CAPITAL MARKET DEVELOPMENT

IN LATIN AMERICA AND THE CARIBBEAN

A Strategy Proposal

Document prepared by the staff of the

Infrastructure and Financial Markets Division

July 1995
CAPITAL MARKET DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN

A Strategy Proposal

Prepared by:

Jesse Wright, Martin Chrisney and Antonio Vives

Infrastructure and Financial Markets Division

Summary and Recommendations

I. Introduction

II. The Problem in Capital Markets

III. Savings and Capital Markets

IV. The Structure of Capital Markets

V. New Products

VI. The Bank’s Mandate

VII. The Bank’s Experience

VIII. The Bank's Strategy

IX. Strategy Implementation

X. Conclusion
 CAPITAL MARKET DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN

A Strategy Proposal

Summary and Recommendations

Perhaps in no other activity is the pace of innovation as great or the cost of failure so high as in
capital markets. When the countries of Latin America and the Caribbean enter the 21st
Century, the structure of the Region’s capital markets will be as different as today’s markets
differ from those of the 1970s. The worldwide forces of change are rapid advances in
information technology, an accelerated pace of financial innovation, greater private sector
participation, and the globalization/integration of domestic markets. At the same time, the
lessons from recent currency crises, that threatened to spread throughout the Region’s stock
and bond markets, point to the consequences of an excessive dependence on foreign portfolio
investment, and especially, investments in highly mobile, short-term instruments.

It is axiomatic that savings are key to sustainable, long-term growth. In the Region, however,
low domestic savings have been the handmaiden of weak capital market development leading
to a greater reliance on external debt. One necessary condition for financial savings is a capital
market that can provide accessible and economical instruments to encourage savings and
lower the costs of financial transactions. Furthermore, as intermediaries of those savings,
efficient capital market institutions will improve the allocation funds to alternative productive
investments in the corporate and public sectors.

Domestic financial systems within the Region differ greatly owing to the separate economic,
political and social development paths chosen. For this reason, the Bank’s capital market
strategy must recognize these differing stages of financial development and their impact on
capital market institutions. Nonetheless, common themes and challenges will face the Region
in the coming years. To meet these challenges it is proposed that the Bank adopt a dedicated
capital market strategy aimed at (a) raising the level of savings and improving its
composition; (b) enhancing the economic efficiency of capital markets, and (c) promoting the
harmonization and integration of the Region’s capital markets.

The elements of the capital market strategy identified here should serve as a guide to the
Bank’s operating departments in the preparation of country and regional strategies. When
deemed necessary, a Country Capital Market Development Program should be designed
that identifies specific barriers and interventions for a given country. Each country program
will have to be coordinated with other multilateral institutions (IMF and World Bank) to
ensure consistency and the appropriate macroeconomic framework. Given the rapid pace of
change in capital markets, the Bank should establish a Capital Market Studies Program to
provide analytical work, support technical assistance, and disseminate information on best
practices. The Program can serve as an independent source of support for regional regulatory
 and supervisory bodies, governmental authorities and the Committee on Hemispheric
Financial Issues.

CAPITAL MARKET DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN

A Strategy Proposal

I. Introduction

The Inter-American Development Bank has been involved in the development of financial
markets in Latin America and the Caribbean for a number of years. A major part of this work
has focused on banking systems and prudential regulation, and because of the importance of the
banking system, this will remain an important part of the Bank’s work. At the same time, the
Bank must focus more attention on non-bank financial issues in long-term debt and equity
markets (i.e., capital markets) as it seeks to deepen and broaden financial systems.

The scope of capital markets includes primary and secondary markets. Both are important to
the effective allocation of scarce capital. Commercial and investment banks, which have a
comparative advantage in the management of private information and client relationships, fund
investments in primary markets. In addition, secondary markets, which trade claims on existing
assets, improve the transactional efficiency of capital markets when information is readily
available. Moreover, secondary markets are associated with increased savings through an
indirect effect of boosting the liquidity of primary markets.

To the extent that capital markets are poorly developed, lack liquidity and transparency, domestic
investors, correctly perceiving the higher level of risk, will reduce investment in favor of
consumption and thereby lower savings. Moreover, riskier markets will cause domestic savings
to flow to offshore accounts. Likewise, international investors, seeking to diversify portfolios,
will invest in those countries that have developed more liquid and transparent capital markets
that offer a variety of investments.

