Development of a capital market in Chile (Vol. 8 of 9)

C- 42 VOL. 8 ---TURiN T' REPORTS DM This report may not be published nor may it be quoted as representing the view of the Bank and its affiliated organizations. They do not accept responsibility for its accuracy or completeness. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT INTERNATIONAL DEVELOPMENT ASSOCIATION DEVELOPMENT OF A CAPITAL MARKET IN CHILE Report of a Mission organized by the International Bank for Reconstruction and Development at the request of the Government of Chile ANNEX VII RELATION OF INFLATION TO CAPITAL MARI January 19, 1965  Chilean Capital Market Study Mission International Bank for Reconstruction and Develowment DEVFJLO:!NENT OF A CAPITAL MARKET IN CBILE ANNES VII RELATION OF INFLATION TO CAPITAL MUARETS Table of Contents Characteristics of Inflation in Chile 1 Causes of Persistent Inflation in Chile 4 Measures to Control Inflation 6 Inflation as a Deterrent to Capital Market 7 Saving and Investment under Inflation 8 Use of Escalation Clauses 11  Chilean Capital Market Study Mission International Bank for Reconstruction and Development DEVELOPMENT OF A CAPITAL TIARlIT IN CHILE AiJII2 VII RELATION OF INFLATION TO CAPITAL XARKETS In Chile inflation has been an important, and often dominating, aspect of economic and financial developments for so much of the time that no economic problem can be appraised without considering the impact - of inflation and methods of dealing with it. In any inflationary develop- ment, the principal manifestations are rising conmodity prices arid, com- monly, currency depreciation. There is always expansion in the volume of money and generally also an acceleration in the velocity, or rate of use, of money. Credit expansion may occur in the private or the public sectors, though most coTmonly in the latter or in both., Behind these manifestations of inflation are the underlying causes. These stem from attempts of a country to consume and invest more than can be produced at the time. Although stimulants to demand may result from a variety of causes, increases in aggregate demand are made possible by the creation of additional money, as well as more active use of existing money. A corresponding increase in output is not forthcoming, and hence prices rise and often imports tend to expand and exports to contract. Interest rates rise as borrowers endeavor to obtain credit, while the supply of lendable funds is limited by the low volume of savings--and the reluctance- of lenders to enter into future commitments on a fixed-value basis. Pay- ments deficits on international account develop and the currency tends to depreciate, unless balance can be maintained by borrowing abroad. Essentially the prevention of inflation, without contracting the economy., depends first upon attaining a volume of internal saving, which, together with foreign borrowing, is adequate to finance investment needed to increase productivity,. This means that consumption.must be less than production. The next problem is to attain a flow of saving into productive investment within the country. In this way, productivity may gradually be increased and consumption may likewise expand, but at first production must increase faster than consumption. Characteristics of Inflation in Chile Inflation has occurred in Chile during.most of the past 80 years, with varying degrees of intensity and differences in motivating forces, For purposes of this analysis, attention is directed to developments during the decade 1953 to 1963, with particular emphasis on those since 1959. Indicators of inflationary developments in Chile for selected periods in - the past decade are showin in the table. The data represent percentage in- creases in significant items, and the particular periods are: the three years from 1953 to 1956, a time of maximum inflation; the three years from 1956 to 1959, when inflationary developments were less extreme; the period of nearly three years from 1959 to early 1962, when conditions of relative stability prevailed; and the year and a half from early 1962 to the latter part of 1963, wJhen inflation again became active. Most of the trends shown in the latest period were continuing in 1964.  2 ILDIC..T03 OF IF I 1 Percentage Increases W'ithin Selected Periods 1953- 1956- 1959- 1st half 1962- 1956 1959 1st half 1962 2nd half 1963 Consumer prices 121 29 96 Minimum salary 255 114 50 *19 Wholesale prices: 355 132 8 72 Home goods 336 126 12 '1 Import goods 380 144 0 79 Stock M4arket: Industrial share prices 344 138 18 175 Market activity (Value of sales) 300 58 - 31 212 US dollar: In "brokers' market" 207 98 39 105 Official rate 312 130 0 85 Central Government: Revenues 425 178 43 90 Expenditures - net 365 191 45 97 Current 1b4 7o 79 : Investment 445 210 32 158 Bank credit: Total domestic credit 195 210 139 70 Public sector 19 -226 20 102 Private sector 211 200 100 48 Money supply: Circulating, private 247 132 84 48 Private & public plus quasi-money 293 164 103 56 Bank debits 315 157 56 70 Gross national product: Current value 365 150 e 50 e 70 Constant value 4 8 e 17 e 4 Foreign trade (in US$): Exports 33 -9 13 - 3 Imports 5 18 14 49 *Adjustment made at beginning of 1964 on basis of price rise in 1963 raised this figure to 73 per cent. NOTE: olost figures are aggregates or monthly averages for years or half-years. The credit and money supply figures are in earlier years averages of end-of- year data and for recent periods averages of end-of-quarter or end-of-month figures. e/ Estimated.  