Financial Market Liberalization in Chile, 1973-1982

Alejandra Salces

• Publisher: Routledge
• Year: 2017
• Print ISBN:
  9781138565197
• eBook ISBN:
  9781351345682
• Topic: Business
• Subtopic: Business General
• Index: Business

Originally published in 1991, Financial Market Liberalization in Chile, 1973-1982, analyses the liberalization of the financial market which took place during the 1973-1982 monetarist experiment. The book addresses the effect this had on the Chilean economy and how this affected effects of the behaviour of the firms which went bankrupt during this period. The book also presents a description of the policies implemented in the Chilean economy during this period and examines the impact that this had on the performance of the financial sector.

1. INTRODUCTION

During the 1970’s important changes in policies occurred in Chile which are of interest to economists studying the development process of Latin American countries. The liberalization and stabilization policies that took place during the period 1973–82 implied drastic changes in the trade regime and the role of markets.¹ In fact, the case of Chile has been considered the purest example of comprehensive economic liberalization in the Third World.

Financial aspects have played a crucial role in the transformation process of the Chilean economy. The financial reform initiated in 1974 resulted in important economic transformations. The most significant change was the freeing of bank interest rates which moved from real levels that were historically negative to levels that were not only positive, but also above international levels. The real interest rate averaged more than 30% during the period 1975–82.

The purpose of this research is to analyze the Chilean experience from the time liberalization and stabilization policies were put into effect in 1973 until 1982. The objective is to estimate empirically the response of the economy to extensive financial policy changes. The study investigates the impact of changing financial and economic conditions on industrial manufacturing firms.

A number of economists, e.g., McKinnon (1973), Shaw (1973), Galvis (1977), Mathieson (1979) and (1980), Kapur (1980) and others, have argued that domestic financial liberalization is necessary both to attain long-run development in LDC’s as well as to stabilize these economies in the short-run.

Even though this approach is more concerned with long-term growth than with short-term macroeconomic policies, as Roe (1982) has pointed out, a bridge has been built between the developmental and stabilization arguments. The International Monetary Fund and the World Bank are now strong advocates of the liberalization of domestic financial markets as part of their stabilization plans for LDC’s.

The central argument of this view is that financial repression, i.e., distortions of financial prices including interest rates and foreign exchange rates, reduces the real rate of growth and the real size of the financial sector relative to non-financial sectors. Foreign exchange controls, interest rate ceilings, and high reserve requirements are the main characteristics of a financially repressed economy. The results are non-price rationing, a segmented credit market, and a strong tendency to finance investments which yield returns barely above the ceiling interest rate.

The policy prescription is to raise institutional interest rates and/or to reduce the rate of inflation. Abolishing institutionally fixed interest rates would increase financial savings, maximize investment and increase investment’s average efficiency.

The reasoning goes as follows: Financial repression involves rationing in the financial market, brought on by the existence of interest rates below the market equilibrium level, which causes the savings level to fall below the desired investment level. Hence, the need to ration credit. It is contended that financial repression would lead to segmented markets since the maintenance of interest rates below the equilibrium would require credit allocation mechanisms outside the market. This would commonly result in credit access for large enterprises with political and financial connections whereas new, small, unknown enterprises would find credit severely restricted. Improvement of the financial intermediation process through an increase in the deposit real interest rate would bring about an increase in the savings-flow, as well as in the quantity and quality of investment. Quality of investment would improve because the interest rate would be the main rationing mechanism, and would furthermore discriminate against inefficient investments.

The McKinnon and Shaw view challenges the traditional monetary theory approach that money and capital are substitutes in the portfolios of private wealthholders and in the aggregate economy. In rejecting the traditional view, the two authors propose and defend the thesis that money and capital are likely to be complements in less developed, fragmented economies where the financial sector has been severely repressed. Potential investors must accumulate money balances prior to their investments; therefore, conditions that make financial assets attractive to hold (i.e. a higher real interest rate on deposits) enhance rather than inhibit private incentives to accumulate physical capital. That is, in the underdeveloped economy the “conduit effect” of financial assets is likely to prevail over the “competing-asset effect” stressed by the traditional portfolio approach.

