DRAFT FOR STAFF USE ONLY Public Disclosure Authorized

FINANCIAL LIBERALIZATION IN URUGUAY: SUCCESS OR FAILURE? Public Disclosure Authorized Public Disclosure Authorized Felipe Larrai'n B. (Consultant)

CPO Discussion Paper No. 1987-1 February 1987 Public Disclosure Authorized

CPD Discussion Papers report on work in progress and are circulated for Bank staff use to stimulate discussion and comment. The views and interpretations are those of the authors. FINANCIAL LIBERALIZATION IN URUGUAY: SUCCESS OR FAILURE?

Felipe Larrain B.* (Consultant)

*Pontificia Universidad CAtolica de Chile. I have benefited from enlightening discussions with Edgardo Barandiaran. I would also like to thank Domingo Cavallo, Ricardo L6pez-Murphy, Carlos A. Rodriguez and other participants of the First Annual Economic Meetings organized by the Central Bank of Uruguay for their comments. Abstract

The recent developments of Argentina, Uruguay and Chile

during the seventies, all of which pursued a liberalization of

their markets, ended up in deep crashes during the early eighties.

Mostly based on these experiences, Diaz-Alejandro has challenged

the supposed benefits of full-range financial deregulation, arguing

for caution in the liberalization process, with the government

playing an important role, especially as regulatory agent.

This paper attempts to draw some lessons out of the

Uruguayan experience, which started with a broad range of reforms

in 1974. After discussing the relevant developments of the economy before 1974 and the different policy periods in which the Uruguayan reforms could be divided, the analysis centers on the liberalization of financial markets, both with respect to international transactions and domestically. As a result of the reforms, financial deepening did occur at the macro level, even if it was geared from the outset

towards foreign assets. However, the deregulatedfinancial markets failed to create long-term credit, and no development of new ways of financing for domestic firms occurred. On the other hand, no improve- ment appeared on the savings and investment performance of the private sector, which seemed to have been more influenced by issues other than financial liberalization. Overall, perhaps the clearest message of the Uruguayan experience'is that the deregulation of financial markets cannot produce its intended benefits unless coupled with a coherent set of macro policies. Particular attention has to be put on avoiding an overvalued currency, especially when capital flows are unrestricted. TABLE OF CONTENTS

I. Introduction

II. The Economic Reforms of the Seventies and Early Eighties

A. Initial Conditions A.1. Relevant Issues Before 1974 A.2. The Sate of the Uruguayan Economy in 1974

B. Policy Periods B.1. Phase I : July 1974-October 1978 B.2. Phase II : October 1978-November 1982 B.3. Phase III: The Post-1982 Period

III. The Deregulation of Financial Markets

A. The Liberalization of International Financial Transactions.

B. The Reforms of Domestic Capital Markets. B.1. The 1974-82 Period: Liberalization. (i) Interest Rates (ii) Legal Reserve Requirements and the Banking Tax. (iii) Entry Barriers (iv) The Exposure of Banks (v) Credit Allocation

B.2. The Post-1982 Period B.3. The Supervision of Banking Activities B*4. The Role of the Central Bank as Provider of Liquidity.

IV. Effects of the Reforms

A. Financial Deepening A.1. Financial Intermediation and Credit A.2. Portfolio Behavior A-". The Financing of Firms

B. Interest Rates and Spreads B.1. The Spread Between Peso and Dollar Rates .B.2. The Spread of Deposit to Lending Rates and Competition in the Financial Industry

C. Savings

D. Investment D.1. Investment Rates D.2. The 1'"ficiency of Investment

E. The Effectiveness of Monetary Policy

V. Conclusions

References

Statistical Appendix I. INTRODUCTION

The economic history of most Latin American countries has been pla- gued with examples of excessively regulated financial markets, where ceilings on interest rates, high legal reserve requirements and forced loans from commercial banks to the government are only part of a wide range of financial restrictions imposed by the economic authority. These type of situations are known among economists as financial repression, after the well-known studies of McKinnon

(1973, 1979).

In a financially repressed environment real interest rates (both de- posit and lending rates) are usually negative. Agents respond, according to this view, by decreasing their savings and channeling their funds out of the established financial system. Since the volume of intermediation is small and real interst rates,low, credit has to be rationed by mechanisms other than pri- ce. This situation is clearly inefficient, since the agents who obtain the scarce funds are generally not those with better projects, but rather the most influential and well connected. Under these conditions the outcome is not only inefficient from a resource allocation viewpoint, but also inequitable, and usually gives rise to corruption. Thus, in a financially repressed economy sa- vings are low because their return is not attractive and investment is also low because of credit rationing. Many agents act both as savers and investors, and therefore loose one of the important benefits of the financial system, which is to separate management from ownership and in this way allow a low-cost portfolio diversification (Barandiaran (1985)). 2

The liberalization of Oapital markets would then give way to the pro- cess known as financial deepening (Shaw (1973)), since interest rates would rise and financial intermediation would increase, expanding credit availability to the private sector and making possible a surge in investment. At the same time, the productivity of investment would increase, since credit rationing will be done through price (interest rates). As a by-product, the growth performance of the economy is bound to improve.

The recent developments of Argentina, Uruguay and Chile during the seventies, all of which pursued a liberalization of their financial markets, en- ded in financial crashes during the early eighties. Mostly based on these expe- riences, Diaz-Alejandro (1985) has challenged the supp6sed benefits of full-range financial liberalization in a work suggestively titled "Goodbye fi- nancial repression, hello financial crash". His ideas are far from defending the goodness of a financially repressed environment, but rather argue in favor of some liberalization with government intervention in the fiiancial markets, especially as regulatory agent.

In studying the specific case of Uruguay, this paper attempts to draw some lessons out of this experience, which started with a broad range of reforms in 1974. Section II discusses the relevant developnents of the economy before

1974, especially with respect to financial markets, and describes the different policy periods in which the Uruguayan reforms could be divided. The next sec- cion Ptscusses the liberalization of financial markets, both with respect to in- ternational transactions and domestically. Section IV analyzes the main effects of the reforms while section V states the conclusions. 4

II. THE ECONOMIC REFORMS OF THE SEVENTIES AND EARLY EIGHTIES

A. Initial Conditions

A.1. Relevant Issues Before 1974

As many other countries in Latin America after the Great Depression,

Uruguay pursued its development along the lines of an import substitution stra- tegy and increasing government intervention in the economy. The outcome of this policy was far from successful, since per-capita output grew at an average an- nual rate of 0.7% from the end of World War II to 1973 and exports stagnated.

Thus, Uruguay lost the opportunity to take advantage of two decades of steady growth and stability in the world economy -the fifties and the sixties- by con- fining itself within its borders. As Ramos (1984) puts it, "...the lack of dy- namism of production and exports was the result of government action exaggerately concentrated on redistributive aspects as opposed to productive ac- tivities, and using preferentially administrative controls in substitution of the marke".

The financial markets were no exception to the overall pattern of the economy. Interest rate ceilings were established on savings deposits as early as in the thirties -and a mounting path of regulations prevailed during the next four decades. The banking system was organized around the state-owned Banco de

1Ramos (1984), p.25. 5

la Reprublica Oriental del Uruguay (BROU), established in 1896, which operated both as the most important lending institution and as the monetary autority Un-

til 1966. The Cental Bank of Uruguay (CBU) was created in t966 and took charge of the issue of currency, the managing of international reserves and the super- vision and control of the banking system.

Excessive use of rediscount operations during the fifties provoked a surge in inflation, which given the existing interest rate ceilings rendered both deposit and lending rates negative in real terms and gave a powerful incen- tive to capital flight. At the beginning of the sixties the persistence of con- trols on interest rates prompted banks to a mounting non-price competition for funds increasing their number of branches and, in general, improving the quality of their service, which led to steep rises in their operating costs2 . The go- vernment reacted with further regulations (imposition of quotas on credit and deposits, higher reserve requirements, stricter rediscounting policies, etc.) in an attempt to stop the growh of domestic credit. But capital flight accelerated and the position of Uruguayan banks turned increasingly weaker. In 1965 this situation reached its lowest point and a generalized crisis of the banking sys- tem developed, prompting bankruptcies and mergers of financial institutions.

The reaction of the authorities followed the lines of increasing re- gulations, since they believed the encessive expansion of banks to be the cause

2 See Daly (1969). 6

of the crisis. This pattera of response of governments to financial- problems is widely extended not only in developing countries, as the post-depression U.S. experience acknowledges 3 . However, it seems clear that the roots of-the Uru- guayan crisis of 1965 were to be found in the excessive regulatory framework, especially with respect to Interest rates, which prompted banks into non-price competition and cost escalation, and which geared private agents to transfer their funds abroad.

The measures taken by the Uruguayan authorities in 1965 included an absolute barrier to the entry of new firms to the banking system, larger subsi- dies to surviving banks and a limitation of the credit available for the priva- te sector. That these policies were not successful in coping with financial problems became clear in the new banking crisis which developed in 1971, when a substantial increase in real interest rates deteriorated to such extent the as- sets of the banking system that new bankruptcies and mergers occurred among fi- nancial institutions.

3See for example Friedman (1969). 7

A.2. The -State of the Uruguayan Economy in 1974

By 1974 Uruguay was suffering the sharp terms of trade deterioration brought about by the first oil shock, whose cost was etimated at 7% of GDP.

Uruguay was particularly hurt by the oil price increase since not only she is a net oil importer, but also there is no petroleum production in the country.

That same year the EEC market for Uruguayan beef was closed, adding to the ba- lance of payments problems of the country and exacerbating the stagnation of ex- ports. The fiscal deficit had risen to 4.4% of GDP and inflation was running high at 77%. In fact, public sector imbalances were at the roots of the infla- tionary problem in.Uruguay since the early sixties, as Harberger (1975) has argued4 . Finally, output continued its disappointing performance of the last three decades.

On the financial side, the banking crises of 1965 and 1971 had provo- ked an increasing trend towards regulation which further contracted the size of the financial market. However, in all fairness it is not possible to attribute entirely the prevailing pattern of financial regulation to the authority's con- cern about preventing a new crisis. These types of policies are also an attempt of the government to obtain the necessary funds to finance its fiscal deficit

(i.e. through the obligation of commercial banks to buy fiscal paper at below

4 The average annual inflation rate in Uruguay during the period 1961-71 was 44.1%, quite high even by Latin American standards. Other cooperating causes of inflation were the use of rediscount operations and the intetrvention ofd the Central Bank in the banking crises, which are part of a broadly defined public sector deficit. 8

the market rates, as occurred in Uruguay) and, to some extent, a way to control conditions allocation of funds in the economy (i.e. through preferential credit to certain sectors). and the After 1965, as finance companies (financieras) were illegal, (parabaneario) formal financial system was shrinking, an informal lending markot public notaries who started to gain ground. -The latter one operated through lender. The financial instru- certified the transaction between borrower and to maturity, which carried ments used were promisory notes of up to three years sixties. The growth in the an annual interest rate of 40% to 60% in the late it was estimated that loans ca- parabaneario market was substantial and by 1970 However, the informal mar- rried out through it were a third of bank deposits. crisis of 1970 which provoked ket shrank tremendously after the exchange the government attempted in substantial capital flight from Uruguay. Further, competition of the .informal sec- late 1970 to protect commercial banks from the 5 of loans over US$400 through tor through two main measures: (i) a prohibition over three years, and (ii) the the parabancario system, unless for a period of to substitute the role of pu- establishment of facilities at Banco Hipotecario registered each operation for a blic notaries in the informal market; the Bank

2% fee. the banking system as interme- At the , ae of the reforms the role of

5100.000 Uruguayan pesos of late 1970. 9

diator of funds was reduced to a critically low level, at approximately 35% of

the real value of loans and deposits that it had in the early fifties.

