Speech

Eduardo Aninat
Deputy Managing Director, International Monetary Fund
Inter-American Development Bank Conference on Capital Market Development
Washington, DC, February 5, 2001

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Thank you Mr. Chairman, ladies and gentlemen, for inviting me to join you in your reflections on capital market development in Latin America. Over the past decade, the region has made great strides on this front. Total gross new funds raised by Latin America in international capital markets rose from slightly under $20 billion in the early 1990s to a peak of around $90 billion in 1997. This was followed by a drop-off in the wake of the Asian financial crisis, with a recovery to close to $70 billion in 2000—and prospects look adequate, at the present, for a somewhat higher level this year.

Even so, the region still has a long way to go. The potential benefits of further mobilizing capital markets are big, as you know; but so, too, are the challenges. On the systemic level, capital markets are more volatile, and a crisis in one country can now more easily ricochet to another. On the micro level, securities markets still need better financial and legal infrastructures, and many of the domestic markets are too thin. In my remarks today I would like to review these challenges, and how emerging market economies and the international financial institutions are tackling them.

Outlook for emerging markets
Let me begin with the near-term outlook for emerging markets. We are cautiously optimistic for a number of reasons. First, the 1990s financial crises brought home the importance of strong macroeconomic policies and sound financial systems. Many emerging market economies have reduced fiscal deficits and lowered inflation, and are restructuring financial systems, and improving prudential supervision and regulation. They are also taking other steps to protect themselves against adverse swings in sentiment—such as boosting reserves, diversifying their financing sources, relying more on domestic currency and longer-term funding, and further developing domestic bond markets.

Second, we are "cautiously realistic" about the external environment. Following the announcement of multilateral financing packages for Argentina and Turkey in December, and particularly the two U.S. interest rate cuts in January, conditions in international bond and equity markets have improved—and we expect external conditions to remain generally supportive. The outlook for emerging market financing, however, also depends on the specific prospects for a "soft" versus a "hard landing" for the U.S. economy, with changing expectations on the likelihood of these two scenarios still keeping markets somewhat volatile.

At this point, world growth now seems likely to be positive, but lower, at around 3½ percent this year, down from its 12-year high in 2000 of 4 ¾ percent. A drop that is steeper than had been expected only some months ago. On the plus side, the timely U.S. interest rate cuts should help the U.S. economy avoid a hard landing, and there is further room for maneuver with both monetary and fiscal policies. But oil prices still remain high, substantial current account imbalances remain among the major industrial countries, Japan's recovery has weakened somewhat, and stock markets are still volatile.

Even in this context, Latin American could well maintain output growth at a respectable 4 percent this year, with inflation declining further to 5-6 percent on average for the region. This forecast, however, assumes a number of conditions: (1) the U.S. economy continues to follow a "soft landing" path; (2) commodity prices (for the region) don't decline abruptly and sharply; (3) the region pursues sound economic policies and follows through with critical reforms—continued fiscal reform, in particular, would facilitate lower domestic interest rates and help pave the way for a recovery in domestic demand; and (4) investor confidence and private capital inflows to the region don't suffer unforeseen setbacks.

Third, we are cautiously optimistic about emerging markets because most global funds now increasingly follow some global benchmark index that has fixed allocations to emerging markets—which can certainly contribute to a more stable allocation of funds to emerging markets, as managers will not be unduly penalized for remaining invested in emerging markets even during partial downturns there.

No doubt one of the most salient features of emerging markets financing in the 1990s was the propensity for "boom-bust" cycles. Why did these occur? One fundamental reason was the predominance of a nondedicated investor base that instead invested only "opportunistically." It is true that in the early 1990s, we saw the appearance of specialized dedicated emerging markets fund managers. However, even in the boom years of 1995-96, dedicated investors never provided a majority of the portfolio flows to emerging markets. Instead, a large part represented (short-run oriented) "cross-over" investments undertaken by global bond and equity fund managers, hedge funds, and proprietary trading desks of investment and commercial banks.

On the downside, however, we must acknowledge the external environment continues to pose three risks. First, the outcome of several external factors such as U.S. economic growth, interest rates, oil prices, mature market equity prices, and major exchange rates will heavily influence flows and spreads, as mentioned earlier.

Second, emerging markets being small relative to global capital markets are affected significantly in the event of reweighting of benchmark indices.

Third, as noted earlier, the investor base in emerging markets at times has been quite unstable. Since dedicated investors typically have been a smaller proportion of emerging markets asset holders than cross-over investors, this makes emerging markets assets too vulnerable to shifts in investor preferences as a result of external shocks.

Microeconomic obstacles
The overall cautiously optimistic outlook for emerging markets provides a valuable opportunity to tackle many of the persisting obstacles to capital market development in Latin America and the Caribbean. Since much of today's roundtable has been focused on microeconomic or regulatory obstacles, let me first touch briefly on that issue.

In domestic bond markets, Latin America is relatively advanced, owing to the traditionally high financing needs of the public sector, the early introduction of private pension funds and the associated growth of institutional investors, as well as recent efforts to improve the financial infrastructure of bond markets. Among the latter, we have recently seen efforts to develop benchmark yield curves, improve the liquidity of benchmark issues (by announcing auction schedules, as well as buying back illiquid issues while reopening more liquid ones), and establish a set of well-capitalized market-makers. There is still a long way to go in developing corporate bond markets, but the progress in government bond markets and the growth of institutional investors now provide a better foundation.