McKinnon (1973) and (1981) also argues that repression of the financial sector is paralleled by the use of tariffs and quotas in an effort to promote development by manipulating the foreign trade sector. He claims that if existing protective tariffs and quota restrictions on imports were eliminated, an enormous implicit burden on export activities would be lifted and, therefore, the need to give them preferred access to low cost credit would be avoided. At the same time more neutral resource allocation would result. Hence, a more effective strategy for economic growth would proceed from a thorough liberalization of financial markets and the lifting of restraints on foreign trade.

Moreover, McKinnon (1973) and (1982) points out that the order of economic liberalization is crucial to attain successful results. The main question is which market should be liberalized first. He argues that trade liberalization and the liberalization of domestic finances should proceed simultaneously. However, liberalization of the current account of the balance of payments should precede the elimination of exchange controls on the capital account.

The argument is the following. Once the domestic financial market has been liberalized, the opening of the capital account may result in large inflows of foreign capital, triggered by substantial interest rate differentials. If such capital inflows are absorbed in real terms, this could force a trade deficit and real exchange rate appreciation on the economy. Since financial markets adjust much faster than goods markets, this real appreciation would be quite abrupt, and imply severe anti-protection in the production of tradable goods.

In this study we will contrast the objectives raised and the assumptions of the “repressionist paradigm” with the response its application elicited from the Chilean economy. The type of questions posed and the short length of the period studied make it necessary to work with microeconomic. data rather than with standard aggregate data. Since financial markets are more highly developed for corporations than for households, a study of the effects the financial liberalization had on the industrial manufacturing corporation will be more fruitful empirically. The most important source of information used in this research consists of microeconomic financial data from a large representative sample of publicly held corporations in the Chilean manufacturing industry.

To anticipate the conclusions of this research three main results are important to note. The first principal finding is that the financial liberalization reform, as implemented in the Chilean economy, made for decapitalization and speculation instead of real investment. Chilean gross fixed investment declined from an average of 20.2% of GDP during the period 1960–70, to 15.5% of GDP during the period 1974–82, while investment in financial assets experienced an important increase from 2.7% of GDP in 1970 to 5.3% of GDP during the period 1977–82. Market signalling, mainly the high real interest rates, led productive firms to decrease their investment in physical capital and to increase financial intermediation. Chapter 4 of this study shows that industrial manufacturing enterprises which survived the period 1977–82 changed their asset composition. The share of financial assets in their total assets increased, and the share of fixed assets in their total assets decreased during the period. This phenomenon not only represents capitalization of interest rates accrued by the financial assets, but also reflects a drop of fixed asset investment in absolute terms. In the financially liberalized Chilean economy the “competing-asset effect” dominated the “conduit effect”. The greater attractiveness of financial assets due to the increase in the real interest rate inhibited accumulation of physical capital. Moreover, when comparing the behavior of productive firms that survived the period of the reforms with firms that went bankrupt, one can see that the latter did not invest in financial assets as a response to the new situation in the internal financial market. It may be that these firms were incapable of adjusting by recomposing their assets as the rest of the manufacturing enterprises did, because they faced important economic difficulties. The impossibility to adjust kept these enterprises from taking advantage of profitable speculative opportunities offered by the market which might eventually have reduced their losses. In other words, contrary to what advocates of financial liberalization in LDC’s postulate, the domestic financial reform brought about a perverse financial deepening in the Chilean case.

As mentioned earlier, theories promoting financial liberalization in LDC’s argue that segmentation is one of the characteristics of “repressed” financial markets. The second finding of this study is that the Chilean liberalization process did not eliminate the financial market segmentation characteristic of financially repressed economies. Chapter 5 shows that when the differential between internal and foreign real interest rates surpassed an annual 30%, foreign currency credit became concentrated in a few economic sectors. These include the industrial sector up to 1977, and thereafter the financial sector.