B. Policy Periods

The Uruguayan reforms of the mid-seventies were more profound and

broader in the financial market as compared to other sectors of the economy.

Even if deregulation occurred too in commodity markets (both internally and in

the trade account) and reforms were also implemented in the fiscal sector, these

were narrower in scope and happened at a much slower pace. Thus, the Uruguayan

experience stands as qualitatively different. from the Chilean one, which pursued

a more comprehensive liberalization-cum-stabilization package and which was less

liberal at the beginning with respect to international financial transactions.

The reforms can be divided chronologically into three clearly defined

policy periods, according to which seemed to be the major concerns of the autho-

rities at each stage.

B.1. Phase I: July 1974-October 1978

The main problem that Uruguay faced in 1974 was the external sector.

Even if the trade account (and generally the current account), had been in sur-

plus during most of the period 1965-73, the capital account normally presented deficits; this latter phenomenum was principally caused by the outflow of priva-

te capital. The tendency to overvaluation in the domestic currency, the lack of 10

attractive financial instruments in the Uruguayan market6 and the existence of political turmoil and terrorism7 , combined to provide a powerful incentive for capital flight. When in 1974 the effects of the quadrupling'of oil pric-es began to be felt in the economy and the EEC market for Uruguayan beef (its main export at the time) became closed, a strong deterioration in the trade balance was ad- ded to the already 'existing problems in the capital account. In July of 1974

Alejandro Vegh Villegas was appointed Finance Minister with the primary task of putting together a set of policy measures directed to reestablish the equili- brium in the external sector and to stabilize the economy.

In order to improve the trade balance, the real exchange rate was driven up by over 25% during 1974-76 and it was approximately maintained at that level until October of 1978, by means of a passive crawling peg. Special incentives were provided for exports in July of 1974, when they were liberated of taxes for up to 50% of profits reinvested and the export taxes on beef and wool were eliminated. Further, exporters had access to subsidized credit lines which by mid-1977 carried an annual interest rate of -30% in real terms. All this helped to provoke an impressive improvement of almost 80% in the value of

6Due to the presence of ceilings on interest rates coupled with high (and rising) inflation, which did not allow the development of readjustable instru- ments.

7The Tupamaros'guerrilla group was very active in the early seventies.

BRamos (1984). . 11

exports from 1975 to 1978. Financial liberalization measures, discussed in de- tail in the next chapter, were partially aimed at reverting the outflow of funds and thus to improve the capital account.

In a parallel development, the broad range of price controls in the economy started to be slowly removed. Lt the beginning of 1974, 94% of the goods in the popular consumption basket had their prices fixed through COPRIN, a governmental agency responsible for price control which had to study and approve at the industry level any rise in prices. Although a trend towards liberalize- tion started in mid-1974, the process was not fast 9 . Between July and December

.of 1975, 13% of goods in the CPI were deregulated. In February of 1976 all pri- ces of goods considered to be competitively produced and not ixi the CPI were freed; the meat market was decontrolled in August of 1978. However, by the end of 1978 approximately 40% of products in the popular consumption basket were still under price control.

A partial liberalization of the trade account took place from mid-1974 to the beginning of 1975, as all quantitative restrictions on imports were removed. In particular, the previous permission for the import of capital goods was eliminated early in July of 1974. Nonetheless, the important set of tariff barriers remained untouched during this phase.

9 1n comparison, the deregulation of goods prices in Chile was much faster, as the bulk of it was done in late 1973. 12

In the inflation front the progress. was slow; by 1977 inflation was still running high at 57%, even if the internal causes of price increases seemed under control: the fiscal deficit was reduced from 4.4% of GDP in 1974 to 1.2% in 197710. Nonetheless, the inflc0 of external resources to Uruguay during this period made foreign exchange operations accountable foi a fast increase in the money supply. This effect was closely linked with one of the most important developments in financial markets during the period: starting in September of

1974, Uruguayans were first allowed to hold dollar accounts in the domestic ban- king system, and capital flows became virtually unrestricted. Since this same date the country started operating under a dual exUhange rate regime: a freely floating rate for capital transactions and the crawlin7g-peg for goods transac- tions. The two rates were unified to the passive crawl in November of 1977.

Towards the end of -this phase, the concern of the authorities shifted markedly from the external sector -whose accounts were close to balance- to the-

inflation rate. In 1978, the Central Bank attempted an open market operation to

control the money supply growth, but capital flowed into the country so as to

offset it. At this point the government came to realize that inflation was not

going to be controlled with the traditional'means of monetary and fiscal res-

traint. Uruguay seemed to be operating under a Mundellian framework due to the

high degree of financial openness, where private capital flows could very

10No major fiscal reforms occurred during this phase. However, it could be men- tioned that the personal income and inheritance taxes were eliminated in July of 1974, while the corporate income tax was left in place. 13

quickly act so as to offset monetary policy. Indeed, empirical evidence for

this period has shown that out of a given increase in domestic credit, 75% of it

was transmitted into a loss of foreign reserves in the next-two quarters. uWhen

this situation became clear to the Uruguayan authorities, they decided to change

the strategy to attack the inflation problem, their main concern by 1978.

B.2. Phase II: October 1978 - November 1982

Even if this period of time has been grouped under a common phase

from the point of view of the economic policies pursued, two important sub-

phases can be distinguished from a performance perspective. On the first, which

goes until the beginning of 1981, Uruguay experienced an unprecedented boom,

with GDP growth rates over 6%; however, since the second quarter of 1981 a

strong recession started to develop, as negative external shocks were combined

with policy mismanagements.

In October of 1978 the exchange rate regime was modified, from a pas-

sive crawl aimed at maintaining the real exchange rate, to an active crawl ("la

tablita") focused on bringing down inflation. Thus, on the next three months

after the new regime was established, the exchange rate went up at a 29.9% an- nualized rate, while inflation was 59.8% over the same basis. This type of po-

licy shift is a common feature of the three Shouthern Cone experiences

(Argentina, Chile and Uruguay) of the seventies. Simultaneously, the Central

Baik of Uruguay abandoned open market operations and frozed domestic credit; 14

thus, changes of the domestic money supply could only come from foreign exchange operations.

Important reforms during this phase also occurred in two other sec- tors. On the trade front, the high and variable import duties were set to change; a program of tariff reductions to take place in six stages was announced in late 1978. This was aimed at a flat final tariff of 35% across the board which was never reached, as the program was suspended due to the economic cri- sis in late 1982. On the fiscal side, a tax reform went into effect in Novem- ber of 1979, which included: a decrease of social security taxes, the abolition of the profits-tax exemption and of subsidized credit for exports, the elimina- tion of the 8.4% banking tax, and the establishment of a uniform 18% V.A.T. for goods considered nonessential.

Nonetheless, the major concern of the authorities during this phase and thus the focus of the stabilization policy was to bring down inflation.

Since the external problem was considered under control, the exchange rate started to be used against inflationary expectations. The "tablita" established a program of preannounced devaluations 6 months in advance; the rate of devalua- tion was set lower than the inflation rate, expecting that both would soon con- verge to a level consistent with international inflation. This was supposed to have a positive effect on interest rates, by taking part of the inflation

1 1 The "tablita" established a devaluation of the peso of 23% over the next 12 months starting in October 1978; inflation over the previous 12 months had been 41%. 15

premium out of them.

However, inflation proved more stubborn than expected, and failed to

1 2 converge quickly to the desired levels . This can be mainly attributed to de-

mand pressures coming from two different sources: on the one hand., the increa-

sing overvaluation of the Argentinian currency during 1979 and 1980 channeled

into stronger demand in the Uruguayan goods market (both through the trade ac-

count and through tourism), and on the other, the increase in the value of as-

sets created an atmosphere of prosperity which also pressed on the goods

markets. On the supply side, Hanson and De Melo (1983) have argued that the

lack of distribution channels for imports made possible substantial increases in

the prices of tradeables, well beyond purchasing power parity levels.

Nonetheless, while the Uruguayan peso was depreciating with respect

to its Argentinian counterpart in 1979-80, this happened only because the latter

country's currency was becoming even more overvalued than the Uruguayan peso

vis-a-vis the rest of the world. Thus, the current account benefited enormously

from the neighbor's circumstances. Moreover, exports to Argentina were sold ta- king advantage of a special treaty which exempted them from duties, but they we-

re not competitive in other markets 1 3 . Not surprisingly, as soon as Argentina

1 2 1nflation was 73% over the 12 months after the establishment of the tablita, while the exchange rate went up by only 23% during the same period.

1 3Hinds (1985). 16

started devaluing her money with respect to the Uruguayan peso, the "hidden" overvaluation of this latter currency began to be felt. During the period that goes from March of 1981 to November of 1982, confidence in the sustainability of the exchange rate policy quickly eroded, as exports of goods and services dete- riorated following the reduction of Argentinian demand. The general feeling that the Uruguayan currency was becoming increasingly overvalued was not reflec- ted in an adjustment of the exchange rate. The openness of financial tarkets allowed capital to start moving out of Uruguay at a fast pace; it is estimated that between January and November of 1982 capital flight was close to US$ 2 bi- llion.

The situation became unsustainable and in November of 1982 the ex- change rate was liberalized, ending the active crawl regime. By 1982, inflation was finally brought down to 20%, but at the cost of a strong recession. The

Uruguayan economy under the "tablita" policy became extremely sensible to the depreciation of the Argentinian currency and to the decrease of capital inflows which occurred after strong doubts about the performance of the ongoing policy arised. In 1981 the private sector's ability to obtain funds abroad decreased substantially, but the public sector compensated it by increasing its foreign indebtedness. This strategy proved unsustainable in 1982, and external finan- cing dried up. Many analysts believe this to be the detonator of the collapse. 17

B.3. Phase III: The Post-1982 period

The flotation of the Uruguayan currency in.November of 1982 prompted

an initial "overshooting" of the exchange rate, which increased more than 100%

on impact; a month later it stabilized at one-half over its pre-flotation value.

This provoked a proportionate increase in dollar liabilities which further wor-

sened the position of debtors, already deteriorated by the ongoing depression..

Consequently, the assets of the banking system strongly worsened with the lower

recuperability of credits. At least in an ex-pott sense, banks deserve part of

the blame in this development since many loans were given accepting as collate-

ral grossly overvalued assets. When the bubbles in. agricultural land and real

estate finally burst 1 4 , the value of the banks' loan portfolio sharply decli- ned.

The economic authorities attempted to manage the crisis through a se-

ries of measures taken by the Central Bank of Uruguay (CBU). When a group*of banks became close to bankruptcy in 1981-82, CBU felt compelled to intervene in

order to avoid a major financial crisis that -- among other things-- would have prompted substantial capital outflows 1 5 . The specific policy actions taken included:

14 0ne hectare of agricultural land was worth US$900 in 1979; two years later the same hectare-could be bought for just US$200.

5 1 Substantial capital flight occurred in spite of the authorities' intervention (and probably was exacerbated by it), especially in the years 198Z and 1983. 18

1 6 (i) OBU purchased over US$ 400 millions of bad loans of the six banks considered to be in the worst situation. Five of these were sold to fo- reign banks and the other was liquidated.

