La Visin Internacional

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La Visión Internacional

• Seminario sobre El Mercado Cambiario en Chile
• David Sekiguchi
• 14 de Junio del 2002
• Santiago de Chile

Emerging Markets Research
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Credibility stands at the core of the development
of the Chilean local capital market

• Chile has a major advantage over most Latin
  American countries Credibility
• Credibility has been earned through the
  responsible management of economic policy
• Chilean policy making has targeted a path of low
  and stable real interest rates
• The success of the disinflation effort has
  yielded also low and stable nominal rates
• Long term markets have developed to an extent
  unparalleled in Latin America
• The transition to a floating exchange rate system
  has been a success despite very adverse external
  conditions (lower capital flows, falling terms of
  trade, regional crises)

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Chile has made important steps to develop its
local capital market

• Over the last five years there has been an
  important opening of financial markets,
  drastically eliminating restrictions in the
  capital account
• After having gradually prepared the market, the
  Central Bank complemented this effort by floating
  the currency in September 1999
• The current administration has introduced
  important reforms in two different phases
• It is broadly acknowledged that reforms of the
  first phase have already improved the structure
  of the market
• Similar positive feedback is given about the
  recently introduced second phase proposal
• However, there are some remaining possible
  reforms that can help make Chile's local markets
  more efficient, as well as more attractive for
  foreign investors

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Opportunities for further market development

• The most important opportunities for the
  Government to further develop Chile's local
  capital market and enhance its efficiency can be
  divided in two areas
• Complete the markets the range of
  instruments available and transactions allowed
  could be significantly expanded. This should
  allow for a better allocation of risks
• Reduce regulatory distortions there still exist
  meaningful distortions that alter relative prices
  and/or increase transaction costs. Some of these
  create biases between different assets or against
  the formal financial system as a whole, and
  generate an inefficient allocation of risk and
  resources

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Completing the markets Issues to address

• The participation of foreign investors in Chiles
  local markets remains limited
• Global fixed income and currency fund managers
  broadly agreed that the main deterrents against
  larger foreign participation in Chile's local
  markets are the following
• Low yields
• Low liquidity
• Inability to sell short in the market
• Very limited availability of derivative
  instruments
• Limited existence of nominal yield instruments

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Completing the markets Issues to address (cont.)

• Of these deterrents, there is a strong consensus
  that currently the most important reason for
  their lack of participation is the low yield
  available in Chiles financial instruments
• This is precisely the one variable that the
  Government is not interested in changing to make
  the market more attractive for foreign investors
  
• Besides the yield issue, the low foreign
  participation in Chiles local capital market is
  due, according to the fund managers, to the
  unavailability of market instruments (the market
  incompleteness shortcoming)

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Completing the markets

• The most important steps that can generate
  meaningful progress toward the completion of the
  market are in our view the following
• Development of a risk-free nominal yield curve
• Development of a security lending market to make
  short-selling feasible
• This is part of the Second Phase of the Capital
  Markets Reform
• Development of markets for derivative instruments
  beyond FX forwards

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Development of a nominal yield curve

• Chile has to a large extent successfully
  completed a steady disinflation process
• Over this period, the development of the capital
  market rested on the creation of
  inflation-protected instruments
• The indexation of the economy protected
  bondholders and left the government more exposed.
  This effort arguably slowed the disinflation
  process
• Nearing the end of the process, the Central Bank
  and the Government have accumulated credibility,
  an asset central to the further development of
  the capital market
• With the successful disinflation, the Central
  Bank was able to nominalize its monetary policy
  tool, the policy interest rate, on (August 2001)
  
• However, nominal yield instruments remain a very
  small portion of the outstanding government debt
  stock

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A nominal yield curve is crucial for the further
development of the local capital market

