Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. 14575

PERFORMANCE AUDIT REPORT

CHILE

FINANCIAL MARKETS LOAN(LOAN 3143-CH)

JUNE 7, 1995

Operations Evaluation Department

This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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Currency Equivalents

Currency Unit = Chilean Peso (P.)

Average Exchange Rate (per US Dollar)

1989 US$1 P. 267.151990 US$1 P. 305.061991 US$1 P. 349.371992 US$1 P. 362.591993 US$1 P. 404.35

Abbreviations and Acronyms

ADR American Depository ReceiptsCORFO Corporacion de Fomentode la ProduccionIDB Inter-American Development BankFICE Fondos de Inversiones de Capital Extranjero (Foreign Capital Investment

Funds)FML Financial Markets LoanOED Operations Evaluation DepartmentPAR Performance Audit ReportPCR Project Completion ReportSAFP Superintendencia de Administradores de Fondos de PensionesSBIF Superintendencia de Bancos e Institutos FinancierosSME Small and Medium EnterpriseSMI Small and Medium IndustrySVS Superintendencia de Valores y-SegurosUF Unidad de Fomento (Inflation-adjusted monetary reference unit)

Fiscal Year

January 1 - December 31

FOR OFFICIAL USE ONLYTHE WORLD BANK

Washington, D.C. 20433U.S.A.

Office of Director-GeneralOperations Evaluation

June 7, 1995

MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT

SUBJECT: Performance Audit Report on ChileFinancial Markets Loan (Loan 3143-CH)

Attached is the Performance Audit Report for the Chile Financial Markets Loan (Loan 3143-CH)prepared by the Operations Evaluation Department. The loan, for an amount of US$130 million, wasapproved in December 1989 and closed in June 1992.

The loan objective was to assist the Government of Chile in further developing the securitiesmarket and investment financing through leasing. More than half of the loan proceeds were allocated fora quick-disbursing component. This aimed at advancing policy measures for improving securities marketinfrastructure, expanding investments instruments and liberalizing restrictions in the placement ofsecurities. The second component was a credit line for the leasing sector. A technical assistancecomponent, separately financed by a Japanese Grant, was designed to strengthen governmental institutionsthat supervise the financial markets and to monitor the developments of these markets.

Project implementation was effective and the goals were successfully met. Almost all the financialsector conditions were fulfilled. The technical assistance improved the capabilities of supervisory boardsin the financial sector. In addition, all the proceeds for the leasing credit line were spent two years fasterthan expected, and the auction system utilized proved to be very effective. Conversely the balance ofpayments support proved to be unnecessary as external sector performance increased substantiallybeginning in 1990, and the second tranche (US$40 million) of the fast disbursing component was canceledat the request of the Government.

Overall, the project outcome is rated as satisfactory, the institutional impact as substantial andsustainability as likely.

The audit confirms the assessment of the PCR. The audit uses recent information collected by theaudit mission to provide a detailed quantitative account of the development of Chile's financial markets,and identifies outcomes that result from the policy and the credit components of the loan. The audit alsoanalyses the effects of the financial market developments on the industrial sector.

Attachment

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contentsmay not otherwise be disclosed without World Bank authorization.

Contents

Preface .. ........................................................ 3Basic Data Sheet .................................................. 5Evaluation Summary .............................................. 7

1. Background................................................... 15

Macroeconomic Review ........................................... 15Financial Policies ............................................... 17

2. Project Objectives, Design and Relevance ............................. 19

Objectives ..................................................... 19Design .. ..................................................... 19Policy Adjustment Component ................... .................. 19Leasing Credit Component ......................................... 20Technical Assistance Component ..................................... 20Assessment of Objectives .......................................... 21

Relation to Basic Bank Objectives ................................. 21Relevance ..................................................... 21Complexity .. .................................................... 22Riskiness ........................................................ 22Borrower Ownership ............................................... 22Demands on Bank Resources......................................... 22

3. Project Outcome, Assessment and Sustainability ........................ 23

Project Outcome.................................................23Balance of Payments Support ...................................... 23Pension Fund Developments ...................................... 23Life Insurance Company Developments ............................... 26Evolution of the Securities Markets..................................27Banking Sector Developments..................................... 30Leasing Sector Developments......................................31Technical Assistance ............................................ 33Strengthening Institutions.........................................34

Main Factors Affecting Outcome..................................... 34Assessment of Outcome............. .............................. 35Sustainability .................... .............................. 35

This report was prepared by Nicolas Mathieu (Task Manager), Stephan Klasen (YoungProfessional) and Derek White (Consultant) who jointly audited the project in September 1994.Jasmine Mason-Anderson provided word processing assistance.

Contents (Cont'd)

4. Bank and Borrower Performance ................................... 37

Bank Performance ............................................... 37Borrower Performance ............................................ 37

5. Conclusions and Lessons of Experience ............................... 39

Conclusions ................................................... 39Audit Ratings .................................................. 40Lessons of Experience ............................................ 41

Tables

1.1 Key Economic Indicators, 1977-93 ................................ 153.1 Distribution of Pension Fund Assets, 1988 and 1994 .................... 243.2 Distribution of Life Insurance Company Assets, 1989 and 1993 ............ 263.3 Distribution of Primary Securities Market Issues, 1990 and 1993 ........... 283.4 Pension Fund & Life Insurance Company & Foreign Capital Investment ...... .30

Annexes

I. Macroeconomic Indicators ........................................ 43II. The Policy Component of the Loan ................................. 49III. Pension Funds .. .............................................. 51IV. Life Insurance Companies ........................................ 59V . Securities M arkets.. ............................................ 63VI. Banking System ............................................... 75VII. Leasing Sector ................................................ 85VIII. Industrial Finance .. ............................................ 97IX . C O R FO . ............................................... ... 111X. Technical Assistance . .......................................... 117XI. Comments from Corporacion de Fomento de la Produccion ............... . 123

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Preface

This is a Performance Audit Report (PAR) on the Financial Markets Loan in Chile.The Bank's financing consisted of a Loan (Loan 3143-CH) in the amount of US$130 millionequivalent which was signed on February 7, 1990, and became effective on July 6, 1990.There was a cancellation of US$40 million.

This PAR was prepared by the Operations Evaluation Department (OED). It is basedon discussions with World Bank staff, the Staff Appraisal Report, the Loan Agreement, theProject Completion Report and the official files of the project. In addition, an OED missionvisited Chile in September 1994 and discussed the effectiveness of Bank assistance withGovernment officials and beneficiary enterprises. Their kind cooperation and invaluableassistance during the mission is gratefully acknowledged.

While the ratings do not differ between the PCR and the PAR, the PCR bases theassessment on the fulfillment of the conditionalities for the policy component and thesuccessful resource transfer for the leasing component. The audit, on the other hand, providesa detailed quantitative account of the development of Chile's financial markets, including aclose analysis of the pension funds, life insurance companies, banks, leasing industry, andsecurities markets. It attempts to distinguish between those outcomes that can be directlyattributed to the policy or credit components of the loan from those that are due to externaldevelopments. Finally, it analyzes the effect of these developments on industrial finance andthe need for further policy reform or directed credit operations to improve credit access toindustrial companies.

Concurrently with this audit, three related projects were audited by OED, namely twoindustrial finance projects (2606-CH, 3053-CH) and a Small and Medium Industry project(2606-CH). References to these other audits are made when common issues are analyzed.

Copies of the draft PAR were sent to the Borrower for review and comments.Comments were received from Corporacion de Fomento de la Produccion and reproduced asAnnex XI.

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Basic Data Sheet

FINANCIAL MARKETs LOAN (LOAN 3143-CH)

Loan Position (Amounts in US$ million)

As of March 31, 1995

Loan Original Disbursed Cancelled Repaid Outstanding

3143-CH 130.0 90.0 40.0 - 90.0

Cumulative Estimated and Actual Disbursements (US$ million)

FY90 FY91 FY92 FY93

Appraisal Estimate 50.0 100.0 110.0 130.0

Actual - 62.5 90.0 90.0

Actual as of % of Estimate - 63% 82% 82%

Date of Final Disbursement: June 29, 1992

Project Dates

Date Planned Actual Date

Identification September 1988 March 1989

Appraisal Mission November 1988 June 1989

Loan Negotiations May 1989 November 1989

Board Approval July 1989 December 1989

Loan Signature July 1989 February 1990

Loan Effectiveness December 1989 July 1990

Loan Closing June 1995 June 1992

Loan Completion -

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Staff Inputs (staff weeks)

FY87 FY88 FY89 FY90 FY91 FY92 FY93 FY94 TOTAL

Preappraisal 0.6 12.7 67.7 - - - - - 81.0

Appraisal - - 3.4 35.4 - - - - 38.8

Negotiation - - - 10.9 - - - - 10.9

Supervision - - - 5.9 16.8 2.3 5.2 4.4 34.5

Other 0.7 4.4 2.7 - - - - - 7.7

Total 1.3 17.0 73.8 52.3 16.8 2.3 5.2 4.4 173.0

Mission Data

Month/Year Number of No. of Dates of OverallPersons Weeks Report Project

Preidentification 05/87 1 2 05/30/87 -

Identification 06/88 6 1.5 07/20/88 -

Preparation 10/88 2 2 11/23/88 -

Preappraisal 04/89 7 3 05/02/89 -

Appraisal 06/89 2 2 06/30/89 -

Supervision 1 07/90 1 0.6 07/13/90 -Supervision II 09/90 2 0.8 09/28/90 -Supervision III 11/90 2 2.0 01/04/91 1Supervision IV 03/91 2 1.0 04/12/91 1Supervision V 12/91 1 0.2 12/26/91 RaySupervision VI 09/92 1 1.6 10/14/92 2

R = not rated.