(ii) As the position of financial companies continued to worsen, CBU decided to purchase further assets of dubious recuperability from commercial banks. In order to be eligible for this transaction, banks had to obtain fo- reign loans from their parent companies to CBU. The value of the purchases which went from october of 1982 to february of 1984, amounted to over US$ 200 millions. In the process, the Uruguayan public sector acquired new loans by US$

540 millions. for a (iii) Commercial banks were led to reschedule their credits

seven-year period. In the first two years debtors were supposed to pay only 60% debtors of the interests; the remaining 40% was given to the banks by CBU, while

capitalized this amount.

The financial crisis and the ongoing depression (which decreased the

real value of tax collections) pushed up the fiscal deficit which rose from 0.1%

of GDP in 1980 to almost9% of GDP in 198217; other cooperating causes were a

1 6 According to CBU, the recuperability of these assets was close to US$130 mi- llions.

170ther side of the increase in the overall public sector deficit was the Cen- As loans we- tral Bank's purchase of bad loans financed with foreign borrowin6. re not recovered at the same rate than the service of the higher foreign debt, the overall public sector budget became increasingly unbalanced. 19

large increase in the deficit of the social security system!8 and a surge in the burden of servicing the public foreign debt. Not surprisingly, both infla- tion and unemployment went up. In an effort to control the fiscal imbalance, most export subsidies and special treatments were abandoned in late 1982; these measures helped to bring back the deficit to the 4-5% range in the next two years.

Quite paradoxically, the liberalization cum stabilization experience ended up leaving Uruguay in a worse position than when it started in 1974. High levels of inflation, unemployment and of the fiscal deficit were back but this time -unlike in 1974- the country was.left carrying the burdens of a huge exter- nal debt and of a virtually collapsed financial system. This was the situation encountered by the new civilian government which came to power in early 1985.

Nonetheless, it is unfair to blame just the liberalization attempts for these results; the deterioration in some key external variables and the policy mista- kes of the stabilization strategy are at least as important in the explanation, as analyzed below.

1 8 increased deficit in the social security system initially occurred because of the late-1979 tax reform, which reduced social security taxes. 20

III. THE DEREWULATION OF FINANCIAL MARKETS

It is reasonable to conclude that the main reason pushing towards the

liberalization of financial markets was a reaction to the unsuccessful economic

performance of the last three decades in an environment strongly regulated by

the state. The excessive regulation was perceived as a crucial deterrent of

economic development. In the Uruguayan case, the post-1974 financial liberali-

zation experience was the most important element of the liberalization and sta- bilization effort.

The financial reform can be conceptually divided in two: the deregu- lation of domestic capital markets, and the liberalization of financial transac-

tions between the country and the rest of the world. It has generally been argued that the former has to.precede the latter; in other words, a country must

open its capital account only after domestir markets have been liberalized. This was not the case in Uruguay, where considerable regulation remained internally well after capital flows moved freely through Uruguayan borders. It is impor-

tant to emphasize that, except in the most extreme liberal view, financial libe-

ralization is not conceived as an attempt to eliminate all regulations from

capital markets.

A. The Liberalization of International Financial Transactions

In 0-ptember of 1974, domestic residents became allowed to hold do-

llar. accounts in the local banking system and exchange controls were elimina- 2i

ted, rendering the peso a fully convertible crrency. Moreover, Uruguayans were also free to hold any type of assets abroad (Wall Street stocks, U.S. Treasury

Bonds, real estate in Miami, etc.) whose earnings did not have to be reported due to the abolition of the personal income tax. Shortly after, foreign inves- tors became allowed to freely repatriate their profits and capital.

Deregulation of international transactions went all the way through at a very early stage. Private non-financial firms had no restrictions attached to foreign borrowing, even if *it is clear that only a small group of big compa- nies could have direct access *o external funds. To complete this picture, commercial banks were free to borrow any amount they could, either short or long term, from abroad. Quite astonishingly, the debt-to-equity limit of 16 to 1 for banks was applied only to peso liabilities but not to foreign currency ones 1 9 .

A more liberal system could hardly be conceived. In fact, the only indirect restriction attached to foreign barrowing was the existence of binding interest ceilings for bank loans denominated in foreign currency; since banks faced an upward sloping supply of external funds2 0 , the amount which they could profita- bly borrow from external sources became limited in practice. This deregulation is all the more remarkable since before September of 1974 it was illegal for

1 9This situation remained until June of 1979 when peso and dollar liabilities became analogously treated with respect to the debt-equity limit.

2 0 The textbook case of small countries facing a given internatonal interest rate can hardly be used in an analysis of financial markets. 22

Uruguayans to hold dollars21 .

Tus, the capital account was liberalized at the beginning of the re-

form period, before any other major policy changes were attempted, even prior to

any 2 2 deregulation effort in domestic capital markets . The benefits that could

be expected from these measures are an increase in the availability of capital

(hopefully long-term capital) and a higher level of competition in the domestic

financial markets. However, those foreign resources which are attracted into

the country for short-Term speculation add an important element of instability to the economy. J. Tobin (1978), looking at the perverse effects of a high va- riability in capital flows on the real side of the economy, has suggested to

"throw some sand .in the wheels" of the extremely efficient capital markets.

In fact, the motivation of the economic authorities in liberalizing

the capital account can not be described as purely ideological 2 3 . An important

objective of this measure was, doubtless, to finance with foreign funds the cu- rrent account imbalance due to the oil shock and the negative developments in the beef market. Bat since this strategy could only work in the short run, va-

2 1Stories are told about people sent to jail after being caught holding a hundred-dollar bill.

22This is an important difference with the cases of Argentina and especially Chile, which were mo"- conservative towards the liberalization of the capital account.

2 3 ldeological in the sense of being part of a general economic strategy aimed at improving the long run performance of the economy. 23

rious incentives were also provided for exports at the time, to improve the per- formance of the current account in the medium to long run.

The issue of liberalization of the capital account. has also provoked What some discussion with respect to Its timing vis-a-vis the current account. the rest of the should be liberalized first: goods or assets transactions with among others, have world? McKinnon (1982), Frenkel (1982) and Edwards (1984), first. One of the main ar- argued in favor of liberalizing the current account adjust slower than as- guments given to back this position is that goods markets first will send conflicting sets markets, and thus opening the capital account these will later be reversed signals to the real side of the economy because argued differently, poin- when the current account is open. De Melo (1985) has by a real exchange rate ap- ting out that the concern about exporters being hurt account first were unfounded in preciation brought about by opening the capital incentives, and there was con- Uruguay because exporters were given compensating the real exchange rate. fidence in the passive crawl aimed at maintaining international transac- With respect to the exchange rate policy for

of 1974: a freely floating tions, Uruguay adopted a dual pattern in September crawl for goods. These dual rates rate for capital transactions and a passive to September of 1981 were unified in November of 1977. Later on, from February in an attempt to shrink the the Central Bank sold exchange rate guarantees,

spread between peso and dollar lending rates. 24

B. The Reforms of Domestic Capital Markets

B.1. The 1974-82 period: liberalization

At the beginning of the reforms the Uruguayan financial system was tightly regulated in many respects. The main reforms which occurred are des- cribed below:

(i) Interest rates

Ceilings existed on peso lending rates, which in September of 1974 were set at 38% annual for rates payed in advance; this is equivalent to a 61.3% rate at maturity. The restriction was binding as inflation ran substantially above 61.3% at the time 2 4 , resulting in negative real interest rates. Not sur- prisingly, domestic currency denominated deposits remained stagnated. In April of 1976 interest rate ceilings were marginally raised to 62% and became nonbin- ding as market rates established below that level. However, inflation rose again in 1977 and in order to avoid the recurrence of negative real rates the authorities increased once more the ceiling to 90% in October of that year. The restrictions did not apply to deposit rates during this period; otherwise spreads would have been fixed.

With respect to dollar lending rates, a cliling of 12% annual existed during most of the period which goes from the beginning of the liberalization

24Inflation was 107% in 1974, 67% in 1975 and 40% in 1976. 25

until October of 1977, when it was raised to 15%. The 12% limit was binding all the way through, which becomes clear when we observe that market rates establis- hed exactly at that level; after October of 1977 the restriction ceased to be binding. In July of 1978 the limit was increased to 20%.

Ceilings on both peso and dollar lending rates were abolished in Sep- tember of 1979.

(ii) Legal reserve requirements and the banking tax

Since the beginning of the reforms, reserve requirements were set lo- wer for dollar deposits in comparison to their peso counterparts. In May of 1975, the Central Bank started paying interest on legal reserves; this was par-

ticularly attractive for dollar deposits, as the interest payed was above Euro- dollar rates. However, fear for the inflationary pressures coming from the expansion of foreign currency deposits and from external borrowing by commercial. banks led the Central Bank to increase the required reserve ratio on dollar de- posits in the second half of 1977. A year later, in October of 1978, legal re- serve requirements were unified for peso and dollar deposits, setting both at 20%. However, in May of 1979 required reserves were eliminated. This evolution reflects a somehow erratic behavior of the -monetary authority with respect to legal reserves.

Another important part of borrowing costs -the 8.4% banking tax- which was in place since the beginning of the reforms, was later abolished in November of 1979. This tax consisted of a 6% levy on the borrower and a 2.4% 26

rate on the bank; its base was the total value of the credit (principal and interest) and thus constituted a substantial cost on financial transactions 2 5.

It applied to both peso and dollar loans.

(iii) Entry barriers

As a reaction to the 1965 financial crisis, new legislation came into effect which not only forbidded the entry of new competitors to the banking sys- tem, but also banned the expansion of the total number branches existing at the time. Thus, if a bank wanted to increase its branches this was only possible through the contraction of a competitor.

Two basic types of institutions existed in this market: commercial banks and banking houses. Prior to the end of 1977, the latter were neither allowed to obtain deposits from domestic residents nor from nonresidents, and thus they could not offer checking account services; their main activity was to borrow abroad and lend those funds in the domestic. market. By the end of 1977 the Central Bank of Uruguay reinterpreted the law permitting banking houses to obtain deposits from nonresidents.

Nonetheless, the entry of new banks to the market and the creation of new branches remained forbidden until 1982, when new legislation allowed the formation of new banks with a limit of 10% of the existing ones per year. At the same time, the expansion of bank branches .was permitted.

2 5In the 1976-78 period, revenues from this tax amounted to over .6% of Central Government revenues. 27

iv) The exposure of banks

Since.the beginning of the reform period, no restrictions were atta- ched to the exposure of banks in foreign currency. Thus, banks could borrow in dollars and lend in pesos facing the exchange rate risk at any level desired. v) Credit Allocation

The targetted credit allocation programs were progressively elimina- ted. In particular, the credit subsidies provided by the Central Bank for pre- export financing, which explained a non negligible part of credit growth to the private sector, were reduced in the second half of 1977 and finally eliminated in the fiscal reform of November, 1979.

B.2. The post-1982 period

After the profound crisis of the economy in 1981-82, government in- tervention in the financial markets initially stepped up again and later on was relaxed. It included the following measures:

(i) Ceilings were reimposed on peso lending rates (although not on dollar

rates) in November of 1984. The limit was set at35% then lifted to 87%

in December of that year, to 90% in January of 1985 and to 95% a month la-

ter. This ceiling was binding all the way through its removal in December

of 1985. Since then interest rates are totally free.

