapersPotentially relevant issues to consider

“One of the most fundamental national policy decisions of the past 25 years has been the liberalization of equity markets across the world.”

Here, allowing foreigners to purchase domestic stocksBut witness size of stock marketsAnd witness effects of capital account liberalization

Which samples/estimations make sense?Mix of developed and developing, including very poor countriesIncluding countries with no change in liberalizationTime series for emerging marketsFixed effects estimations

Coefficient diminishes to 0.56But why including countries with no variation in liberalization here?

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4. Liberalization Papers4. Liberalization Papers

Potentially relevant issues to consider (continued)More on econometrics

Overlapping observationsHow are common factors treated besides SUR specification?How is endogeneity addressed, specially given that it comes up in the growth paper?

Removing 97-00 seems arbitraryCrises as outliers? Rationale?Why including 99 and 00?Perhaps, crises consequence of liberalization, as suggestedEven with crises, other evidence points towards lower volatility

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4. Liberalization Papers4. Liberalization Papers

Caveats related to liberalization measuresWider set of financial liberalization measuresPace of liberalizationReversalsIntensity of liberalizationCapital account liberalization

Might seem more important to many readersTreatment of capital account liberalization

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4. Liberalization Papers4. Liberalization Papers

Other specific pointsMore on economic significance would be welcomedResults weakened with other controlsFor LAC countries, mean results insignificantOther regressors

Other controls, like GDP per capitaLevel of inflation might matter

Risk sharing Perhaps, could be another paper

Ability versus actual risk sharing

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5. Creditor Rights Paper5. Creditor Rights Paper

Great paper!

Important points of the paperEffectiveness of creditor rights, interacted with

With rule of lawWith efficiency of the judiciaryWith small and medium firms

Perhaps nicest results

Three effects of creditor rightsCredit/GDPShare of bank credit financing of small and medium firmsChange in real credit (procyclicality)

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5. Creditor Rights Paper5. Creditor Rights Paper

Potentially relevant issues to considerMore consistency across empirical analysis Creditors rights, rule of law, or broad institutions?

No multivariate analysis, omitted variablesOnly done very partially for change in credit, when controlling both for creditor rights and rule of lawPerhaps, control for GDP per capita, given that GNP and GDP growth not significant

Interaction might result more from law and order explanatory power than from creditor rights

Perhaps interact with GDP per capita and other variables

Why is creditor rights insignificant by itself second part?

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5. Creditor Rights Paper5. Creditor Rights Paper

Potentially relevant issues to consider (continued)Why procyclicality?

Risk can be reduced ex-ante, knowing state of institutionsMore explanation would be welcomed

Policy recommendationsCross section evidence versus time series recommendation

More reforms neededForeign jurisdictionsSystemic shocks and creditors right

Repudiation of contractsShocks to collateralIn fact, acknowledged importance in institutional analysis

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5. Creditor Rights Paper5. Creditor Rights Paper

More on data and variablesMacro variables not significant, except budget deficitWEBS survey

Only for 1999Share of investment financed with bank credit and legal protection

What about other type of financing

Other specific pointEconometrics

Procyclicality results weak using IVsClustering standard errors