《北美自由贸易协定》、资本流动和墨西哥的金融体制

WPs I llq POLICY RESEARCH WORKING PAPER 1984 NAFTA, Capital Mobility, Several analytical approaches are integrated to answer and Mexico s Financial three questions: Are there aspects of the NAFTA accord. System combined with liberalization of Mexico's financial system, Thomas Charles Glaessner that will affect the efficiency Daniel Oks with which financial services are provided or the size and composition of capital flows to Mexico? How does NAFTA affect macroeconomic and microeconomic policies related to the financial system? And through which channels will NAFTA affect macroeconomic stability or risk in the financial system? The World Bank Latin America and the Caribbean Region H September 1998  -)LICY RESEARCH WORKING PAPER i 984 Summary findings T-ypically the impact of thie North American Free Trade Glaessner and Oks combine the two approaches to Agreement (NAFTA) is analyzed from a macroeconomic examine how NAFTA will affect capital flows and the perspective, to examine the implications for capital efficiency with which financial services are provided in market flows or for the aggregate degree of financial Mexico. integration. This analysis often involves examining They also call attention to domestic financial system whether certain conditions of arbitrage or efficiency tend and monetary and exchange rate policy issues that to hold, given greater integration of financial markets. Mexico must address if greater financial integration is Alternatively, other work examines only the effects of not to result in increased risk for the domestic financial greater financial integration for the efficiency with which system or greater macroeconornic instability. financial services are provided microeconomically. The two approaches are rarely combined, nor are the effects of integration considered within such a combined framework. This paper - a product of the Latin America and the Caribbean Region - is part of a larger effort in the region to examine the impact of cross-regional policy lessons. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Miguel Navarro, room 15-076, telephone 202-458-4722, fax 202-522-2106, Internet address mnavarromartin @worl dbank.org. Thomas Glaessner may be contacted at thomas glaessner@sfmny. com. September 1998. (55 pages) The 1'olicy Research Wlorking Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not nzecessarily represent the view of the W/orld Bank. its Executive Directors, or the countries they represent. Produced by the Policy Research DisseminationI Center  NAFTA, Capital Mobility and Mexico's Financial System Thomas Glaessner * and Daniel Oks * World Bank Washington, D.C. * The views in this paper are those of the authors and should not be attributed to the World Bank. Paper presented at the session of "Capital Mobility and Financial Integration in North America", Allied Social Science Associations (ASSA) annual meetings, Boston, January 3-5, 1994.  2 NAFTA, Capital Mobility and Mexico's Financial System I. Introdiuction 1. On November 17, 1993, the United States ratified the North American Free Trade Agreement treaty. Debate continues as to the effects of this treaty on both capital inflows and outflows and their composition, and the implications for the Mexican financial system in particular. Analyses of the causes of capital flows typically derive from a macroeconomic framework based upon basic arbitrage conditions and are linked to key macroeconomic policies, (see Hanson (1992), Calvo et al.(1993)) for good reviews). In contrast, several authors have focused more narrowly on how the financial service provisions of the NAFTA treaty are likely to effect the degree of competition in the Mexican financial system. This work has either focused on the eifficiency of banking services (see Gruben, Welch and Gunther (1993) or Garber and Weisbrod (1992)) or has attempted to examine the microeconomic implications for the financial system of capital account opening (see Mathieson and Rojas-Suarez (1993)). Finally, still other authors have argued (see Vittas et al. (1993) that the NAFTA financial service provisions did need to provide for a certain period of adjustment for newly privatized Mexican financial groups to compete with US and Canadian institutions. This paper tries to partially integrate a number of these approaches to answer three basic questions: * Are there aspects of the NAFTA accord, combined with liberalization of the financial system, that will fundamentally effect the efficiency of financial service provision and the size and composition of capital flows to Mexico? * How does the NAFTA accord heighten the significance of certain domestic macroeconomic policies (exchange rate, monetary and fiscal policies) and microeconomic policies relating to the financial system? D Given the answers to the first two questions, through which channels will NAFTA either increase or decrease "systemic risk" in the financial system and/or "macroeconomic instability"? In this context, would a more rapid opening with respect to the provision of financial services be warranted than is currently planned? 