This paper highlights the problems facing the Region’s capital markets and the importance of
raising domestic savings in the context of well-functioning capital markets (Section II & III);
discusses the conditions, structure and instruments for efficient and complete markets and new
products (Sections IV & V); and reviews the Bank’s mandate and recent experience in capital
market activities (Sections VI & VII) . Based on this analysis, a strategy and its implementation
are proposed to assist the development of Latin American and Caribbean capital markets
(Sections VIII & IX). The strategy proposes that the Bank intensify its efforts in this area and
take a more comprehensive view of capital market issues in the region and their linkages with
those of developed countries.

It is proposed that the Bank adopt a dedicated capital market strategy aimed at (a) raising the
level of savings and improving its composition (i.e., shifting from real to financial assets and
transforming savings to longer-term, more stable sources); (b) enhancing the economic efficiency
of capital markets; and (c) promoting the harmonization and integration of the Region’s capital
markets.

The proposed strategy will deal only with the non-bank segment of financial markets, as the
Bank is developing concurrently, a complementary Financial Markets Strategy, which will
address the special needs and conditions of the banking system and will integrate both strategies.

II. The Problem in Capital Markets

A Recurring Problem: The debt crisis of the 1980s demonstrated the dangers of Latin
American governments, banks and businesses carrying excessive amounts of foreign bank debt.
The recent currency crisis in Mexico, which threatened to unsettle other Latin American stock
and bond markets, points to the consequences of an excessive dependence on foreign portfolio
investment, and especially, investments in highly mobile, short-term instruments. Additionally,
the continuous withdrawal of the public sector from large infrastructure finance has created a
need for private sector capital, the bulk of which should be raised in the local capital markets to
match the local currency of most revenues from these projects.

The Need to Develop Internal Savings: These examples demonstrate that the availability of
foreign capital, while a valuable complement to domestic investment, cannot wholly substitute
for domestic savings. The bulk of Latin American economic and social development must
undeniably be financed through domestic savings and investment. This places a heavy burden on
domestic stock, bond and money markets to efficiently raise domestic savings and channel these
into productive investments.
The IDB’s Role: The Bank has worked, for a number of years, with the banking systems of
member countries to improve their efficiency, prudential oversight and maximize access to
financial services by all elements of society. As these financial systems have evolved and
become more complex, new markets and financial instruments are assuming increasing
importance. Accordingly, the Bank’s assistance (and more recently the IIC and MIF) is adapting
and we find ourselves working with new types of financial intermediaries such as leasing
companies, stock and bond markets, guarantee funds, pension funds, etc.

III. Domestic Savings and Capital Markets

Savings, Growth and Capital Markets: It is axiomatic that savings are key to sustainable,
long-term growth. Although much attention is focused on international capital flows (or foreign
savings), domestic savings are a more important source of investment funding. However,
domestic savings in Latin America is low, averaging 18 percent of GDP in a sample of countries,
compared with 33 percent in the fast-growing East Asian economies. As a corollary to lower
domestic savings, Latin economies have a higher dependence on external debt and
commensurately lower domestic stock market capitalization and bank credit (see Table).

Savings depends on a host of variables including income levels, population growth and age
composition, as well as the return on assets. One of the necessary conditions for financial
savings, however, is the development of domestic capital markets. Capital markets provide an
accessible and economical variety of financial instruments to encourage savers, largely
 - 3 -

households, to shift from real assets into financial assets. Furthermore, new instruments that
lower the risks inherent in securities transactions can encourage longer-term, stable savings as
risks are appropriately priced and distributed more widely throughout the market.

There are widespread benefits from capital market development. Capital markets direct savings
into the most profitable investments available in the economy. By doing so they improve the
overall efficiency of the economy. This also permits corporations to expand beyond the limits
imposed by self-financing from retained earnings. Money market price “signals” also gauge the
costs of government capital and permit monetary authorities to control liquidity through these
markets. The participants in capital markets also enhance the professionalism and independence
of these markets and improve corporate governance.