Other Project Data (Borrower: Corporacion de Fomento de la Producion (CORFO))

AmountRelated operations Loan no. (USSM) Board date

Small and Medium Industry 2613-CH 40.0 August 27, 1985

7

Evaluation Summary

Introduction

1. Economic Background. After several years of strong growth in the late 1970s, acombination of a highly overvalued currency, low domestic savings, lax supervision of thefinancial system, increasing foreign indebtedness, and the sudden termination of foreignlending led in 1982 to Chile's worst economic crisis since the Great Depression. Thegovernment responded with a severe devaluation of the real exchange rate, which greatlyinflated the peso-denominated burden of private companies' external debt. Recession-depres;ed revenues and greatly increased external debt service payments left many industrialfirms in serious financial trouble and led to a large increase in the bad loan portfolios of thecommercial banks. Government efforts to deal with these problems included establishingpreferential exchange rate arrangements for companies with external debts, arrangingconcessionary debt reschedulings and taking over the banks' bad loans. However, the bankswere required to repay the Government out of future profits and thus have remained seriouslyweakened.

2. Resumed Growth. Following the immediate aftermath of the debt crisis, Chile'seconomic growth resumed, stimulated by the exchange rate devaluation, reduced imports,declining public spending, rising private investment, and, after 1985, a drastically decliningdebt/GDP ratio, falling tariffs, and improved export earnings. Since 1988 economic growthhas been strong, averaging over 7 percent a year.

3. Bank Support. Since 1986, the Bank has given strong support to Chile'smacroeconomic and financial restructuring with three SALs. The Bank also supportedfinancial reforms with three directed credit programs to finance investment to both largeindustrial companies and SMEs. The Financial Market Loan (FML) was designed to carry theprocess of liberalizing and developing the financial markets further.

Project Objectives and Design

4. Basic Features. The FML, approved in December, 1989, was a hybrid loan, with twocomponents: (1) a US$ 80 million quick disbursing, policy-based component, in two equaltranches, aimed mainly at deepening the securities market; and (2) a US$ 50 million creditcomponent, to provide term funds to the leasing sector. It was supplemented by a US$ 1.96million technical assistance grant, financed by the Japanese Grant Facility.

5. Objectives. The FML's overall objectives were to: deepen Chile's securities markets;ensure profitable investment opportunities for the increasing assets of pension funds and lifeinsurance companies; strengthen the banks; encourage and finance leasing; support Chile'sbalance of payments; develop CORFO, the state development bank, as a second-tier lender tothe leasing companies; and strengthen the Government's capacity to supervise the financialsector.

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6. Deepening the Securities Market. The FML's approach to the securities market wascomprehensive. First, it aimed at improving the market's basic infrastructure by supportingthe introduction of computerized securities trading, a central depository system and astrengthened security risk-rating system. Second, on the demand side of the market, itsupported liberalization of pension funds and insurance company investment options byexpanding their access to corporate shares and allowing them to invest in newly formedclosed-end mutual funds and real estate investment companies (REICs), corporate short-termpaper, and securitized and collateralized bank loans. Third, on the supply side of the market,it sought to: simplify the issuance of corporate securities; promote corporate use of thesecurities markets; and facilitate creation of closed-end mutual funds, REICs, and a corporatebond guarantee company.

7. Fourth, the banking system was to be helped by: permitting banks to issue securitizedand collateralized loans; raising the ceiling on their guarantees; allowing them to expand theircapital through the issuance of subordinated bonds. Finally, bank subsidiary leasingcompanies were to be subject to formal regulation and the bond issuing capacity of leasingcompanies was to be doubled.

8. Leasing Credit. The US$ 50 million leasing credit was to be allocated to leasingcompanies through a series of periodic auctions administered by CORFO on the basis ofcompetitive interest rate bids.

9. Technical Assistance was mainly directed towards fortifying the Government's capacityto supervise the financial markets.

Project Outcome

10. Supporting the Balance of Payments. Given the unexpectedly strong recovery inChile's balance of payments position, reflecting higher-than-projected copper prices,repatriation of Chilean capital held abroad, and resumed foreign capital inflows, the firsttranche of US$40 million proved unnecessary, and the US$40 million second tranche of thepolicy component was cancelled at the Government's request. None of these developmentswere readily predictable so that neither the Bank nor Chilean authorities can be faultedforecasting a need for balance of payments support at the time.

I1. Pension Fund Investments. The growth of pension fund assets, propelled by Chile'scompulsory saving scheme almost tripled in real terms over 1989-94. About 42 percent of theincrease in assets represented enlarged holdings of corporate stock, a development broughtabout by the liberalizations supported by the FML, although also due to higher share prices,driven up to an important extent by the pension funds' own purchases as well as the surge inforeign portfolio investments.

12. Another 40 percent represented increased holdings of public bonds, encouraged bylarge government sales of such securities to finance a build-up in Chile's exchange reserves.The pension funds doubled their real holdings of corporate bonds but these holdings declinedas a proportion of total assets. Deposits in financial institutions declined somewhat in absoluteterms and fell sharply as a proportion of total assets.

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13. The pension funds invested very little, over 1989-94, in closed-end mutuals, REICs,and company short-term paper (although some interest in the mutual funds has materializedrecently). Furthermore, delays in passing and implementing the necessary legislation meantthat bank-initiated securitized and collateralized loans have been unavailable. Thusdiversification of pension fund investments proceeded among more conservative lines thananticipated by th, SAR. At the same time, the increasing real returns earned by the pensionfunds, averaging 16.6% between 1990-1994, indicate that one substantive aim of the FML,ensuring profitalle investment opportunities for the pension funds, was clearly achieved.

14. Life Insurance Company Investments. Life insurance company assets witnessedsimilar, higher than expected, growth and with the support of the FML, these assets have beendiversified considerably, with an increasing share going into corporate shares, althoughinvestments continue to be dominated by purchases of government bonds.

15. Securities Markets Developments. The introduction of computerized trading incompetition with traditional trading has been highly successful and has led to reduced tradingcommissions. A securities risk assessment supervisory unit was set up in the stock and bondcommission (SVS) and has reduced the dispersion among private risk assessment company riskratings. Fhe central securities depository has been established, is currently at the testing stage,and will go into operation in 1995.

16. Primary Securities Markets. While stock issues have, as envisioned by the FML,increased vigorously in recent years, buoyed by increasing demand from pension funds,foreign capital investment funds, corporate bond issues have stagnated. Part of the reason forthe stagnant bond issuing activity is the increasing ability of Chilean companies to tapinternational capital markets.

17. Securities market capitalization more than doubled over 1990-93. Over four-fifths wasattributable to almost a tripling in the value of outstanding shares. This resulted mainly fromstepped-up purchases by pension funds, insurance companies, and Foreign Capital InvestmentFunds (FICEs) in the still relatively thin market for actively traded stocks. The share of totalmarket capitalization represented by public bonds fell sharply, although such bonds rose over40 percent in absolute terms. REICs and closed-end mutuals represented a negligible 0.2percent of total market capitalization in 1993. Both pension funds and insurance companies,with their high asset growth, increased their shares of virtually all types of outstandingsecurity, both public and private. This, together with their impact on share prices, suggeststhey may still need additional outlets for their funds. This development was recognized byChilean authorities and further liberalization of pension funds and life insurance companyinvestments was decreed in March of 1994.

18. Thus the FML-supported policies gave rise to: a considerable increase in the volume ofdomestic share issues; high returns earned by pension fund and life insurance companyinvestments; no increase in new domestic corporate bond issues; a large increase in tradedstock prices (and thus in the overall market capitalization of outstanding shares); and, to date,negligible overall demand for REICs and closed-end mutuals.

19. Banking System Developments. With the securitization and collateralization of bankloans still not implemented, the impact of the FML on the banking sector has been small, apart

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from its effect in reducing the share of pension fund and insurance company assets held in thebanking system. The raising of the ceiling on bank guarantees has contributed to some growthin the guarantee business. The issues of subordinated bonds (to increase bank capital), whilegrowing rapidly, have not yet reached significant levels.

20. At the same time, the fundamentals of the banking system had been improvinggradually since the mid-eighties, despite a decline in total assets prior to 1991. Between themid-eighties and 1991, the banks liquidated investments and other assets to clear up long-termliabilities dating back to the 1982 debt crisis. This was made possible by strong growth andan improvement in corporate finances. Other indicators of financial health, such as provisionsfor bad loans, nominal profits, and capital and reserves, all show improvement since the mid-eighties.

21. Leasing Sector Developments. In the face of extremely strong demand for funds bythe leasing companies, the US$ 50 million leasing component was disbursed far more quicklythan anticipated, in larger and fewer tranches, a year ahead of schedule. The innovativeauction system functioned extremely well and has been subsequently used to allocate US$370million of IDB and CORFO funds to banks and leasing companies. The main beneficiaries ofleasing have been the productive sectors of the economy. Leasing has thus contributedsignificantly to Chile's strong growth. Although large companies received most of the funds,the majority of the contracts were with SMEs. With increasing access to investment financingthrough leasing, SMEs have been able partly to offset their limited access to bank financing.

