Comments on the Brazilian financial system

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EPGE

Escola de Pós-Graduação em Economia

Centro de Estudos de

Reforma do Estado

IEX10 PARA DISCUSSÃO

TV" 002

COMMENTS _ON _THE _BRAZILIAN

FINANCIAL _SYSTEM

Rubens Penha Cysne Lauro Flávio Vieira de Faria

Julho de 1997

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Comments on the Brazilian Financial System ~ ,

Comments on the Brazilian Financial System

Rubens Penha Cysne" Lauro Flávio Vieira de Faria***

July 1997

Addresses for Contact: Rubens Penha Cysne

Escola de Pós Graduação em Economia da Fundação Getulio Vargas

Praia de Botafogo 190, 1 lo. andar, Sala 1124

Rio de Janeiro - RJ - Brasil Diretoria de Pesquisa

Telephone: +55-21-552-5099

Fax: +55-21-536-9409

e-mail:

rubens@fgv.br

Lauro Flávio Vieira de Faria IBRE / CECON

Fundação Getulio Vargas

Praia de Botafogo 190, 9o andar, Sala 923 Rio de Janeiro - RJ - Brasil

Telephone: +55-21-536-9299

Fax: +55-21-551-2799

e-mail:

laurof@fgv.br

Refom^tud^CenteT DÍre°t0r * ^ GetU'Í0 VargaS Foundation Graduate School of Economics and Director of its State

«nH^T F1.áV'° Vi®'ra de Fa"a 's Chief Editor of the magazine Conjuntura Econômica and former Superintendem of Economic Proje and Studies for the Secunties Exchange Commission (CVM).

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I - Macroeconomic Aspects of the Financial System

1.1 Introduction

The Brazilian financial system needs to move towards a _greater autonomy of a currency

controlling agency, more efficient bank supervision _(preventive) and self-determined by the

market, less instability in the rules of the _game, the existence of more technically defensible

deposits insurance mechanisms, increase in the _portion of credit allocated by market

mechanisms, reduction in the taxation and _{lower reserve requirements charged on deposits, a} public debt with greater facility for the monetary

policy (involving an extension of its _profile and less use of securities bound to short term interest), as well as a more active and less

concentrated capital market _{(whether in terms of stock or stock holders).}

As a basic condition for the Brazilian financial system to _perform its duties satisfactorily,

however, there is still an urgent need to adjust

public accounts, which have deteriorated substantially during 1995 and 1996. _{Without this, the Central Bank will continue to see itself} endogenously _obliged _to _continue _regulating

and operating to _provide the

government with cheaper funds.

1.2- Development Funding

An important item to be discussed is the _question of financing the overall national

infrastructure, bearing in mind the need to revive the development

process. Taking into consideration the relative

price of capital goods, it is found that between 1971 and 1982 the

gross formation of fixed capital in Brazil was equal to 21.6% of the GDP. Between 1983 and 1988 this figure dropped to 17.2% of the GDP. More recently, between 1989 and 1994, the

gross fixed capital formation was a scanty 14.8% of the GDP. In the three

periods,' the average GDP

growth rates were 6.4% between 1971 and 1982, 3.4% between 1983 and 1988 and 1.1% between 1989 and 1994, respectively. To again be in a _growth situation it is

necessary to have favorable expectations and a return to _{public saving.}

Government savings _(calculated on real interest) has been negative in recent

years, having dropped from 6.4% of the GDP between 1970 and 1974 to -1.9% of the GDP between 1990

and 1994. The drop of 8.3 _percent in the GDP has been continuous, bearing in mind the

figures of 5.3% between 1975 and 1979, 2.0% between 1980 and _{1984, and -1.2% of the GDP} between 1985 and 1989. It is interesting to see how the drop in _government savings during

the 1970s to the _{period of} 1990-1994 _{(from 6.0% to} -1.9%

of the GDP) is _{practically equal to} the drop in _gross capital formation for the same

period (from 21.6% to somewhere around 14.8% of the GDP).

In order to increase

government saving, the nearest control variables are _{privatization}

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The average _{profitability} of the central _government as a major stockholder in state-owned

companies was only 0.4% over the invested capital between 1988 and 1994. By the end of

1994, the central _{government held R$} _{88 billion of capital in stock in state-owned companies.} The sale of such stock with a respective repurchase of the debt, working with an interest rate of 15%

per year, would produce an annual net savings of 2.0% of the GDP. Not to mention

privatizations by the states and revenue from concession auctions. Moreover, these

calculations do not include the higher tax collection from the increase in

productivity and profíts of privatized companies. This increase in

productivity is evident when compared with the _productivity on the _governmenfs risk capital of 0.4% a

year and the 500 largest companies, which between 1988 and 1994

gave an average profitability on net equity of 7.6% a _year.