Savings, Growth and Capital Markets - 1993

(US$ billi )
Real GDP Stock Market Domestic Credit External Bonds
US$ %GNP US$ % GNP US$ % GNP

Latin Total a/ 1,154.2 4.1 b/ 17.8 b/ 442.7 49.4 b/ 676.2 45.1 b/ 131.5 12.5 b/

East Asia Total c/ 1,144.8 7.3 b/ 32.9 b/ 668.8 92.2 b/ 1,017.8 78.5 b/ 34.9 4.3 b/

a/ Argentina, Brazil, Chile, Colombia, Mexico and Venezuela.

b/ Average.
c/ China, Indonesia, Korea, Malaysia, Philippines and Thailand.

SOURCE: (See Annex 1)

IV. The Structure of Capital Markets

Complete Markets: The objective of every emerging economy is to develop depth and breath in
financial markets to meet the needs of the real economy. This would include making a wide
range of choices available to investors and issuers of securities in fixed-income and equity
markets. Bond issuers, for example, would ideally be able to issue a variety of maturities
ranging from overnight to long-term in both variable and fixed rates. Stock markets would
provide large and small companies access to individuals' savings directly or through pension,
insurance and mutual funds.
Money Markets: The market for securities of less than one year includes government and
central bank bills, repurchase agreements of government paper reportos), commercial bank
certificates of deposit, corporate commercial paper and trade finance instruments such as bankers'
acceptances. These markets, in their inter-bank or over-the-counter (OTC) form, have long been
used in most Latin countries. A newer phenomenon, however, has been for these instruments to
be listed on organized stock exchanges and for central banks to increasingly conduct monetary
policy through open market operations in these instruments. The advantages to investors of
having highly-rated, short-term paper available as a vehicle for temporary placement of funds are
many.

Debt Markets: Public entities (finance ministries, central banks and specialized government
agencies for housing, agriculture, export and industry), are the most creditworthy borrowers and
generally dominate the issue of local currency debt. However, we are seeing an increasing ability
to issue corporate obligations beyond one year in local bond markets. The maturity structure
 - 4 -

(yield curve), however, generally does not extend beyond two or three years, and the central
problem for both government and corporate borrowers is to push out maturities as far as is
possible. This is not easy. Bondholders are exposed to inflationary policies, inadequate
information due to poor accounting systems, lack of credit review agencies or a legal system that
is unable to enforce foreclosure judgements in a commercially meaningful time period.

Equity Markets: Organized stock exchanges in emerging economies have been slow to develop
because of the traditional reluctance of closely-held firms to divulge information to the public or
an unwillingness to dilute voting power and control of the firm. For these reasons, closely-held
private placements have historically been more important. However this is changing as a larger
number of shareholders are looking to secondary markets to provide an exit mechanism in which
to divest. Moreover, stock markets attract a different kind of investor than bond markets. Risk
capital that seeks a higher return through ownership is willing to accept more uncertain returns
than bondholders and thus is an important adjunct to fixed-income markets.

Institutional Money Managers: Insurance companies, mutual funds and pension funds achieve
important economies of scale through pooling small savings, diversifying investments and
monitoring market information. Institutional investors are also able to do this at a lower
transaction cost. Institutional investors raise the level of professionalism within markets through
requiring better information and increased transparency. Institutions are the largest pool of
savings and investment, in emerging as well as mature economies. Efforts to mobilize savings in
emerging markets therefore cannot ignore their dominant role. But in fact, severe restrictions are
sometimes placed on their investment policies. For example, it is not uncommon to find public
pension funds restricted to investing in government debt sometimes paying less than market
rates. Restrictions placed on purchases of common stock, corporate debt or real estate keep rates
of return to the funds low and deprive the domestic capital market of the largest source of
investment and liquidity.

Financial Infrastructure: Capital market participants nearly unanimously agree that they
should not engage in underwriting, trading or asset management activities in the absence of a
secure legal and regulatory environment. Foreign investment funds usually cannot go into a
market that lacks adequate legislation and oversight. Even so, capital market activities in some
countries continue to operate under antiquated civil or commercial codes that did not anticipate
many of today’s markets or financial instruments. Similarly, many organized exchanges operate
as self-regulatory organizations (SROs) that may not meet internationally recognized norms for
transparency and disclosure. OTC trading activity sometimes does not take place within rules
promulgated by a trade association’s "master agreements" or a similar legal framework.

Although exchanges perform a self-regulatory function, most developed financial systems

additionally have a securities exchange commission-type institution (comision nacional de
valores, CNV) that provides an additional layer of oversight. Investors look to these
organizations to safeguard the

markets through establishing minimum standards of capitalization, registration of securities and

market participants, timely and material disclosure and effective enforcement.