22. Bank and IDB funds channelled through CORFO have in recent years represented adeclining fraction of the total financing obtained by leasing companies, reflecting bothgovernment policy to restrict credit so as to reduce inflation and better access by the leasingcompanies to bank and bond financing. The FML played a role in this by supporting theestablishment of a formal regulatory framework for bank subsidiary leasing companies and byraising the ceiling on leasing company bond sales, so that leasing companies have become lessdependent of the directed credit provided by the Bank and IDB.

Technical Assistance

23. Technical Assistance was well conceived, properly directed, competently carried out,carefully supervised, and effective.

Project Assessment

24. The main objectives of the loan, using the increasing assets of pension funds and lifeinsurance companies to achieve securities market deepening have been achieved. However, forvarious reasons, including large-scale government borrowing to build up exchange reserves,increased corporate recourse to financing from foreign sources, delays in introducing theproposed securitized and collateralized bank loan packages, and the conservative investmentpolicies of the pension funds and insurance companies, the deepening of the securities marketshas continued along more conservative lines than expected. While stocks, mortgage-backedsecurities, and bonds all increased their presence in the securities markets, the more innovativeinstruments supported by the FML, e.g. closed-end mutuals, REICs, securitized andcollateralized loans (which have yet to be implemented) have played a small role so far.

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25. It would be premature, however, to conclude that the FML has failed in these areas.As bank-originated, loan-backed securities become available and institutional investors acquirefamiliarity with the other new instruments supported by the FML, there seems to be no reasonwhy the securities market objectives of the loan should not increasingly be realized,particularly if public bond issues remain at low levels in coming years.

26. The other main component of the loan-the provision of credit to leasingcompanies-was an unqualified success. Leasing credit met a real need, its distribution waswell manared and the results were highly beneficial, contributing significantly to Chile'sstrong growth. Furthermore, the private market failure initially justifying the involvement ofthe Bank and the IDB in this type of lending is rapidly disappearing, in considerable part dueto the regulatory changes supported by the FML.

27. Technical assistance was unusually well managed and successful. Although bothtranches of the balance-of-payrrents support proved redundant in the event, it was not possibleto predict the drastic improvement in the external environment that made the first trancheunnecessary and led to the cancellation of the second. An indicator of Chile's high ownershipof the reform effort is the fact that they implemented all second tranche release conditions inspite of ics cancellation.

Institutional Strengthening

28. The loan contributed to institutional strengthening in two ways: First, the technicalassistance helped strengthen the analytic and regulatory capacities of the various agencies andministries responsible for overseeing the securities markets, the pension funds, and the banks.Second, technical assistance as well as the successful implementation of the auctionmechanism assisted CORFO in moving from a loss-making and arrears-prone first-tier lenderto a successful and profitable second-tier lending institution.

Sustainability

29. The basic policy objectives of deepening Chile's securities markets, broadeningcorporate access to the expanding investment resources of the pension funds and insurancecompanies, and facilitating increasing bank involvement in the securities market are compatiblewith Chile's realization of vigorous long-term growth. Thus, the essential thrust of thechanges appears sustainable.

30. Given Chile's high commitment to the ongoing process of financial liberalization andreform as well as its strong capacity to oversee and regulate the financial system, there is littledoubt that this reform process will provide sustainable improvements in Chile's financial sectorperformance.

Bank Performance

31. The Bank's previous substantial involvement in Chile's financial sector and itsthorough preparatory work on the FML paid off in the significant successes-particularly inthe area of leasing-achieved by the loan. The limited impact so far of the securities marketchanges is tnot attributable to any Bank shortcoming in loan design, preparation or supervision,

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which were all commendable. Furthermore, the Bank cannot be faulted for its failure topredict the increase in copper prices and changes in investor attitudes towards Latin America,which rendered balance of payments support unnecessary. Finally, the technical assistancecomponent was unusually well conceived and supervised. In short, the Bank's performancemerits very high marks.

Borrower Performance

32. The Government's sound economic and financial policies, which stimulated strongeconomic growth, were a key underlying factor in the sharp rise in pension fund and insurancecompany assets, as well as in the considerable improvement in the financial performance ofthe banking system. Moreover, despite the Government's cancellation of the second tranche ofthe policy component, it continued to implement the changes that had been agreed upon andwas not responsible for the legislative delay in introducing bank-packaged, loan-backedsecurities. CORFO performed well in channelling the credit component, and the governmentministries and agencies involved in implementing the technical assistance componentsdischarged their responsibilities satisfactorily. Thus, regarding the technical and managerialaspects of the loan, the Government's performance was also commendable.

33. However, Government efforts to prevent a real appreciation of the exchange rate in theface of increasing foreign capital inflows, which led to a large build-up in Chile's foreignexchange reserves, has provided the pension funds and insurance companies with the option tocontinue their heavy reliance on government bonds instead of increasing their holdings inprivate securities.

Conclusions

34. The Financial Markets loan has made a number of significant contributions tosecurities markets development. First, it has facilitated the matching of long-term institutionalfunding with long-term corporate investment requirements, in the process enhancing returns onpension fund and insurance company assets. The improvement in the allocation of financialresources has contributed to Chile's strong growth. Second, it has, via leasing, financed soundinvestments, including a rising number of SME investments, thereby contributing to thissector's development and easing their constraint on investments and growth. Third, throughtechnical assistance, it has strengthened and improved the quality of financial marketsupervision. This is aiding the sound growth of the financial markets and again contributingto improved overall economic growth.

35. Audit Ratings. The FML's outcome is rated satisfactory, the institutional impactsubstantial, and sustainability likely.

Lessons of Experience

36. The main lessons to be learnt from the FML are as follows:

Bank support of financial market reforms can give impetus to the reform process andhelp ensure that the reforms are comprehensive and well integrated.

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A highly complex, hybrid project, with a detailed T.A. program, can succeed provided:(a) the macroeconomic, financial and industrial policy framework is sound; (b) theGovernment is fully committed to the project and implementation is in the hands ofcompetent officials and institutions; (c) there is close Bank/Government cooperation;(d) the Bank is able to draw upon a sound base of prior sectoral and institutionalknowledge; and (e) the Bank is prepared to devote adequate resources to loanpreparation and supervision.

* Prcviding credit to leasing companies can represent a very useful and practicalsupplement to the problem of giving SME access to investment financing.

* Auctioning can be a practical means for allocating long-term credit where the capitalmarket does not provide reliable, competitively determined, bell-wether interest rates atwhich such credit may be priced.

* S.multaneousiy supporting the liberalization of financial markets, on the one hand, andproviding directed credit for an activity such as leasing, on the other, are notnecessarily inconsistent with one another, provided that the directed credit addresses aciear case of market failure and does not impede the evolution of private sectorfinancing alternatives.

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1. Background

Macroeconomic Review

1.1 Over the past two decades or so, Chile has witnessed massive changes in politicalphilosophy, economic policy and economic conditions. The economic regime changed fromimport substitution policies in the early 1970s to free market rule and, more recently, to amarket-oriented -egime with more government intervention in social and economic policy.Four distin:t sub-periods may be identified since the mid-1970s: economic boom of the late1970s; the 1982 depression and debt crisis (1982-83); recovery in the mid-1980s (1984-87);and the present period of very vigorous and sustainable growth based on strong economicfundamentals.

Table 1.1: Key Economic Indicators, 1977-93'

GDP Gross Private GNS Unemployment CPI RER Debt/GDPGrowth Investment Consumption Rate Change (1980 Ratio

(%) (% GDP) Growth (%/6 GDP) (%) (W/o) =100) O)

1977-81 7.9 18.7 8.9 10.7 12.2 44.0 103.6 44.4

1982-83 -7.7 10.6 -9.7 3.3 17.0 18.6 107.7 101.5

1984-87 5.0 14.7 2.6 7.2 11.9 22.5 152.2 111.4

1988-93 7.2 21.6' 7.2 16.6b 6.0 17.8 183.7 48.2

* 1988-92. b Based on data for 1988 and 1990-92.* Chile's debt/GDP ratio reached a peak at 141.7 percent in 1985.GNS = Gross National Saving CPI = Consumer Price IndexRER = Real Exchange RateSource: Annex 1, Tables 1, 2.

1.2 Economic Expansion of the late 1970s. After a severe recession following the 1973military coup, Chile was enjoying the benefits of sharply rising copper prices and revenuesover 1977-80 while reaping the benefits of the previous policy reforms. The countryexperienced five years of very strong growth, accompanied by high levels of investment and arapid rise in private consumption. However, with low rates of national saving, investment washeavily dependent upon a massive expansion of risky external private borrowing stimulated bythe global glut of investment funds. Moreover, the Government's maintenance of a fixednominal exchange rate in the face of continued high levels of domestic inflation led to asevere overvaluation of the exchange rate, thereby hurting Chile's exports, promoting capitaloutflows, and necessitating further foreign borrowing. This acceleration of foreign borrowingleft the economy highly vulnerable to external shocks.

1.3 Recession and Debt Crisis. In 1982, the effects of this unsustainable policy, combinedwith rising international interest rates, adverse terms of trade shifts, and a sudden cut-off in

1. For more detailed tables, refer to Annex 1.

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external lending led to Chile's worst recession since the Great Depression, with GDP droppingby a massive 14 percent in 1982. Investment fell to well under half its 1981 level and privateconsumption dropped 14 percent in 1982. A major devaluation of the nominal exchange rateresulted in a sharp depreciation of the real exchange rate over 1982-83. This gave rise to ahuge increase in the external debt when expressed in pesos or as a percentage of GDP. As aresult, many banks and private companies experienced severe difficulties servicing their heavyforeign debt.