Another more _politically complicated form of increasing

public savings, but with great impact, is by reforming the social security. _{In this sense, the reform should be at least}

partly ruled by the capitalization mechanism. The federal

governmenfs expenditure with the National Social Security Institute _(INSS) and the central _governmenfs inactive assets rose

from 4% in 1989 to 7.8% of the GDP in 1995, largely due to the increases in benefits

stipulated by the 1988 Constitution.

The social security reform is important not only because it will _permit the recovery of

government savings, after the difficult transition stage from the old to new system _(which

may be mitigated by instituting a mixed system), but also by encouraging _private savings.

Chile successfully increased its savings rate from 13.8% of the GDP in 1987, when the social security reform was implemented, to 21.2% in 1994.

It is also worth mentioning the

positive effects of these reforms (social security and equity) in the sense of reducing the _public debt risks and its financing costs. In _particular, it is also

found that the National Treasury, _{Consolidated to the Central Bank, has incurred losses as a} result of the accumulation of approximately R$ 60 billion reserves in Central Bank assets,

reducing

public savings. Such reserves are funded by liabilities which _yield a variation of

about 11% a _{year over the} dollar. On the international market, the reserves are invested at

rates of 6.5% a _year, costing the Central Bank something around 4.5% a _year to maintain

them. _{This is an annual cost of R$ 2.7 billion.} _The

government regards this cost, which was higher in 1995, as an insurance

premium for the Real Plan. A _premium which may also be reduced after the macroeconomic fundamentais of the Real Plan are on the _{proper course.}

In every case mentioned here, it is clear that

private sector savings would also be affected pari passu with the rises in _government savings, and it may not be so simple to assume an equal

increase in domestic savings. Yet examples for a _group of 50 countries show that the

exclusive net effect of an increase in

public savings on domestic savings would be clearly

positive, probably producing increases in domestic savings of at least 50% of the increases in public savings.

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II - Performance in Saving Rates

Before trying to assess the Brazilian savings for each sector, we must bear in mind a

problem concerning the form of calculating the national accounts in Brazil by the IBGE Foundation,

which uses only nominal interest accounting, in detriment to a more suitable

procedure, which would be to evaluate the different macroeconomic aggregates belonging to the national

accounts also on a real interest basis. When attempting to assess the contribution of each

sector _(family and corporate, _government and international) in Brazil to form savings, we

reach, as a result of the normally high inflation and consequent restatement on the

public debt, overestimated

private sector gross savings and underestimated government savings. This fact is clearly shown in the following

graph which shows the performance of these two variables over the _years. _{A clear broadening of the skew trend between those two different series when} inflation increases in the last _years of the _{period under} study, basically due to using nominal

interest in calculating the division of income between each of these sectors. In the last _years

of the series it is seen that the increase in _{private savings} is absorbed by reduced _government savings..

GRAPH II.l

Performance in Time of Private and Government Savings

0.5 Govt. Savings/GDP # 0,4 • ¦ "Private Savings/GDP , * • * 0.3 * * * ' _\ ' I » 0.2 \m _\ 0.1 • . _,0.' •r-" ^r\ 19471949195119531955195719591961196319651967196919711973197519771979198119831985198719B919911993 Years

The data relating to the division of savings for Brazil between the different

private, government and international sectors, calculated at nominal interest, is _{given below:}

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Comments on the Brazilian Financial System _{Rubens Penha Cysne} Lauro Flávio Vieira de Faria

TABLE II.l

Average Saving Rates in Brazil as % of the GDP

1947-49 3,80% 8,70% 12,50% 0,73% 13,23% 1950-59 2,78% 12,37% 15,15% 0,78% 15,93% 1960-69 1,24% 16,05% 17,29% 0,54% 17,83% 1970-79 4,43% 14,75% 19,18% 3 49% 1980-89 -5,65% 24,57% 18,92% 2,03% 20 95% 1990-94 -4.78% 0% 20.22% 1947-94 £L32%_ JL2S& 17.58% L47%_ _m

• ' VJV-IU..U icugíu 1 uuiiuauuii _{VIVJ viyu,} Historical Statistics of Brazil, Vol. 3, IBGE, 1986; Aries Project - FGV.

As a complement to

graph H.1, a drop of 9 percent of the GDP is clearly seen in table II.2 1.2 under _{government savings from the} _{1970s to}

1980s, when inflation rose steadily as the

private sector _{gross savings rose during the same}

period.

Assuming an absence of a monetary illusion, the _government's contribution to forming the

country's total savings would be much better measured in real interest accounting. For

theoretical considerations in this respect, see, among others, Simonsen & Cysne (1989 or

1995).

The

problem of using nominal or real interest can be overcome in table D. 1 if we stay with domestic savings, which corresponds to the sum of

government savings with the private sector gross savings. It is found that domestic savings increased in the 1950s, 1960s and 1970s,

when it then _{reached the rate of 19.2% of the GDP.}

In the eighties domestic savings dropped to 18.9% of the GDP, _presenting, nevertheless, a slight recovery in the first four

years of the nineties, when it reached 20.2% of the GDP.