The timely disclosure of material information is a key ingredient generally lacking in emerging
 - 5 -

markets. The problem is deep-seated as it generally results from an inadequacy of local

accounting conventions or an ethos of secrecy pervading the markets. In addition, there is a lack
of credit rating agencies that render objective judgements on increasingly complex financial
instruments and markets.

In addition to the legal and regulatory framework, the financial infrastructure should include a
non-bank payments system for the organized exchanges. Commonly called clearance and
settlement within a central securities depository, these clearing houses depend importantly on
legislation enabling their establishment and on the clarification of legal concepts such as netting
and the treatment of guarantees in bankruptcy for their effective operation.

Swift and effective enforcement of the securities laws and regulations is necessary to maintain
the integrity of financial markets. This will require that the regulatory authorities have access to
electronic audit trails of organized exchanges, as well as bank and other financial records of OTC
transactions. The integration of private capital markets throughout the world will also require an
increasing degree of cooperation among the world’s regulatory authorities.

Ideal capital markets, as described above, do not develop in a vacuum and their growth is
facilitated or diminished by the quality of macroeconomic policy. Fixed-rate lending or bond
holding, for example, will not develop in an inflationary environment and foreign participation in
a market can be enhanced or discouraged by exchange rate policy. Tax policy will also exert an
important influence on savings and investment behavior. For these reasons, the Bank’s capital
markets strategy must always be viewed within the context of the country’s overall economic
policy program.

V. New Products

Securitization is a relatively recent financial technique that is gaining in popularity.

Securitization allows a comparatively riskier firm access to capital markets or to lower financing
costs by segregating higher quality receivables or assets from the risky firm. The default rate of
the receivables or the quality of the assets should be known or measurable. The assets are placed
in a trust or other legal structure that is bankruptcy remote from the parent firm, called a special
purpose vehicle (SPV), it issues securities collateralized by the assets or receivables. Since the
SPV contains only comparatively high quality assets or receivables legally separate from the
parent, its credit rating will likely be higher than the parent firm permitting it to issue securities at
a lower cost.

Securitization can also be used to make a firm’s balance sheet more liquid by turning long-term
assets such as mortgages (collateralized mortgage obligation, CMO), bank loans or physical
inventories (warehouse receipts) into cash through securitizing these assets. The firm or
financial institution is then free to originate more mortgages or loans or purchase more inventory
to grow its business.

Securitization, moreover, is also finding its way into infrastructure and project finance where the
 - 6 -

cash flow from the project (i.e. electricity tariffs, oil revenues, etc.) can be securitized and the
proceeds used to finance project development. A claim on the cash flow generated by the
project, as opposed to a claim on the physical asset as in a bond financing, may be less risky and
thus a more attractive financing option.

Guarantees: Latin America as in other developing areas of the world has not been immune to
unstable political conditions and unwarranted regulatory change. Sovereign and regulatory risks
frequently pose the greatest threat to a project’s viability, particularly infrastructure projects with
extended payback periods, and therefore are the most feared by investors. The Bank, because of
its knowledge of the country and long-standing relationship with member governments, may be
uniquely qualified to raise the confidence level of private investors through providing
performance guarantees of government and regulatory actions.

Project Finance is closely related to securitization and guarantees and can involve the
simultaneous use of all three financing techniques. As in securitization, project finance does not
look to the general balance sheet or total cash flow of the firm for repayment, but rather to the
specific project that will give rise to the cash flow. Firms can undertake very large projects
through syndication of the funding and sharing of risks among a number of creditors or investors.
Project finance lends itself to a wide variety of financing techniques, many of which depend on
the ability to raise money in the local capital markets and to hedge local currency receipts and
outlays.

Derivatives and Risk Management: Notwithstanding the adverse publicity surrounding

derivatives recently, these instruments perform a valuable economic function and their continued
use will grow in Latin America. Properly used, derivatives facilitate the transfer of price risks of
commodities, foreign exchange and interest rates to investors willing to accept these risk for a fee
or profit. This allows businessmen or bankers to concentrate on their core business through
hedging exposure to these uncontrollable external factors.