1.4 Renewed Growth and Adjustment. As a consequence of the steep devaluation of thepeso, which stimulated a pick-up in exports, and drastic curtailment of imports, externalbalance was restored. Investment recovered and growth resumed. However, governmentintervention to prevent collapse in the financial and corporate sectors led to heavy net transfersto the private sector and a large expansion of the public long-term debt, particularly over1982-85, as the Government took over private debt. The burden of the public debt wasintensified by continuing real exchange rate depreciation, which spanned the entire period1982-88 and resulted in a real value for the peso by 1988 of less than half its 1981 level.Total (public and private) long-term foreign debt reached a staggering 142 percent of GDP in1985, prompting the Government to initiate an extremely vigorous program of debt reduction.After 1985, the Government resumed the reduction of tariffs, which had been temporarilyincreased over 1983-85 to shore up domestic demand and strengthen the balance-of-payments.

1.5 Sustainable Expansion. A very strong expansion, averaging over 7 percent annualGDP growth, began in 1988 and continued under the new elected government which tookoffice in 1990. This expansion was stimulated by Chile's sound economic policy framework,was given momentum by sharply rising copper prices and revenues over 1987-89 andreasonably well sustained revenues thereafter. Government efforts to reduce the external debtproblem, via debt/equity swaps, external/domestic debt swaps, buybacks and strongly sustainedfiscal restraint were highly successful, leading to a reduction in the ratio of overall (short- andlong-term, public and private) debt to GDP from 142 percent of GDP in 1985 to 48 percent ofGDP in 1993. In 1992, Chile was accorded full investment grade rating by U.S. securityrating agencies. Furthermore, the large Chilean companies are now increasingly able to selltheir bonds externally and to raise external equity capital directly on US capital markets.

1.6 At the same time, government's current expenditure, as a share of GDP, has continuedits downward drift from a high of 32% in 1982, and has stabilized at around 19% since 1990,leading to a considerable public sector savings. In addition, Chile has continued to liberalizethe economy by cutting tariffs. Strong export growth featuring rising non-traditional exports,rapidly rising personal consumption, and very rapidly increasing corporate and individualsaving have stimulated a mainly domestically-financed investment boom. The investment/GDPratio reached a remarkable 27 percent of GDP in 1993. Official unemployment rates haveplummeted from 13 percent in 1987 to 4.5 percent in 1993, while social indicators havesignificantly improved. The Financial Markets Loan (FML) was approved in December, 1989,during the early stages of this period of very rapid development.

1.7 Inflation has dropped considerably and has stabilized at around 12% since 1992.Efforts to further reduce inflation have been hampered by the large volume of capital inflowswhich left the government with the choice of allowing large exchange rate appreciation ordefending the real exchange rate. The government chose an intermediate strategy. While it

17

allowed the real exchange rate to appreciate somewhat in the last two years, it tried to preventfurther appreciation by building up foreign exchange reserves to a level equivalent to 11months of imports in 1993.

Financial Policics

1.8 Post-Alhnde financial reforms designed to re-establish market-based interest rates andmore efficient credit allocation were unfortunately accompanied by lax regulation andsupervision, leaving the door open to risky bank lending, often to associated enterprises oflarge industrial-financial groups ('grupos'). The 1982-83 debt crisis was accompanied by asevere recession and high growth in the peso-denominated value of the foreign liabilities ofdomestic enterprises. This undermined the financial position of Chilean companies catering tothe domestic market. Deteriorating loan portfolios of the commercial banking system led tobankruptcies, government take-overs, preferential exchange rate ar-angements for companieswith external obligations, and debt reschedulings on concessionary terms. The Governmentassumed banks' bad loans to forestall a collapse of the banking system. At the height of thecrisis, some banks were taken over by the government and reprivatised later. With animproving economy and the take-over of their bad loan portfolios, Chile's banks were able toimprove their financial health following the immediate aftermath of the 1982 debt crisis buthave been very slow to return to profitability in real terms. In addition, the terms of the take-over, which treated the sold loan portfolio as subordinated debt and required the banks torepay the Government out of future profits, left them in a weakened position and impairedtheir growth potential.

1.9 An exemplary aspect of Chile's economic restructuring and growth strategy has beenvigorous promotion of national saving. Specific steps taken included: (1) the establishment (in1981) of a privatized pension fund system requiring mandatory contributions of 10 percent ofgross income: (2) the provision of incentives to save for housing; (3) a progressive reductionin corporate taxes and exemption from tax of corporate retained earnings in 1984 and 1989(which was partially reversed in 1990); and (4) a sustained effort to maintain a high level ofpublic savings, which have averaged over 4 percent of GDP during 1991-93.

1.10 These measures have produced a remarkable resurgence in national savings, from alow of 2 percent in 1982 to above 22 percent of GDP in 1990-92, much of it channelled intoan enormous expansion in the assets of the growing number of private pension funds (21 in1994), as well as, although to a lesser extent, into life insurance companies. Reflecting welljustified concerns, given Chile's financial history, that these funds might be investedimprudently, the pension funds and insurance companies were initially confined to investing ingovernment bonds, mortgage securities, bank deposits, and the stocks and bonds of about adozen approved corporations.

1.11 The expectation of diminished government role and borrowing needs, and rapid rise inpension fund and insurance company assets led to rising concerns, at the time the FinancialMarkets Loan was being prepared, that these institutions, without improved access to suitable

2. For a detailed discussion of the banking sector, refer to Annex VI.

18

investments in the private sector, would be obliged to increase their already large deposits inthe banking system and face declining investment returns. The FML attempted, inter alia, toaddress this problem.

1.12 The Leasing Sector. Chile has had a leasing sector since 1977. Leasing activitiesexpanded rapidly following a 1986 change in the Banking Law permitting banks to establishleasing subsidiaries. This increased the number of leasing companies from 5 to 14. Leasingoffered important advantages over bank loans (simplicity of contract, absence of onerouscollateral requirements, tax advantages, among others) and continued to expand rapidly andcater increasingly to the investment needs of small and medium enterprises. However, theleasing companies faced serious constraints on their access to term funds stemming fromrestrictions on bank lending to leasing subsidiaries, restrictions on leasing companies' issuanceof bonds, and limited access to external funds.

19

2. Project Objectives, Design and Relevance

Objectives

2.1 The FML was intended to: (a) deepen Chile's securities markets; (b) ensure profitableinvestment oppoitunities for the assets of the pension funds and life insurance companies; (c)strengthen the banking system and the leasing sector; (d) provide additional funding for theemerging leasin( sector; (e) support Chile's balance-of-payments; (f) develop and strengthenCORFO, Chile's only state development finance corporation, as a second-tier lender to theleasing companies; and (g) enhance the Government's ability to supervise the financial sector.

Design

2.2 The loan was a hybrid comprising two components: a US$ 80 million policyadjustment component, divided into two $40 million tranches, and a US$ 50 million leasingcredit component. It was supplemented by a US$ 1.96 million technical assistance package,funded entirely by the Japanese Grant Facility, and intended to provide support for institutionalimprovements relating primarily to financial market supervision.

Policy Adjustment Component'

2.3 The policy component comprised a number of complex, interlocking changes intendedto facilitate the efficient flow of saving into productive, private sector investment and tostrengthen commercial banking and leasing (see Annex II). These basic objectives were to beaccomplished by:

(a) modernizing securities market infrastructure by creating a computerized stockexchange, create a central securities depository system and improve the riskclassification of securities;

(b) increasing the supply of private sector securities available for investment byfostering the creation of closed-mutual funds and real estate investmentcompanies, easing the informational constraints on issuing securities, andsupporting the development of a privately operated bond guarantee scheme;

(c) expanding the demand for such securities by allowing the pension funds andlife insurance companies to invest their rapidly rising resources in these newinstruments as well as liberalizing the rules governing their investments instocks, commercial paper, and newly created securitized and collateralizedloans issued by the banks;

(d) strengthening and providing additional earnings opportunities to thecommercial banks by allowing them to increase their capital base via the

3. For a complete list of the individual measures, please refer to Annex II.

20

issuance of subordinated bonds,' increase their guarantee business by raisingthe limit on guarantees, and to market securitized and collateralized loans inthe securities markets;

(e) formalizing the status, and strengthening the role, of the leasing companies byincreasing their ability to issue bonds and by providing a regulatoryframework.

2.4 Second Tranche Release Conditions. The majority of the policy-related sub-components described above were already in place or were conditions of effectiveness.However, there were substantial second tranche release requirements, the most important ofwhich pertaining to the securitization and collateralization of loans.

2.5 Balance of Payments Support. The US$80 million balance of payment support wasdesigned to reduce the shortfall that was projected if unusually high copper prices of 1988 and1989 returned to trend levels in 1990, requiring the inflow of capital to finance the resultingincrease in the current account deficit. This balance of payment support was part of a largerexternal financing strategy including a stand-by agreement with the IMF.