3 Commodity prices in Chile have risen in almost every one of the past 80 years. The average annual rise was less than 6 per cent before 1940, but has generally been more rapid during the past quarter century, reaching an average of 70 per cent a year in the three years 1953 to 1956. It mod- erated to about 30 per cent a year froi,m 1956 to 1959. Then in 1960, 1961, and the first half of 1962, there was a period of relative stability, when consumers' prices saowed an average annual rate of increase of less than 10 per cent. VJholesale prices, influenced by stable prices in w-jorld markets, together with the maintenance of a stable exchange rate for the Chilean cur- rency, rose only slightly in the 1960-62 period. WIages and salaries during the decade were adjusted in close accord with the consumers' price index, and in fact from 1959 to early 1962 rose somewhat faster than prices.* The Chilean peso, which prior to 1952 was valued at less than 100 to the US dollar, depreciated to about 1,000 to the dollar by 1958 and was replaced in 1959 by the escudo, equivalent to 1,000 pcoos, wTith a foreign- exchange value of about US$ 1.05. This value was maintained until the end of 1961, but during 1952 the currency depreciated under the pressure of accumulating unsatisfied demands for foreign currencies. By early 1963 the rate for the US dollar in the so-called brokers' .market, at which various capital movements and other limited transactions could be settled, had almost tripled and it rose somewhat further in the following year. The rate in the bankers' market, at which trade transactions and certain other authorized exchanges are settled, was maintained at a lower level, but by the beginning of 1964 was more than double the previous stabilized rate. In the latter part of 1962 price rises accelerated, and by early 1964 consumner prices wrere close to double the early 1962 level. Wholesale prices of both national products and import goods rose by similar amounts, corresponding closely to the rise in the value of the US dollar at the bankers' rate. Various upward adjustments were made in wages and salaries, as well as in some other costs. These adjustments generally lagged some- what behind the exchange depreciation and the price rise, but substantial adjustments put into effect early in 1964 brought salaries and wages generally into line with price changes up to that time. Honetary e-pansion over the years has generally exceeded the price increases, thus allowing for some growth in the "real" volume of output and activity, as well as providing for the price irnflation. The rates of charge in the money supply and in the value of national product have not alwa.ys been identical in any short period of time, as the velocity of monetary turn- over has tended to increase in periods of accelerated inflation and to de- cline in periods of relative stability. *For a comprehensive account and analysis of the course of inflation in Chile until 1962 see Albert 0. Hirsclmar. JOURTMEYS iQOWARD PROGRESS, Chapter 3; The Twentieth Century Fund, New York, 1963.  '- 4 Hlonetary expansion through 1959 stemmed mostly from increases in bank credit advanced to the private sector. Although the rate of expansion in bank credit advanced to the public sector was large before 1959, the absolute armounts iwere not as great as increases in private sector credit. From 1959 until 1962 the increases in credit to the Government, mostly advanced by the Central Bank, was at a faster pace and in terms of escudos was fully as imnportant as private credit expansion. horeover, the increase in Central Bank credit provided the commercial banks with reserves that served as a basis for further credit expansion. In 1963, expansion of bank credit to the Government moderated considerably, as the budget deficit was covered to a greater extent by borrowing abroad, but a large increase in credit to tae private sector provided the basis for sufficient raonetary expansion to support the inflationary developments of the period. Throughout the decade increases in the current values of gross national output and of national income were dominated by the price rises. Growth in "real" output and income was quite small through 1959, amounting to only 13 per cent in 6 years -- less than population Crowth. After 1959, during the period of relative price stability, real output increased by an average of 5 per cent a year, but with resumiiption of inflation, the 1963 growth was slower. Imports, expresses in US dollars, increased somewhat more rapidly than real domestic output in most periods. Exports, which were rather large in 1956, have subsequently shown no increase in dollar terms. Maintenance of imports has been made possible by foreign borrowing, and in some years large imports helped to moderate domestic pr-ice increases. The maintenance of the foreign trade deficit has depended upon continued foreign borrowing and has not been corrected by currency depreciation. Causes of Persistent Inflation in Chile Various explanations lhave been advanced for the persistence of inflationary tendencies in Chile, and this Report can add little to the discussions and analyses that are available.* Some of the explanations point to structural features of the economy, which result in low produc- tivity relative to needs or desires for consumption and investment and in high costs of production for products that have to compete with those of other countries. In particular, the low productivity of agriculture in Chile is citcd as a factor. WTorld market conditions have at times been unfavorable for some of Chile's principal exports, with adverse effects on the terms of trade. It should be noted, however, that since 1958 prices of import goods ex- pressed in dollars have declined, while those of Chile's export products -- mostly copper -- have been relatively stable. Nevertheless, Chilets balance *See, for example, Hirschman, op. cit. for an excellent account of these explanations.  - 5 of trade has not improved. Even depreciation of the currency in 1962 and 1963 had little evident effect in stimulating exports or restraining imports. One possible reason for the failure is that the various upward adjustments in costs and incomes largely offset the effect of the lower currency valua- tion. It is said by some that Chile is so dependent on imports for certain necessities that import demands are inelastic in their response to price changes, and it may also be said that, at least in recent years, Chile's principal export products have been relatively price inelastic in wJorld markets or have been linited by capacity. In view of the historical tendency to-ward inflationary price rises, procedures have been developed in Chile for fairly prompt readjust- ments in vages, salaries, and various costs and also in the valuation of certain assets and liabilities. These adjus tments, designed to protect various groups from the harmful effects of inflation, tend at the same time to continue and accelerate the upward spiral of prices and costs, and hence the depreciation of the currency. This serves as a discouragem,lent to saving and internal investment, and an encouragement to capital flight. Uneven distribution of income holds down consumption for a large portion of the population, while other sections maintain nigh consumption standards likely to involve imports. Hioreover, those who have incomes that allow a margin for saving tend to invest at least part of their savings abroad. This combination of factors not orly creates internal pressures but also causes balance-of-payments difficulties and contributes to further currency depreciation. Atterimpts through puolic policies to provide relief to those in need and to supply many social services, as well as to engage in invest- ment activities designed to increase productive capacity, have resulted in overall budgetary deficits. It has been difficult, if not impossible, to finance these deficits by borrowing domestic savings. Instead the Government hias borrowed heavily from the Central Bank, as well as from abroad, and this has resulted in expanding the money supply more rapidly than the public's desire to hoLd cash balances. Hence private spending has been stimulated in excess of the availability of goods and services, and price rises have resulted. As a consequence, needs for working capital in private business also increased and created demands for credit. In the absence of facilities for tapping domestic savings, these credit demands fell upon the banking system. Credit to the private sector thlerefore expanded to the extent that banks were able to meet the loan demands. This private credit expansion has been at times a significant contributing factor in the inflationary spiral. Notilthstanding the substantial increase in private credit, business has complained of inability to obtain credit needed. This is a common character- istic and result of an inflationary spiral.  6 This spiral could have been prevented or retarded to the extent that borrowing demands - pubilic and private - could have been met out of current savings. This w-ould require a functioning capital market as well as an adequate volume of savings. Savings, howsever, Ilave not been avail- able for internal investment in adequate amounts, in part because the persistent depreciation in the value of money has tended not only to dis- courage the investment of savings in internal fixed-value assets but also to encourage their flow into foreign assets. In this difficult dilemma some relief has been obtained by borrow- ing abroad and 'by foreign aid. To the extent that these funds are spent abroad to obtain needed imports, they may permit expansion in investiaent and consumption uithout inflationary consequences. To the extent, however, that the foreign exchange made available is used for consumption or to cover outflows of capital, the productive resources of the economy are not enhanced. Foreign borrowings, moreover, build up future obligations. It is, therefore, vital to expand domestic productivity and either to reduce reliance on imports or to increase exports. Continued increases in domestic costs, how-aever, tend to reduce or offset any effects of currency depreciation in bringing about adjustment in the country's balance of payments position. In essence, it appears that various structural factors in Chile cause low productivity relative to desires for better levels of living and also result in high costs relative to other countries. Fiscal and monetary measures have been adopted in attempts to overcome these essentially de- pressant forces and raise levels of consumption and investment, but these measures have not corrected the basic structural deficiencies that hold down productivity. Instead they have resulted in L1oneta:'y inflation and contributed to rising prices and currency depreciation. Adjustments of wzages, salaries, and other sources of income to cormpensate for cost of living in- creases have raised production costs, increased credit demands, and tended to worsen imbalances in international payments, and thus contributed to the inflationary spiral. Measures to Control Inflation Efforts have been made