Latin American Local Capital Markets: Challenges and Solutions

Economic growth depends on the efficient allocation of resources, including the two main factors of production: labor and capital. Markets, operating on each factor, have allocated these resources in economies worldwide in ways that arguably approach optimality and have fostered economic development for the benefit of billions. Capital markets, both for debt and equity securities, have allowed firms to secure funding for productive uses while providing investors with opportunities for portfolio diversification. The importance of capital markets for the development of economies and for the betterment of society cannot be overstated. This is just as true in emerging economies with free markets, such as those found in Latin America, as it is in developed markets. However, capital markets in the region are not being utilized to the fullest. What challenges face Latin American countries in the development of their local capital markets? How can these countries unlock the true potential of their markets and thus spur growth? The idea behind this collection of articles is to offer a primer on the development of local capital markets in several select countries in Latin America. We discuss not only their history and current status but also their future. To this end, seven authors contributed to this project, each writing about one of seven countries: Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Uruguay. Each author decided which issues they believe matter most to the progress of their local capital markets. Some authors chose a qualitative and institutional description of local markets, whereas others adopted a more quantitative approach. Lionel Modi, CFA, provides an account of the recent evolution of capital markets in Argentina and identifies five stages in their development, culminating with the current stage that has prevailed since 2015. As Mr. Modi shows, in 2016, Argentina emerged from the international debt default status into which it fell in the early 2000s. This recovery was fundamental for attracting foreign investors to Argentina’s local markets. His article discusses the main asset classes that exist in Argentina and points out that political commitment and market, tax, and pension system reforms in Argentina will be key to the future growth of its capital markets. I discuss Brazil’s equity and debt capital markets in an article that starts with a brief outline of the way these markets evolved over the past several decades. Although important advancements have occurred in the development of the country’s capital markets, macroeconomic issues—including high interest rates, fiscal indiscipline, and the crowding out of private capital markets by public issuance—have constantly challenged such progress. Progress in Brazil also depends on more efficient regulations and financial education. I argue that some of the necessary conditions for the accelerated growth and development of Brazil’s capital markets are already in place, so stakeholders must take advantage of current opportunities. Nicolas Alvarez, CFA, covers the local fixed-income market in Chile. After providing information about the characteristics of, and main players in, that market, Mr. Alvarez offers a quantitative analysis of how the market is integrated with international markets in terms of price co-movement. He also discusses recent changes in the Chilean regulatory environment and indicates that both administrative and tax reporting requirements are now friendlier to investors, especially foreign ones. Challenges that need to be tackled in Chile include the dominance of pension funds and the effect of such dominance on market liquidity and international integration. Cesar Cuervo, CFA, begins his article on Colombia by stating that there is ample room for growth and improvement in that country’s local capital markets. He discusses several issues that are essential to making Colombian capital markets more functional and efficient. Although the local equity market is underdeveloped in terms of the ratio of market capitalization to GDP, the local fixed-income market is relatively robust and liquid, albeit more on the government side than on the corporate side. Mr. Cuervo lists stronger regulator supervision, more formalization in the economy, and better governance regarding voting and nonvoting shares—as well as other changes—as prerequisites for stronger and deeper capital markets in Colombia. Jorge Unda, CFA, discusses Mexico’s recent financial history and its impact on the development of the country’s local capital markets. He acknowledges that important structural changes have taken place in the last two decades, including pension reform, the creation of a benchmark yield curve, consolidation in the banking sector, and a commitment to macroeconomic prudence. Although the crowding-out effect exists in Mexico, Mr. Unda argues that the participation of foreign investors has mitigated it. However, predicting the long-term impact of some recent reforms, including those of 2014, is difficult. For Mexico, the key to capital market development—and economic growth—seems to lie with the expansion of credit. The recent development of the local capital markets in Peru is the theme of Melvin Escudero’s article. He argues that a combination of excessive regulation, tax structure, and the predominance of banks in financing activities provides a disincentive for companies to tap the capital markets, affecting the supply side of securities. In addition, the absence of a financial culture, a preference for foreign assets, and taxes on income and capital gains on capital market securities (while bank instruments are tax exempt) have negatively affected the demand side. Given these circumstances, it is not surprising that liquidity in the Peruvian capital markets is thin. Governmental and private sector initiatives are needed to improve this scenario. Barbara Mainzer, CFA, examines the features that make Uruguay a stable and reliable international center for business. Ms. Mainzer points out that, although the country has a long history in the financial markets, its capital markets are less developed than those of other countries in the region because of the small size of companies, corporate governance issues, and regulatory weaknesses. The primary market is more important than secondary markets, and the issuance and amount of government debt dwarf those of private debt. Still, the high-income investor base, government incentives, and increased participation of private pension funds are attractive elements that can promote the development of local capital markets in Uruguay. Although capital markets in the countries discussed in this brief differ in their distinctive characteristics, stages of development, and relevance to the local economy, the articles collected here show that these nations share some familiar challenges, including the considerable size of the government bond markets, inadequate or insufficient regulatory oversight, and cultural characteristics that lead investors to look for investment opportunities elsewhere. The articles also share some potential solutions for promoting the accelerated development of local markets, such as economic reforms, increased regulatory efficiency, improved governance, and greater internationalization. I hope that this publication will add to the debate on how to improve local capital markets and will encourage all stakeholders—especially issuers, investors, and regulators—to collaborate in proposing and implementing those solutions for the benefit of society.