(ii) A limit was set on the net exposure of banks in local (not foreign) oZtc

rrency since 1984. Thus, banks could borrow in dollars and lend in pesos 28

assuming any risk desired; however, a restriction was attached to their

exposure through borrowing in pesos and lending in dollars. The limit

is not homogeneous for all banks, and it results from the application of a

formula. This regulation is somehow curious, since in most other places it

is applied the other way around, to the dollar exposure.

(iii) Legal reserve requirements on domestic currency deposits, after having

been set at zero for almost 4 years, were raised to 10% in January of

1985, in an effort to restrain the excess liquidity of the market. At the

end of the year this ratio had been increased to 14%; no requirement ap-

plied for dollar deposits.

At the beginning of 1984 a change in the term structure of legal reserves

occurred. For very short-term peso liabilities (30 days or less) the ra-

tio was raised to 15%, while for one-to six-months deposits reserve requi-

rements decreased from 14% to 5%, and these were eliminated for deposits

over six months. This situation prevailed until late 1985 when legal re-

serve ratios were increased to 24%, 11% and 5% respectively for the three

types of deposits. During all the period since January of 1984 reserve

requirements have been substantially lower for dollar liabilities; these

are currently 10% for deposits under 6 months and 4% for thse over 180

days.

(iv) Targetted credit allocation resumed, a 8% of bank's deposits had to be

invested in government bonds at below market rates (LIBOR + 2%). 29

(v) The deposits of Banco de la Repiablica Oriental de Uruguay .(BROU) at the

Central Bank, amounting to US$115 millions, were frozen.

Thus, despite all the changes occurred in the Uruguayan economy since

.1965, the diagnosis of the authorities in front of a financial crisis appeared

to be gea iinhe same direction. In both cases it seemed to have been attri- bute K o excessively liberal financial markets -even if in 1965 controls were

much more profound than in 1982-and regulation increased.

B.3. The Supervision of Banking Activities

The supervision of banking activities in Uruguay has been mainly con-

fined to the traditional control of capital and reserve requirements. Balance

sheets and states of results are also reviewed to judge if they are appropria- tely elaborated so that they accurately reflect the financial situation of the bank. This supervisory role is done through the Department of Control of the

Financial System, which is part of the Central Bank2 6.

Restrictions for the concession of loans have traditionally been very

soft. Even if at the beginning of the liberalization period it was not allowed

for a bank to grant loans to the members of its board of directors or to its lawyers, nothing was established with respect to firms where the owners of the

2 6 1n other countries the supervision is done through an independent agency, re- gularly called Superintendency of Banks and Financial Institutions. 30

bank could have a property interest. In May of 1975 it was decreed that no lban could exceed 20% of a bank's capital; in August of that year this figure went up to 25%. By December of 1978 the limit was set at 40% and in March.of 1980 this restriction was abolished.

For a brief period between January and August of 1981 it was again established that no person or institution could borrow more than 25% of a bank's capital; for The first time a borrowing limit was also set for conglomerates 2 7 at a maximum of 35% over the same base. This was abolished in August of 1981, when this restriction was substituted for a more detailed information about borrowers; the Central Bank started demanding a detailed analysis of every cus- tomer, according to a uniform methodology.

Finally, in September of 1982 a prohibition was established for loans given by a bank to its own personnel, as well as to firms where those people had any managerial role. Once more, no special restriction applied to the borrowing of firms or institutions which had a property relationship with the bank.

2 7 Conglomerates have been a much less important issue in Uruguay as compared to other Latinamerican countries like Chile and Mexico. 31

B.4. The Role of the Central Bank as Provider of Liquidity

The Central Bank of Uruguay has played a fairly donservative role in providing liquidity to the financial system. The main source of expansion of the domestic money supply in the 1974-82 period were foreign exchange opera- tions, as balance of payments surpluses were validated. Occasionally, the aut- horities have even attempted to sterilize part of the increased liquidity

through the sale of government bonds 2 8.

Rediscount operations were abolished in 1976, being replaced by the "extraordinary financial assistance". This is not an automatic mechanism; banks have to apply for funds, which may or may not be provided by the authority. Mo- reover, the interest rates on these loans is not very attractive for commercial banks, since it is set at 1.25 times the lending rate. In practice, this is mo- re of a punishment than an assistance, and it carries a negative repercusion on the bank's standing as perceived by the market. Analogously, banks who fail to comply with the legal reserve requirement face a severe fine; this eliminates other avenue which is occasionally used in other countries to expand domestic credit.

Finally, open market operations have been normally used either to finance a fiscal imbalance or to sterilize the monetary effects of a foreign ex-

change operation. They have not generally been a source of liquidity.

2 8 A case in point was the failed sterilization operation of mid-1978. 32

IV. EFFECTS OF THE REFORMS

Perhaps the broadest indicator of economic performance is the rate of growth of GDP. Judging by this standard, the package of- liberalization-cum-

stabilization measures substantially improved the economic development of Uru- guay from 1974 to 1980. Per-capita GDP growth was roughly at 4.0% annual average rate during this period, more than 5 times the corresponding figure for

1;50-73. This improvement occurred in spite of the sharp terms of trade dete-

rioration resulting from the oil shocks of the seventies. Nonetheless, these

encouraging results did not last long, as GDP fell by more than 15% from 1981 to

1984. Neither the success, nor the crisis could be entirely attributed to fi- nancial liberalization. As it has been discussed, a number of other policy re-

forms as well as external developments are also accountable for the results.

The effects of the reforms are analized below ih terms of different economic indicators.

A. Financial deepening

Financial deepening is broadly understood as the process of increase

in the intermediation of funds through the financial system. It is considered

desirable because it presumably increases the productivity of those funds by di-

recting them to activities that generate higher returns29 . Besides from the

2 9 With respect to the case where-the savings-investment process is done by the same agent. 33

aggregate measures of intermediation, there are two other specific issues which

deserve consideration in a financial deepening process: the way in which firms

obtain financing and the portfolio allocation of households.

A.1. Financial intermediation and credit

- The level of development of financial markets is generally measured

by the summary statistic (M2 /GDP). For industrialized nations like Belgium,

Switzerland and the U.S., this coefficient was around 0.6 on average for the pe-

riod 1960-75; in Germany it was close to 0.8 and in Japan over 1.0 for the same

period. On the other end, for developing economies in Latin America (i.e. Ar-

gentina, Brasil, Chile and Colombia) (M2 /GDP) was on average below 0.2 during

1960-75. Thus, financial sectors of developed nations were at leat 3 to 4 times

bigger in proportion to national income with respect to their conterparts in

semi-industrialized economies. In fact, as Mckihnon (1979) has argued, the gap

in the size of financial markets is much bigger than what (M2 /GDP) could sug-

gest, because of the existence of more developed stock markets, pension funds

and insurance companies in industrialized nations.

The ratio (M2 /GDP) presented an impressive growth in Uruguay during

the post-reform period, as Table 1 shows. From levels well below 0.20 in the

early seventies, it increased steadily after 1974, to reach close to 0.43 in

1981. The public sector had an almost nil participation in this development,

which can be completely attributed to a rise of private deposits in the Urugua- TABLE 1: MONETARY AGGREGATES OF THE URUGUAYAN BANKING SYSTEM (as % of GDP)

Net International Domestic Credit Monetary Central Bank Reserves Liabilities Foreign Debts

(M2 ) (Long Run)

1973 2.41 20.25 19.23 1974 -1.02 23.32 18.90 1975 2.09 25.01 19.60 1976 7.10 26.96 26.07 1977 12.00 29.50 28.77 - 1978 20.00 31.87 36.10 - 1979 13.85 33.76 37.58 - 1980 10.75 37.52 39.14 - 1981 12.15 40.53 42.89 - 1982 7.50 90.25 70.91 7.03 1983 10.79 82.54 56.07 37.44 1984 7.17 83.51 55.09 40.49 1985 10.72 75.64 60.36 39.99

Source: Central Bank of Urug2ay.

Notes: Uruguayan Banking System (UBS) includes Central Bank, Banco de la Rep'blica Oriental del Uruguay (BROU), commercial banks and banking houses. 34

yan banking system.

Peso deposits did not account much for this increase in the period

1974-77' (see Table 2), as binding interest rate ceilings 6xisted and real rates

were normally negative. Rather, dollar deposits grew importantly, from 2% of

GDP in 1974 to almost 15% of.GDP in 1978. From 1978 to 1981 the most important

source of foreign exchange to the domestic banking system were deposits from

nonresidents. In particular, the overvalued currency in their country and the

unstable political situation provided a powerful incentive for many Argentinians

to deposit their funds in Uruguay, whose banking institutions did not need to of-

fer exorbitant rates to attract those deposits. On the other hand, when cei-

lings on interest rates became nonbinding -after 1977- peso deposits increased

too (almost 10 percentage points of GDP in 3 years).

Nonresident deposits continued increasing until 1981, when they rea-

ched close to US$ 1 billion. After that they started decreasing, as confidence

in the permanence of the Uruguayan economic policy -and in particular the ex-

change rate policy- waned. At the same time, a number of devaluations of the

Argentinian currency occurred, which diminished its overvaluation.

From 1982 on, the impressive surge in the ratio (M2/GDP) has to be

regarded very cautiously, since it is more than totally accounted by the effect

of the higher exchange rate on dollar deposits. Indeed, foreign currency depo- sits went down every year from 1981 to 1984 whera measured in dollars, but in- creased as a proportion of GDP as Tables 2 and 4 show. TABE 2: M0NMARf LIABELITIES OF THE URUGUAYAN BATIN SYSTII (as % of GIP)

Currency 1eso Deposits Dllar Deposits- Private Other Total Private Se otor Other To tal Total Monetary Sector Residents Nonresidents Total Liabilities (12)

0.63 9.77 1.16 0.22 1.38 0.21 1.59 19.23 1973 7.88 9.14 18.90 8.97 0.76 9.73 1.68 0.34 2.02 0.21 2.23 1974 6.94 4.22 19.60 5.75 8.73 0.89 9.62 3.13 0.83 3z96 0.26 1975 26.07 9.63 1.60 11.23 6.72 1.65 8.37 0.27 8.64 1976 6.21 28.77 8.85 1.29 10.14 10.74 1.91 12.65 0.39 13.04 1977 5.59 36.10 12.89 2.13 15.02 10.43 4.13 14.56 0.67 15.23 1978 5.85 37.58 15.48 2.59 18.06 8.84 4.50 13.34 0.65 13.99 1979 5.53 13.55 39.14 5.52 1845 1.65 20.08 6.96 5.81 12.77 0.78 1980 0.63 19.89 42.89 1981 5.02 17.44 0.54 17.44 9.95 9.31 19.26 0.82 46.17 70.91 1982 6.12 17.26 1.35 18.61 22.97 22.38 45.35 0.82 35.98 56.07 1983 4.54 14.85 0.70 15.55 17.58 17.58 35.16 0.81 36.20 55.09 1984 4.18 14.20 0.51 14.71 19.12 16.27 35.39 38.66 0.96 39.62- 60.36 1985 4.55 15.39 0.81 16.19 21.27 17.39

Source: Central Bank of Uruguay and estinations by the author. public enterprises and foreign exchane -Notes: Other includes deposits of Banco Hiptecario de Uruguay (BHU), houses. TABLE 3: DOMESTIC CREDIT PROVIDED BY THE URUGUAYAN BANKING SYSTEM (as % of GDP)