2. hliis paper does not examine all parts of the NAFTA treaty, nor does it analyze the many domestic legislation changes that could have an important bearing on capital flows, (e.g. the foreign investment law, treatment of intellectual property, tax legislation, the new anti-monopoly law etc.) in order to address these questions. Rather, the focus of this paper is on the financial provisions of the NAFTA accord and their interaction with measures to liberalize the domestic ' The authors would particularly like to thank Augustin and Catherine Mansell Carstens, Moises Schwartz, Patricia Armendariz, Tomas Ruiz, Guillermno Barnes, Guillermo Prieto Trevino, Miguel Cano, Marin Maydon, Ruben Yesin and many other govemment officials and private market participants for helpful discussions. They would also like to thank Mr. Bachman from Cleary Gottlieb, and Messrs. David Scott, Don Mclsaac, Dimitri Vittas, Ross Levine, Salvador Valdes, Frank Lysy, Pat White, Jeffrey Marquardt, Ernesto May and Alfredo Thome. Special thanks are extended to Roberto Panzardi and Tony Ollero who provided research assistance, and to Virginia Clarke who helped in the production of this paper.  financial system that have been implemented since 1988 to the present. At the same time, we examine the interactions between these provisions and certain key macroeconomic policies (exchange rate and monetary policy). 3. Section IJ provides a setting for our discussion by reviewing recent macroeconomic trends in respect to the composition of capital flows. This section also provides a recent snap- shot of the factors which helps to explain the very high before tax nominal rates of interest still observed in Mexico as well as some background regarding the structure and health of the financial services industry in Mexico. Finally, it outlines some aspects of the NAFTA financial services provisions. 4. Section III examines how the NAFTA accord and, in particular. its financial service and investment provisions will impact on the level and composition of capital flows. In addition, it examines the extent to which efficiency in the provision of financial services will be improved. It identifies some channels that will promote greater competition and efficiency in financial services that have not been highlighted in the paper by Gruben et al.(l993). 5. Section IV argues that certain types of domestic financial policies take on particular importance in light of the NAFTA provisions at both the microeconomic and macroeconomic level. Specific domestic financial and macro policy areas are highlighted here to show how NAFTA would effect either systemic risk of the financial system or macroeconomic instability. Some options for changes in these domestic policies to ameliorate these problems are discussed. 6. Section V summarizes and comments on the implications of the above analysis for a more rapid opening of the financial services industry in Mexico than called for under NAFTA. II. The Setting 7. The implications of NAFTA for capital flows and efficiency in provision of financial services must start from an adequate understanding of the economic environment that would be faced by a prospective investor. The sections below outline characteristics of the macroeconomic environment. the size, structure, and composition of capital flows, and some information in respect to the reasons for the continued high lending rates and their relatively large dispersion across borrowers of different size. It also focuses attention on the microeconomic structure of the Mexican financial conglomerates that provide various types of financial services and concludes with a discussion of some of the key characteristics of the NAFTA financial services provisions. A. Capital Flows 8. The magnitude and composition of capital flows into Mexico have not been independent of the macroeconomic environment (see Sections A. I and A.2 below). Moreover, the destination and composition of the flows of capital into Mexico has changed markedly in relation to the early 1980's (see section A.3).  4 A. 1. Macroeconomic Background 9. Economic growth ground to a virtual halt over 1982-87. During this same period there was a sharp deterioration in living standards, the infrastructure deteriorated, high inflation was prevalent, and investor confidence was undermined. Policy makers responded to the inflation explosion of 1987 (inflation peaked at 159 percent) with an ambitious stabilization program, known as the "Economic Solidarity Pact" or "Pacto". Mexico's unprecedented fiscal austerity program was crucial for the success of the Pacto. The Pacto, announced in December 1987, was an agreement between business, labor, and government which called for accelerated structural reform, fiurther tightening of fiscal policy, wage controls. and control of basic public and private sector prices. The cornerstone of the Pacto was a freeze of the nominal exchange rate (ER) against the US dollar. Monetary policy was tightened in order to support and sustain the ER policy. The Pacto was renewed, with important modifications, by the new Mexican Administration under the name of "PECE" (Pact for Stabilization and Growth). Under the PECE and its successive renewals (the latest one was in October 1993), public tariffs and minimum wages were revised, contractual wages in the private sector were liberalized in 1989, controlled prices were revised and most were de facto liberalized in 1990, and a daily adjustment of the peso ER against the U.S. dollar was introduced (1 old peso a day for most of 1989, 80 cents for most of 1990, 40 cents for most of 1991). The preannounced daily rate of devaluation was, in November 1991, replaced by an ER band. The floor of the ER band remained fixed at the November 1991 level while the ceiling was depreciated daily, based on a preannounced schedule (20 old cents for most of 1992, 40 cents in 1993 and 1994). 