• The existence of nominal yield instruments will
  facilitate the participation of foreign investors
  and offer more choices to domestic investors also
• The vast majority of foreign investors are
  uncomfortable with inflation indexed paper
• A nominal yield curve would allow foreign
  investors to take positions that reflect their
  views on future inflation
• The development a a nominal CLP yield curve is a
  necessary building block to increase the
  availability of FX derivatives
• The creation of nominal yield instruments will
  also allow the Government to further reduce risk
  mismatches
• Nominal debt is in fact state-contingent debt in
  real terms, with the Government able to influence
  the real value of its liabilities
• Obviously the Government has to be prudent with
  this tool, but this flexibility can help the
  Government better absorb price shocks

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A market of securities lending

• The ability to short-sell will be critical to the
  development of the local capital market
• The possibility of short selling risk-free
  securities should greatly facilitate the growth
  of the credit market
• It should also help the progress of interest rate
  derivative instruments
• It would also allow for a more efficient
  allocation of risk for the entire economy (a
  welfare argument)
• With the recent reform that authorizes securities
  lending (starting August 1 2002), the Government
  has already taken what could prove to be the
  decisive step for the development of a short
  selling market
• An important issue is the expectations that
  institutional investors have about the
  Reglamento that should set the rules for
  securities lending
• Some investors expressed concerns that it might
  be so restrictive that it could actually
  discourage the emergence of a meaningful market

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Expand the derivatives market

• The combination of a nominal yield curve and the
  possibility of short selling provides the
  building blocks needed for the existence of an
  interest rate swap market, as well as a
  significant extension of the cross currency swap
  market
• These swap markets would allow for better
  management of economic risks, for the benefic of
  the Government and the private sector
• This should also be very beneficial for the
  growth of non-Government issues in CLP
• Private sector parties would be able to issue
  plain vanilla fixed rate nominal paper to
  maximize market receptiveness, while hedging
  risks to generate a potentially different
  liability structure that better matches their
  desired liability profile

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Enhance liquidity

• Liquidity stands at the core of investor worries.
  The Government can foster liquidity in the
  markets by undertaking the following actions
• Facilitating the creation of new types of
  financial instruments
• Facilitating the creation of new (nominal)
  benchmark instruments
• Introducing a system of market-makers

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Facilitating the creation of new instruments

• A trade starts with a difference in views between
  two market participants
• However, even with different views and the
  willingness to trade at a price that would be
  acceptable by both buyer and seller, there are
  just no instruments or markets available
• Therefore, the existence of more instruments
  should lead to a higher trading volume and to
  enhanced market liquidity

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Facilitate the creation of new (nominal)
benchmarks

• The emergence of nominal benchmarks would
  facilitate a gradual shift to a nominal fixed
  income market
• The benchmarks should be structured so that
  trading is facilitated and encouraged
• Auctions should be held regularly and predictably
• The instruments should be simple and homogeneous
• They should be similar to those used by investors
  globally, typically zero coupon instruments at
  the short end of the curve, and coupon bullets
  for longer tenors
• The government should conduct exchanges to retire
  issues of small sizes by issuing or expanding
  benchmarks

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Introduction of a system of market makers

• Market makers typically act as financial agents
  to the Government in all domestic debt
  transactions and placements
• Market makers usually meet with the authorities
  before the auctions to analyze and provide
  feedback on the market situation
• Market makers face a number of obligations,
  providing a minimum demand in the primary market,
  and liquidity in the secondary market
• Below are some of the rules by which market
  makers have to abide
• Participate in every auction
• Constantly supply bid and offer quotes at a
  reasonable spread
• Need to reach a minimum participation level as a
  share of total trading volumes
• The list of market makers should be periodically
  revised

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Conclusions Chile has taken very important
steps, but there is still significant room for
improvement

• Credible and prudent macro policies are a
  necessary component, and these have strengthened
  again after a deterioration under the previous
  administration
• However, further progress is still needed to
  continue strengthening what has become a very
  open economy in a context of volatile capital
  flows and terms of trade
• Both the government and the private sector can
  smooth the volatility they face with deeper
  markets for exchange rates, interest rates, and
  equities
• The government can facilitate advances to
  complete the markets, as well as to eliminate
  regulatory distortions