International savings as a

percentage of the GDP rose slightly in the fifties in relation to the last three

years of the forties, dropped in the sixties and then rose substantially in the seventies when it was 3.5% of the GDP. This trend was reversed in the next two decades, when

international savings dropped back to 2.0% of the GDP in the eighties and was _practically

zero in the first four

years of the nineties. 1995 features another backward trend with international savings of 3.5% of the GDP.

Moving on to total savings, a _persistent increase is seen in the averages in each decade until

the end of the seventies, when it was 22.7% of the GDP. Since the eighties, however, Brazil*s total savings showed a downward trend which continued into the first

years of the nineties. This was due to the fact that the due and necessary increase in domestic _{savings did not offset} the drop in international savings.

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III- Performance of the Brazilian Financial System

At least five basic tasks must be expected of the financial system in any economy. Two of

them are attributed to the monetary financial system, formed by the Central Bank and

commercial banks which receive demand deposits. These are the settlement functions and the management function of the money supply. The other three tasks are attributed to the

financial system as a whole, and so the efficient intermediation of resources between the

economic agents is included, facilitating allocative and _productive efficiency, _protection

against risk and cut in costs in the event of mergers and market takeovers, which increase

corporate administrative efficiency.

It is known _(King & Levine, 1993b) that higher degrees of financial intermediation are

normally

positively associated with the rise in productivity. The

problem is that the Brazilian financial system has cost annually somewhere around 13.9% of the GDP _(average for

1990-1994, while in 1995 there was a drop to 8.3% of the GDP, IBGE data),

quite a high figure when compared to those of such _{stable economies as the United States and Germany, where} this cost does not normally exceed 5% of the GDP. It is worth seeing if this high cost has

been

paid for through the efficient performance of the five aforementioned tasks.

With _{the exception of the settlement task, very well}

performed in Brazil, bearing in mind the strong market stimuli in this sense when inflation was high, the answer to the four other

requisites is not very

positive. Let us start with the question of money stability.

In this

particular item, our performance has always been _poorwith regard to inflation rates and money spread in Brazil. _{The fact that Brazil, since the 1950s, shows an average welfare cost} of inflation of 3.1% of the GDP _(Simonsen & Cysne, 1994) and an inflationary transfer of

4.2% from the non-banking sector to the banking sector of the economy leaves no room for

doubt: the institutional design _{of the Central Bank since its creation has not been successful,} needs to be modified and the institution

given greater autonomy.

It is found

particularly that only 2.2% _{of the aforementioned 4.2% of the GDP refers to} inflationary taxation, the rest _going to the commercial banks. In other words,

historically, the _{Central Bank inflicted on the country a cost of 3.1% to collect 2.2% of} the GDP.

The current institutional design is eventually detrimental to the whole financial system. In its non-monetary

part, as savings intermediator, because it favors the federal

government as déficit agent and _{prevents competitive efficient allocation of resources.}

Examples of this kind are the compulsory demands created by

public liabilities or assets in the

government's power. And in its monetary _part, as manager of the money supply, because it _proves to be too

vulnerable to

political pressures, and eventually relegates to a second _plane what should be its

principal objective, that of fighting for the value of the currency. The historical collection of inflationary tax is _proofof this second deviation.

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It is also clear that the central bank to which

you need to give autonomy is not the Brazilian kind, which has too many attributes, but is rather the classic type, restricted to its functions as the banker of the _government _(not exclusive) and of the banks, depository of BraziFs

international reserves and which manages the money supply.

Let us now move on to the financial system's third task, that of intermediating savings for

investments. _{In this sense, the negative assessment begins when observing the following} fact: between 1971 and 1982, BraziFs

gross formation of fixed capital was equal to 21.6% of the GDP; between 1989 and 1994, this dropped to 14.8% of the GDP, a drop of seven

percent. Something, therefore, is fundamentally wrong with the Brazilian economy in the

past few years. Would the origin of this ailment be in our financial system,

precisely in so well remunerated a sector, with a high concentration of human capital? No, not the origin but

rather the instrument. The troubles obviously originate in the increase in _government

spending not destined for capital formation. On this basis, the financial system becomes a

vehicle operated in order to reduce the cost of covering the

public déficit, bearing in mind its low financing capacity by the market.

This

point is evident when it is seen that, in a _period equal to that which we have _just

mentioned above, _government savings showed the same drop, that is seven _percent of the

GDP. Government savings _(calculated at real interest) was around 5.0% of the GDP in the

1970s, having fallen to somewhere around -2.0% of the GDP between 1990 and 1994. In

other words, the drop in _gross capital formation is easily explained by the increase in excess consumer spending, subsidies, interest _{payment and} social _{security transfers over the total tax} revenue.

