Politics, Business & Culture in the Americas

NO: Leaders Should Resist the Temptation to Meddle



Shielding countries from the free flow of capital and financial innovation will dampen economic and social development. Among other things, regulation tends to diminish the liquidity of local markets. For example, the comparatively less regulated equity markets in Mexico average a daily trading volume of around $500 million, compared to only $20 million in Argentina, where regulation is very strict. The lack of stock trading intensity implies that companies have less capacity to issue stocks, and hence are hindered from raising capital under more convenient terms.

Capital market liberalization in Brazil fueled 63 new initial public offerings (IPOs) during 2007, totaling some $30.4 billion. Thanks to financial liberalization, the average daily trading volume of the Bovespa (Brazil’s stock exchange) increased to $4 billion that year. Without such level of liquidity, there would have not been room for this flourishing of IPOs.

A more relevant concern is the perennial housing deficit plaguing the region, and the speed with which Latin American countries can address it. If governments overreact to the current market turmoil in a way that discourages financial innovation, there would be a deceleration in housing construction. The housing deficit cannot be addressed unless governments endorse widespread securitization of assets (e.g. the issuance of mortgage-backed securities) and support the continued growth of private-sector pension savings. Without private-sector pension funds, there will be no buyer of last resort for these securities.

The most important challenge to national leaders in forthcoming years is staying abreast of changes in the world financial markets. In fairness, this financial crisis, the most dramatic since the Great Depression, caught most people unaware. As Alan Greenspan argued to members of the U.S. Congress last year, this degree of crisis was a “one percent probability event.” And just as people have not stopped flying because of the one percent probability of a plane crash, people did not and should not have hedged massively against the one percent probability of a financial crash.

I have two strong convictions. First, the world financial structure will increasingly limit the capacity of the financial sector to generate high profits. Leverage will definitely be more constrained in the future. (Leverage relates to the number of times that an investor can increase the nominal size of a position based on a set amount of capital.) In my view, less leverage will mean lower salaries on Wall Street, and hence the brightest minds could decide to move on.

Second, investors and dealers will be less willing to participate in over-the-counter transactions. For example, there is no evolved “clearing house” for credit default swaps (CDSs) or for collateralized debt obligations (CDOs), just as there is for more traditional financial instruments such as bonds, options and futures. CDSs and CDOs are bilateral contracts, tailor-made for each case. Creating government-monitored clearinghouses for illiquid assets will diminish the interest of banks and investors to buy and sell these tailor-made structured products because contracts will likely standardize. This development will constrain the speed of financial innovation as well.

It’s important to underline that the credit default swap market does not yet exist in Latin America. The risk here is that these contracts may not be allowed to evolve in the region because of what happened in the United States. The problem is that credit default swaps today are what foreign-exchange-forward contracts were ten years ago. Currency forwards have allowed many corporations in Latin America to hedge their exposure to movements in world currencies. The capacity to hedge has been a positive social development because it reduces the volatility of the revenues of exporters. The lower the volatility of revenues, the lower the need for layoffs when the currency moves. In the future, credit default swaps will help Latin American corporations to contract debt at a lower spread. That development will also help boost employment.

The same goes for mortgage securitization. A lot of people will likely argue that the securitization of mortgages should be controlled or banned because of what happened in the U.S. If that happens, it will slow the market’s ability to deal with the region’s housing deficit. Also, the people that tend to argue that mortgage-backed securities should be outlawed tend to criticize private-pension funds, supporting the re-nationalization of those savings.

But this is bad reasoning. Such funds are the natural buyers of these mortgage-backed securities. In Colombia, since the creation of the fully funded pension system in the early 1990s, the value of pension savings has increased from zero to around $32 billion or 17 percent of GDP, in 2008. Some of those resources are invested in mortgage-backed securities and other securities supporting infrastructure investment projects. Most of the Colombian Peso $3.9 trillion ($1.7 billion) in mortgage-backed securities that have been issued by the Titularizadora Colombiana (Securitization of Colombia) have been bought by pension funds. In addition, $7 billion is invested in Colombian stocks, some of which invest and deal in housing projects. The fact that pension funds hold those stocks and all those securities implies that more employment has been created and that more houses have been built in the country. On top of that, the fact that Colombian pension funds hold around $10 billion in government debt (or about 25 percent of the total local debt portfolio) has allowed Colombia to invest more in housing and infrastructure and to have a working yield curve.

A liquid local interest rate curve (that permits investors to move money at ease) allows a government to finance itself at lower rates and permits productive investments (because, for example, the markets can estimate the risk of a corporate bond). That said, as the case of Argentina demonstrates, the efficient development of private-sector pension funds requires governments to provide room for financial professionals to diversify portfolios, and therefore hedge against violent downturns. Therefore, capital-market liberalization is also a key ingredient in the successful development of local capital markets.

The pro-regulation lobby will likely win this argument in both the developed world and in the developing world-—which is a shame. I hope at least that regulation will be tempered with caution. In the rush to respond to popular belief that the system has failed, we may suffocate innovation and kill the capacity of many of the region’s poor to finally overcome the poverty trap.

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Any opinions expressed in this piece do not necessarily reflect those of Americas Quarterly or its publishers.
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