10. In the case of almost every macroeconomic target under direct or indirect governmental control. performance under the PECE (or, interchangeably, Pacto) has been exemplary, in some instances going far beyond what was originally planned (Table 1). Inflation dropped from 159 percent in 1987 to 19 percent in 1989; it rose temporarily during 1990 (to 30 percent) due to the price de-control of most private goods. The downward trend was resumed in 1991 and by 1992, inflation wvas less than 12 percent; 8 percent inflation is expected for 1993. After virtually stagnating from 1982-88, output growth averaged 3.5 percent in 1989-92. It peaked in 1990 and has since declined to 2.6 percent in 1992 reaching almost zero in mid-1993. Confidence in the economy, a key factor in the economic recovery, was reflected in sharp declines of the nominal interest rates and massive private capital inflows.  5 Table I Basic Macroeconomic Indicators 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 Money and Finance: [ntlation%(CPI) 1/ 101.9 65.5 57.7 86.2 131.8 114.2 20 26.7 22.7 15.5 Mil Growth Rate 2' 41.4 62.4 53.8 72.1 129.7 58.1 40.7 62.6 119.8 17.3 14.2 Interest Rate (Cetes 28 75.4 62.2 82 135.2 156.4 114.5 56.9 42 21.4 17.1 days. Annual) BOP - US$ Trade Balance 14105 13184 8398 5020 8787 2610 405 -882 -7279 -15934 ExportsofGNFS 30004 33886 31503 26339 32975 36712 42307 48673 51401 55299 61242 Imports ofGNFS 16216 21028 23741 21805 23894 34146 42426 51535 60508 73617 76394 Current Account 5424 3765 404 -1771 3820 -2922 -6085 -7114 -13780 -22800 Capital Account 339 1306 -316 -2716 -1189 -1163 3176 8164 24134 25955 Fiscal Primary BaL./GDP 4.8 5.5 3.9 2.6 5.6 8 8.5 7.7 5.3 4.5 Economic Bal./GDP -8.1 -7.1 -8 -14.5 -14.4 -9.3 -4.8 -2.2 -0.3 1.6 0.7 Oil Price ($/Bar) 4/ 28.37 28.25 26.98 13.82 17.79 14.15 17.19 22.05 18.3 19.22 LIBOR 9.7 10.9 8.4 6.9 7.2 8 9.3 8.3 6 Real Sector: GDP Growth Rate -4.2 3.6 2.6 -3.8 1.9 1.2 3.3 4.4 3.6 2.8 0.1 I Mfc. Growth Rate -7.8 5 6.1 -5.3 3 3.2 7.2 6.1 4 2.3 -1.5 Real Exchange Rate 1.49 1.31 1.28 1.65 1.56 1.34 1.350 1.302 1.189 Consumption.GDP 5,' 69.7 72.3 73.7 77.1 74.6 78 78.8 79.3 80.7 82.9 Investment/GDP 5' 20.8 19.9 21.2 18.3 19.3 20.4 21.4 21.9 22.4 23.2 A.2. The Magnitude of Capital Flows 11. Associated with these macroeconomic developments was a sharp improvement in confidence of both Mexico's private sector and foreign investors. Long-term capital inflows, including massive capital repatriation, skyrocketed to US$24 billion in 1991, after being negative (on average) over 1985-88. Capital inflows remained strong in 1992 at US$26 billion, and during the first half of 1993 at US$16 billion. Although Mexico's economic rebound can be traced back to structural reforms which began well before the Pacto, the reform program was intensified (both in scope and in depth) after the Salinas Administration came into office in late 1988. Among the more important actions have been: the comprehensive commercial foreign debt restructuring cum-debt reduction reached in 1990; commercial bank privatization over 1991-92; application of most privatization proceeds to domestic debt reduction; NAFTA ratified in 1993; reform of the land-tenure "ejido" system, and. the central bank autonomy law passed in December 1993 by an overwhelming congressional majority. Most of these reforms were virtually inconceivable in 1988. 12. With all the successes that Mexico has had in restructuring its economy, regaining access to foreign capital markets, and in bringing down inflation to single-digit levels, the recent evolution observed in several macroeconomic indicators are a cause of concern. The strong deceleration in economic growth over 1991-92 has coincided with a sharp real peso appreciation and large trade deficits. Although trade and current account deficits were over-financed by private capital inflows, and the real ER appreciation was, in large measure, induced by these capital inflows, the sustainability of economic growth per se is now in question. Economic  6 growth in 1993 is expected to be close to zero. Lower domestic and. particularly. private saving accounted for more than half of the account deterioration in 1988-92. As a result. private external indebtedness has risen sharplv (albeit from a low base). Non-bank private debt rose from approximately US$5 billion in 1989 to almost US$15 billion in September. 1993; and Mexican commercial banks net external debt increased US$12 billion between 1989 and September, 1993. 