The rules which _guide the Brazilian financial system's operation have usually been made

taking as the ultimate

guiding element an offset to the _problem of imbalance in

public accounts. This

problem can arise in any other country, but it is endogenous and

particularly accentuated in Brazil for two reasons;

i. the _{lack of limits in re-issuing Temporary Measures, which}

has made this legal instrument

potentially more detrimental than the Decree Law _{(the latter was approved by lapse of time}

while the former was re-issued by lapse of time);

ii. _{the Central Bank's reduced autonomy, causing this institution}

to usually be led to legislate and operate and obtaining resources for the _{government as a background.}

The Brazilian financial system also leaves a lot to be desired with regard to the functions of

risk reduction and as facilitator of stock control transfers in order to increase efficiency. In the risk reduction function, because of its little institutional credibility due to the frequent changes in the rules of the

game, even having suffered an assets freeze in 1990. Lastly, the concentration and small volume of the Brazilian market _placesus _{quite far from markets such} as the American, which facilitates takeovers on a much more frequent basis.

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IV - State and Federal Bank Reforms

There are several theoretical arguments to explain why _public companies tend to be more

inefficient that

private companies. The absence of any bankruptcy risk would hinder an administrative takeover by a more competent team. Greater

job stability would reduce the employees' efforts which can be monitored indirectly. Moreover, the lack of administrative

flexibility would lead to a slower

pace in the buying and selling operations, implying larger stocks, hence higher costs, in addition to _{grasping less market opportunities.}

As theoretical arguments may always be _queried, _{albeit sometimes without much deference to} common sense, it is worth

giving some empirical examples in the case of the _{public financial} sector.

According to Andima & IBGE _(1997), in 1995 the size of the _public financial institutions

measured by the share in the GDP, was 3.20%, and of the _private 3.59%, that is, the

public representing 47% and the

private institutions 53% of the total. _{It might then be expected that,} with the drop in inflation since July 1994, the financial _{marketability assistance to the official} and _private bank sector would follow the same trend. This, however, does not occur.

According to data _published in the Central Bank Bulletin of April 1997, between July 1994

and January 1997 the stock of financial marketability assistance to the official banks leaped

from R$ 4.2 billion to R$ 44.1 billion, while financial _{assistance to the}

private banking sector leaped from R$ 0.01 billion to R$ 27.0 billion.

In other words, the financial assistance

provided after the Real _(not to be confused with subsidy) was approximately R$ 40 billion for official banks and R$ 27 billion for the state

banks. Therefore, the official banking sector, which represents only 47% of the total added

value in the financial intermediation, was _{responsible for approximately 60% of the financial} assistance

provided by the Central Bank.

In a short

parenthesis, it is _{important to note that of such variations}

in the Central Bank asset accounts of R$ 40 billion and R$ 27 billion respectively, Central Bank non-performing fund

transfere to the banking system do not apply, but rather loans, capitalization and/or assets

exchange of the bank

portfolio for securities issued by the Central Bank. The

possible subsidies involved depend on the exchange conditions of the securities taken in relation to

their market values, a fact which we do not intend to discuss here.

Secondly, although, as we have seen, only 47% of the value added by the financial system

onginates in the

public sector, official IBGE figures for 1995 show that the _public financial institutions

are responsible for approximately 62.5% of ali wage earners' remuneration in the financial sector.

Such data is compatible with third

party evidence, obtained from studies carried out by Cysne & Soares _(1996), who show

personnel expenses in relation to the earned income of 46.0%, 69.6% and _{142.5%, for a sample of}

private, state-owned and federal banks respectively _{in the} first half of 1995.

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Certainly such differences are not explained

just by the differentiated sub-contracting practices.

In the specific cases of _public banks, however, the major _problem for Brazil does not lie in

microeconomic efficiency but rather in the threat to macroeconomic stability. State

governments, knowing that the Central Bank of Brazil cannot suddenly start operating as a

central bank that says no, use the state banks to tax the other states on a competitive basis

Just as in the case of the disputes over ICMS _(VAT) reduction, a lack of direction in

centralized coordination leads to a decrease in social _{security for the country as a whole.} The federal

government, on the other hand, does not act with the energy that the situation

demands,

given the imbalance of the federal banks. _{The challenge of such banks did not end} with the need to adapt to a less inflationary situation. From now on, there is the further

challenge of competing with international banks, which makes the outlook of the

public financial institutions even

gloomier.

The foregoing history of streamlining the state banks makes it clear that

political streamlining agreements are _generally not adopted when such institutions are under the control of the

states.