to control or linit the inflationary con- sequences of this combination of factors. Restraints have been imposed on bank credit expansion to thie private sector, but their effectivenoss has often been counterbalanced by the continued expansion of credit to the public sector, particularly by the Central Ban]k, and also by the adoption of measures designed to provide private credit for purposes considered essential, including increased working capital needs that result from in- flation. In addition, to relieve pressures on foreign exchange, various types of irmort restrictions have been imposed, including advance registra- tion, prior deposits, and special surcharges, C-apital flight has been  .7 discouraged by limiting foreign exchange made available for this purpose and by adopting a system of dual exchange rates, under which the dollar rate for capital movements is higher than that for trade purposes. Ceil- ings have been iaposed by governmental decree upon prices of important goods and services, while permitting some upward adjustments. These various measures of so-called direct controls, however, do not correct the underlying causes of inflation; they merely suppress manifestations or consequences, some of wlhch, if not suppressed, might help to retard inflation. Illflation as a Deterrent to Capital Market In an inflationary environment such as has prevailed in Chile many of the requisites for the development of a capital market are lack- ing. A capital market is dependent upon the flow of savings froa the original savers through intermediary institutions to the ultimate users of the funds for investnent purposes. ilost of the int er.ediary financial institutions operate on tne basis of acceptance of deposits or other forms of contracts to pay fixed amounts of money. W1here the value of money is subject to extensive depreciation, savers are reluctant to direct their savings through channels which provide no protection against depreciation in value. The penalties that this situation involves may be summarized as follows: Because of anticipated depreciation in the value of money, there has been natural resistance against holding claims to fixed amounts in domestic currency. This has resulted in a lower rate of money holdings relative to national product in C,-Lile than in any other country. This lowv; level of money supply means that the banking system has fewer resources for lending than would otherwise be the case. Interest rates are relatively high, as lenders attempt to com- pensate for anticipated losses of real values. In practice, however, although borrowers in Chile pay wllat appear to be high nominal rates, the rates prevailing hiave fallen far short of co.apensating lenders for the loss in buying power of their savings. The level of interest rates is one cause of high costs of doing business in Chile, thereby nandi- capping its competitive position in international markets. The propens. ty to save is inevitably reduced. W.Jhile investment in equity shares might provide a safeguard against loss of buyling power, for many people such investment is not an alternative to fixed interest securities, whichn promise a steady income and the return in due course of the capital sum invested. People may feel ill-equipped to undertake a proper analysis of the stock market; they may fear, perhaps more impor- tantly, that the inevitable fluctuations in stock market quotations will make it impossible to sell their investment when they wish to, except at a loss; they may need the certainty of a fixed return even at the cost of  -. 8 foregoing tlhe chance of earning higher, tllouTh less certain, returns from an equity participation. For any of these reasons, amon-g others, they may have a strong preference for fixed interest investments. In- flation, however, elirinates this possibility to a 'large degree. Con- sequent reduction in the incentive to save hinders the development of many types of financial institutions needed for an effective capital market. The Government itself is not in a position to cover its needs by issuing obligations expressed in national currency that attract domestic savings. Nor are business enterprises, though many would uish to do so if they could. Inflation has many other serious disadvantages for the economy in general, which have been the subject of many reports received by the Chilean Government or are otherwise available and need not be repeated here. For the purposes of this Report, it needs only to be brought out that inflation makes the development of an efficient capital market difficult, and, from many points of view, impossible. Although this Report points out the importance of inflation control from the standpoint of developing a capital market, the Capital harkets Study Mission has not attempted to presenit a comprehensive pro- gram for the control of inflation in Chile. Such a program requires action on many fronts -- economic and political, governmental and private, financial and nonfinancial. hany of these questions go beyond the sub- jects assigned to the rmission for study or the special competence of its rmiembers. Implicit in the analysis of the situation presented in this Report are suggestions as to broad areas of actions that are needed. Some of the specific measures proposed should help to foster domestic saving and investment and thereby reduce inflationary pressures, if rLot eliminate them. Emphasis in this Report has been placed upon measures that might be adopted to foster saving and investment until inflation can be brought under control. Further