13. The combination of very slow growth and very large trade and current deficits raises concerns about the medium-term capacity of Mexico's private sector to service external liabilities. In view of these concerns. Mexico remains vulnerable to volatile capital inflows in the short term. Private saving must eventually improve and. in this process. medium-term prospects for output growth will brighten. However, in the short term, the improvement in private saving (a reduction in consumption) will require a domestic economic contraction. It is possible that this is in fact what we began to observe in 1993: a sharp real contraction of private consumption (in absolute terms) associated with low or even zero economic growth. The 1993 slowdown has been compounded by a sharp deceleration in private investment due. in part. to uncertainties related to NAFTA, and in part, to high real interest rates. A.3 D)estination and Composition of Capital Flows 14. The surge in capital inflows has been associated with a large change in the composition of the sources and destination of those flows. As Table 2-a shows, the bulk of the new flows financed the private rather than the public sector. Most of the new flows were direct foreign investment (DFI) rather than debt-creating flows as was the case in the late 1970's and early 1980's. In turn. the bulk of DFI was portfolio investment. Portfolio investment rose from 0 in 1988 to US$9.8 billion in 1991, US$13.5 billion in 1992 and US$7.8 billion in the first half of 1993. Among the debt-creating flows, bond issues were the most important. There were almost no new syndicated bank loans to Mexico. Outstanding bond offerings in foreign capital markets (see subsection B. 1) rose from US$0.6 billion in 1989 (of bonds issued during 1982-89) to US$19.4 billion in 1993 (of bonds issued during 1982-93). Table 2-a MEXICO: Capital Inflows 1989-92 1989 1990 1991 1992 ).Total Capital Flows 3,037 8,163 24,133 25,954 2. Total Private Flows 881 5,910 15,807 21,142 Foreign Direct Investment 3,669 4,628 14.632 18,919 Net Direct Investment 3,176 2,633 4,762 5,366 Portfolio Investment 493 1.994 9.870 13,553 Private Non-Guaranteed Debt (2,788) 1.282 1,175 2,223 (Net) 15. In view of the growing importance of portfolio flows, it is useful to show as well how the composition of these flows evolved. Up until 1991, the bulk of portfolio investment went into equity (see Table 2-b). Thereafter, foreign investment in Mexican domestic government paper gained inmportance, partly reflecting Mexico's growing fiscal strengths, and partly reflecting the slowdown in economic growth in 1992-93 (Table 2-c). By October of 1993 portfolio investment  7 by foreigners in government securities amounted to 44 percent of the stock outstanding of all forms of securities. Portfolio investment in CETES amounted to almost 50 percent of the stock of such securities. Finally equity holdings by foreign investors now account for more than 60 percent of the value of shares outstanding which are being transacted. Table 2-b Foreign Investment in the Mexican Stock Exchange Amount Outstanding at Market Value (Millions of Dollars) Month ADR's Free Subscription Neutral Fund Mexico Fund T'otal Amount Shiare Amount Share Amount Share Amount Share Amount Share Dec 1989 402.0 49.8 107.0 13.2 35.0 4.3 264.0 32.7 808.0 100.0 Dec 1990 2.086.8 51.2 i.072.7 26.3 676.0 16.6 243.9 6.0 4.079.5 100.0 Dec 1991 13.733.5 74.1 2.961.0 16.0 1.348.8 7.3 499.3 2.7 18.542.5 100.0 Dec 1992 21.154.0 73.8 5.097.0 17.8 1.798.1 6.3 619.01/ 2.2 28.668.0 100.0 .Jun 1993 16.202.4 73.3 3.780.1 17.1 1.460.9 6.6 674.4 3.0 22.1 17.7 100.0 Dec 1993 21.154.0 73.8 5.097.0 17.8 1.798.1 6.3 619.01/ 2.2 28.668.0 100.0 Annual Variations Dec-90/ 419.1 902.6 1,831.5 -7.6 404.9 Dec-89 Dec-91! 558.1 176.0 99.5 104.8 354.5 Dec-90 Dec-92/ 54.0 72.1 33.3 24.0 54.6 Dec-91 I/ Portfolio value at October 1992. SOURCE: Anuario Bursatil 1992, Bolsa Mexicana de Valores, January, 1993 Table 2-c Foreign Investment in Mexican Government Securities Amount Outstanding at Market Value (Millions of New Pesos) D)atc CETES PAGAFES I/ BONDES TESOBONOS I/ AJUSTABONOS TOTAL Amount Share Amount Share Amount Share Amount Share Amount Share Amount Share .lan-31-91 4.056.6 4t.1 262.1 2.7 4.634.7 47.0 53.4 0.5 862.2 8.7 9.868.9 100.0 jutn-25-91 6.692.4 45.3 667.8 4 5 4.008.2 27.t 23.8 0 2 3,379.1 22.9 14,771 3 100.0 D)cc-30X-9I 0.075.1 54.0 64.8 0.4 2.231.1 13.3 790.1 4.7 4.641.5 27.6 16.802.7 100.0 Jun-30-Q2 15.039.3 58.4 0.0 0.0 1,695.4 6.6 924.3 3.6 8.078.8 31.4 25.7377 100.0 Dec-30-92 28.539.9 64.3 0.0 0.0 3.856.8 8.7 615.6 1.4 11,355.8 25.6 44.368.1 100.0 Variations Dcc-91.Jan.-9I 123.7 -75.3 -51.9 1.381.0 438.4 70.3 I)cc-92ADcc-91 314.5 NA. 72.9 -22.1 144.7 164.1 1. For 1'AiAFEs and TESOBONOS the average exchange rate of'current month was used. SOt R('E Itanco de Mexico  8 B. Trends in Cost of Offshore Borrowings 16. Since the signing of the Brady deal for restructuring its foreign commercial debt in 1990. Mexico has consistently improved the terms of its new borrowings in international capital markets (subsection B. 1). Quite independentlv from this trend. the terms obtained reflect increasing differentiation in terms of the risks associated with specific financial institution borrowers (Subsection B.2). B. I Corporate offshore borrowing operations and rates 17. With the restructuring of its external public debt under the Brady plan, Mexico's access to international capital markets improved sharply. This was not just reflected in improved access for both debt and equity issues but also in the terms for the new bonds issued (see Table 3). In 1982- 89, total new bond issues totaled US$1.3 billion, of which US$0.6 billion was issued in 1989 (the year in vvhich the Brady plan was launched). In 1990 alone, new bond issues reached US$3 billion. This figure was surpassed in 1991, US$3.2 billion, and once again in 1992, with US$4.2 billion. During 1993, there was another sharp rise of new bond offerings. totaling US$9.8 billion up through November. 