As for stock markets, the obstacles are somewhat more challenging; but we see some progress here. Some of Latin America's stock markets have achieved a reasonable market capitalization, although turnover, liquidity, and new offerings are still relatively low. Moreover, domestic market participants are concerned with the decline in liquidity in regional stock markets, as former benchmark stocks are delisted and new offerings are done offshore. Volatile capital flows, transaction taxes and other controls, antiquated trading and settlement systems, as well as a lack of protection for minority shareholders' rights, have contributed to this decline. It is encouraging to see, however, that several countries are tackling these obstacles and revamping legal infrastructures—witness recent initiatives in Brazil and Chile to strengthen minority shareholders rights and corporate governance with high-quality new legislation.

Turning to market size, this issue is intimately linked to the integration and deepening of capital markets. Opening up to capital flows has benefits and costs that are well-known to you. And one widely recognized benefit of integration—especially for small countries—is the access to a greater (and hopefully, better diversified) pool of capital. In this respect, it is encouraging to see recent initiatives by several stock exchanges in the region to establish alliances with each other, as well as with exchanges outside of the region. These initiatives, driven in part by recent improvements in information and telecommunications technologies, are likely to enhance liquidity in regional stock markets and provide companies in the region with a much larger investor base.

Systemic obstacles
But Latin America also faces major obstacles at the systemic level, which is where the IMF has a bigger role to play. The past boom-bust cycles prevented the building of a broad investor base—which is critical for the development of its capital markets. Indeed, one of the region's biggest challenges is to come to grips with this volatility. In recent years, it has become abundantly clear that the stability of the world economy depends increasingly on the stability of its financial system. That is why Latin America needs to make further progress on implementing sound macroeconomic and financial policies. The IMF will reinforce these efforts by strengthening its work on capital markets and issues in banking system stability. We are also rethinking the way we monitor the global monetary system.

In terms of crisis prevention, we have begun a permanent dialogue forum with borrowers and creditors, with the recently created Capital Markets Consultative Group, launched by our Managing Director, Horst Köhler, just prior to the Prague Annual Meetings of the IMF and World Bank. This group, which includes representatives of the private financial sector, held its first—highly productive—meeting in London last September and will meet again in March. We are also convening regional meetings with financial sector participants on occasion with active senior management presence; the first of these was held a few weeks ago in South East Asia. The theme of these fora is "constructive engagement"—that is, a continuing dialogue with the private sector in good times as well as bad, in order to learn from our experiences.

One important initiative of the IMF, jointly with the World Bank, to reduce country vulnerability to external shocks is thorough "health checks" of a country's financial sector. We want to know how well the financial system would handle adversity. We also want to get a reading on indicators that have signaled crises in the past, and on the precise quality of the supervisory and regulatory system. Of course, risk-taking is an integral part of a dynamic, market economy. But this new program—known as the Financial Sector Assessment Program (FSAP)—should help reduce the incidence of crises, by identifying weaknesses in a country's financial sector, and by making timely suggestions of remedial policies in the policy dialogue. Where needed, the IMF and World Bank stand ready to support the national authorities with follow-up technical assistance to help overcome the identified weaknesses.

The IMF, in cooperation with the World Bank, is also in the process of developing guidelines for public debt management. Although government debt management policies may not have been the sole, or the main cause of several recent debt market crises, these policies certainly have contributed to the severity of the crises. Not enough attention was paid to the maturity structure, and interest rate and currency composition of the government's own debt portfolios. And not enough attention was paid to obligations in light of contingent liabilities. This was true even in situations where sound macroeconomic policies were being pursued.

Thus, we now welcome the steps that many countries have recently taken to improve these practices. Brazil has taken steps to limit borrowing by lower levels of governments, an issue which in the past had generated contingent liabilities for the central government. Mexico has continued to develop its domestic financial markets, thereby increasing its reliance on longer-term financing from domestic residents. Both countries have increased the duration of their external debt by embarking on sophisticated debt swaps and buybacks, which might be of interest to other emerging markets.

Of course, if Latin America hopes to attract a broader group of investors, it also has to step up its level of transparency—getting better and more timely information out to the markets and the public generally at all levels. Transparency enhances the accountability of policymakers and the credibility of policies. It also facilitates the orderly and efficient functioning of financial markets and creates greater competition. One way the IMF is trying to help is through the crafting of international standards and codes of good practice. We now have standards for data dissemination, fiscal transparency, monetary and financial policy transparency, and banking supervision. Other agencies, with our cooperation, are developing standards for effective markets at the sectoral levels.

As for crisis resolution—for crises will still occur—the IMF is making progress on a framework for private sector involvement. Argentina and Turkey provide recent examples of countries for which our strategy has been to use the catalytic approach. This is based on the expectation that—with the sustained implementation of corrective macroeconomic and structural policies and the provision of official financing—countries stand a good chance of regaining access to international capital markets relatively quickly.

But how about when countries face more difficult situations? In these cases, we need to explore a wider range of financing options, including encouraging the private sector to stay involved.

Finally, we are hopeful that some Latin American countries will choose to take advantage of a new loan facility set up in 1999 by the IMF, the Contingent Credit Line facility. Unlike other IMF facilities, which are aimed at countries already in trouble, this new facility is aimed at keeping countries out of trouble. It offers countries with strong policies an additional, preventive defense line against potential episodes of financial contagion and of excessive volatility.

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All in all, this is a rather big agenda that will require strong resolve on the part of country authorities. However, working together, there is reason to believe that Latin America can build more efficient capital markets that provide financing for sustainable economic growth and widely-shared prosperity. This will mean tackling the weaknesses head on, and opening up further the opportunity frontier in this new millennium.