steps needed to develop a capital market, once inflation has been curbed, are also considered. Saving and Investment Under inflation Many people cognizant of the situation in Chile hold the view that experience in Chile over many decades indicates that the economic and political difficulties of keeping inflation under control are vir- tually insurmountable. It is firr,ly believed by some that inflation cannot be prevented w-ithout actions that would lead to an even more undesirable situation, such as economic stagnation or serious civil and political disturbances leading to the breakdown of democratic government or even to civil war. If this position is taken, then it is difficult to escape the conclusion that Chile cannot expect to have a satisfactory capital market, and probably not the volume of saving and rate of growth of which it might be capable. A further question that may be raised is  9 whether the continuation of inflation would not present even more strongly the same risks that the inflationarj policies are supposed to avoid. A less extreme view is that, even if inflation could be brought to an end, ingrained attitudes and habits resultilg from the long persist- ence of inflation will be difficult to change. It is not unreasonable to suppose that an economy which has adjusted itself to inflation over many decades would have difficulty in reacting immrediately to the ending of an inflationary enviromnent in ways that would be suitable and desirable. Even if inflation ended tomorrow, it is likely that some considerable time would be needed before the attitudes and mechanisms appropriate to in- flation were abandoned and before possibilities inherent in the new situa- tion were apparent to business men and officials. Under this view, the process of changing habits of saving and investment would have to be gradual, operating largely through a number of structural changes that are brought about one at a time and that -will eventually break dowm existing barriers and build up newJ habits. Even if one holds the view that inflation in Chile could be curbed relatively quickly by measures that would have no dire consequences and would, in fact, promote stable growth and higher living standards for the bulk of the population, allowance has to be made for political difficulties of getting such a pro- gra-m adopted, for the magitude of adjustments needed, and for the time re- quired to make the effects felt. Even though inflation continues, some investment maay take place, and in the meantime, many measures to foster domestic investnent could be put into e-fect and serve useful purposes. This might eventually lead to attainment of a balanced economy with a functioning capital market. First to be considered are the possibilities of obtaining investment even though inflation is not effectively curbed. (a) Inflation itself may result in a form of forced saving and also act as a stimulus to investm,lent. Some students believe that in a developing econormr more investment can be obtained in this manner than would come about in an environment of restraint on credit expansion and stability of prices. In inflation, saving and investment result largely from income distortions, particularly large profits. It may be questioned, however, whether excess profits can be expected in a situation, as in Chile, where wages and salaries are so promptly adjusted to rising prices. The principal effect is a continuing spiral of inflation with little or no forced saving. IMoreover, even if profits do increase, the distortions thnat occur with inflation are often inecuitable or otherwnise undesirable.  10 (b) In Chi-le a large portion of total investment is financed by the public sector, partly as a deliberate policy of economic direction and partly because financ- ing is not avai-lable for the private sector. Because, howJever, of the inability to raise funds by borrowing private savings -- a situation attributable in turn to the anticipated effects of inflation -- financing of public investme-nt in Chile has been obtained to a large extent through inflationary Central Bank credit and foreign borrowing. To be sure, public investment is desirable and necessary. Thie question is whether the inflationary process of financing puolic investment discourages domestic investment of private saving and encourages capital flight to such an extent as to pro- vide less aggregate investment of a productive nature than would otherwise take place. (c) A large portion of private savings -- both business and personal -- go into real property as a hedge against in- flation. Some of this investment, howuever, is not pro- ductive and in any event the result has no doubt been distortion of the flows of investment funds. (d) Direct investment in business oumership might be expected to be stimulated by inflation. This happens to a con- siderable extent through accumulation of undistributed profits by individual businesses. idovements of share price averages indicate tlwat the oi^merslhip of corporation shares in rmost periods has provided a satisfactory hedge against inflation. Yet neither the stock market nor other distribution of shares to the investing public in Chile have pro-vided important channels for the flow of private savings into investament. Sortie of the reasons for this are historical or structural, and actions in this area offer hopeful possibilities for increasing saving and investment. (e) Permitting interest rates to rise sufficiently to offset anticipated depreciation in the value of money should theoretically be a means of attracting savings into in- vestment. This woild require the removal of ceilings or other arbitrary restrictions on interest rates and con.