Credit to the Private Sector Credit to the Consolidated Total Peso Dollar Total. Public Sector

1973 13.28 2.98 16.25 4.00 20.25 1974 15.35 3.38 18.73 4.59 23.32 1975 14.39 5.08 19.47 5.54 25.01 1976 14.16 7.3' 21.46 5.50 26.96 1977 14.14 11.05 25.17 4.33 26.96 1978 15.33 13.09 28.42 3.45 31.87 1979 18.15 14.91 33.06 - 0.70 33.76 1980 20.16 16.88 37.04 0.48 37.52 1981 20.19 18.68 38.87 1.66 40.53 1982 20.37 57.18 77.55 12.70 90.25 1983 16.45 44.59 61.04 21.50 82.54 1984 14.96 43.89 58.85 24.66 83.51 1985 12.68 44.04 56.72 18.92 75.64

Source: Central Bank of Uruguay. TABLE 4: F=GN EXCHANG ASEI OF THE PRIVATE SBMTR (RESIIMM AND NONREI) (In tusands of US$ dollars, end of period)

apoits in the RmIdkng System Rablic Sector Oligations Total Exchange Treasuy Treasury Total Iate Fesidents 1%nresidents Total Ibnds Bills (N1$/1TS$)

1974 46.5C4 9.411 55.915 117.879 28.233 146.112 202.027 1,64 1975 94.5eB 25.0E2 119.667 228.083 19.170 247.253 366.920 2,70 1976 214*524 52.673 267.197 261.036 36.145 297.181 564.378 3,96 1977 39.080 70*439 466.519 282.640 24.398 307.038 773.557 5,40 1978 458.156 181.418 639.574 274.460 13.113 287.573 927.147 7,04 1979 603.396 307.559 910.955 265.910 6.206 272.116 1.183.071 8,44 1980 641.808 535.762 1.177.570 260.455 1.497 261.952 1.439.522 10,00 1981 1.053.742 965.964 2.039.706 265.136 1.496 266.632 2.306.338 11, 56 1982 882.404 859.739 1.742.143 275.750 153.594 429.344 2.171.487 33,50 1983 756.300 756.300 1.512.600 407.057 276.298 68*3.55 2.195.955 43,00 1984 748.1 11 636.598 1.384.709 544*391 401.321 945.712 2.330.421 74,00 1985 875.899 714.485 1*5a.38% 619.612 510.497 1.130.109 2.718*493 124,75

Source: Central Bhnk of Uruguay and estimations by the author.

Note: !'fobtain the division of dollar deposits between residents and nonresidents we used the same proportions that these two types of agents had on dollar deposits in the private ban- king institutions (which had over 80%of dollar deposits at any time). 35

It was in fact the expansion of M2 -mainly deposits- which permitted

the increase in domestic credit. An important part of the increase in M2 was

accounted by the surge in deposits from nonresidents. Being these "hot money",

this aspect can help to understand why long-term credit never really developed

in the Uruguayan economy. Nonetheless, it is clear from Table 1 that financial

deepening in the sense of Mckinnon and Shaw took place in Uruguay during the pe-

riod 1974-81 as the higher level of deposits were translated into greater avai-

lability of funds. More importantly, credit effectively reached the private

economy, as net loans to the government decreased all the way from 1975 to 1980

and were very low in 1981 (Table 3). However the collapse and attempted rescue.

of financial markets after 1982 soon had the government back as a significant borrower of funds; net credit to the public sector, as a proportion of GDP, Fent

from 1.66% in 1981 to 21.50% in 1983.

Overall, potential fears that increased availability of loanable funds could possibly not be translated into greater credit for the Uruguayan private sector were unfounded. Neither did the banking system invest abroad a significant fraction of the funds captured in Uruguay, nor did the government compete for extra resources with the private sector until 1981, a development which is expected given the strong contraction of the fiscal deficit.

The expansion of deposits and credit between 1978 and 1981 was also accounted by the materialization of capital gains by the private sector as the value of real assets in the economy- especially agricultural land and real 36

estate- strongly increased.

It is important to mention that after 1982, a portion of the credit to the private sector has been, to some extent, given involuntary. Banks have been forced to roll-over bad loans which, if accurately reflected on balance sheets, would have probably washed-out the capital of most banks. Thus, the post-1982 surge in private credit should be regarded skeptically with respect to its presumed benefitial effects, since it mainly reflects distress borrowing.

A.2. Portfolio behavior

The financial deepening process was strongly geared from the outset towards foreign currency. It is quite natural that nonresidents would invest only in dollar deposits, but the fact that domestic residents would maintain such a proportion of their assets in dollar instruments is explained by a num- ber of factors:

- In the period 1974-77 binding ceilings existed on peso rates, which made domestic currency deposits unattractive. Thus, they did not expand during this period, as presented in Table 2.

- There were no good hedges against inflation in Uruguay, other than the dollar. In fact, the only existing adjustment clause was the unidad rea- justable, an index which reflected the evolution of wages and other selected prices, but there seemed to exist widespread distrust in this index, as people believed that it was manipulated by the economic authority. However no adjust- ment clause based on consumer price inflation appeared even if it was legally possible. This is importantly accounted by a high and variable inflation, where 37

relative prices present big variability. In such a scenario the average infla-

tion rate means very different things for different agents; if these are risk

averse, they would be reluctant to contract under adjustment-clauses based on average inflation.

It is important to notice that the expansion of dollar deposits of

residents was not only due to their increased demand for foreign currency as-

sets, but also to a switch in dollar deposits of Uruguayans from abroad to the internal banking system. The data shows that during the period 1976-79, depo-

sits of domestic residents in U.S. banks decreased in nominal terms. This is one sign of the confidence given by the reforms, which were able to revert the chronic deficits in the capital account.

In the 1980-81 period, an even stronger surge in foreign'currency de- posits of Uruguayans (US$ 400 million in one year) was mostly explained by the expectation of capital gains in dollar assets, as confidence in the sustainabi- lity of the exchange rat policy quickly eroded. Agents proved to be right and were rewarded by an astonishing return of almost 400% on their dollar deposits30.

Deposits in the Uruguayan banking system were not the only dollar as- s.et available in the economy. The private sector (both residents and nonresidents) had also access to gobernment debt denominated in foreign currency which had substantial acceptability due to the long tradition of the Uruguayan

30 Expressed in domestic currency. 38

authorities in honoring their external obligations. Thus, in the year after the reforms started the public sector was able to raise more than US$100 million th- rough the sale of treasury bonds. From 1975 to 1981 there was a major surge in dollar deposits in the banking system -an almost US$ 2 billion increase- while foreign currency denominated public debt remained virtually flat. When the cri-

sis of 1981-82 provoked substantial capital flight, the domestic authorities

started selling again dollar bonds and bills, most of which went to finance

their intervention in the financial markets.

It is important to emphasize that the overwhelming portion of finan-

cial instruments were short term (less than one year to maturity), most of them

for 90 days or less. This can be partially accounted for by the lack of "good"

indexed assets in an economy of high and variable inflation. The virtual stag-

nation of the private insurance business -due to a virtual state monopoly over

many types of insurance and the prohibitian to expand ther total number of insu-

rance companies- and the absence of other institutional investors such as mutual

funds or pension funds help to explain why long-term assets never developed in,

the Uruguayan economy. Another factor explaining why long-term credit did not

develop is the fact that most deposits were short-term, especially the "hot

money" of nonresidents.

Finally, and as mentioned below, financial assets such as stock and

bonds issued by firms were a negligible part of the portfolio of private agents. 39

A.3. The financing of firms

During a process of financial development, new and more sophisticated

instruments come to play a role in the market. In particular, firms usually

discover the possibility of raising funds directly from the public, as an alter-

native to borrow from intermediaries. In the Uruguayan case it is rather sur-

prising to discover that no firm issued bonds (either with or without

collateral) during the whole post-reform era, in spite of the high level of

spreads through the first part of that period. This might be partially explai-

ned by the fact that only a few, big and well-known firms could command enough.

public trust in order to attract private agents offering reasonable rates on

their debt. Moreover, these firms were preferential borrowers in banks, and the

spreads that they were charged decreased enormously after 1979. Further, the

absence of indexing practices in the economy was probably another element which

precluded the existence of company bonds as a means of financing. Finally, the

existence of a very soft bankruptcy law might help to explain this phenomenum.

On the other hand, the stock market in Uruguay has an almost nil par-

ticipation in financial markets. Even if it experienced some development in,the

years 1976 to 1979, the total value of stock transactions in any given year ne-

ver reached half a percentage point of GDP. Therefore, the financing through

stock emission has never been an alternative for Uruguayan firms. One reason

for this meager development of the stock market seems to lie in the Uruguayan corporate law, which provides little protection for minority stockholders. 40

Thus, even in one of the most liberal environments, the development confined of new forms of financing for firms simply did not occur. Firms were alternatively, to use their own resources in order to develop new projects -or, to fall and to borrow from banking institutions. After 1980, earnings started was to borrow either firms turned increasingly to debt financing. Their option rate in pesos was rising and banks in pesos or in dollars; as the real interest in dollars, the exposure of Urugua- pushed their customers to renew their loans 3 1 . Thus, the heavy devaluation yan firms in foreign currency rose importantly for the financial situation of firms. of the peso in late 1982 was a major blow

B. Interest Rates and Spreads were binding in Uruguay un- Ceilings on peso and dollar lending rates

during most of the early reform pe- til 1976, resulting in negative real rates lending rates limited the funds that riod. The existence of these ceilings on allowing for the banking tax, the cost the banking system could attract: after costs, the deposit rate was determined of holding reserves and other operating

as a residual. became nonbinding and they From 1977 on, ceilings on interest rates

levels after' 1978. As table 5 shows, started climbing towards very high real 40% in 1981, since agents were increa- real rates on peso deposit reached almost

dollars had been rising steadily since 3 1 The exposure of Uruguayan firas in 1974. On this issue see Tybout (1985). TABLE 5: INEREST RATES AND SPREADS

M-Post Nominal Teposit 1tes Real Deposit 1ates Nominal lending Real lending Spreads on peso rates (Nonal) 1ates (Normal) Loans Peso hilar 1so (1 -6 months) l)ollar Ieso Iblar Peso Dbllar Nonal Preferential (1-6 months) lyr.+ Ex-ante Fk-post Ex-ante E-post .

1974 30.0 48.0 7.0 -44.92 -17.58 -6.02v -13.70 61.3 12.0 3.57 50*95 31.3 1975 30.0 48.0 7.5 -26.33 11.20 -17.66 35.38 61.3 12.0 42.50 39.88 31.3 1976 30.0 46.0 6.5 -21.15 -21.95 -7.11 -12.08 62.0 12.0 -2.74 -11.78 32.0 17.6 1977 51.4 63.2 7.5 2.89 10.35 -2.15 -9.47 76.6 13.8 20.95 -5.01 25.2 14.4 1978 42.6 45.4 8.0 -5.66 -18.74 -1.26 -25.64 .71.2. 14.2 -2.44 -20.10 28.6 17.1 1979 '50.6 49.2 11.9 -21.21 3.35 -33.98 -15.08 68.1 16.8 20.85 -11.75 17.5 -0.7 1980 50.3 52.7 14.6 11.77 19.13 0.05 -0.23 65.1 18.5 33.93 3.60 14.8 -0.5 1981 47.4 49.8 13.1 19.82 36.54 0.53 18.47 59.8 18.4 48.94 23.77 12.4 -0.9 1982 66.2 67.3 10.2 35.15 0.87 601.20 216.87 763 18.2 10.97 224.87 10.1 -9.5 1983 67.8 66.0 9.8 29.85 -4.51 48.73 -. 50 85.0 17.2 9.28 -1.29 17.2 -0.7- 1984 75.2 79.0 10.6 18.16 -5.32 43.09 -3.32 86.6 17.3 1.56 0.56 11.4 -5.9 1985 74.4 76.2 8.1 -3.67 5.54 -2.25 -10.15 95.0 15.8 26.14 -5.59 20.6 5.6

Sburce:, Central Thnk of Urtguay and estimations of the author.