18. The improved terms of new offerings refers both to lower interest spreads with comparable maturity instruments (US T.Bills) and longer maturities. Yield spreads over risk- free, 5 year public paper have narrowed in the primary market from 820 basis points on unenhanced paper (i.e., unsecured) which BANCOMEXT launched in June 1989. to around 400 basis poiints in the second half of 1990 (NAFIN obtained a 424 basis points spread and PEMEX 377 towards the end of 1990). The spread of the 5 year unenhanced public paper over the 5 year US T.Bill fell to around 250 basis points in late 1991 (PEMEX) and to slightly above 200 basis points in April 1992 (for maturities of up to 10 years). There has been some fluctuation since then: although we don't have spreads for public paper, the spreads of unenhanced private paper tended to increase for the rest of 1992 (for example, CEMEX obtained a 280 basis points spread in November 1991, but had to pay a 465 basis points spread in May 1992), suggesting that something similar may have happened with public paper. During 1993. yield spreads over risk- free. 5 year selected public paper evolved as follows: 208 basis points in March (U.M.S.), 215 basis points in July (BANCOMEXT) and 225 basis points in November (NAFIN). 19. A gradual lengthening of the maturities of new offerings has also been observed. While the typical maturity in 1989-90 was 2 to 5 years, more or less frequent issues (mainly public) of 7- 10 year maturity paper appeared in 1991-92. In 1992-93, maturities of 5-10 years also become accessible to a few private firms including commercial banks. Another breakthrough took place in November, 1993 when PEMEX issued a 30 year US$250 million note with a spread of 220 basis over the 30 year US T.Bill.  9 Table 3 Terms of Offshore Debt Issues Issuer Date of Issue Amount Currencv Interest Spread over Maturitv Rate US T Bill l Bancomext 06/01/89 100.000.000 US Dollars 10.250 820 5 Nafin 08/02/90 100.000.000 US Dollars 11.750 424 5 Pemex 12/13/90 100,000.000 US Dollars 11.430 377 5 Pemex 10/08/91 150.000.000 tUS Dollars 10.250 245 7 Cemex 11/15/91 100.000.000 US Dollars 10.00 280 5 Nafin 06/01/92 100.000.000 US Dollars 9.375 195 10 Cemex 11/05/92 280.000.000 US Dollars 10.000 455 7 UMS (UN Mex St) 03/16/93 200.000.000 US Dollars 7.250 208 5 Bancomext 07/06/93 200.000.000 US Dollars 7.5 215 7 Cemex 08/31/93 120.000.000 US Dollars 8.5 311 7 Nafin 11/10/93 100.000,000 US Dollars 6.25 225 5 Pemex 11/18/93 250.000.000 [JS Dollars 8.5 220 30 Source: Comision Nacional de Valores B.2 Commercial Bank Offshore Borrowing Rates 20. Besides data on the cost to the Mexican government on borrowing in international markets and to larger non-financial corporations through ADR and ADS offerings. it is interesting to examine the costs of short term borrowing in intemational markets to different banking groups. This can be done by examining the costs of short-term borrowing rates in the offshore Euromarkets. Rates quoted in this market suggest significant tiering across Mexican commercial banks of different size and capital strength. For example, immediately after commercial bank privatization, the cost of funding in the Euro-bond market hardly reflected any dispersion. The range of rates had widened by as much as 200 to 300 basis points for Mexican commercial banks of different size by December 1993. This can be seen by examining the differences in similar maturity zero coupon bond offerings by such banks as seen in Table 4. These changes reflect investor expectations about the relative solvency and risk of investments in these institutions. Such differences have started to become more pronounced as the Government of Mexico (GOM) increasingly sends the signal that it is prepared to permit commercial banking groups to take significant losses as witnessed by the 1992 episode with Ajustabonos.' These trends would suggest that remaining competitive may require that medium and small Mexican financial groups without extensive branch networks and limited capital strength will increasingly consolidate with other smaller financial groups. This is a trend that has already begun.3 2 In the first quarter of 1992, the real interest raid paid by the Ajustabonos (inflation indexed public debt) declined to a record low of about 2 percent. Following a series of measures aimed at curbing the growth of the dollar exposure of commercial banks, as well as a sharp increase in the current account deficit, real interest rates began to increase. As a result, many banks that were holding Ajustabonos as part of the liquidity requirement imposed by the Bank of Mexico, incurred substantial capital losses since their purchases of these bonds were funded with short term repurchase agreements. The government suspended new issues of Ajustabonos for the rest of 1992. At this writing, at least 2 mergers between financial groups are in process.  10 Table 4 Offshore Costs of Borrowing by Selected Mexican Financial Groups * s Instrument I issuer Date of Issue Maturity Date Interest Rate Amount lD Bancomer (London) 15-Sep-93 15-Dec-93 3.7500% $3.400 i CD Banorte 23-Nov-93 21-Feb-94 5.1250% $4.000 CD Comermex 03-Dec-93 01-Jun-94 5.1875% $10.000 CD Confia 13-Oct-93 11-Jan-94 5.3730% $0.600 C D -Union (Formerly 08-Oct-93 06-AprO94 3.7500% $2.600 Bco BCH) . * As of December 1993 C. Economic Factors Beyond Mexico's Control 21. TUhe integration of Mexico into the world economy and, particularly, the US economy, has increased its vulnerability to external and domestic exogenous factors. It is important to identify what these factors may be and how thev may evolve over time in order to assess their potential impact on systemic risk in the financial sector as well as on monetary and exchange rate policy. 