- plete flexibility in rate movements. Unless, however, other causes of inflation are curbed, this process could result in extremely high and rising rates of interest and hence de- clines in prices of fixed interest obligations which would discourage their acquisition. It would also raise production costs.  11 (f) Escalation clauses, whereby interest and principal of outstanding obligations are automatically adjusted in accordance with price changes, are often suggested as a means of protecting savers from depreciation in the real value of investment in fixed-return obliga- tions, and thus inducing saving and domestic invest- ment savings, despite inflation. The advantages and difficulties of such devices are discussed in the following section. Use of Escalation Clauses It has sometimes been suggested that the adverse effects of in- flation on investment could be minimized if it were possible to adjust capital sums at regular intervals in accordance wifth the movements of a suitable price index. Indeed, Chile already has some experience with this device: the deposits and loans of the Savings and Loan Associations and of the Housing Corporation (CORVI), and some of the loans made by CORFO, for example, are adjustable in various ways to compensate for the fall in the purchasing power of the escudo. The important question is whether this mechanism is satisfactory, and whether it could be extended to other parts of the economy with advantage. It would be as well to consider this problem in broad terms, as well as in the context of the imm.ediate situation in Chile. The case in favor of readjustment clauses may be summarized as follows: (1) Their main advantage is that, to the extent that these clauses are technically adequate and consistently applied, lenders are enabled to re- cover the "real" value of a Loan and debtors are prevented from obtaining windfall advantages arising from general price increases. (2) V4here fear for the future internal or external value of a currency exists, the availab4lity of assets with such clauses may Mitigate the impact of these fears upon inducements to save and invest. Thus escalation clauses should have the eff-ect of increasing the total volume of saving and particularly the channeling of savings into productive domestic investment rather than into capital flight or unproductive uses. (3) In a situation, as in Chile, where many types of income and other elements of costs are fairly promptly adjusted to price changes, it is unfair and inadvisable to discriminate against income from the invest- ment of savings. In fact, it is more important that saving be encouraged as a means of promoting growth in output than that consumption be stimulated, which is the principal effect of most income adjustments.  12 (4) Such clauses may be of advantage to borrowers as well, in that the reduction in risk of loss of purchasing power for lenders makes it possible to borrow at lower rates of interest than on readjustable loans. Indeed, if inflation is expected to be large, borrowing may not be possible at all without an adjustable provision. The eventual cost of the borrowing under an adjustable clause will depend on the degree of inflation that actually occurs, but presumably the ability of the borrower to meet higher servicing costs will also vary accordingly. For similar reasons, with an adjustable provision, the nominal rate of interest under some circumstances might be very low. (5) Experience of three countries -- France, Finland and Israel -- which have used value-linking, shows that the device may be workable and use- ful and that it is widely accepted as being a desirable technique where political and other circumstances seem to preclude control of inflation. These arguments favoring readjustment clauses must be considered against their known or potential defects. (1) Such measures do not correct the major underlying cause of inflation, namely an increase in effective demand without a corresponding increase in production. Indeed, the application of such clauses, added to the various other adjustments in incomes, will tend to stimulate demand, although their influence toward increaslng savings would hopefully offset th-is tendency. (2) The more widely readjustment is used in an economy suffering from inflation, the more complete and efficient will be the process of in- flation itself. One might argue that, in the end, if the principle of re- adjustment were applied across the board, the incentive to inflate would disappear since nobody would be seen to be benefitting from the inflationary process; but in practice it would be impossible, for administrative reasons, to adjust certain contracts and obligations often enough to prevent them lagging in the race -- for example, some types of wages and salaries, pension payments, time deposits withdrawable on short notice, and various contract provisions. Thus, while reducing some distortions, value-linking would create others. (3) Readjustments on loan obligations of business enterprises would increase costs of doing business, and those on personal loans would raise living costs. In tilis respect they would be similar to interest rate increases. Such higher costs in themselves could be anti-inflationary, but only if the inevitable pressures for compensatory fiscal and monetary measures, to increase aggregate demand, were effectively resisted. (h) Institutions liable for readjustable claims would need counter- balancing readjustable assets, which it would be hard to obtain and keep in adequate balance with liabilities. Goverrment and other borrowers would have to adjust taxes and prices accordingly, and these adjustments would involve formidable accounting and administrative problems and serious uncertainties.  