54 accounting terms. The compensation bonds promised (but as of the second quarter of 2003 not yet fully delivered) amounted to about $9 billion in face-value terms. As a result, in accounting terms the banking system returned to positive net worth of about 15 billion pesos once again, albeit this time at pesos only worth about one-third as much as at the end of 2001. However, if the compensation bonds are valued at a market price of about 50 cents on the dollar, then the net worth of the banking system is negative, amounting to about -$7 billion in dollar terms (about -20 billion pesos).

These are broad approximations, as the most recent data published by the central bank on the consolidated accounts of the banking system are for December 2001. The overall result is that whereas in the second half of 2001 the banking system was solvent but illiquid (as depositors continued withdrawing funds in the face of the growing crisis), today it is liquid but insolvent. Deposits have begun to rise again and the banks have considerable liquidity, as their deposits with the central bank have risen sharply in the absence of new loans and in the face of exchange controls precluding their placing liquidity abroad. However, their non-performing loans and especially their holdings of government paper mean they are probably insolvent in meaningful economic terms. Estimates of claims on the government held by the banking system typically place them at about one-half to two-thirds of the banks’ assets, so if these claims are worth only half of face value, the weakness of government paper alone wipes out about one-fourth to one-third of bank assets. In addition, perhaps half or more of loans to private sector borrowers have defaulted or been restructured with large haircuts.

The banking regulatory authority has allowed the banks to carry their government bonds on their books at nearly face value so far, but has ruled that they must be marked to market values gradually over five years, with most of the adjustment toward the end of the period. At the same time, banks owing rediscount loans to the central bank are being allowed to repay them with government bonds at full face value. Both the rediscount obligations and the holdings of government bonds are concentrated in the public banks, giving them an advantage that helps offset their weak loan portfolios. This process does raise the question, however, of the resulting impact on the central bank’s balance sheet as it acquires government bonds with low market value.

The weak underlying solvency position of the banks means in turn that they are reluctant to begin lending again to households and firms. Instead, they have tended not to make new loans, but to use repayments on maturing loans to increase their liquidity, building up balances at the central bank (despite a punishing spread between interest rates of about 25 percent paid to their depositors versus only 1.2 percent earned on deposits at the central bank). The result has been a steady reduction in outstanding credit to the private sector. From the beginning of 2002 through January 2003, loans outstanding to the private sector fell by cumulative amounts of about 45 percent for personal loans, credit card debt, and consumer durable debt; about 30 percent for mortgage debt; and about 35 percent for loans outstanding to business (Banco Central, 2003, pp. 9-10).<sup>50</sup> Consumer credit now stands at only about 10 percent of GDP, down from 25-30 percent of GDP in the 1990s.

50 These percentage declines are after taking account of pesification of dollar-denominated debt.