Both the Lending Support Program

(PAC), instituted by a vote of the National Monetary Council 233/83, of 07.20.83, specifically to solve _problems of the Rio de Janeiro, Ceará,

Santa Catarina, Goiás, Pará, Amazonas and Alagoas _{state banks, and the Financial Recovery} Program

(PROREF) of 1984, instituted by the CMN vote 446/84 of 04.04.84, are _{proof of}

this. Such _programs foresee not only adjustments in the state banks _(closing branches,

downsizing, _{reassessing the banks' asset operations,}

as well as changes in their capitalization by the state _{governments),} _to _offset _the _help

they would receive from the Central Bank, but als° _Penalties _(CMN vote 232/86, of 09.04.86) for those who would not achieve the agreed

goals. The results were by no means encouraging. Few of the state institutions which were

involved in either the PAC or PROREF showed significant improvement. Most continued

operating in _{a similar fashion to that which had caused}

their liquidity

problems. The agreed requirements to close down déficit branches and recovering

past due loans were simply not met. Since then, several other failed attempts by adjustment

programs are part of the historical evidence that the Central Bank does not have

political powers to enforce the agreements made with the states.

V - The Capital Market

V.l. General Aspects

The

poor performance of the capital market between 1972 and 1975 led its _participants and authorities to engage in a new round of reforms. _{The main measures adopted were as follows:} a) a new Corporation Law _(6404/76) imposed the standardization of financial statements,

stipulated more explicit disclosure rules, obliged the distribution of a minimum dividend and

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Commission

(CVM, Law 6385/76), a regulating body specifically focusing on the capital

market, ín order to restore the trust shaken with the 1971 crash. CVM aims explicitly to

regulate, oversee and encourage development of the securities market; and c) the increase in

compulsory resources through institutional investors. The

government make it obligatory to invest in stock and debentures of _{part of the technical}

reserves of the insurance companies and pension funds; created specialized subsidiaries, managed by BNDE, in _{order to subscribe the} pnvate sector s stock issues and

permitted international investment through investment companies regulated by Decree Law 1401/75.

The first

positive results of such measures appeared in mid-1983, when the market foresaw the end of the recessive cycle which had begun in 1981. _{The total business volume}

grew 103% in 1,13% 10 1985 and 36% in 1986' in real terms, again approaching the 10% mark of the

GDP which had not been achieved since 1971

(table V.l).

TABLE V.l

Volume of Business on the Stock Market _{(US$ million)}

198C 81 82 83 2.834 1-641 2.168 2.717 216 32 92 455 2.412 4.217 2.977 234 29 305 669 1.448 82 131 188 213 5.573 6.326 6.094 5.067 3 QHUI 3 2 84 85 5.556 12.660 1.220 1.945 3.443 407 304 272 81 nd 1.241 837 146 51 1.441 4.716 7.399 3.104 4.756 2.083 448 2.199 2.697 828 10.286 4 86 87 18.681 6.412 1.759 146 21.917 29.815 7 9 88 89 12.789 13.966 76 213 10.102 18.067 3 5 90 91 4.956 9.002 792 95 nd nd 17.114 5.581 4 1 92 18.122 UU nd 11.313 23.753 3 5 93 27.701 nd _mam 6.265 •nd _39.590 94 QS 59.677 19 nd - 17.669 O fYT A nd 87.864 u 17

Note: 1995 until July.

8.974 _nd _78.924

2?

Source: CVM Monthly Newsletter, various numbers.

There was also a return to _primary stock issues, which _{reached the record mark of US$ 1,198} million in 1986 _{(table V.2).} _The

primary debenture market rose sharply in 1981 and 1982 as a result of the scarcity of bank loans, but this rise was not sustained later since authorities

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TABLE V.2

Stock Issue _{(US$ million)}

¦R 81 157 133 290 42,8 07 82 224 245 469 38,7 1,2 83 92 157 249 34,3 0,7 84 140 390 530 46,1 1 ₂ 85 169 416 585 57,8 1^0 86 223 975 1198 60,7 2,0 87 165 225 .§390 83,3 0,5 88 211 318 529 94,8 0,6 89 262 496 758 111,5 0,7 90 325 450 775 91,7 0,8 91 207 395 602 83,0 0,7 92 257 686 943 95,0 1 ₀ 93 534 307 841 97,0 0,9 94 1178 1412 2590 106,2 2,4 95 447 1574 2021 111.6 1.B

Sources: CVM Monthly Newsletter, Central Bank Bulletin, IBGE National Accounts,

various numbers.