Notes: W) Naminal interest rates are at Decanber of each year. (ii) Ek-ante real interest rates on peso deposits are calculated adjusting the ndminal rate with the annualized inflation ra- te over the 6 months previous to December (the average tenm of deposits was certainly less than one year and probably less than six months). (iii) Ex-post real peso rates are adjusted using the annualized inflation rate over the six months after Decanber. (iv) Ex-ante real interest rates on dollar deposits are calculated analogously to (ii), using the annualized exchange rate depreciation of the 6 months previous to Decenber as expected depreciation. (v) Ex-post real dollar rates are calculated using both the inflation rate and the exchange rate depreciation over the six months after Decanber (annualized). (vi) 1br the real ex-post dollar rates of 1932 a correction was made -using the November exchange rate- to avoid the probles of the exchange rate overshooting. 41

singly doubtful about the sustainability of the exchange rate policy. The high rates could also be explained in this period by the increase in demand for cre- dit fueled by the capital gains on real assets. Even if spreads were declining at the time, they were still quite high and nonpreferential borrowers faced enormous financial costs, particularly so since they had practically no other sources of financing. In the post-1981 period, demand for credit was influenced agents who by distress borrowing (i.e. borrowing to avoid bankruptcy) since many conti- saw their positions deteriorate in the period of high real interest rates their nued pressing for funds in an attempt. to postpone, or avoid if possible, de- capital losses. This situation usually happens in periods of generalized assets pression when it is extremely unattractive- to pay-off debts by selling whose prices have plummetted. resul- Binding ceilings on peso lending rates were reimposed in 1984,

ting in low or negative real returns to investors. is presen- The evolution of interest rates during the period 1974-85 of real ted in Table 5. It is important to keep in mind that the calculation using inflation rates faces important limitations. Ex-ante rates were computed inflation. In addi- over the previous six months as the expectation of future loans and depo- tion no exact information exists as to the average maturity of periods of high and sits, although this was clearly below one year. Further, substantial changes in variable inflation accompanied by external shocks witness rate as a common relative prices which obscure the meaning of the real interest

figure. 42

B.1. The Spread Between Peso and Dollar Rates

The liberalization of financial markets vis-a-vis the rest of the world was not able to bring about a ':,;avergence between domestic and internatio- nal interest rates. Paradoxically, this spread rose between 1977 and 1980 as the financial sector in Uruguay was becoming increasingly deregulated.

Banks operating in the domestic market had basically two alternatives to obtain loanable funds: through domestic currency denominated instruments or through foreign loans, which could be gotten by attracting dollar deposits from nonresidents or by directly borrowing abroad from financial institutions. The two latter options differ with respect to the speed with which the funds could be obtained; an external loan from a foreign institution takes time to be com- pleted, especially if it is a syndicated loan, whereas an increase in dollar de- posits from nonresidents could be gotten much faster. In the Uru6uayan case, syndicated loans represented a very minor part of the increase in external debt, unlike other cases like Chile. Only three banks carried through this type of transaction (Banco Pan de Azu'car, Banco Comercial and Banco de Credito); the to-- tal value of these loans did not exceed US$70 million, an almost negligible por- tion of the Uruguayan foreign debt. This ocurred at a relatively late date, since the first of these operations occurred at the beginning of 1981.

The reason for this particular pattern of borrowing probably lies on the ability of the Uruguayan banking system to obtain dollai deposits both from

redisents and from nonresidents. Apparently, the long tradition of the authori- 43

ties in honoring their external commitments gave confidence to private agents that the government would keep their hands off from dollar deposits in the do- mestic 3 2 market . So far,.their expectations have been confirmed since no inter-

vention of this sort has occurred33 .

During most of the post-reform period, there was no restriction as to the exposure of banking institutions in foreign currency. Thus, it was possible to borrow in dollars and lend in pesos, assuming any level of risk desired. In fact, the Uruguayan banking system had a negative net exposure in foreign cu- rrency during all the post-reform period, as dollar loans plus net international reserves were significantly above dollar deposits. However, part of this safe exchange position was only nominal; in many cases banks covered their risk by renewing peso loans only if they were converted to dollars. For borrowers which were not engaged in tradeable activities, a strong devaluation of the curr'ency would almost surely mean bankruptcy and the bank would recover only part of its credit, or, alternatively, would have to get involved in dis-tess lending. This type of situation certainly accounts for a major part of the tumbling financial position of banks after 1981. A safer way for financial institutions to have li- mited their exposure was to change their structure of liabilities, replacing do-

3 2 1n fact, the three main political parties which took part in the 1984 campaign .promised not to nationalize the dollar deposits in the Uruguayan banking system. 3 3 other investors in Mexico and Peru have recently had a contrasting experience, as their dollar deposits in the domestic banking system were frozen. 44

liar for peso deposits. Nonetheless, this is a slow process that would have required a developed structure of branches3 4 .

Dollar deposit rates in the Uruguayan banking system were close to those in foreign markets, as could be expected, since access to deposits in the U.S. or the Eurodollar market was open to most agentg. But the spread between dollar and peso rates was high, in the range of 10 to 20% after adjusting for the ex-post depreciation of the Uruguayan currency with respect to the dollar. Before 1981 this difference can not be attributed to expectations of devalua- tion. The fact that binding interest ceilings existed on dollar loans after these were removed for peso loans can explain part of this spread since the

middle of 1976 to October of 197735. Moreover, dollar deposits faced lower re- serve requirements than peso deposits from September of 1974 to October of 1978, when legal reserve ratios were unified at 20%; on the other hand, interest rates paid on reserves were comparatively more attractive for dollar deposits, as they were set above Eurodollar rates. The latter two elements decreased the costs of intermediation in foreign currency relative to domestic money, and thus could explain part of the spread between peso and dollar lending rates even if inte- rest rate ceilings on dollar loans were nonbinding. Ramos (1984) has pursued a different line of argument, suggesting that foreign funds were in fact rationed

34Up until 1982 the expansion of bank branches was not allowed.

3 5Binding constraints existed on peso rates essentially until the middle of 1976, when ceilings were raised to 62%. However, binding ceilings on dollar ra- tes remained in place until October of 1977. 45

by quantity rather than price, and that internal demand for credit in Uruguay.

.grew much more than what foreign lenders were willing to provide.

In the period 1981-82, as confidence in the sustainability of the ex-

change rate regime progressively eroded, expectations of devaluation started to

play a more prominent role in explaining the spread between peso and dollar ra-

tes. The Central Bank attempted to close this gap by selling exchange rate gua- rantees starting in February of 1981. This policy proved successful as the

interest rate gap decreased substantially, but it was discontinued in September of that year.

B.2. The Spread of Deposit to Lending Rates and Competition in the Financial

Industry

One of the benefits expected from financial liberalization is to strengthen the competition in the banking industry, which should be translated in better service and lower costs of intermediation. However, the spread bet- ween lending and borrowing rates remained quite large, during most of the post- reform period.

A difference has to be made between gross and net spreads. The ob- served gap between borrowing and lending rates (the gross spread) is influenced by legal reserve ratios and by taxes on financial intermediation. Reserve re- quirements on peso deposits were progressively lowered since the beginning of financial reforms. Moreover, in May of 1975 the Central Bank started to pay in- 46

terest on reserves, thereby lowering the cost of maintaining these previously idle funds for banks. In May of' 1979 required reserves were finally eliminated and in November of the same year, the 8,4% banking tax was abolished, 2.4% of which was borne by the bank and 6% by the borrower of funds. The expected ef- feet was felt for preferential borrowers, whose spreads came down fron an avera- ge of 15.8 percentage points in 1977-78 to virtually nil or negative from 1979 to 1984. Nonetheless, no.-preferential borrowers' spreads were maintained over

15 points practically until 1982.

In any case, legal reserve requirements and financial taxes do not explain by themselves the high level of the spreads. This has also been attri- buted to a lack of competition in the banking market. We recall that the 1965 banking law actually forbid the entry of new competitors into the industry, a situation that prevailed until the middle of 1977 when the law was relaxed for banking houses, allowing them to obtain funds.from nonresidents. As a result, the number of these institutions increased from one to more than twenty and their participation on dollar-denominated loans went from 4.3% to 11.5% of the market between 1977 and 1979. Nonetheless, the share of banking houses in peso loans was kept at a very low level, which could be partially accounted by their inability to obtain domestic currency deposits.

Spiller and Favaro (1984) have shown, based on econometric evidence, that the threat of new entrants made possible by the 1977 regulatory change sig- nificantly reduced the extent of 0.ligopolistic interaction among firms in the 47

banking industry. This finding supports the argument that the decrease in

spreads after 1978 can be partially attributed to the weakening of entry ba-

rriers to the market.

On the other hand, the 1982 reform which allowed the entrance of new banks, with a maximum number of 10% of the existing ones per year, did not have much -impact. Only one new institution (the Trade Development Bank) established

3 6 on net terms in Uruguay , even if more applications were received-and rejected- by the authorities. Quite obviously, the depression did not make the Uruguayan market a particularly attractive one to establish in.

C. Savings

Financial deregulation, according to McKinnon, should increase savings as more attractive returns are offered to postpone present consumption, and a wider variety of financial instruments emerge3 7 . However, not only capi- tal markets deregulation had an influence on savings during the post-reform pe- riod in Uruguay. At least two other issues could have affected savings:

(i) The perception of a higher wealth when asset prices (agricultural land,

real estate) increased, which should have induced agents to spend more out

of a given income, to the extent that they behaved according to the life-

3 60ther few cases in which one bank bought another also existed.

3 7 The increase in deposits as interest rates increase to more attractive levels is bigger than the effect on net savings, because of portfolio substitution ef- fects from other assets in which people hold wealth. TABLE 6: SAVINGS (Millions of New Uruguayan Pesos and % of GDP)

Year Total* % GDP Public** Private (% GDP) (% GDP)

1970 57 9.39 2.07 7.32 1971 79 10.94 -2.33 13.27 1972 141 11.35 6.75 4.60 1973 348 13.59 3.48 10.11 1974 373 13.59 3.48 10.11 1975 661 8.09 2.15 5.94 1976 1.538 12.17 5.09 7.08 1977 2.157 10.83 7.12 3.71 1978 3.766 12.18 8.20 3.98 1979 6.997 12.14 7.09 5.05 1980 9.998 10.84 5.93 4.91 1981 13.278 10.84 -0.15 10.99 1982 12.202 9.48 -3.29 12.77 1983 14.707 7.80 -1.82 9.62

1984 19.754 6.68 -1.45 - 8.13

Averages of Period

Period Total (% GDP)

1951-55 14.20 1956-60 11.00 1961-65 12.10 1966-70 11.20 1971-73 11.96 1974-78 10..30 1979-82 10.83 1983-84 7.24

Source: Central Bank of Uruguay

* Gross National Savings. ** Includes only general government. 48

cycle hypothesis.