Leasing Credit Component

2.6 The US$50 million credit component was intended to overcome market failurespreventing leasing companies from obtaining an adequate supply of longer-term funds fromprivate sources. It was intended as a one-time operation to bridge the gap until leasingcompanies would be able to receive sufficient long-term funds from private sources partially asa result of the regulatory changes supported by the loan. Leasing activity was and is ofparticular benefit to smaller companies having limited collateral and poor access to termcapital. An innovative aspect of the loan design was the proposal to determine appropriatemarket-based, longer-term interest rates on subloans to the leasing companies by CORFOdistributing the funds through regular public auctions at which the leasing companies wouldcompete for funds on the basis of the interest rates they were prepared to offer.

Technical Assistance Component

2.7 Although under US$ 2 million, the T.A. component was again detailed and complex,originally containing 14 sub-components and an unallocated residual. Almost all of thecomponents involved the undertaking of studies or the establishment of systems designed tohelp the Government discharge its responsibilities vis-a-vis the financial sector moreeffectively. They included the creation of flow of funds accounts, studies and informationsystems for the Ministry of Finance and the supervisory agencies of the banks, the securitiesmarkets and the pension funds, as well as several components designed to promote technologydevelopment.'

4. Subordinated bonds differ from subordinated debt. The FML permitted to issue subordinated bonds to increase their capital base.Subordinated debt is the non-performing portfolio that was taken over by the Central Bank as part of the financial rescue package inthe 1980s. Banks are obliged to service this subordinated debt out of their profits.

5. For a listing of the individual T.A. sub-components and planned vs. actual spending, see Annex X.

21

Assessm'ent of Objectives

Relation to Basic Bank Objectives

2.8 Private Sector Development. The loan was primarily directed towards improving thefunctioning of private financial markets and thus in line with the Bank's emphasis on privatesector development. While the objective of strengthening CORFO, a state developmentcorporation, migt appear to run counter to that aim, it was justifiable as an interimarrangemert in light of the evident failure of the financial markets to provide the expandingleasing companies with adequate recourse to term capital.

2.9 Strengthening Management of the Public Sector. The aim of strengthening theregulatory agencies was also in accordance with the Bank's objective of supportingimprovements in the capacity of the public sector to discharge its functions effectively andefficiently.

2.10 Environmental, Gender, Poverty Considerations. The loan did not have directenvironmental, gender, or poverty implications although the support of the leasing sector mightbe seen as an attempt to strengthen the SMI sector which, through its employment- generatingeffects, may contribute to poverty reduction.

Relevance

2.11 Following the successful implementation of basic financial sector reforms, and at atime of accelerating economic growth, rapidly rising national saving, and an expanding rolefor the private sector, it was particularly appropriate to remove legal, regulatory andadministrative obstacles to the efficient allocation of savings and to deepen Chile's financialmarkets. Furthermore, it was appropriate to support the financial recovery of the commercialbanking system.

2.12 The FML followed six earlier Bank loans which had a two-pronged approach towardsstrengthening the industrial and financial sectors, focusing on structural reforms and onproviding direct investment financing as an interim measure.6 Three SALs (2625-CH, 1986;2767-CH, 1987; 2892-CH, 1988) as well as the policy component of the FML involvedmacroeconomic adjustment, financial sector rehabilitation and reform to improve thefunctioning of the financial sector. Three industrial finance operations provided investmentfinancing to large companies (2606-CH, 1986; 3053-CH, 1989, see concurrent audits)7 , smalland medium companies (2613-CH, 1985, see concurrent audit), and leasing companies (FML).The FML thus fit neatly into this strategy of progressive reform of the financial sector, withdirect support for industrial development being used as a transitory component. All of theseloans supported the process of returning Chile to economic prosperity.

6. See Annex VIll for a more detailed discussion.

7. The definitions of large and medium-sized companies differ between the IFRP and IFP projects on the one hand, and the FMLand SMI projects on the other. Using its own, much larger definition, the IFP (3053-CH) served medium-sized companies, while,using the definitions used in the FML and the SMI, it clearly targeted large companies (see Annex VIII for details).

22

2.13 At the time, the arguments for balance of payments support appeared valid. While itwas risky to approve balance of payments support on the basis of difficult-to-predict copperprices, a reversal of copper prices to trend levels could have severely hampered Chile's effortsto further reduce its foreign debt burden to manageable levels. Chile had created a copperprice stabilization fund in 1985 as part of SAL I (2065-CH), but the fund had accumulatedinsufficient resources to cover the projected shortfall in revenue in 1990 so that this alternativewas not available at the time.

Complexity

2.14 The loan was a highly complex operation. Not only was it a hybrid loan includingpolicy, credit and technical assistance components but the policy component entailed numerouscomplicated elements, such as legal, regulatory and administrative changes, a number of whichremained to be completed as second tranche release conditions.

Riskiness

2.15 Given the loan's complexity, it involved a substantial degree of risk that required theBank to have considerable confidence in the Government's commitment to carrying out of thenecessary changes. The element of risk was heightened by the political transition to an electedgovernment at the end of 1989. A further element of risk, associated with the leasing creditcomponent, was the potential of excess supply of funds because of concurrent involvement ofthe IDB and IFC in such lending, and thus the possibility of slow disbursement of the Bank'sfunds.

Borrower Ownership

2.16 The preparation of this loan was characterized by a high degree of borrowercommitment to the financial sector reforms supported by the loan. While there was importantBank input in the development of the financial sector strategy, most notably in the form of aindustrial finance report preceding the loan (Report 7737-CH), it was clear that Chileanauthorities had both the will as well as the capacity to implement this highly complexoperation.

Demands on Bank Resources

2.17 The Bank's earlier continuing and close involvement with the financial sector meantthat it already had a detailed understanding of the sector. This made it relatively easy torecognize the need for, and the institutional context of, the changes supported by the loan, aswell as the leasing companies' need for longer-term financing. Nonetheless, the loanconsumed 120 Bank staff weeks through appraisal and an additional 37 staffweeks thereafter,indicating significant absorption of Bank resources. However, this appears justified, takinginto account the size of the loan, its complexity and the risks involved.

23

3. Project Outcome, Assessment and Sustainability

Project Outcome

Balance of Payments Support

3.1 An unexpected improvement in Chile's balance-of-payments situation began duringlate 1989 and became increasingly apparent during 1990, when the overall balance reached aUS$2,334 million surplus, compared with a US$427 million surplus in 1989. As a result, theforeign exchange provided by the loan proved to be unnecessary. In fact, Chilean authoritieshave been trying hard to limit the impact of these surpluses on the exchange rate. In light ofthis situation, the US$40 million second tranche of the FML's policy-based component wascancelled in June, 1992 at the Government's request. Despite the cancellation, the governmentdid, with delay in some cases, implement all second tranche conditions.

3.2 In evaluating this outcome, the question arises whether the improvement in Chile's netexternal position was foreseeable when the loan was being prepared. Three factors wereresponsible for the improvement. First, copper prices remained unexpectedly strong.Second, a substantial amount of Chilean flight capital was repatriated. Third, during thisperiod a significant, positive shift took place in the attitudes of external investors towardsLatin America in general and Chile in particular, leading to increasing levels of portfolio andforeign direct investment. Thc timing of these events was not readily predictable.' Hence, itmust be concluded that the cancellation of the second tranche was not due to any lack of Bankor government rigor in preparing the loan but is a result of a combination of fortuitous eventsand Chile's better than expected ability to attract foreign capital.

Pension Fund Developmentso

3.3 Rapid Growth of Assets. Since the loan was approved, an unexpectedly large increasehas taken place in the assets of the pension funds. These almost quadrupled, in US dollarterms, over 1989-94, from US$ 4.5 billion to US$ 17.6 billion (Figure 1), whereas the SARhad projected only US$ 8 billion for 1994. This expansion reflected the combined impact ofvery strong growth in Chilean output, employment and incomes, accompanied by a rapid risein pension fund contributions, and high real rates of return on pension fund investments(averaging 16.6 percent a year over 1990-94).

3.4 Major Shifts in Distribution of Assets. The 1989-94 increase in pension fund assetsamounted to 5,047.5 billion in 1993 pesos (Table 3.1). About 42 percent of the increase isaccounted for by increases in holdings of stocks. Another 40 percent represented enlargedholdings of state debt instruments. About 10 percent flowed into mortgage-backed instruments

8. The Chilean economy is highly sensitive to changes in the price of copper. Each 5 cent change in the price produces approximatelya $100 million change in the balance-of-payments.

9. By mid 1990. when the loan became effective, the change of the balance of payments into a surplus may have been morepredictable. However, regarding the first tranche, the Government felt at that time that balance of payments support was still necessary.

10. A fuller discussion of pension fund developments is provided in Annex III.

24

issued by financial institutions, 7 percent into corporate bonds and other corporate instruments,and about 2 percent into foreign investments. Deposits in financial institutions were the onlycategory registering an absolute decline, accounting for minus 2 percent of the total change.