It can be argued that there is nothing wrong with the fact that most of the external credit became concentrated in the financial sector, since its role is precisely to allocate these resources. However, as Dahse (1979) has shown, since the financial reform of 1975 the Chilean capital market was characterized by the existence of economic conglomerates; that is, a group of firms organized around one or more domestic banks. Under these conditions financial intermediaries pursued the objectives of the economic group to which they belonged rather than the objectives of the depositors. The present research confirms this hypothesis: Chapter 5 also shows that large enterprises with connections to the economic groups had privileged access to cheaper foreign credit. This differential access to credit led small firms without connections to borrow in domestic currency in the recently liberalized internal financial market, and to pay the persistently high real interest rates being charged in this market. Therefore, the completely deregulated domestic loan market played a similar role to the one performed by informal credit markets in financially repressed economies. In contrast with a repressed-economy formal financial market, where firms willing to pay high interest rates do not necessarily obtain loans, in the Chilean peso-loan market firms willing to pay the high interest rates had ample access to loans. Two facts explain this behavior: On the one hand there was “portfolio liberalization”, i.e., the elimination of regulations ruling credit allocation brought about by the financial liberalization; on the other hand, from 1977 on there was strong competition for market shares in the banking industry. One of the elements which explains this fact was the expansion of the existing banking system as well as the entry of new banks. These new banks were responsible for around 45% of the credit expansion during the period 1977–82. The increased competition, however, did not manifest itself in price competition; banks did not increase deposit interest rate and decrease lending rates in order to maintain or increase their market shares. On the contrary, increased competition manifested itself in a relaxation of the criteria used to select debtors, and a lowering of the standards and quality of collateral required. The result was a great increase in the risk of banks’ portfolios. This perverse behavior of the domestic credit market revealed a very weak financial structure that could go bankrupt any time. In fact a serious problem was the collapse of the liberalized banking and financial sector that occurred in 1982. This collapse was the consequence of a very large proportion of bad loans held by the banks.²

The third main finding of this research is that during the 1974–82 period many firms borrowed in order to overcome what they foresaw as only transitory difficulties. Specifically, an important part of bank loans were used to cover current operating losses incurred by firms hard hit by increased foreign competition. ³ In Chapter 6 a cross section time-series microeconomic financial data set of Chilean manufacturing firms is examined. The results show that bank borrowing of import-competing firms went to finance not only investment but also operating losses. In the case of export firms and firms producing nontradable goods, losses were not a statistically significant determinant of bank debt. Import-competing firms borrowed in the recently liberalized financial market in order to remain in operation, and were able to do so because their losses were believed to be temporary.

Moreover, during a period when an outward looking development strategy was being implemented firms producing tradable goods, which theoretically should have been the dynamic engine of the new economic model, suffered an important decline in profitability. Chapter 6 also shows that firms producing nontradables enjoyed very positive conditions during the period. These firms showed the best results in terms of profitability; they had easier and more fluid access to cheaper foreign credit, and they registered an important increase in fixed-asset investment. In contrast, export firms ended up the period with a level of fixed assets similar to their 1977 level, and import-competing firms suffered a significant decline in fixed assets in absolute terms. Therefore, in the Chilean case the interaction of domestic financial liberalization with foreign trade and external financial liberalization resulted in a perverse resource allocation,

The financial liberalization reform, as implemented in Chile, induced a substitution between real and financial investment. This substitution was encouraged by the enormous differences existing between the returns on real capital and interest rates in the financial market. This fact implied unbalanced economic growth between the real and financial sectors. The performance of the liberalized domestic financial market, together with service-oriented economic growth, led to increasing indebtedness in the real sector that gave rise to the deep financial crisis which began in 1981.

