MMost 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 26, compared with more than $8 trillion in China. These assets equal 154 percent of gross domestic product for Latin America, compared with 37 percent in China and 25 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 22. But the overall picture is problematic. Although Still Waters Run Shallow large companies can raise funds in the By Diana Farrell and Susan Lund 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 4 percent of business executives in Latin America say they have good access to external financing, compared with 6 percent of executives in other emerging markets. The situation may brighten. Since 22, 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 22. Many countries have significantly reduced inflation and have adopted more flexible exchange rate regimes; both steps are essential to maintaining macroeconomic Latin American Finance 24 The Milken Institute Review
stability. Foreign investors are taking notice, with inflows into the region s stock markets and private equity investments both up in 25. 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. missing money will steeley/alamy 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, in emerging Asia (measured in terms of purchasing power), compared to $8,8 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. Fourth Quarter 27 25
45% 4 35 3 25 2 15 5 latin american finance Latin America s shallow financial depth is reflected across banking as well as corporate bond and equity markets. The region s banking system assets amount to 45 percent of GDP, compared with 73 percent in India and 76 percent in emerging Asia (excluding China, where banking sector assets are 169 percent of GDP). Chile s equity market is deep at 131 percent of GDP, exceeding the depth of Europe s markets. But Brazil s equity-market depth is just half that, at 67 percent, while the figure for Mexico is just 41 percent of GDP. FINANCIAL ASSETS AS A PERCENTAGE OF GDP, 26 Equity Private Debt Securities Government Debt Securities Bank Deposits Eastern Europe Latin America India Emerging Asia China Europe U.K. U.S. Japan source: McKinsey Global Institute Global Financial Stock Database DIANA FARRELL is director of the McKinsey Global Institute, McKinsey & Company s economics research arm, where SUSAN LUND is a senior fellow. Not surprisingly, then, Latin American companies use less equity financing than companies in other regions. In McKinsey s survey, just 14 percent of Latin American executives report using stock offerings to finance new investments, compared with 3 percent in India, 25 percent in China and 22 percent in other emerging markets. By the same token, corporate bond markets are anemic in every Latin American country, with capitalization averaging just 17 percent of GDP. Chile s is the largest, but at 24 percent of GDP, it is one-third the size of South Korea s or Malaysia s. Note, too, that Latin American markets are dominated by short-term, floating-rate or inflation-indexed bonds. One study found that 83 percent of domestic currency bond issues in East Asia are long-term fixed-rate bonds, compared with just 13 percent in Latin America. Short-term and variable-rate bonds raise the cost to borrowers and increase the risk in financing long-term investments. out of sight, out of mind Latin America is also not getting its proportional share of the rapidly growing volume of capital sloshing across national borders. In 26, Latin America received $45 billion of net foreign capital inflows (or 2 percent of GDP), just one-fifth the amount received by Eastern Europe or by emerging Asia (which received 8 percent and 5 percent of GDP, respectively). As recently as 21, foreign capital inflows to Latin America were twice the size of flows to Eastern Europe. But since then, foreign investors have fled Argentina and shunned the rest of the region, even as they flocked to Eastern Europe. Private equity investors, converging on emerging markets these days, are shunning Latin America. Put off by the region s history of financial instability, they invested just $2.7 billion in the region in 26. Although this is twice the figure for 25, it is barely more than the amount invested in sub-saharan Africa in 26. Over the past 15 years, foreign direct investment has been the only consistently bright spot in capital inflows to Latin America. Apart from a dip in 22 and 23, it has been steady at around $6 billion annually 26 The Milken Institute Review
and immigration. Countries that rely on remittances are thus missing out on a large and growing source of financing. little savings and large government debts Why does Latin American financial depth remain so low? Our research suggests that one important factor is the region s historically low savings and economic growth rates. In 199 to 25, emerging Asia s gross savings rate has been 1 to 2 percentage points higher than Latin America s. Household saving is BANK DEPOSITS AS PERCENTAGE OF GDP, 26 18% 16 14 12 Latin America Other countries 8 6 4 2 China Malaysia Japan U.K. Euro area Chile Czech Republic U.S. India Korea Republic Brazil Philippines Turkey Poland Colombia Argentina Mexico Peru Venezuela source: McKinsey Global Institute Global Financial Stock Database since 1999. Net cross-border bank lending, in contrast, has been negative in every year since 1999, reflecting foreign banks efforts to reduce their loan exposure to the region, as well as Latin American borrowers repaying debt. Foreign purchases of Latin American stocks have