Between 1987 and _{1991, the capital market was seriously harmed by}

galloping inflation and a drop in the economy's

growth rate. Three new quotation crashes had the effect of keeping the small _{and middle investors away from the stock market for}

good. Between mid-1986 and late 1987, due to the disastrous Cruzado Plan, the São Paulo stock exchange _{(Ibovespa) recorded a} real drop of 83%. In June 1989, _{due to the excessive concentration and leverage of}

positions of a _powerful

group of investors, this rate fell 54%. In 1990, due to recession and a drastic tightening of liquidity caused by the Collor Plan, _{Ibovespa fell 64% in real terms.}

The debenture market continued stagnant because of the lack of continuity and _govemment

support. _{Pnmary issues dropped to US$ 27 million in 1987, to immediately}

recover due to the atypical issue of Siderbrás securities but again dropped in 1992 when they reached onlv US$

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TABLE V.3

Simple Convcnible Total Domestic Savings %

(US$bi)

a/b Debenture Issues _{(US$ million)}

1980 81 82 83 84 85 86 87 88 89 90 91 92 93 93 3.314 94 1.430 95 6.275 70 45 115 57,8 0,2 42 97 139 60,7 0,2 24 27 83.3 0,0 2-625 628 3.253 94,8 3 4 735 750 1.485 lllj U 735 750 1.485 111,5 13 806 110 916 91,7 1,0 971 40 1.011 83,0 \2 284 55 339 95,0 0,4 33 *4 529 _3.843 _97,0 _4,0 1 430 1.874 3.304 106,2 3 ₁ 960 7.235 111.6 6^5 158 150 308 40.47 0.76 l-452 283 1.735 42,8 4,1 1-395 357 1.752 38,7 4 5 35 1.752 38.7 4,5 176 520 696 34,3 2,0 104 '95 299 46,1 0.6 70 45 115 57,8 0,2

Note: 1995 until July

Sources: CVM Monthly Newsletter, Central Bank Bulletin, IBGE National Accounts.

numbers. , various

After this criticai

period, the securities market recovered and had a boom apparently with new charactenstics. _In _fact,

they seem to have diminished the volatileness _{and cyclothymia which} were until _{recently their strongest characteristics.}

Ibovespa rose 205%, in real terms in 1991 and 97% in 1993, but lost only 8% in 1992, 3% in 1994 and 21% in 1995. The' business

volume on the stock market reached the _{record of 12.6% of the average GDP, in the 1993-94} period. Primary issues of stock, debentures and

promissory notes continued the upward trend since 1992 _{and reached a record of around 8.3% of}

gross domestic savings in 1995. This was despite the slowmg down in the rate of activities in the domestic economy and _problems of

financing on the international market.

These _{positive results can} _be _related

to three factors. First, _{the capital market was opened up} to international ínvestors, in order to acquire resources supported on strict technical analysis

and taking advantage of the increased flow of capital towards the emerging economies.

International investments in such _{a market began, as we see, in 1974 and have been}

released since then. By 1991 they were only

permitted in collective forms - investment companies and unds - but since then, foreign individual and corporate investors have been _permitted to

participate (Appendix IV of Central Bank Resolution 1832/91) _(Faria, 1993). Secondly, the

capital market has benefited from the structural reform

process which had accelerated since 1990,

particularly through the

privatization _{of state-owned companies. Thirdly, there was} _the dramatic drop in inflation as a result of the Real Plan which is clearly a factor of _price and

business volume stabilization on the stock market.

However, the reform of the capital market must continue _{if it intends to reach an outstanding} Place in ^e national economy. Bearing in _{mind the increasing world trends in international} trade of

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be called upon to _play a role whose economic importance cannot be doubted. This is what

has been happening in the world, as can be seen in table V.4.

TABLE V.4

Stock Market Indicators of Selected Countries _{(US$ million)}

Years VM 1983 VT VM 1992 VT 1- % GDP VM VT I GDP92 Japan 1898 565 797 231 4.757 2.399 2.678 635 7.014 80 65 45 17 5.950 3.690 England 226 42 838 382 80 37 1 044 Gsrmany. 82 33 348 892 21 53 1 «wlf 1.675 )eveloped Markets 3.203 1.193 16.436 10.124 5.263 117.637 15 6 48 14 120 35 40 South África ; r 83 4 151 8 145 1M 8 104 nge) 15 5 45 20 12 w 5 406 phile 3 o _WÊsm 29 2 78 5 37 IndiT 3 1 139 44 42 13 329 ¦HHHI 2 mm 65 20 23 7 280 Ko^ea ; 4 2 107 116 37 40 290 Taiwan ₈ 9 101 241 55 130 185 Thailand ₂ ₀ 58 72 58 72 100 Erxvpraiòg Markets^ L 181 35 973 616

Sources: IFC Emerging Markets Factbook 1993; IFS/IMF VM = market value

VT = transaction volume

NE = number of open companies

The capital markets of emerging countries such as _{Korea, Singapore, Taiwan, Thailand, índia,} Chile, México and South África, at a similar levei of development as Brazil, have shown

remarkable

growth since the early 1980s. In 1992, the volumes negotiated on their stock

markets were equal to 40%, 35%, 130%, 72%, 7.1 %, 5.4%, 13.4% and 7.7% of the respective GDPs and the market value of ali their open companies was 36.9%, 120%, 54.6%, 58.0%,

23.2%, 78.4%, 42.2% and 145.2% of these GDPs. Brazil _{was at the bottom of the list} _having negotiated a volume _{of only 5.28%}

of the GDP on the basis of a market value of the open companies of 11.9%. _{There is, therefore, ample room for}

growth.