22. I)uring the next Sexenio, Mexico will find itself under strong pressure to modernize its political institutions. While this will lead to greater stability eventually, there is the risk that during the transition there may be periods of greater macroeconomic policy uncertainty. The creation of an autonomous Central Bank will help to diminish these risks. 23. During the 1 980s and early 1 990s, the business cycles of Mexico and the US do not appear to have been closely correlated. However, the ongoing economic integration between Mexico. Canada and the US under NAFTA will increase Mexico's dependence on US economic activity and. in particular, US monetary policy. 24. Mexico will remain vulnerable to the traditional sources of risk -- foreign interest rates and oil prices. However, these sources are likely to be less important for several reasons in the years ahead. First, about half of Mexico's public foreign debt is set at fixed rates (the Brady par bonds). Second. a large share of growing private foreign liabilities has taken the form of equity with foreigners absorbing much of the risk. Nevertheless, an increase in foreign interest rates may prompt a reversal of capital flows that were previously driven by low US interest rates. Mexico has also reduced its dependency on oil revenue: oil exports accounted for less than 20 percent of total exports in 1992, compared to more than two-thirds in the early 1980s.4 25. ]Finally. Mexico will remain vulnerable to investor perceptions that treat the country as "a new junk bond market". One of the more interesting reasons for the massive capital inflows into Mexico has been the drying up of the developed country junk bond market: the implications go beyond Mexico and apply to all Latin American countries that are receiving large capital inflows from developed countries. As Mexico becomes "accepted" on international markets, 4 Part of this shift is due to lower oil prices.  11 international investors may reorient portfolios away from Mexico as opportunities to invest in high-yield securities open up in other parts of the world. D. Micro and Macro Factors Affecting the Costs of Capital In Mexico 26. Although substantial reforms were implemented to the financial svstem involving extensive deregulation of financial services over the 1988-92 period, nominal and ex-post real lending rates of interest before and after taxes have remained high. Chart I plots both the lending rates by commercial banks and the government cost of funds as reflected in CETES rates. It also shows the average cost of funds to commercial banks as measured by CPP. The spreads between CPP and Cetes has been widening over the 1989-93 period.5 This is due to the fact that the investment grade rating obtained for CETES elicited a strong demand by foreigners. The growing spread also reflects the fact that the relative solvency of the banking system has deteriorated slightly since the time of privatization.! 27. Underlying these high interest rates are both macroeconomic and microeconomic factors. Looking at these helps to highlight the types of Chart I Costo del Credito y Margen de Intermediacion Tasas Noinales en Por Cientos 60 Je40 0 I,., *,, T_ *l**co oo;0) 0D OD OD OD OD m m Tasa Activa Tasa Activa CPP CPP channels through which NAFTA provisions could have a beneficial effect on efficiency of financial intermediation in Mexico. Although the numbers are not precise, and are based on average. rather than marginal funding rates to commercial banks, the decomposition in Table 5 gives a sense for the magnitudes involved.' This widening would also occur if the new average interbank rate were used (TIIP). By June 1993, non-performing loans (as a percentage of total loans) had deteriorated to about 7.2 percent versus 5 percent in 1991-92. 7The approximation error introduced by using CPP rates (i.e a weighted average of all rates quoted on different commercial bank liabilities) is not that large to the extent that all liabilities, even checking accounts, pay interest.  12 28. The margins starting at the UJS Treasury Bill (US T Bill) rate are high. Of course, these margins will never go to zero given the differences in credit risk across countries. tax treatment, and in efficiency of financial service provision. However, by comparing these margins to those which might reasonably be expected under more favorable macroeconomic conditions, or. given a more efficient financial system and securities markets, it is possible to highlight where attention should be placed. 29. M1,acroeconomic factors account for 9 percent of the difference between GOM borrowing rates as measured by CETES and the rate on U.S. treasury bills as of December 1993, when these calculations were done. About 1 percent can be attributed to the country risk premium; about 4.5 percent can be attributed to expected inflation (minus expected inflation abroad); and the remaining 3.5 percent can be attributed to the real exchange rate risk.8 30. MAlicroeconomic factors help to explain an additional 8-25 percent of the margin between government borrowing rates and rates to large or small and medium enterprises. This additional margin can be separated into several components. 