been small and volatile over the last decade. Although they reached $12 billion in 25 and $1 billion in 26, these inflows totaled just one-third the amount received by emerging Asia in 26. Because of the dearth of money from foreign investors, remittances from Latin America s emigrants make up a large portion of capital inflows in many countries. Mexico receives the most, averaging $14 billion annually in 2 to 26. But across Central America and even in larger countries like Colombia, remittances represent 3 percent or more of capital inflows. Remittances are a limited source of foreign funds, though: they have grown at only half the rate of cross-border capital flows since 199 (4.8 percent, compared with 1.7 percent), in line with increases in GDP growth also lower in Latin America, averaging 8.8 percent of disposable income over the last decade, compared with 1.4 percent in the Philippines, 25.6 percent in India and 32.1 percent in China. Even in China, one of the world s largest recipients of foreign capital, the volume of domestic savings is many times greater than imports of foreign capital. Latin America s persistently low savings rate has thus deprived its financial markets of the resources to grow. Compounding the problem of low savings Fourth Quarter 27 27
latin american finance is the fact that many Latin Americans lack confidence in their domestic financial systems no surprise in light of the region s history of financial crises and macroeconomic volatility. Households with money invest abroad or in tangible assets like real estate and commodities. While this is a rational choice in light of the region s history, it diverts savings from local banks, equity markets and bond markets, stunting their development and reducing capital market efficiency. Going hand in hand with Latin America s TOTAL CAPITAL INFLOWS TO EMERGING MARKETS US$, BILLIONS (26 EXCHANGE RATES) $5 45 Eastern Europe Emerging Asia Latin America 4 35 3 25 2 15 5 1996 97 98 99 2 1 2 3 4 5 6 source: McKinsey Global Institute Capital Flows Database feeble savings rate is its low economic growth rate. Since 1995, Latin America s economies have grown at an average of 3 percent (net of inflation), compared with 4 percent in emerging Asia and Eastern Europe. Financial assets as a percentage of GDP have increased at roughly the same rate in both Latin America and emerging Asia since 1995. But emerging Asia started out with greater financial depth 176 percent of GDP, compared with percent in Latin America. For many Latin American countries, large government debts also dampen financial development. Despite progress in reducing government financial liabilities, Latin America s government bond markets (with the exception of Chile and Peru) are quite large. Brazil and Argentina s outstanding bonds amount to more than 5 percent of GDP higher than the percentage in the United States or in other emerging markets. The regional average is 41 percent of GDP, putting government debt slightly lower than in the United States, but twice the level of that in Eastern Europe. The import is mixed. On one hand, government debt contributes to financial depth by adding to the stock of liquid assets. But it can slow growth in other components of the financial stock, and it exacerbates Latin America s savings problem by absorbing already low domestic savings that could otherwise be funneled to private enterprise. Banks frequently hold (often by mandate) a large percentage of their assets in government bonds, reducing the volume of private lending they can manage. In Colombia and Venezuela, for instance, banks hold 26 percent and 23 percent, respectively, of their assets in government bonds, compared with less than 1 percent in Malaysia and none in the United States. In other countries, banks lend directly to the government. In Brazil, Argentina and Mexico, for instance, more than half of all bank loans went to the public sector in 21 to 23, compared with less than 1 percent in Thailand, China and Malaysia. In Chile, which has Latin America s deepest financial system, just 1.5 percent of bank loans go the public sector. Financing the government, either through bond purchases or direct loans, is often a wise strategy for banks in terms of the risk-adjusted return. But it promotes lazy banking, dampening incentives to adopt new credit assessment and risk management technologies. 28 The Milken Institute Review
Diverting assets to government bonds also reduces loans going to the corporate sector, the driver of economic growth. Academic research by Rafael LaPorta of Dartmouth (with others) has found that banks with more lending to the public sector are more profitable but significantly less efficient than banks that lend to private borrowers. In addition, an outsized government debt increases interest rates for all borrowers. Since 1997, Brazil has paid on average 11.9 percent on its government debt, some seven percentage points higher than the United States over the same period. Compared with East Asia, Latin American governments have paid on average two percentage points more for government debt over the last decade. Corporations, which carry additional risk, must then issue debt at even higher rates. This limits the amount of debt they can carry, inhibiting financial deepening. Indeed, David Hauner of the International Monetary Fund found that, across countries, a 1 percent increase in government borrowing results in a.5 percent lower annual growth rate of credit to the private sector. small firms are squeezed Shackled by shallow