Table 3.1: Distribution of Pension Fund Assets, 1988 and 1994(Billions of 1993 Pesos)

Dec. % July % S.A.R. 1989-94 %1989 1994 Proj. Change

Government Institution 1085.5 41.6 3078.6 40.2 (23.2) 1993.1 39.5

Financial Institution Deposits 543.3 20.8 455.7 6.0 (24.3) -87.6 -1.7

Financial Institution Mortgages 462.1 17.7 984.1 12.9 (7.7) 522.0 10.3

Financial Institution Other 18.3 0.7 91.9 1.2 (0.0) 73.6 1.5

Corporate Stocks 263.7 10.1 2396.2 31.3 (13.7) 2132.5 42.2

Corporate Bonds 237.3 9.1 499.3 6.5 (6.1) 262.0 5.2

Corporate Other 0.0 0.0 75.0 1.0 (24.9)a 75.0 1.5

Foreign Investment 0.0 0.0 74.3 1.0 (0.0) 74.3 1.5

Disposable Asset 0.5 0.0 3.1 0.0 (0.0) 2.6 0.1

Total 2610.7 100.0 7658.2 100.0 (100.0) 5047.5 100.0

a REICs:4.9%; closed-end mutual funds: 10.0%. and short-term company paper: 10.0%Source: Annex Ill, Table 2

3.5 The result was a substantial shift in the distribution of total pension fund assets,with the pattern significantly different from the SAR projections (Table 3.1). The share ofstate bonds barely declined, despite the enormous increase in total assets, due to continuedconservatism in pension fund investment policies, and to the Government's issuance of verylarge quantities of bonds to finance the expansion of Chile's foreign exchange reserves. Onthe other hand, the sharp drop in the share of total assets represented by deposits in financialinstitutions was not anticipated.

25

Fig. 1: Pension Funds, Life InsuranceActual and Projected Asset Growth

20

Pension-Act.Pension-Proj.

0 Life Ins.-Actual

1988 1989 1990 1991 1992 1993 1994 L Ins-Projected

3.6 There was a far greater than expected rise in the proportion of direct holdings ofcompany shares. However, this was partially offset by a much smaller than anticipated rise inthe share of indirect stockholdings via closed-end mutual funds, (see "other" in the table).Taken together, the nine-fold real rise in the value of overall company shareholdings (directand indirect) raised their share of total pension fund assets from 10 to 32 percent, far higherthan the 24% anticipated by the SAR. The massive shift into stocks reflects a combination of:(i) higher anticipated returns on stocks than on other securities; (ii) the impact of the measuressupported by the FML both to stimulate an increased supply of corporate shares and permit amore broadly-based pension fund ownership of them; (iii) much higher share prices.

3.7 At the same time, the newly created instruments, shares in real estate investmentcompanies (REICs), closed-end mutual funds, and commercial paper, attracted far less pensionfund assets than anticipated, attracting only 1% instead of the projected 25%. Securitized andcollateralized loans have not been issued and have thus not been bought by the pension funds(see para. 3.18). These developments are due to (i) a time lag in establishing closed-endmutual funds" and the securitized and collateralized loans; (ii) lower than anticipated pensionfund interest in REICs; and (iii) the competition of banks in short-term lending that forestalledthe development of a commercial paper market. Finally, holdings of corporate bonds, whiledeclining in relative importance, increased in absolute terms, as sought by the FML.

3.8 The combined effect of these developments have been that pension fund investmentshave remained more conservative than anticipated, concentrating most of their assets intraditional government bonds and corporate stocks while so far shunning the most innovative

I1. Which have grown vigorously recently.

26

instruments. To be sure, this more conservative investment strategy has not hurt profitability.In fact, the pension funds have earned an average annual real return of 16.6% between 1990and 1994, considerably higher than in previous periods. This suggests that one of the aims ofthe FML, providing sufficient suitable and profitable outlets for increasing pension fund assets,was clearly met.

Life Insurance Company Developments 2

3.9 Life insurance companies are an integral part of Chile's social security system byproviding mandatory disability insurance and the option to transfer accumulated pension fundassets upon retirement to the life insurance companies in return for an annuity. In tandemwith the growth of pension fund assets, life insurance company assets grew in real terms toalmost two and a half times their initial level between 1989 and 1993, which was also muchfaster than anticipated by the SAR (Figure 1).

3.10 Changes in Distribution of Assets. Initially confronting similar restrictions as thosefaced by the pension funds, the insurance companies have similarly taken advantage, althoughto a lesser extent, of the freeing-up of their investment choices. The distribution of the 1989-93 overall increase in their assets of 1013 billion (Table 3.2) shows that proportionately largerholdings of government and miscellaneous corporate debt instruments accounted for most of

Table 3.2: Distribution of Life Insurance Company Assets, 1989 and 1993(Billions of 1993 Pesos)

1989 % 1993 % 1989-93 Change %

Government 214.3 30.4 660.6 38.5 446.3 44.1Institutions

Mortgages 115.8 16.5 257.0 15.0 141.2 13.9

Financial 78.4 11.1 82.1 4.8 3.7 0.4IntermediariesDeposits/Bonds

Corporate Stocks 41.1 5.8 147.1 8.6 106.0 10.5

Corporate Bonds 136.5 19.4 242.3 14.1 105.8 10.4

Corporate Other' 83.1 11.8 265.7 15.5 182.6 18.0

Other 34.0 4.8 61.3 3.6 27.3 2.7

Total 703.2 100.00 1716.1 100.0 1012.9 100.0Other corporate investments include real estate, loans to clients and cash. Real estate is the major component.

Source: Annex IV, Table 2

the increase, followed by mortgage securities and stocks. The shares of total assetsrepresented by government bonds and corporate stocks rose between 1989 and 1993, as in the

12. For a fuller discussion, see Annex IV.

27

case of the pension funds. However, financial institution bonds and deposits barely increasedin real terms and fell sharply as a share of total assets. Life insurance companies, like thepension funds, appear to have so far shown little interest in the new REICs and closed-endmutual funds.

Evolution of the Securities Markets"

3.11 Improvements in Securities Markets Infrastructure. The computerized stock exchangeis now operating and currently accounts for about one-third of all securities markettransactions. A particularly beneficial consequence has been a narrowing of commissioncharges on the traditional exchange as a result of the increased competition. The riskclassification monitoring system is also in place at the Superintendency of the Stock Market(SVS) and has contributed to narrowing the dispersion of assessments by the four privatelyoperating risk classification companies. The privately operated central depository is not yet inoperation but is expected to be in March, 1995, following completion of the operational testingof its equipment and procedures.

3.12 New Security Issues. New security issues underwent a drastic change over 1990-93(Table 3.3), mainly reflecting a major cutback in net issues of government bonds from 1780.6billion 1993 pesos in 1992 to only 396 billion in 1993 (Annex V, Table 1). Stock andmortgage bond issues both rose very strongly, but total issues still declined by almost a third,dominated by the major cutback in public borrowing. A consequence of this shift was adecrease in the public (bond) share of new security issues from 73 to 32 percent and anincrease in the private sector share from 27 to 68 percent. Stocks rose in importance from 7to 28 percent of total new security issues as the number of companies issuing shares increasedfrom 245 in 1990 to 350 in August 1994. The share of corporate bond issues also roseslightly but declined significantly in absolute terms.

13. See Annex IV for a more detailed description.

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Table 3.3: Distribution of Primary Securities Market Issues, 1990 and 1993"(Billions of 1993 Pesos)

1990 % 1993 % 1990-93 %Change

Stocks 128.1 6.9 348.7 28.0 220.6 36.9

Corporate Bonds 147.3 8.0 120.1 9.6 -27.2 -4.5

Financial Institution Bonds 31.8 1.7 10.6 0.9 -21.2 -3.5

Commercial Paper 37.1 2.0 2.3 0.2 -34.8 -5.8

Mortgage Bonds 144.9 7.9 343.2 27.5 198.3 33.1

Endorsable Mortgage Loans 11.1 0.6 25.6 2.1 14.5 2.4

Total Private 500.3 27.1 850.5 61.3 350.2 58.5

Total Public (Bonds) 1343.9 72.9 395.5 38.7 -948.4 -158.5

Total 1844.2 100.0 1246.0 100.0 -598.2 100.0

Source: Annex V, Table I

3.13 Overall Securities Market Capitalization. Overall capitalization" was dominated in1990 by corporate shares (54 percent) and, to a lesser extent, government bonds (31 percent)(Figure 2). As noted, over 1990-93, share prices rose very sharply, contributing to almost atripling in their market valuation. This increased valuation accounted for most (80 percent) ofthe 1990-93 increase in the overall capitalization of the securities markets. As a result, theproportion represented by company shares rose to 68 percent from 54 percent in 1990. Theproportion represented by government bonds fell to 21 percent.

3.14 The overwhelming impact of the rise in share prices meant that the proportion ofcorporate and financial institution bonds"' declined as well, despite considerable absoluteincreases in both categories, as sought by the FML. The new vehicles (REICs and closed-endmutuals) supported by the FML currently account for a negligible 0.2 percent of securitiesmarket capitalization.

3.15 Causes of the Rise in Share Prices. The increase in share prices appears to haveresulted, on the one hand, from growing confidence in Chile's future economic growth" and,

14. Note that the figures for coporate bonds refer to gross emissions, while for government and financial institution bonds they referto net emissions (emissions minus redemptions).

15. Primary issues plus previously issued securities.

16. Including leasing company bonds.

17. And, hence, company profits.

29

on the other, the effects of the large stock purchases made by the pension funds and, to asmaller extent, life insurance companies and foreign capital investment funds (FICEs). MostChilean shares (with the exception of a few recently privatized companies) are closely held,rather than widely owned and traded. The pension funds, life insurance companies, and FICEswhich increased their share of total stock market valuation from 9.1 percent in 1990 to 16.1percent in 1993 (Table 3.4), are thus very large market players, and exert a very large impacton the relatively thin margin of stocks that is actively traded." A consequence of the rise inshare prices has been an increase in the overall stock market price-earnings ratio (p/e) from 7.1in 1990 to 21 in 1993. The increased share prices have accelerated efforts by companies toissue stocks who hope to benefit from this source of capital.

