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.