financial markets at home, the largest Latin American companies and their governments raise a large portion of their funds in the United States and other foreign markets. Over the last 1 years, they have relied on international debt issues nearly twice as much as Asian companies and governments. Latin American companies are also more likely to list equity shares on foreign stock markets than are Asian companies. As a result, the number of companies listed on domestic stock markets in Latin America has actually declined from about 1,4 in 1995 to 1,35 in 26, while in emerging Asia it increased from about 2, to 3,7. Over all, little financing is available to the private sector in the region. The value of corporate loans and bonds outstanding amounts to just 38 percent of GDP in Latin America in 26, compared with 97 percent in emerging Asia. Excluding Chile, which has Latin America s deepest financial market, credit to the private sector amounts to just 24 percent of GDP. This lack of financing particularly hurts the small and midsized companies that are not large enough to raise capital abroad. BANK LENDING + PRIVATE BUSINESS LENDING PERCENTAGE OF GDP, 26 18% 16 14 12 8 6 4 2 Malaysia Korea Corporate Bonds Corporate Loans Thailand Chile Philippines Brazil Mexico Colombia Indonesia Argentina Peru Venezuela Includes domestic and foreign debt issuance source: Central banks of respective countries; McKinsey Global Institute Global Financial Stock Database; Global Insight As a result, companies in Latin America rely heavily on supplier credit and retained earnings limited sources at best to provide working capital and investment funds. In McKinsey s survey of business executives, 43 percent reported reliance on supplier credit, compared with 27 percent of respondents over all. About 3 percent reported that it is one of the top two sources of external financing for their companies, compared with 17 percent of respondents worldwide. Fourth Quarter 27 29
latin american finance Some 83 percent of Latin American respondents also reported that a majority of their funds for new investment come from retained earnings, compared with 66 percent for companies worldwide. This dearth of external financing constrains growth. Indeed, nearly a third of respondents from Latin America report that insufficient financing for investment is likely to be a limiting factor in their companies expansion over the next three years, compared with 15 percent worldwide. TOTAL FINANCIAL STOCK FOR LATIN AMERICA US$, BILLIONS (26 EXCHANGE RATES) $5 Equity 45 Private Debt Securities 4 Government Debt Securities Bank Deposits 35 3 25 2 15 5 1995 96 97 98 99 2 1 2 3 4 5 6 source: McKinsey Global Institute Global Financial Stock Database on the verge of a breakthrough? For all of its problems, the region s stock of financial assets has increased from $1.7 trillion in 22 to more than $4 trillion in 26. Equity market capitalization has increased even more, and the region s markets have outperformed emerging markets as a whole by 4 percent. Most of this increase has been due to earnings growth of companies. Brazil is seeing more initial public offerings. Corporate bond markets, although small, have increased by 63 percent since 22. Banking sector assets grew by 85 percent over that period. International investors have taken notice. Foreigners provided $1 billion (net) to Latin American equity markets in 26. Private equity and venture capital money, still small, is on an encouraging growth trajectory albeit far below its peak of $5 billion in 1998. Not surprisingly, economic growth is also on the rise. Real GDP growth has averaged 5.5 percent over the last three years, compared with just 2.1 percent in 1995 to 22. Gross domestic savings are up as well, to 21.7 percent in 22 to 25 from 19.8 percent in 1995 to 22. These trends fuel financial deepening, as more saving goes into financial assets. Whether this momentum can be sustained remains to be seen. The region s financial markets have been hammered by a series of financial crises, beginning with the debt crisis of the 198s, then Mexico s Tequila Crisis in 1994, followed by Brazil s financial turmoil in 1998, and most recently Argentina in 21. Not surprisingly, 17 percent of business executives in Latin America believe that a domestic financial crisis will constrain their companies growth in the next three years, compared with 7 percent worldwide. But cautious optimism is the order of the day. Private pension assets are growing rapidly in Argentina, Mexico and Colombia. In Chile, as in other emerging markets, pension reform was critical to financial market development because it created a class of domestic institutional investors with a longterm perspective. It also created a larger pool of investable assets than a pay as you go retirement system. The assets of mutual funds and insurance companies are growing as well. And given the relative youth of Latin Americans, net pension asset accumulation should continue in years to come. 3 The Milken Institute Review
beth wald/aurora In addition, most Latin American countries have been able to reduce inflation significantly and have adopted more flexible exchange rates; both are essential to maintaining macroeconomic stability. Lower domestic interest rates are helping to catalyze consumer lending, which in turn is giving a boost to consumer demand. 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 2 percent of the value of the debt, compared with 23 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. M Fourth Quarter 27 31