The capital _{market should be the}

proper vehicle for the companies to be able to obtain better balance between their own and third

party resources and between bank loans and borrowing obtained directly from the

public (by means of debentures, _{promissory notes, etc.), in order to} democratize the capital with the _population, so that the

privatization of state-owned companies can operate transparently and openly and

properly support the volume of resources that will certainly be channeled into the

pension funds, principally after the success of a serious social security reform. However, in order to fulfill this role, it is necessary to

eliminate various obstacles and drawbacks which have so far _prevented its full development

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V.2. Analysis of Primary and Secondary _{Stock Markets}

Primary Stock Market

Table v-2 above shows the small scope of the _{primary stock market} _in

relation to the savings requirements _of _the _Brazilian

economy. Primary stock issues as a _percentage of the _gross domestic savings were, on average, only 1% between 1980 and 1994.

The lack of vitality of the

primary stock market has several explanations and mention may írst be of the typical Brazilian businessman's aversion to risk, expressed in the tradition of

e closed family company, unwilling to absorb new _partners into its capital. A studv

performed by CVM

(Mendes, 1987) discovered in 1987 that Brazilian open companies were on _{average controlled with around 70% of}

the common stock in the hands of the controlling

parties. This fact can be compared with what happens, for example, in the North American

corporations where the voting stock is very widely scattered and it is not uncommon for the

largest stock holder to have only 5% of the voting capital. _{Another reluctance to issuing stock} is because of the way interest and dividends

are taxed, which we will discuss herein below. Secondly, on the side of the investor, there is the unequal competition of fixed income

secunties. In the _past, they would

promise to pay full restatement, which was considered an advantage in relat.on to the stock. Currently, restatement no _{longer exists, but it is evident} at real interest rates such as those we have seen since 1991, fluctuating between 15% and

25% a

year, tax net, are another setback to acquiring shares. Thirdly, there was _{(and still} _{is) the}

problem of lack of credibility of the intermediaries _which was

particular y felt by the míddle and small investors, usually individuais, _{as they were rarely} respected

(mcluding m the matter of _{guaranteeing reliable execution}

of trading orders) by the

broker houses and distributors. y

ecoMmy

Pnmary St°Ck 'SSUeS haVe been

Prejudiced by the instability of the Brazilian

Lastly, there is the

question of the high cost of

going public for the companies.

Since the early 1980s, the number of open companies _has _continued

in a steady downward trend. _{They have dropped from 1,152 in 1983}

to 839 in 1993 _{(currently they are}

874). Less than 200 of them

part.cipate actively in the capital market and only 50 shares may be considered as having suitable liquidity _{on the stock market.}

For the

pnmary stock market to _grow in size, there must be, first and foremost, a better

perception of the _{market on behalf of the small saver.}

Measures _{to reduce the cost of} going public would also be important. _{Other suggestions are}

given below.

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The concentration _of _the _market _has

increased in recent

years and is expressed in various forms. _{First, there is the concentration of business in a few shares,}

in _{general, of state-owned} companies. This was to be expected, since such companies have a low bankruptcy risk and

control the markets where they operate. In 1980, the five most negotiated shares were

responsible for 31% of the total business volume; in 1994, this

percentage rose to 67% (table

TABLE V.5

Business Concentration on the Secondary Stock Market irninrniniif¥fr»,i«Miri¥»»nMii[iiiiiiiiiiiii««»ii 82 ^^^^57 7 ₇ 84 50 58 78 85 54 61 81 86 47 55' 74 87 54 59 79 88 67 75 85 89 58 64 83 90 56 63 84 91 7OMBMBB>79 9i;flBH| 92 72 80 ' ' " 94 93 65 75 92 21 67 75_ 91 ^

Source: CNBV Annual Report, several numbers.

Similarly, in _{1980, of the 50 shares most negotiated}

on _{the demand market, 52% were issued} by state-owned companies; in 1994, this

percentage rose to 74% (table V.6).

TABLE V.6

Fifty most negotiated shares on the o ver the counter market State-owned Brazilian Drivats Pr»rôion Drivatft

1980 52 37 ₁₁ 81 63 ₂₇ 10 82 65 25 10 83 48 ₄₂ 10 84 51 ₄₅ 4 85 56 ₄₅ 2 86 38 58 4 87 48 51 ₁ 88 59 40 1 89 42 56 ₂ 90 49 ₄₉ 2 91 74 25,5 _0,5 92 76 _23,4 0,6 93 74 _WÊÈÊÊÈ. 26 "'WÊÊÊÊÊÊÊÊ 0 94 74 26 0

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By the end of 1995, Telebrás trading represented _{more than 60% of the total business volume} on the São Paulo Stock Exchange.