(ii) The appreciation of the real exchange rate, which prompted substitution in

consumption towards tradeables. If people believe that this appreciation

is temporary (as it seeraed during 1981-82) the price of tradeables today

becomes cheap compared to its expected level tomorrow, leading to a strong

increase in spending on tradeable goods, particularly durables3 8 .

If one looks at the evidence on savings rates presented in Table 6

they actually declined in the post-reform period; measured as a proportion of

GDP, savings were on average 12.1% in the period 1951-73, 10.3% in 1974-78 and

10.1% in 1979-83. But the predictions of the theory apply to private savings, whose decline in the post-reform period is even more drammatic than that of to- tal savings (especially fo.r the years 1.975-80). Private savings recover only in the post-1981 period, when the public sector continuously dissaves as a result of higher interest payments on debt, lower tax revenues and the social security reform.

It is desirable to separate the effects of the reform from other in- fluences, as De Melo and Tybout (1985) have done. Their most important findings are that the real interest rate is not significant in explaining private 3 9 savings while the real exchange rate plays a protagonical role in it. The

3 8This effect was clearly at work in the Chilean case, as Dornbusch (1984) has argued. However, part of the spending on durable goods is an investment for fu- ture consumption and thus- it can not be considered, in a economic terms, a de- crease in sayings.

3 9Although this may be due .to the fact that they use ex-post rates instead of the theoretically correct ex-ante rates. Of course, the difficulty with ex-ante rates is how to measure them. 49

latter variable's influence goes according to the conceptual arguments

discussed; a real exchange rate apreciation increases spending on tradeables' and

exerts a negative effect on savings. Finally, they find evidence supporting the

view that the reform itself induced a positive shift in the savings function af- ter 197440.

D. Investment

Two types of issues will be analized with respect to investment.

First, whether investment rates actually increased and second, whether the pro-

ductivity of investment improved as a consequence of the reforms.

D.1. Investment Rates

Casual observation of the figures in Table 7 shows that the experien-

ce regarding investment rates proved more successful than that with respect to

savings. Measured as a proportion of GDP, investment was 12% in the period

1956-74, 15.1% in 1975-78 and 14.7% in 1979-83, even if this rate was steadily

declining after 1980. The upward surge was importantly influenced by public in-

vestment, which more than. quadrupled between 1974 and 1978 as two big hydroelec-

tric projects, the Salto Grande and Palmar dams, were carried through. The

question to ask, is whether this improvement could be attributed to the libera-

lization of capital markets which -according to the financial repression view-

4 0 This evidence was provided by a positive and significant dummy variable intro- duced for the period 1974-83., in a regression having private savings as the de- pendent variable. TABLE 7: INVESTMENT (Millions of New Uruguayan Pesos and % of GDP)

Year Total* % GDP Public Private (% GDP) (%'GDP)

1970 69 11.26 2.86 8.40 1971 91 12.60 3.49 9.11 1972 147 11.84 2.74 9.10 1973 322 12.57 2.64 9.93 1974 525 11.55 2.91 8.64 1975 1.102 13.49 3.45 10.04 1976 1.871 14.80 6.20 8.60 1977 3.028 15.20 6.99 8.21 1978 4.951 15.89 7.92 7.91 1979 9.975 18.52 7.43 11.09 1980 15.994 18.67 5.93 12.74 1981 18.802 15.36 4.93 10.43 1982 18.555 14.42 6.87 7.55 1983 20.785 11.03 4.44 6.59 1984 25.673 8.69 2.81 5.88

Averages of Period

Period Total (% GDP)

1951-55 12.50 1956-60 12.30 1961-65 11.10 1966-70 10.20 1971-73 12.33 1974-78 14.19 1979-82 16.74 1983-84 9.86

Source: Country Economic Memorandum. The World Bank, various years.

* Includes variation in stocks and fixed investment. 50

had investment savings-constrained in the pre-reform period, or whether it was

due to other factors. In particular, Harberger and Wisecarver (1977) reported

that the after tax return on investment was between 6 and 7 percent for the pri- vate sector during 1968-73. This was apparently due to heavy taxation of pro-

fits, which was lowered after 1974. Thus, low investment rates may have

responded more to unattractive returns rather than to a savings constraint.

De Melo and Tybout (1985) have studied this issue and concluded that

financial repression was not an important determinant of the increase in invest-

ment in the post 1974 period. Rather, they report that standard accelerator ef-

fects were at work throughout the 1962-83 sample period, suggesting that

savings constraints were not significant. Investment was found to be responsive

to interest rates in the usual negative way, although the effect is rather weak;

also, an appreciation of the real exchange rate stimulated investment by making

imported investment goods cheaper. However, their conclusions have to be taken

cautiously since they are based on strictly ad-hoc regression. equations where

the treatment of expectations -a crucial issue in explaining investment- is

highly rudimentary. Overall, it appears that the rationalization and decrease

of profits taxes as well as the elimination of quotas on imports of capital

goods and the real exchange rate appreciation were of greater significance in

explaining the shifts in investment in the post-reform period than the liberali-

zation of financial markets. 51

D.2. The efficiency of investment

When credit is rationed by quantity, the pressumption is that its allocation among borrowers will be less efficient than what*would result if it is rationed by price. In the pre-reform period, interest rate ceilings preclu- ded the use of the price mechanism to allocate funds. What evidence do we find in favor of higher productivity of capital after the reforms? A rough measure of investment efficiency, the output-capital ratio, increased by 40% after 1974,' although this can also be accounted for by an increased utilization of capacity

and the relaxation of restrictions for imports of capital goods.

Thus, an upward movement in the output to capital ratio is not con-

clusive evidence of an improvement in the efficiency of investment.

A more formal test of this issue was done by De Melo and Tybout (1985). Their working hypothesis was that when interest ceiling existed, banks could not discriminate towards small firms, which presented both higher transac- tions costs per peso and a more uncertain pattern of earnings, by charging hig- her interest rates. Thus,, banks may have instead pressed these firms to alter their balance sheet by taking some "safety" measures (i.e., holding more liquid assets and reducing their leverage). They found that "...with financial libera- lization, small firms increased their leverage and reduced their liquidity so- mewhat relative to large firms, and they payed a larger premium to do so" 4.1.

4 1 De Melo and Tybout (1985), p. 30. 52

These results suggest the existence of some efficiency effects of the reforms, although they do not seem to be of great significance.

One further issue arises from the segmentation of capital markets and the different financial costs that faced various agents. In effect, small and less well connected borrowers faced spreads which exceeded those of preferential borrowers by anywhere from 10 to 30 annual percentage points, after interest ra- te ceilings were removed. This gap appears to be greater than what could be ex- plained by differences in borrowers' risk and higher administrative costs of credit for smaller borrowers.

With respect to the currency distribution of credit, dollar loans be- came more important after 1979 not because banks were financing more projects in the tradedble sector, but rather because the'y wanted their customers to-bear the exchange risk. This policy backfired on banks, since after the devaluations borrowers' positions deteriorated markedly, especially those operating in the nontradeable sector. Consequently, the value of banks assets sharply decreased.

Another weakness of the financial sector, on efficiency grounds. was the apparent. inexistence of long term credit in private banks. By the end of

1979 roughly 98% of all private bank credit was under one year of maturity, and most of it was under six months. This is a strong obstacle for long run in- vestment projects because, even if credits are finally extended at maturity, the costs of rolling over and the inherent uncertainty remain. 53

E. The Effectiveness of Monetary Policy

The effectiveness of monetary policy, i.e. its potential to affect real variables, has been threatened both in closed economies and in cases where

4 2 only the current account is open . When capital mobility exists, the competi- tion of other monies further weakens the potential of monetary policy.

The phenomenum known as currency substitution (OS) occurs when the demand for foreign currency rises above the levels required by international trade and tourism. When dollar deposits are allowed in the national banking system and capital flows become virtually unrestricted -as in Uruguay- the subs- titution between domestic and foreign money increases. Thus, the easier resi- dents could switch between currencies, the more efficiently they can attain their desired menu,of assets and, if inflation becomes a threaten, the easier they can avoid the tax on their money holdings.

The Uruguayan authorities realized the ineffectiveness of their mone- tary policy when- in late 1978 they pursued an open market operation, whose ef- fects on the supply of domestic money were completely offset by capital flows.

This prompted a major revision in the exchange rate policy.

CS goes together with monetary instability, particularly in periods when exchange rate expectations fluctuate widely. Ramirez-Rojas (1985) has stu- died this issue for Uruguay and has found econometric evidence suggesting that

4 2 1n a full employment model of a small country with no capital mobility, Dorn- busch (1974) shows that expansionary monetary policy has no long run effects ot- her than the loss of reserves. 54

CS was quite important in Uruguay for the postreform period. The test is done by regressing the ratio of domestic to foreign money on its own lag and the ex- pected rate of depreciation of the exchange rate (through some proxy); the coef- ficient of the latter variable turns out to be clearly significant. Thus, currency substitution should have been an important consideration in the design of monetary policy in Uruguay, at least during the period 1974-82. 55

V. CONCLUSIONS

While the final outcome of the post-1974 Uruguayan experience was a deep crisis in the early eighties, it is precipitate to blame financial libera- lization for the sole responsibility of the crash. External conditions worsened for Uruguay in the early eighties: terms of trade deteriorated following the se- cond oil shock, and then again and more sharply in 1983 and 198443; real interest rates rose in international markets at a time when Uruguay had significant fo- reign liabilities, and external credits all but stopped; finally, the highly in- flueatial Argentinian demand decreased sharply following the set of devaluations in that country.

External developments are of course not all the story; a faulty com- bination of policies was also important in explaining the results. When unres- tricted capital mobility was put together with a currency rate that was becoming increasingly overvalued, capital started flowing quickly out of the country. As expectations of devaluation increased, the spread between peso and dollar inte- rest rates widened. Since the currency adjustment was slow to come,* the overva- luation provoked a strong burden on borrowers with peso denominated liabilities.

When devaluation finally came it had to be sharper than if effected at the begi- ning of the capital flight period, and it severely punished dollar borrowers.

The picture was then complete, with all debtors in a precariously weak position

(or directly bankrupt) which threatened the collapse of the financial 'system.

43 Almost a 10% drop of the terms of trade in each year. 56

Moreover, a good part of the subsequent increase in credit to the private sector was due to not-fully-voluntary rollovers, which mainly attempted to postsone (or avoid if possible) capital losses. Why did not agents sell assets to pay-off their debts, and thus avoid the exaggerated interest rates? Perhaps because they thought the high real rates were temporary or, if permanent, the government would somehow rescue them. Thus when the option of selling assets in a deeply depressed economy was evaluated, the decision was to continue building up liab'i- lities.

Overall, the main conclusions coming out of the Uruguayan financial liberalization experience are:

(i) GDP growht remarkably improved over the period 1974-80, in spite of the

two adverse oil shocks of the period. This development has to be credi-

ted to the whole reform package, even if financial liberalization was the

most important part of it.

(ii) Financial deepening at the macro level did occur after the liberalization

reforms, even if it was geared from the outset towards foreign assets.