Moreover, during the period the tradable goods sector experienced a decrease in profitability vis-a-vis the nontradable goods sector. Also, investment loan demand had to compete with loan demand from losses in the import-competing sector. The problem for economic growth engendered under these conditions is that changes in relative prices do not increase the demand for products generated. The contrary occurs if investment is oriented toward export industries.

Finally, it is important to point out that it is not the aim of this research to question the structural changes the Chilean economy needed at the beginning of the seventies. These changes include the development of an efficient capital market designed to improve resource generation and allocation and a greater openness of the domestic economy to foreign trade, with specialization in those productive sectors with higher growth possibilities. What is being questioned is the way these changes were implemented in the context of the monetarist model in use during the 1974–82 period. On the one hand, a fast opening-up of the economy proceeded at the expense of domestic industrial growth, instead of accompanying a domestic industrialization process. Successful trade liberalization requires greater, more rapid growth in the tradable goods sector. This implies a reallocation of resources toward this sector throughout the years and, therefore, a relatively higher return in the tradable sector than in the nontradable sector. A successful opening-up to foreign trade requires a change in the productive structure. Tariff cuts are only a tool which needs to be complemented with active development policies. Trade liberalization requires an increasing allocation of investment in infrastructure (transport and communications), research and development, and human capital. Moreover, the exchange rate policy should ensure a stable real exchange rate in order to make the traded goods sector permanently profitable and competitive.

On the other hand, there was a financial reform which relied completely on the ability of the market to allocate funds efficiently. The application of “neutral” rules produced non-neutral results in an environment where unequal market power and unequal initial distribution of wealth prevailed. Economic reform wherein market forces are left free to guide most of the economy’s decisions can not produce neutral results in a context where there is an oligopolistic structure. In this sense rules were only seemingly neutral in the Chilean case. For instance, the government was unwilling to regulate the behavior of economic conglomerates and their financial institutions in order to ensure sound practices on the part of financial intermediaries. Moreover, the persistent disequilibrium between the interest rate and the rate of return on real capital encouraged financial investment, speculation, and consumption of luxury goods instead of real investment. Active financial and monetary policies should be used in a financial development strategy. This program should be aimed at encouraging and complementing capital accumulation and discouraging short-run speculation.

This study is organized in the following manner: Chapter 2 discusses the main issues related to the theory of financial liberalization in LDC’s. Chapter 3 presents a description of the policies implemented in the Chilean economy during the period under study: 1973–82. The objective is to provide background information concerning the effects of the policies on the performance of the financial sector. Chapter 4 studies the effects of the financial reform on the Chilean manufacturing industry. It analyzes the behavior of the firms which adjusted and survived the period of the reforms as well as the behavior of the firms which went bankrupt during this period. Chapter 5 investigates the extent to which financial reform eliminated segmentation of the financial market characteristic of financially repressed economies, i.e., whether large firms and firms connected with financial institutions maintained differentiated access to cheap credit. Domestic financial market liberalization was only one of the structural changes which enterprises had to adjust to during the period under study. Trade reform and the liberalization of the capital account of the balance of payments also influenced the behavior of manufacturing firms. Chapter 6 investigates the effect of the interaction of these reforms on the behavior of industrial firms. It also attempts to answer the question of the extent to which import-competing firms chose to contract debt at high existing interest rates in the domestic financial market in order to adjust and survive in the face of increa...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• Preface
• Acknowledgments
• 1. Introduction
• 2. The theory of financial liberalization in less developed countries. A review of the literature
• 3. Chilean economic reforms and their impact on the financial sector: 1973–82
• 4. Financial reform and the manufacturing industry: 1977–82
• 5. Capital market segmentation and financial liberalization
• 6. Trade liberalization and financial reform
• 7. Financial behavior of companies in a liberalized capital market: Some case studies
• 8. Firms’ financial behavior in a liberalized capital market: A formal approach
• 9. Financial liberalization in Chile: What can we learn?
• References