31. First, the 4 percent difference between CETES and CPP can be attributed equally to the risk of the banks themselves and to taxes that apply to commercial bank liabilities, but not to government liabilities. This margin is rather high and could be reduced through a combination of improved supervision and tax policy changes. 32. Second, the difference between CPP (the average cost of funds to commercial banks) and lending rates to large borrowers is about 6-8 percent. This difference, discussed in more detail in Annex 1 and in a recent study done by the Mexican Banking Commission, can be attributed primarily to the cost of bank operations (i.e. administrative and personnel costs account for about 70 percent of gross spreads). It also reflects implicit taxes such as capital requirements or deposit insurance quotas to FOBAPROA and provisions on bad loans i.e. "reservas preventivas".9 This spread also reflects the costs imposed due to nonexistence of markets in which to manage domestic interest rate risk at low transactions costs (and lack of market liquidity) that forces greater holdings of reserves for liquidity purposes.'" Finally, the high spreads also reflect profit margins. Annex I provides a more detailed analysis of banking spreads based on both the work of the authors and the CNB in Mexico. See Notes in Table 5 for an explanation of this decomposition. 'Commercial Bank loans are classified and it should be noted that having loans that are overdue (Cartera Vencida) does not imply that provisions have to be held against these assets. "' Recent changes in Central Bank operating procedures have eliminated the need for commercial banks to keep deposits with the Central Bank to effect clearing of payments.  13 Table 5 Decomposition of the Lending Rate1, Macroeconomic Factors Percent 1) Base Rate (US Treasury Bills) (1 month) 3.0 2) Country Risk Premium ., 1.5 _ -~~~~~~~~~~~~~~~~~~~~~~~. 3) Real Exchange Rate Risk y, 3.0 4) Inflation differential Risk , 4.5 5) GOM Government Borrowing Rate (Cetes Rate) (2+3+4) 12.0 Microeconomic Factors 6) Taxes applied to bank liabilities vs. Government liabilities 2.0 7) Risk of Banks 6/ 2.0 8) Average Cost of Funds to Commercial Banks (CPP rate) (5-t-6+7) 16.0 9) Bank Operating Costs, Profit Margin, and Implicit and Explicit Taxes 7 6-10 10) Estimated average lending rate (8+9) 22-26 1 1) Rates to Prime Borrowers 17-22 12) Rates to SME Borrowers 27-3 Source: Central Bank and authors estimates 1/ Assumes the foliowing levels for interest rates: ic (Cetes)=12%: it (Tesobonos)=4.5%: ia(Ajustabonos)=5%: iTB(US T.Bill)=3%. Tesobonos are dollar-indexed domestic debt instruments, A justabonos are inflation-indexed domestic debt instruments: Cetes are peso-denominated domestic debt instruments. We also assumed foreign inflation of 2.5%. 2/ Equal to: (it - iTB) 3/ Equal to: (ic - it) + 2.5 - (ic - ja) (foreign inflation) expected domestic inflation 4/ Equal to: ic - i - 2.5a- To the extent that ajustobonos are of maturity 3-5 years and of longer duration that CETES (28 days) this approximation is biased downwards because of the liquidity premium inherent in the ajustobonos rate which is not reflected in the CETES rate. 5/ The exact size of the tax effect is dependent upon whether it is foreigners or domestic residents that purchase government or commercial bank liabilities as tax treatment differs. If it is foreigners it is 15% (tax rate applied to foreigners) of 15% (rate on bank liabilities) or 2.2%: if it is a mix of foreigners and domestic corporations. it would be (2.2% + 1.4%)/2 = 1.8%. 6/ These rates reflect the risk differential between government and commercial bank liabilities. The bias introduced by comparing marginal government borrowing rates to average bank deposit rates is not allowed for but should be borne in mind. 7' Recent reforms suggest that the most important components of commercial banking spreads are profit margins and operatina and administrative costs. Implicit and explicit taxes taking the form of reserve requirements of liquidity coefficients have been eliminated in local currency. The exception relates to limitations on dollars denominated liabilities (no greater than 20%). 15% of which are subject to special investment guidelines relating to liquidity. This latter limitation obviously has implications for domestic lending rates as it limits the extent to which banks can pass on the lower costs of funding abroad to domestic borrowers. These calculations only consider banks and do not consider other entities within the financial group where other explicit taxes such as the value added tax of 10% would apply thereby having implications tbr the pricing of these services or for spreads charged in commercial bank lending operations as a means of compensating for these taxes. 8/This spread was estimated by comparing the cost of a typical leasing contract (i.e.) where repossession is not a problem with the terms of credit contracts for small and medium enterprises. Note that this spread may understate the effective rates paid by small and medium sized borrowers as they must post collateral to obtain the loan that can amount to more than the value of the loan contracted.  14 33. Irn the United States, the difference between government borrowing rates and loans by commercial banks to prime customers is about 3.5 percent. This suggests that commercial bank ing spreads could be reduced by perhaps 3-5 percent. Measures to achieve this objective and the possible channels through which the NAFTA accord will create pressures to reduce commercial banking spreads are discussed further in the sections that follow. 