Derivatives have been used extensively in Latin America principally for commodity swaps and
price hedging. Coffee, sugar, copper and oil are only a few of the physical commodities whose
prices have been fixed through forward sales. In addition, financial transactions such as stock
indices, currency and interest rate swaps or hedges are becoming more common. This is a proper
use of derivatives where business risk is reduced when businesses and banks layoff their price
risks on those better able to manage these risks. Similarly, some Latin countries are instructing
their ministries of agriculture to experiment with pilot programs that use derivatives to hedge
agricultural price risks in return for a gradual phasing out of crop price subsidies. The financing
of some infrastructure projects can be made more secure if futures contracts are used to fix the
prices of inputs and outputs. In addition, some countries already have extensive over-the-counter
derivatives markets and are establishing derivative contracts on local stock and commodity
exchanges.

However, there have been disquieting press reports of some Latin American financial institutions
 - 7 -

using the derivatives markets, especially the large Brady Bond market, to assume large
speculative positions. In the case of commercial banks, operating under guaranteed deposit
schemes, this is imprudent behavior that exposes the banking system to moral hazard.

Risk management systems that measure, monitor and report derivatives risk on a real time basis
to top management and shareholders are likely to be inadequate or non-existent in most Latin
American banks and companies. Moreover, the regulatory authorities in these countries have yet
to catch up to these recent financial developments and may be unaware of the extent of risks the
banking system and corporate sectors are running.

VI. The Bank’s Mandate

Bank’s Mandate: In the Eighth Replenishment, the Bank recognized the key role of domestic
savings and investment and will continue to assist its members’ efforts to reform and modernize
their financial sectors. Moreover, the Heads of State of the Republics of the Americas, in their
most recent Summit, endorsed the principals of open, transparent and integrated capital markets.

The Bank Group Enjoys An Important Comparative Advantage: In many respects, the Bank
Group is uniquely qualified to provide loans and technical assistance in the area of capital
markets development. As a development bank owned by its membership, there is a degree of
trust and common purpose that does not normally exist in an "arms-length" commercial
transaction. This allows both parties to work in areas that would be considered too sensitive for a
normal commercial venture. This is especially true in the area of capital markets development
and reform which have wide implications for the economy and society.

VII. The Bank’s Experience

The Bank, in more than three decades of lending activity, has been actively involved in financial
market development (see Annex 2). There have been two particularly productive periods of
financial markets activity for the Bank, with the first period beginning in the mid-to-late 1970s
and the second period beginning in 1990. Annex 2 at the end of this paper reviews all non-bank
capital markets activity by the IDB since 1990 within Investment, Financial, and Global Multi-
Sector Loans. In addition, selected Pre-investment and Multilateral Investment Fund operations
were reviewed.

The Bank’s capital markets activity can broadly be categorized into operations dealing with
prudential/supervisory concerns and those operations that dealt with capital market institutions or
financial instruments. The former would include: national securities legislation; securities
supervisory agencies; financial disclosure; oversight and enforcement; and, payments systems or
clearance and settlement. The second type of activity involves: money and debt markets; equity
markets; commodity exchanges; institutional savings; and risk management.

The Bank’s prudential/supervisory activity can be summarized as follows: The Bank has worked
with 18 countries to modernize and improve their national securities legislation and in some
cases to help draft new legislation; in six countries we have provided institutional strengthening
 - 8 -

for the comisiones nacionales de valores; in five countries the Bank assisted in improving
financial disclosure which generally consisted of creating guidelines for auditing, risk
classification and investor disclosure standards; the Bank worked with four countries to define
regulatory oversight; and finally, the Bank Group has worked with fourteen stock exchanges in
eleven countries to improve or install central securities depositories in each country.

Within the realm of capital markets institutions and financial instruments, the Bank Group has:
worked in five countries to issue disclosure guidelines for debt issues by private corporations and
incentives for the development of a long-term debt market; the Bank Group has also assisted 16
countries’ stock exchanges to develop or improve internal rules and regulations and brokers’
access to new financing techniques; in two countries the Bank has assisted with efforts to amend
tax legislation to encourage commodity market development. The Bank Group is currently
moving forward with cash market development in four countries; in ten countries, the Bank has
assisted in the preparation of guidelines for insurance companies and pension funds to invest in
equities and provided technical assistance in the drafting of insurance legislation; and finally, the
Bank has helped two countries with risk management through the creation of a risk rating system
for publicly offered securities.