Figure 2: Security MarketsCapiralization(Billions of 1993 Pesos)

i 219| 6778

1990 618TJ966

13904

:R527 ________________ _

1993 1661l l 111526

| 5972

0 5000 10000 15000 20000

D State In stit. [E Mortgages M Corp. Bonds

N Fin. Bonds M Shares 0 Mutual Funds

3.16 Market Shares of Pension Funds, Insurance Companies, and Foreign CapitalInvestment Funds (FICEs). Pension funds and life insurance companies have increased theirdominance of the markets for government, corporate, and financial institution bonds, as well asmortgages. For example, in 1993 pension funds and life insurance companies combined hold57% of all outstanding government bonds, 75% of all mortgages, 85% of corporate bonds, and67% of financial bonds (Table 3.4). This, together with their impact on stock prices, suggeststhat their demand for securities is tending to outrun the available domestic supply. Thistendency was temporarily obscured by the large increases in government bond offerings over1990-92.

18. The pension funds held shares in 82 of the 325 companies traded on the stock market as of March, 1994.

30

Table 3.4: Pension Fund and Life Insurance Company and Foreign Capital InvestmentFund (FICEs) Shares of Securities Market Capitalization, 1990 & 1993(Percentages of instruments held by pension funds, life insurance companies, and FICEs)

1990 1993

Pension Life FICEs Pension Life FICEsFund Insurance Fund Insurance

Government 38.2 8.7 1.0 45.2 11.8 0.1Institution Bonds

Mortgages 46.5 10.9 0.0 58.4 16.8 0.0

Corporate Bonds 60.8 28.7 0.1 55.1 29.6 0.0

Financial Bonds 23.4 n.a. n.a. 67.1 n.a. n.a.

Shares 5.6 0.6 2.7 11.9 0.8 3.4

Mutual Funds 0.0 0.0 2.0 0.0 0.0 1.3

Total 22.0 5.4 1.8 22.9 4.8 2.4

Source: Annex V, Table 5.

3.17 Evaluation. The measures aimed at improving securities market infrastructure as wellas the demand and supply of securities were highly successful, particularly with regards tocorporate stocks. The number of companies issuing stocks increased rapidly, issuing activitytripled, and demand for stocks rose vigorously. 9 In fact, the demand for stocks, induced bypension funds, insurance companies, and FICEs, outstripped supply, leading to a considerablerise in stock prices. The FML had less success in stimulating domestic bond market activitywhich increased only slightly, in spite of heavy demand by pension funds and life insurancecompanies. Large companies were able to tap international capital markets at morecompetitive rates than the domestic bond market.20

Banking Sector Developments2 1

3.18 The FML included a number of measures (para. 2.3) to strengthen the banking system,increase its profitability, and allow the banks to participate more fully in the growing securitiesmarkets. One measure, allowing banks to issue subordinated bonds and count it as capital,

19. In addition, issuing activity by Chilean companies abroad increased from 34 billion 1993 pesos in 1991 to 333 billion pesos in1993.

20. International real interest rates remained below Chile's real interest rates throughout the last few years. One indication ofincreased activity in international captial markets is the increase of private non-financial long-term foreign debt from 55 billion 1993pesos in 1990 to 595 billion in 1993.

21. See Annex VI for a fuller discussion and supporting tables.

31

was implemented and has been used in a limited amount by some banks to increase theircapital base. The second measure, raising the global limit on guarantees to twice the capitalhas given banks the flexibility to increase their guarantee business substantially.22 The mostimportant measure, however, the passage of legislation permitting banks to securitize andcollateralize loans and sell them in the securities markets was delayed until 1994 and there is acontinuing delay in implementing the provisions of the legislation, pending a decision as to theterms of repayment of bank subordinated debt.23 Thus, most developments in the bankingsystem essentially reflect trends that have taken place independently of the FML measuresdirectly aimed at the banks.

3.19 Recent Banking System Trends. The financial position of the Chilean banks hasregistered a substantial improvement since the mid-1980s and they have enjoyed a vigorousrecovery beginning in 1990-91. Over the entire 1986-93 period, the banks have progressivelyreduced their domestic liabilities to the Central Bank and the State Bank (Banco del Estado).The same was true for foreign and other liabilities (contingent liabilities, interest due, currencyadjustments, etc.) until 1991 and 1992, respectively. Since then, the banks have substantiallyincreased both their short-term foreign borrowing, their issuance of guarantees, as well as theirmortgage business. All indicators of financial health (capital adequacy, return on equity,return on assets) have improved considerably, with real profits being positive for the first timein 1993.

3.20 At the same time, overall assets have grown little, suggesting that banks did notparticipate much in the rapid growth of the pension funds, life insurance companies, andsecurities markets. Moreover, banks continue to be burdened by the obligation to repay theirsubordinated debt (cartera vendida) which still amounts to 1.5 times their capital in 1993,down from 2 times their capital in 1988. It thus appears that banks have spent the last fewyears restoring their Enancial health and profitability, but without benefitting much from therapid growth of the rest of the financial sector.

Leasing Sector DevelopmentS2

3.21 The leasing sector was the recipient of the $50 million directed credit component ofthe FML. The SAR had identified a long-term financing gap of US$ 350-400 million for thesector over 1990-93 with US$ 300 million needed by the two largest leasing companies.CORFO was to auction the funds, subject to minimum lending rates based on market-basedlong-term comparator rates. Leasing companies would be limited to obtaining 35 percent oftheir financing through CORFO. Loans would be in both US dollars and U.F. pesos.25

22. The banking system has, as a whole, not surpassed the previous limit on guarantees, while individual banks may have. Theissuance of guarantees is likely the accelerate when the provisions of the FML relating to the collateralization of bank loans go intoeffect.

23. The issue being debated is whether, in order to speed up the repayment of the debt, an overall time limit (e.g., 40 years) shouldbe established for the completion of repayment, with the schedule of repayment linked to the banks' profitability (see Annex VI).

24. For a fuller discussion and supporting tables, see Annex VII.

25. The U.F. (unidad de fomento) peso is an inflation-adjusted unit of account.

32

3.22 In addition, the policy component of the FML supported the establishment of aregulatory framework for leasing company that are bank subsidiaries, and raising the limit onthe amount of bonds that could be issued by a leasing company, thereby developing aneventual alternative to directed credit.

3.23 The Credit Component. In the face of extremely strong demand, the credit componentwas disbursed quickly, in larger-than-anticipated and fewer tranches, a year ahead of schedule.The loan closed three years earlier than planned. Initial and not unreasonable fears (describedin detail in the PCR) that concurrent financing of leasing company operations by the IFC andthe IDB might compromise the projected pace of disbursement of the Bank's credit lineproved groundless in light of the leasing companies' huge need of funds. In fact, in additionto the Bank's US$ 50 million under the FML, IDB funds and CORFO counterpart fundschannelled into the leasing sector totalled US$ 370 million over the past four years, bringingthe total amount of directed credit to US$420 million.

3.24 At the same time, the overall value of outstanding leasing contracts has risen morethan sixfold over 1989-94, from US$180 million to US$1270 million. Leasing-financedinvestment has jumped from 5 percent of gross investment in 1988 to 15 percent in 1993. Thephenomenal growth of leasing is to be explained by a number of factors including: (i) the taxadvantages arising from the accelerated write-offs applied to leased assets; (ii) the absence ofonerous collateral requirements; (iii) reduced own financing requirements;2 1 (iv) speedierprocessing; (v) the absence of compensating balance requirements; (vi) associated equipmentselection and maintenance services; (vii) easier access than to bank credit, particularly forSMI; and (viii) simplicity of contract and ease of repossession flowing from the retention ofownership of leased goods by the leasing company.

3.25 While CORFO funds (from the FML and IDB) have clearly played a substantial rolein the overall growth of leasing, the importance of such funding has declined from 31 percentof total leasing company liabilities in 1992 to only 15 percent in June, 1994, as theGovernment has reduced CORFO financing in an effort to control credit and containinflationary pressures. Instead, leasing companies have financed their growing assets andliabilities by borrowing heavily from the banks and greatly increasing their sales of bonds(Figure 3). In 1993, outstanding bonds almost equalled capital and reserves for the sector as awhole and exceeded this amount in the case of the two largest leasing companies. Thus,raising the previous ceiling on bond sales under the FML removed a constraint that wouldotherwise have existed and facilitated a better balancing of long-term assets and liabilities."

3.26 The innovative auctioning mechanism introduced under the FML worked extremelywell, producing a band of (unsubsidized) interest rates lying between bank deposit and lendingrates (Annex VII, Table 1). It has been adopted as the means for allocating the continuingflow of IDB funds and has been extended into other areas.

26. Up to 100 percent of the cost of the acquired asset is covered by the lease.

27. However, an analysis of the 1993 assets and liabilities of the leasing sector reveals a considerable mismatch between long-termassets (273 billion 1993 pesos) and long-term liabilities (190.3 billion). Lending long and borrowing short carries risks associated withthe possibility of sharply rising short-term borrowing rates, although the leasing companies as a group have a large cushion of networth.