Part of this pattern was accounted by the absence of attractive indexed

assets, which rendered the dollar as the main hedge against inflation for

domestic residents. Another part of it is explained by a surge in dollar

deposits from nonresidents.

(iii) To the extent that the inflow of capital into the financial system was

largely speculative -as it appeared during the second phase- the macroe-

conomic situation was rendered highly unstable. At any rate, the increa- 57

sed availability of funds was able to reach the private sector, as long

as the fiscal deficit was shrinking. However, the expansion of private

credit in the post-1982 period has to be regarded cautiosly, since a por-

tion of it reflected distress borrowing.

(iv) Financial development did not occur in terms of expanding the financing

opportunities of firms. Neither bonds nor stocks were ever used by en-

terprises to raise funds directly from the private sector. The stock

market never developed.

(v) Private financial markets failed to create long term credit to finance

investment projects, which is a serius shortcoming for a development pro-

cess. Most loans were given short-term, even if substantial rollovers

occurred at maturity.

(vi) After binding ceilings were removed, real interest rates climbed to very

high real leves. This was partially explained during 1978-80 by the in-

crease in demand for credit fueled by the capital gains achieved on real

assets (mainly real estate and agricultural land). In 1981-82 high peso

rates were accounted by increasing distrust in the sustainability of the

exchange rate policy. After 1982 demand for credit was influenced by

distress borrowing, the rollover of debts to avoid bankruptcy.

(vii) Interest rates, after -the removal of binding ceilings, climbed to very

high real levels, partly because the spread between peso and dollar rates 58

be the was very high; a rather successful way of decreasing this gap may supporting an sale of exchange rate guarantees as long as these are not

4 4 rates are overvalued curreacy . The other side of high real interest are certainly the big spreads between lending and borrowing rates. These competitive condi- influenced by legal reserve requirements, but also by shows. Since tions in financial markets, as the Uruguayan experience a case could be made entry to the banking industry is always restricted,

for government supervision against oligopolistic behavior.

more influenced by wealth (viii) The poor performance of savings was probably than by financial li- effects and the exchange rate overvaluation rather present low responsiveness to the beralization per-se. Private savings

real interest rate.

the removal of res- (ix) A similar situation occurs with capital formation; lowering of the profits tax trictions on imports of capital goods and the of the investment surge. Fi- appear to be the most important determinants in improving the producti- nancial liberalization seemed more successful public sector had an vity of investment. On the other hand, the investment surge; private in- important participation in the post-1976

vestment only picked up between 1979 and 1981.

equilibrium value of the ex- 4 4 Even if it is difficult to determine the exact real exchange rates, like giraf- change rate, "...grossly over-or urder-valued (Diaz Alejandro (1985), p. fes, are not so difficult to recognize on sight". 21). 59

(x) The ability to pursue an independent monetary policy is significantly lo- wered in environments with virtually no restrictions on capital flows,

where currency substitution increases to very high levels.

(xi) Overall, perhaps the clearest message of the Uruguayan experience is that financial liberalization can not produce its intended benefits, unless coupled with a coherent set of macro policies. Special attention has to be put on avoiding too low exchange rates when capital flows are unres- tricted. 60

REFERENCES

Barandiaran, E. (1978) "Las Tasas de Interes en Uruguay". Mimeo, October.

Barandiaran, E. (1986) "Financial Liberalization in Developing Countries: An Analytical Framework". Mimeo, The World Bank.

Daly, H. (1969) "The Pathological Development of the Uruguayan Financial System". Economic Development and Cultural Change. October. pp. 91-96.

De Melo, J. (1985) "Financial Reforms, Stabilization and Growth Under High Capi- tal Mobility: Uruguay 1974-83". Mimeo, The World Bank. .

De Melo, J. and J. Tybout (1985) "The Effects of Financial Liberalization on Savings and Investment in Uruguay". Discussion Paper N*DRD129, The World Bank.

De Melo,. J., R. Pascale and J. Tybout (1985) "Microeconomic Adjustments in Uru- guay during 1973-81: The Interplay of Real and Financial Shocks".. World Development, August, pp. 995-1015.

Diaz, Alejandro, C. (1985). "Good-bye Financial Repression, Hello Financial Crash". Journal of Development Economics, pp. 1-24. Rate Dornbusch, R. (1974) "Real and Monetary Aspects of the Effects of Exchange Changes' in R.Z. Aliber (ed.) National Monetary Policies and the International World Financial System, University of Chi- cago Press.

Exchange Dornbusch, R. (1985) "External Debt, Budget Deficits and Disequilibrium Rates". In G. Smith and J. Cuddington (eds.)". Internatio- nal Debt and the Developing Countries. The World Bank. Capital Ac- Edwards, S. (1984) "The Order of Liberalization of the Current and counts of the Balance of Payments". Essays in International Finance N*156, Princeton University.

K. Brunner and Frenkel, J. (1982) "The Order of Economic Liberalization". In A. Meltzer (eds.) Economic Policy in a World of Change, North-Holland. Journal of Friedman, M. (1969). "Controls on Intere'st Rates Paid by Banks". Money, Credit and Banking, February, pp. 13-32.

Liberalization Hanson, J. and J. de Melo (1983) "The Uruguayan Experience with and Stabilization: 1974-81". Journal of Interamerican Studies and World Affairs, November, pp. 477-508. 61

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Harberger, A. (1975) "El Rol de los Factores Fiscales en la Inflaci6n Uruguaya". Cuadernos de Economia, December, pp. 33-45.

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McKinnon, R. (1979) "Represi6n Tinanciera y el Problema de la Liberalizaci6n dentro de los Paises menos Desarrollados". Cuadernos de Eco- nomia, April, pp. 3-22.

McKinnon, R. (1982) "The Order of Economic Liberalization: Lessons from Chile and Argentina" in K. Brunner and A. Meltzer (eds.) Economic Policy in a World of Change, North-Holland.

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Ramos, J. (1984) Estabilizaci6n y Liberalizaci6n Econ6mica en el Cono Sur. E.C.L.A.

Shaw, E (1973) Financial Deepening in Economic Development. Oxford University Press.

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Tybout, J. (1985) "A Firm Level Chronicle of Financial Crises in the Southern Cone". Mimeo, The World Bank,.April. 긔 TABLE 8. BASIC MACROECONOMIC INDICATORS

0 (2) -3 (4) (5) GDP Growth Per capita Inflation Terms of Trade2/ Real exchange rate3/ GDP growth 1/ Index % L.Index % 1980=100 Change 1980=100 Change

1973 -2.1 -3,1 77-5 134.1 -13.2 1974 3.1 1.8 107.2 144.9 114-3 -14.8 1975 5.9 5-1 66.8 106-5 -26.5 134-5 17-7 1976 4.0 3.3 39.9 108.1 1-5 144-3 7-3 1977 1.2 0.8 57.2 97.8 -9.5 142.1 -1,5 1978 5-3 4.8 46.o 101.9 4.2 139.4 -1.9 1979 6.2 5.5 83-1 103.6 1-7 121.9 -12.6 1980 6.o 5.3 42.8 100.0 -3.5 100.0 -18.0 1981 1.9 1.2 29.4 103.2 3.2 101-3 1-3 1982 -9.7 -10.4 20.5 103.3 0.2 122.9 21-3 1983 -4-7 -5.3 51.5 93.3 -9.7 230.2 87.3 1984 -1,8 -2,5 66.1 84.7 .-9.2 1985

Sources: (1) and (4) E-C-L-Ae (2) IFS, (several years) (5) Hanson and De Melo (1985). (3) IFS "Supplement on Price Statistics"

Notes: 1/ Inflation is computed as December to December variation in the CPI. Terms of trade of goods and services. Real exchange rate is computed as the nominal exchange rate corrected by the difference between world inflation (WPI USA) and domestic inflation (CPI Uruguay)* TABLE 9. BALANCE OF PAYMENTS - (Millions of U§§T

1972 1973 1974 1975 1976 1977 1978 1979 190 1981 19 1983 1984.

1. Current Account 7 18 -154 -198 -82 -172 -133 -363. -716 -468 -235 -60 -124

1.1 Trade Balance 31 43 -111 -125 -9 -106 -57 -309 -618 -397 -48 217 227

- Exports 311 410 468 551 696 809 913 1.194 1.526 1.701 1.537 1.411 1.289 Goods 242 328 381 385 565 612 686 788 1.059 1.230 1.256 1.156 925 (Traditional) 240.4 237.4 194.4 259.3 263.2 248.6 222.7 416 519.2 534.7 519.7 339 (No-tradit.) 87.6 143.6 190.6 305.7 348.8 437.4 565.3 643 710.8 721.3 636.3 586 Real Services 69 82 86 166 131 197 227 406 468 471 281 255 365

- Imports 280 367 579 676 705 914 970 1.504 2.144 2.098 1.586 1.194 1.062 Goods 179 249 437 494 537 687 710 1.166 1.668 1.592 1.038 740 733 RealServices 101 118 142 182 168 228 260 337 476 506 547 455 329

1.2 Factor Services -24 -25 -43 -71 -72 -68 -77 -55 -10) -74 -197 -28f -362 11 10 1.3 Unilateral transfers - - - -2 -1 2 1 2 2 3 10

2. Capital Account 6 9 102 136 156 351 262 454 811 494 -182 -10 37

2.1 Long Ten Capital, 27 16 50 135 78 19 152 359 404 346 468 647 30

- Direct investment - - - - - 66 129 216 286 49 -14 6 3 - Portfolio Investment -6 34 31 110 33 21 -9 -31 -7 3 -7 -16 -7 - Debt 33 -18 19 25 45 14 32 174 122 294 424 657 20 (Public Sector) 8 5 - 38 154 108 246 419 336 46 (Commercial Barks) -5 4 - -2 -3 5 -3 -5 34 -1 (Others - private) 22 36 14 -4 23 9 51 75 287 -25

2.2 Short.-tenncapital 19 5 126 30 83 203 -54 94 311 326 511 -335 158 - - Public sector - - - 19 9 16 -9 9 -23 -5 90 -2 -67 67 - Commercial bas - - - 26 -36 74 -39 128 307 87 239 -Others - private - - - -15 110 113 -7 -42 26 243 189 -333 43

2.3 Of icial Unilateral transfers 12 .19 22 8 9 5 6 6 7 7 - - - -322 -151 2.4 Errors and Omisssions -60 -31 -96 -38 -13 42 159 -5 90 -185 -1.161 -70 -87 3. Overall balance 13 27 -52 -62 73 179 129 91 95 26 -417

Source: E.C.L.A. TABLE 10. SOCIAL SECURITY

Surplus (+) or Revenues Expenditures ) Deficit (-) GDP GDP GDP

1973-1976 8.2 8.7 -0.5 1977-1979 8.3 8.4 -0.1

1980 6.7 8.8 -2.1

1981 6.2 11.0 -4.8

1982 7.4 13.2 -5.8

1983 7.0 11.4 -4.4

Source: E.C.L.A. TABLE 11. EXTERNAL DEBT (Millions of Dollars)

Total Public Sector Privat6 Sector

1975 1.031 861 170 1976 1.135 962 173 1977 1.320 1.028 292 1978 1.240 910 330 1979 1.682 1.012 670 1980 2.155 1.182 974 1981 3.129 1.464 1.655 1982 4.255 2.705 1.520 1983 4.589 3.197 1.392 1984 4.593 3.165 1.427

Source: E.C.L.A.