In addition, there are a number of operations in the pipeline that should be approved before the
end of 1995. These loans also deal with national securities legislation, CNVs, stock exchanges,
pension and insurance systems etc. The countries include: Barbados, Dominican Republic, El
Salvador, Honduras, Mexico, Panama, Uruguay and Venezuela.

VIII. The Bank’s Strategy

In less than five years, Latin America and the Bank will enter the 21st Century. Given the rapid
rate of development, the structure of the Region's financial markets will be as different in the
year 2000 as today's markets differ from the 1970s. The Region's capital markets will be carried
along by the same forces that are driving change in the rest of the world such as rapid advances in
information technology, an accelerated pace of financial innovation, and the
globalization/integration of domestic markets.

Owing to the separate economic, political, and social development paths countries of the Region
have chosen, their domestic financial systems differ greatly. Moreover, within the realm of
economic policy, markedly different fiscal, monetary, and tax policies prevail as well as differing
degrees of reliance on private markets. The Bank’s capital market strategy must recognize these
differing stages of financial development and their impact on capital market institutions.

The Bank should adopt a capital market strategy to achieve the broad goals of (a) raising the
level of savings and improving its composition (i.e., shifting from real to financial assets and
transforming savings to longer-term, more stable sources); (b) enhancing the economic efficiency
of capital markets; and, (c) promoting the harmonization and integration of the Region’s capital
markets.

In pursuit of these goals the Bank should stimulate its borrowing member countries to pursue five
 - 9 -

strategic objectives in the financial sector:

1. To maximize access to financial services by all elements of society;

2. To promote new and varied sources of long-term domestic savings;
3. To develop modern financial infrastructure and innovative instruments to channel domestic
savings into private investment;
4. To attain maximum efficiency through promoting competition among the providers of
financial services leading to a lower cost of intermediation; and,
5. To improve the prudential regulation and supervision of the financial system and the
enforcement of its laws.

To achieve these objectives, activities should concentrate on the following areas: (a) national
securities laws, (b) regulatory norms and practice, and (c) financial or commercial practices
within each market and their implications for the development and integration of the Region’s
capital markets. Highlighted below are activities in support of these strategic objectives.

Regulatory Infrastructure

1. Securities legislation is the basic foundation for a capital market. Those countries without
a national securities act should enact one or update existing statutes. The Bank Group in
the past has offered technical assistance to countries in the form of expert review of
securities laws. In some cases, the addition or improvement of clauses dealing with the
establishment and operation of futures and options exchanges, clearance and settlement,
netting and similar legal concepts have been recommended.

2. Establishment of a comision nacional de valores (CNV) should be a high priority in those

countries that presently do not have a securities regulator as well as the institutional
strengthening of existing CNV’s. The Bank and the U.S. Securities and Exchange
Commission have signed a Memorandum of Understanding (MOU) for the SEC to
provide technical cooperation to member countries’ CNVs. The Bank has also had
preliminary discussions with the U.S. Commodity Futures Trading Commission (CFTC)
and the U.S. Federal Reserve Board toward similar MOUs.

Regulatory Operations

3. Adequate financial disclosure is crucial for investors to make informed investment

decisions. This requires internationally recognized accounting standards (commonly called,
Generally Accepted Accounting Principles, GAAP) and credit rating agencies. The
critical document for informing investors is the information memorandum or
prospectuses. The most demanding standard is that all material information is divulged
to the investor at the time of offering and investors subsequently must be informed on a
timely basis of all material changes in the company’s status. Efforts are needed to
encourage CNVs and the private sector to move toward this information standard within
each market and eventually to harmonize these standards across the Region.
 - 10 -

4. The growth of OTC markets and organized exchanges mean that broker/dealers, securities
issuers, investment companies, and investment funds (mutual funds) will proliferate. This
puts an added burden upon CNVs to maintain adequate oversight and enforcement over
the operations of securities markets and market professionals. CNVs should establish
minimum standards and registration systems for market professionals, securities issuers and
investment companies. In addition, the Bank Group can provide assistance with the
installation of automated audit and registration systems within CNVs.

5. As capital markets become increasingly integrated the possibilities for cross-border

malfeasance increase, necessitating a higher degree of inter-country cooperation between
CNV’s in their enforcement efforts.