34. Third. although along a continuum, the range between the lending rates to large borrowers and the rates to SME borrowers of 22-36 percent respectively is higher than one would expect in a more well developed and efficient financial system." This large continuum reflects a variety of defects in Mexico's legal and institutional infrastructure that limits secured lending to SMEs. Different types of reforms involving modernization of the law of secured transactions and institutional improvements to Mexico's system of registries will be hastened by the NAFT?A accord (see Section IV below). These types of reforms could remedy some of these problems and might reduce this continuum of rates by 4-6 percent. 35. A.n important proviso associated with the analysis of the microeconomic factors causing high commercial banking spreads is that such calculations do not take into account the financial services offered by all entities within a typical Mexican financial group. This can make the typical analysis of spreads for commercial banks misleading particularly given the growth and profitabil.ty of some types of non-banking services (e.g. leasing). E. The Structure of the Mexican Financial Services Industry 36. Any analysis of the effects of the NAFTA financial service provisions cannot proceed without a careful examination of the rapidly evolving structure of Mexico's financial service industry (see Table 6 for detail). In this context, it can be important to understand not only what is legally required, but also how financial groups operate in practice. In addition, a number of important changes have been made in the legal and regulatory framework since the massive set of changes made over the 1990-92 period. 37. Newly privatized financial groups in Mexico are rapidly becoming fully diversified providers of financial services. These groups can provide retail banking services, insurance services, brokerage services, factoring and leasing services, asset and eventually pension managemznt services, and investment banking and financial advisory services through the commercial bank. These products are cross-sold through branch networks both within Mexico and offshore. Moreover, it is important to note that very few of these services are offered through segmented, separately capitalized subsidiaries. The preeminence of commercial banks in terms of total financial system assets can be seen in Table 6 below, which portrays the data available on the proportion of total financial system assets controlled by each type of entity. 12 Usually some of these services are offered both by the commercial bank in the group and by a subsidiary that can offer the service. In addition, recent changes in the financial groups law in 1993 perniit the holding to create multiple numbers of subsidiaries of the same type and to cross- " This range of rates does not even include the capitalized value of collateral (usually taking the form of real estate equal to as rnuch as three times the value of the loan) that would increase the bands of interest rates between large and small borrowers.  15 sell most financial services out of the offices of any of these entities. Cross-investments between subsidiaries are not permitted as a means of preventing pyramiding of capital. 38. In contrast to many other countries, the financial holding in Mexico (Controladora) is ultimately liable for the actions of any subsidiaries.'.' In this way, the structure of Mexican financial groups is somewhat unique within the context of Latin America. Unlike multiple banks. the financial group in Mexico is typically organized under a financial holding (i.e. Controladora) where the industrial groups may ultimately control this financial holding. This occurs despite attempts under the financial groups law to limit "control" by any one industrial group. 14 39. Chart 2 illustrates a typical structure. The chart shows that the industrial holding can have interests in both a financial group and in an insurance company. Present regulations might not treat the insurance company in this structure as related to the financial holding and permit cross-investments by the insurance company into the subsidiaries underneath the financial holding company. 12Note that this table excludes assets of credit unions a form of auxiliary credit institution that is not inconsequential. ' The extent to which liability extends upstream to the industrial holding depends on the authorities knowledge of the extent of actual shareholdings by the industrial group in the financial holding. 14 This refers to the limitation that each series A shareholder not hold more than 5 percent of the shares which requires the ability for supervisors to determine the relation between parties.  16 CHART 2 STRUCTURE OF FINANCIAL CONGLOMERATES: MEXICO INDUSTRIAL HOLDING SUBSIDIARY INSURANCE SAR IND/HOLD. COMPANY H [EINANC. HOLD| _ I I BANK || BROKER FOREX WAREHOUSE LEASING FACTORING || . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ......... : :::: :: :::. ... . . SA] |MUTUAL | |SAR* MUTUAL * SAR: (Sistema de Ahorros para el Retiro)  17 Table 6. Assets of the Financial System by Type of Institution (in billion Pesos) 1986 (%) 1987 (%) 1988 (