Secondly, there is also concentration at the investor levei. Institutional investors,

pension funds, in _particular,

namely employees of state-owned companies, hold investments in stock equal _{to 24% of the market value of the open companies.}

As a considerable

portion of shares on the Brazilian market is to be found in the hands of the controlling interest _(46%, on

average between July/84 and Dec/85 _(10)), the

participation of such _portfolios in the value effectively in circulation is close to 40%.

Thirdly, there is a concentration in the sector of financial intermediaries. Between 1980 and

1995, the _{number of broker houses and distributors dropped}

but the overall number of banks

(commercial and multiple) rose. In other words, it is very

probable that the market is more dominated than before by bank brokers instead of independem broker companies which, in

theory, would be more interested in the stock _{market rather than the fixed income market.}

Fourthly, there is regional concentration. The number of stock exchanges has continued the

same but the concentration of business in São Paulo is

patently obvious. While in 1980 São Paulo Stock Exchange negotiated 48% of the Rio de _{Janeiro Stock Exchange, this}

percentage increased to 692% in 1995. The other stock exchanges are and always have been of lesser

importance.

Market concentration is detrimental since, as there is a high number of _poorly marketable

shares, abnormal

price movements are _given more _potential _{(manipulations)} _and _volumes

(artificial marketable conditions) as well as corners and squeezes on derivative markets

(contrai of a supply of securities on the demand market by a _group of investors and the

adoption of high forward

positions at the buying end). These _{phenomena compete} _to _reduce the competition and, therefore, the allocative efficiency _{of the stock market.}

The lack of trust occurs for various reasons.

First, too volatile a _past itself frightens off most investors, even individuais who are

experienced in the twists and turns of the financial system.

Secondly, there is a tradition of the intermediaries'

poorly attending the small and middle investors. Such investors

generally operate only in _{times of bounty but, during these booms,} many intermediaries are only interested _{in trading large orders.}

Thirdly, it is _{acknowledged that there is insufficient}

enforcement of the negotiating rules and minority stockholder rights by the self-regulating institutions _{(the stock exchanges) and CVM.} CVM has, in fact, had difficulty in obliging many open companies to at least

perform the minimum, that is, sending it a

quarterly report which they are obliged by law to do.

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The following suggestions for enforcement are a result of the above:

1- Improve enforcement by the CVM, both with regard to the _prudential regulation and

overseeing of the stock market relating to the stockholder/company relationship,

particularly respecting the rights of the minority stockholder. The objective must be to create a free

market, competitive and efficient. As discussed below, CVM stagnated as the market grew and became more sophisticated. There would, therefore, be a need for it to keep apace with

such

progress. This would involve amendments to Law 6385/76, and training and

technological upgrade

programs should also be considered _(involving _increased _computer installations), bearing in mind a better monitoring of the market.

2- _{Establish the right to recess in cases of a company merger,}

amalgamation or split, under the terms of Law 6404/76. In order to do so, it is necessary to revoke Law 7958/89 which

eliminated such a right.

3- Eliminate the accounting

gaps which make it easy to draw up balance sheets which do not reveal a company's real situation and make it obligatory to _provide a complement of the

statement and changes in its financial

position with the cash flow.

4- _{Diminish the unstabilizing legal activism of the Executive.}

5- _{Privatization of state-owned companies.}

In addition _{to improving the management of such} companies, contributing to reducing the

public déficit and diminishing one of the concentration factors of the stock market,

privatization could aim at broadening the stock base, which has been successful in several countries, especially England.

6- Reactivate the Capital Market Development Committee _(CODIMEC). _CODIMECs

expenence in organizing the stock market by writing

prospectuses, publishing books and penodicals and providing courses on the capital market was

generally positive. Its closing down in 1990 was due less to any faults it might have had than to an unfavorable

macroeconomic conjuncture which caused drawbacks to its financing agencies _(stock

exchanges, ANCOR, ABRASCA, ANBID etc., in short, the various market institutions). A

new committee should set up an aggressive _{marketing strategy, not forgetting those individual} investors who withdrew after the 1986 crash, linked to the _{collapse of the Cruzado Plan.}

In the case of institutional investors, the following _{measures should therefore be adopted:}

First, it _{must be the duty of CVM or some other independent}

regulatory agency to be created to

perform prudential regulation and the routine overseeing of ali institutional investors with

regard to their investments in capital market securities. It is obvious that the autarchy must

have the necessary means to carry out this task efficiently.

Secondly, it is necessary to standardize such investors' financial statements and _grant them

proper dissemination by publishing them in widely circulating

periodicals in order to increase the transparency of their operations.

(19)

Lastly, the social security reform will be of the utmost importance for the capital market.

With the change in the system from allocation to capitalization, the expectation is that the

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Comments on the Brazilian Financial System Rubens Penha Cysne Lauro Flávio Vieira de Faria

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