Capital Market Development

6. Local currency debt and equity markets are needed. The goal is to promote the issuance
and transaction of longer term securities (i.e. to extend the yield curve) for public and
private debt and to encourage the growth of organized stock exchanges. Exchanges,
especially the smaller ones in the Region, generally lack adequate trading systems,
clearance and settlement mechanisms and depositories. The Bank, in the past, has
worked to make the banking systems’ payments mechanism safer, and should continue its
work with the clearing systems of organized exchanges.

7. A number of countries are in the process of establishing cash markets and commodity
exchanges for agricultural goods. As governments decrease their intervention in
agricultural pricing and commodity merchandising, the private sector must take up this role.
Cash commodity markets, with well defined contract standards, provide an alternative
marketing outlet offering transparent price discovery for farmers. Commodity exchanges
with futures and options on futures have been used for more than a hundred years in the
major Latin markets. They allow primary producers and processors to hedge their
commodity price risk. On a limited basis, these products may be useful in smaller markets.

8. The development and democratization of capital markets is greatly enhanced via the
activities of domestic institutional investors. Given their liability structure, insurance
companies and pension funds are natural long term investors. Mutual funds, venture capital
funds and other institutional investors are also important longterm investors. Recognizing
the importance of institutional savings, the Bank has worked in the development,
modernization and often in the privatization of social security and pension systems in a
variety of member countries. Significant effort has been made and should continue in
legislative reform and regulatory oversight of pension systems and especially in the area of
opening up investment opportunities in those asset classes needed by social security,
pension, insurance, trust banks and mutual funds.

9. Capital markets are complementary to traditional financial intermediaries (such as deposit

banks) and should not be viewed as a substitute for a well functioning banking system.
Each market serves a particular need and there are important synergies between them. For
 - 11 -

example, securities markets often use the banking system to clear payments while the
banking system benefits from the price information generated by securities trading. The
competition between the two markets also serves to lower transaction costs and increase
allocative efficiency. The Bank’s strategy for supporting banking systems will be
addressed in a complementary strategy statement for financial markets.

10. Capital controls affect the flow of foreign funds and have an important effect on the
development of domestic capital markets. Regulations affecting the types of investment
instruments available, distinctions between residents and non-residents, minimum holding
period, tax withholding and other policies affect the amount and composition of foreign
capital are examples of capital controls. These controls should be carefully reviewed,
within the context of macroeconomic objectives, so that their impact on capital markets is
known.

Capital Market Deepening

11. Local currency financing exposes banks and businesses to price risks that cannot be hedged
in international futures markets. For this reason, the domestic financial system will
generally need a U.S. dollar/local currency futures contract, a local currency short-term
interest rate product and an index on the local stock exchange. In addition, access to
offshore hedging opportunities should be available to control the risks of international
transactions. This will permit the growth of risk management by exporters/importers,
banks and institutional money managers. The increasing use of derivative products in Latin
America will also challenge regulatory authorities and top management of banks and
businesses to inform themselves of the risk inherent in these products and how they will
manage these risks.

12. Commodity securitization may be a mechanism for countering the traditional scarcity of
credit going to the agricultural sector. This type of instrument can help farmers and
processors to improve the liquidity of their assets and enhance cash flow and should be a
part of a total rural finance package offered by the Bank. There are numerous problems,
however, associated with the use of commodity securitization. A warehouse receipt or
bono de prenda representing a claim on a physical commodity in storage must be
commercially and legally secure. A commercially secure instrument would require a
system of standards and grading for the commodity and approval and inspection of
warehouses. In addition, legal security would involve perfecting claims and bankable
property rights. The Bank Group has a long history of involvement in these areas, and
should continue this activity.

IX. Strategy Implementation

The Bank Group is in a unique position and has an array of programs that can be used to support
capital market development. The Bank’s activities should focus on local and regional activities
that support the goals of the Capital Market Strategy.
 - 12 -

The Capital Market Strategy outlined above is intended to serve as a guide for the MIF, the
Regional Departments and the Integration and Regional Programs Department in the preparation
of country and regional strategies and in the design and preparation of specific operations for
capital markets development. These operations should be designed with the goals and strategic
objectives in mind.