13 (5) Debtors subject to readiustable obligations would doubtless press for legislative action to relieve th'em of part, if not all, of the consequences of readjustment; and there would be strong political tempta- tions for the govJernmental authorities to try to satisfy these requests. There has already been soame evidence of this danger in Chile with respect to housing loans and in the case of some CORFO loans; and the pressures would be greatly increased if business enterprises in the private sector, instead of benefitting from windfall gains from inflation as in the past, were faced with constantly increasing charges on readjustable bonds issued by them. (6) The Government itself, should it issue readjustable obliga- tions, might find difficulty in raising funds to meet the increased liabili- ties at their full adjusted value. An example is seen in the case of the handling of maturing dollar bonds issued by the Chilean Government in recent years. (7) Questions arise as to the suitable index to use for readjusting the obligations. There are wide variations in the impact of inflation upon individual debtors and creditors. Windfall gains or extraordinary burdens would still occur in specific cases, though they might be smoothed out on the average. Should a general index be applied universally or should some specific index be applied to each particular activity on the basis of its own costs or prices? Involved questions of procedure and equity arise in either case. M4oreover, methods of compiling the indexes raise controversial questions and affect vested interests, and the underlying data are generally imperfect. (8) Although such de-vices have been useful in some countries, there is little experience with their use in situations of long-continued, very large inflationary movements. They are not likely to be effective unless they are associated with a vigorous and consistent program to bring infla- tionary forces under control. Readjustable obligations, in short, are no substitute for a frontal attack on inflation itself. If used indiscriminately, they may even aggravate the distortions and dangers of inflation. Nevertheless, the mission believes that their application at certain strateglc sectors of the economy, with the aim of capturing a greater share of scarce resources (e.g. for housing or for the more important parts of the investment program), is desirable in the circumstances that prevail in Chile. For, given the duration and magnitude of the inflation, extraordinary inducements are required to bring about sav- ing and the mobilization of saving for domestic investment. To the extent that saving can be encouraged, or more effectively mobilized by the use of adjustable obligations, inflation might be moderated and the need to make the adjustments therebyr reduced.  14 Proposals for limited use of such clauses in Chile are included in the recommendations of the mission and discussed in Background Memorandum F of this Report. These suggestions relate particularly to debt obligations that might be issued to the Government or the autonomous public agencies. Such adjustable obligations might be sold to individual investors and to savings institutions. Tne latter in turn could provide corresponding adjust- ments on savings deposits or similar commiitments. These schemes would help to attract private savings into the financing of public-sector investment. They would supplement already existing adjustable arrangements for financing housing. With regard to financing private business investment, special emphasis has been given in this Report to measures for fostering greater participation in the market for equity shares of corporations. Urntil in- flation is kept under control, it would not be fLeasible for business enter- prises to obtain long-term loans on a fixed-value basis. The issulsnce of obligations conveztible irto shiares on some specci_ied basis th ml izht offer some protection against inflation, has not 'been customary in v`hile. Under conditicns of persistent inflation, ownership of such secur4ties offer no particular advantages over the direct purchase of shares. Some businesses might find it feasible to issue adjustable obligations, but in view of the uncertainties involved, and the accounting and other procedural difficulties, such obligations would seem to offer no particular advantages over share issues for either the corporation or the i.nvestor. In conclusion, it may be said that, as long as inflationary ten- dencies persist or are anticipated, it would be difficult, if not impossible, to develop a fully functioning capital market in Chile. Vieasuares might be adopted, however, to foster a greater flow of private savings into the equity shares of business enterprises. It may also be possible to attract more private savings into public-sector investment boy issues of obligations with value-indexed escalation clauses. Some steps might also be taken to develop a market for Government obligations through the ba-nking system in a manner that would not be inflationary. Through these means investment in Chile might come to be more largely financed witth domestic private savings and inflationary pressures avoided. Eventually a broader capital market might then be developed.