Priorities: The priority assigned to the twelve activities discussed above, depend of course on the
particular stage of a country’s capital market development. The four areas of activities above are
listed in order of priority and it is expected that operations will be proposed for Bank financing in
the more advanced areas only when it can be shown that the level of development in Regulatory
Infrastructure and Operations is satisfactory. For instance, work on disclosure guidelines or
regulatory oversight and enforcement should necessarily wait until a securities law and regulatory
agency have been organized to define these activities. Similarily, the introduction of
sophisticated financial products makes little or no sense if basic capital market institutions are
not well-developed or do not exist. Operations that work concurrently on several of the priorities
listed will have to be carefully sequenced and articulated.

Lending and Technical Assistance: In the past, the Bank has used Investment Sector Loans,
Global Multisector Loans, Technical Cooperation Agreements and the Multilateral Investment
Fund (MIF) to assist and effect reform in the capital markets (see Annex 2). These programs
provide an important foundation and should continue to be applied on a country basis through the
Regional Departments or on a regional basis through the Integration and Regional Programs
Department and the MIF.

Capital Market Development Program: The interrelation of all the elements involved in a
well-functioning capital market requires a global approach to avoid the pitfalls of a piecemeal
aproach. Therefore, in those countries where capital market development is a priority, a full-
fledged Country Capital Market Development Program may have to be developed. The
Program will review the conditions prevailing in those markets, analyze the barriers to their
development and propose specific interventions. The operational departments of the Bank are
responsible for the preparation of these strategies, with technical support from the central
departments. In addition, since the evolution of capital markets is intimately related to the
overall macroeconomic framework, each country strategy will need to be coordinated with the
actions of the IMF and World Bank.

Capital Markets Studies Program: Given the complexities and rapid change in capital markets,
the Bank will need to develop and transfer know-how. For these purposes, the Bank should also
develop a Capital Market Studies Program to produce analytical work, support technical
assistance, and disseminate information on best practices to improve capital market efficiency in
the Region. The Program will provide a focal point for the Bank’s know-how and technical
expertise on regional capital market issues and can serve as an independent source of support to
regional regulatory and supervisory bodies, governmental authorities and the Committee on
Hemispheric Financial Issues.
 - 13 -

The Capital Market Studies Program should support international and regional bodies, like the
International Organization of Securities Commissions (IOSCO) and the Council of Securities
Regulators of the Americas (COSRA), and promote their efforts to coordinate and integrate
securities regulatory commissions. As well the Capital Markets Studies Program would convoke
international conferences to bring Latin American government officials, bankers, investors, and
corporate end-users of capital markets together with their counterparts in developed financial
markets.

X. Conclusion

Clearly, capital market development is a complex and long-term process. In this document, only
some of the basic principles are highlighted, while the examples are illustrative and do not
exhaust all the technical issues regarding capital market instruments or institutions. The
approach suggested here is to pursue the broad goals of promoting saving, capital market
efficiency, and regional integration through capital market development within the Bank’s
lending and technical assistance programs. These activities should be complemented by efforts
at the regional level to improve the integration of markets in coordination with regional
institutions and governments. As well, the Bank should promote these efforts by providing a
forum for discussion of these topics and designing a program of studies to support them.
 ANNEX 1

Savings, Growth and Capital Markets - 1993

(US$ billions)

Real GDP Stock Market Domestic Credit External Bonds

US$ % GNP US$ % GNP US$ % GNP

Argentina 252.3 6.1 15.5 36.9 14.6 60.9 24.1 43.7 17.3
Brazil 426.7 1.0 20.4 189.3 44.4 426.6 100.0 18.7 4.4
Chile 42.1 6.4 21.2 68.2 161.8 26.6 63.1 0.3 0.7
Colombia 48.6 4.2 16.5 14.0 28.9 9.6 19.8 0.9 1.8
Mexico 326.2 3.0 17.4 130.2 39.9 140.6 43.1 46.7 14.3
Venezuela 58.3 3.8 15.7 4.1 7.1 11.9 20.5 21.2 36.4

Latin Total a/ 1,154.2 4.1 b/ 17.8 b/ 442.7 49.4 b/ 676.2 45.1 b/ 131.5 12.5 b/

East Asia Total c/ 1,144.8 7.3 b/ 32.9 b/ 668..8 92.2 b/ 1,017.8 78.5 b/ 34.9 4.3 b/

a/ Argentina, Brazil, Chile, Colombia, Mexico and Venezuela.

b/ Average.
c/ China, Indonesia, Korea, Malaysia, Philippines and Thailand.

SOURCE: World Bank, International Monetary Fund.

Sep/6/95