33

3.27 The main beneficiaries of leasing (including, specifically, beneficiaries of the FMLcredit component) have been the productive sectors of the economy. Although largecompanies have received most (84 percent in 1993)" of the total amount of leasing sectorfunds, average contract size has been falling and the number of contracts involving small andmedium companies was over 75 percent of the total in 1993 (Annex VH, Table 7). SMI thusappear to be gaining increasing access to investment financing through leasing arrangements,partially overcoming previous market failure associated with SMIs' difficult access tocommercial bank financing.

Technical Assistance

3.28 The outcome of the individual components of the technical assistance financed by theJapanese Grant Facility are detailed in Annex X. Officials in the recipient agencies confirmedto the audit mission that the technical assistance provided under the FML had been bothappropriate and useful. Three items, namely the development of flow of funds accounts, theassistance to set up the risk classification monitoring unit (see para. 3.11), and the support inthe creation of a second-tier lending department within CORFO, were mentioned asparticularly useful in allowing better supervision of the financial markets and improvingCORFO's lending operations, respectively.

Figure 3: Sources of Funds for LeasingShares

100%

80%-

60%-

40%-

20%-

0% -1992 1993 1994

8 oBanks o Bonds C ORFO

MOther [II]Net Worth

28. A somewhat lower percentage of IBRD funds (66 percent) went to large companies (Annex VII, Tabic 7).

34

Strengthening Institutions

3.29 While Chile's strong economic growth has been a rising tide lifting all vessels, FML-supported reforms have made a noteworthy contribution to the institutional strengthening ofthe financial system. The profitability of the pension funds and insurance companies has risenand they have been able to diversify their assets. Securities market infrastructure has beenmodernized and improved. The auctioning of credit has become an efficient allocativemechanism. Leasing companies have obtained much readier access to private financing, and anumber of ministries and supervisory agencies have meaningfully improved their informationbases and oversight capacity.

3.30 A particularly positive development has been that CORFO, which had been a first-tierlending institution with a low performing portfolio, has, with the help of the loan and thetechnical assistance, transformed itself to an effective and profitable second-tier lender with noarrears on its second-tier lending portfolio. This change has enabled CORFO to tackle theburden of its, mostly non-performing, first-tier lending portfolio and improve its overallfinancial position in recent years."

Main Factors Affecting Outcome

3.31 Important external influences on the outcome of the project were sustained copperrevenues, continued strong economic growth, high national savings, heavy capital inflows, andlarge government bond sales to sterilize these inflows, and the ability of Chilean companies todirectly tap international capital markets. Sustained copper prices and heavy capital inflowswere more than adequate to sustain a strong balance of payments position, rendering thebalance of payments support unnecessary. Strong growth and high national savings combinedto assure rapid expansion in pension fund and life insurance company assets and investments,progressive retirement of commercial bank long-term liabilities, rising short- and long-termdeposits in the banking system, strong demand for residential mortgages, and sustainedimprovement in the commercial banks' profitability and financial health. Rapid growth alsoled to strong demand for leased assets. The foreign capital inflows have boosted securitiesmarkets directly through heavy portfolio investments, while also increasing the supply ofgovernment securities to sterilize these inflows. The ability of Chilean companies to directlytap international capital markets has probably dampened domestic security marketdevelopment, particularly the bond market, as many large companies found it more convenientand cheaper to issue bonds and stocks abroad.

3.32 At the same time, the measures supported by the FML are to a considerable extentresponsible for the overall positive developments in the financial markets. In particular, theliberalization of pension fund and life insurance investments, the efforts to increase the supplyof securities, improvements in security market infrastructure, and improving the ability ofleasing companies to issue bonds have had a major influence on the impressive performance ofthe securities markets, especially the stock market. The new instruments promoted by the loanhave not had a major impact to date; neither did the measures aimed at strengthening thebanks, which have not been implemented yet or had only modest impact. The credit

29. For a discussion of the role of CORFO, see Annex IX.

35

component to the leasing industry, in conjunction with follow-on support provided by IDB andthe policy changes regarding the issuance of bonds, was largely responsible for the very rapidgrowth in the leasing industry and the positive impact leasing has had on industrial finance,particularly for small and medium enterprises. On the institutional side, the leasing componenthelped transform CORFO into an effective second-tier lending institution (see Annex IX), andthe technical assistance contributed considerably to improved analytic and supervisory capacityof agencies charged with regulating the financial markets.

Assessment of Outcome

3.33 While external factors had an important influence on the positive development of theChilean financial markets, the measures supported by the FML were essential in managing thisgrowth and channeling it into the securities markets, thereby providing high returns toinstitutional investors and, at the same time, industrial finance to enterprises of all sizes.

3.34 In light of these rapid developments in the financial markets, the question ariseswhether the FML led to the successful conclusion of the two-pronged strategy pursued by theBank to assist with structural changes to improve financial markets while at the same timeproviding industrial finance in the interim (see para. 2.11). Annex VIII takes up this questionin detail and concludes that, as a result of these development, there is still room forimprovement as far as access to term finance for micro, small, and smaller medium-sizedenterprises, particularly those not affiliated to large industrial groups ('grupos'), isconcerned.30

Sustainability

3.35 The FML supported an ongoing process of legislative and regulatory changes designedto foster the development of the securities market. Notwithstanding cancellation of the secondtranche, the Government has continued to honor its commitments under the loan (althoughperhaps more slowly than would otherwise have been the case) and has since initiated furtherchanges to improve the operation of the securities markets (e.g., authorizing increased externalinvestment by the pension funds and insurance companies, see Annexes III and IV). Thisindicates high Chilean commitment to, and ownership of this reform effort and makessustainability of the reform effort likely.

3.36 Leasing currently meets a real need and is likely to continue to do so for some time.The role of external agencies such as the Bank and the IDB in financing leasing operationsappears likely to diminish further, as leasing companies continue to improve their access toincreasingly competitive bank and security market financing. Thus, while the Bank and IDBcontributed considerably to the growth of this sector, sustainability is likely even withoutfurther support.

30. Note that this conclusion is dependent on the definitions chosen for small, medium, and large enterprises. Using the much largerdefinitions of small and medium enterprises employed by the IFRP and IFP audits would no longer imply a need for further actionto improve the credit access to larger small and all medium enterprises (see Annex VIII for details).

37

4. Bank and Borrower Performance

Bank Performance

4.1 It is apparent from the SAR that loan preparation was meticulous and based on a goodunderstanding of Chile's financial sector, its constraints and its development needs. Inparticular, a detailed Industrial Finance Study (7737-CH) prepared much of the groundworkfor the FML operation. Subsequent security market developments, broadly in the directionsprojected by the SAR, indicate that the Bank's underlying analysis was correct and the designof the project sound. The credit component met a clear need to overcome market failure and,given the sound policy environment, was fully justified. The auction mechanism was wellconceived and appropriate. Technical assistance was well conceived and properly targeted.Bank officials worked cooperatively with country counterparts and achieved a goodunderstanding with them. Supervision was adequate and included continuous follow-up of theT.A. component. Shortfalls in relation to projected results cannot be attributed to poorpreparation or supervision of the financia! market aspects of the loan but rather to otherfactors.

4.2 The main questions regarding the Bank's performance relate to the size of, the needfor, and the appropriateness of, the balance of payments support provided by the loan. Asindicated above, the change in the external environment that obviated the need for the balanceof payments support could not readily have been anticipated and cannot be linked to poorBank preparation.

Borrower Performance

4.3 Borrower performance was excellent, especially with regard to implementation of thishighly complex operation. High ownership and high quality at entry are two factors thatcontributed to the overall success of this project, and Chilean authorities deserve much creditfor this. CORFO has performed well as a second-tier intermediary and has continued toauction substantial IDB funds to both banks and leasing companies.

4.4 One shortcoming of the policy component of the project has been the failure, so far, toimplement the loan's provisions relating to commercial-bank- initiated securitization andcollateralization of loans. This appears largely attributable to political factors and not to anylack of commitment by the Government. The Government's commitment is demonstrated byits adherence to the FML's conditions relating to release of the second tranche,notwithstanding its cancellation. Audit mission conversation with officials confirmed that theGovernment remains firmly committed to prudent financial management and efficientallocation of financial resources.

4.5 The Government's sound overall macroeconomic and financial policies have beenimportant factors contributing to the generally favorable evolution of the financial sector.Whether its continued attempt to prevent a real appreciation of the exchange rate by buildingup large quantities foreign exchange reserves is, in the long run, sustainable, remains an openquestion and will depend much on the evolution of capital flows to Chile.

s e

a

a

39

5. Coi.clusions and Lessons of Experience

Conclusions

5.1 Liberalizing Pension Fund and Life Insurance Company Investments. Overall, theliberalization of pension fund and life insurance company investment options has beensuccessful, mainiy in providing expanded opportunities for investment in company shares andin enhanciig the earnings of the funds and insurance companies. However, large increases inthe demand for shares has driven up their prices suggests that further pension fund portfoliodiversification or further increases in the supply of stocks is still needed. The furtherliberal zations approved in March, 1994, allowing greater foreign investments and furtherliberalizing the domestic portfolio (see Annex III) point in the right direction, and the supplyof securities, stocks as well as the newly created instruments, is rising rapidly as well. Thesedevelopments are all 'he more important if the Government abandons its large-scale issuanceof bonds to finance the build-up of foreign exchange reserves.

5.2 Those Government bond offerings obviously influenced the investment decisions ofboth the pension funds and the life insurance companies and may have partially underminedthe impact of FML-supported changes by reducing the demand for REICs and closed-endmutuals. By the same token, if public bond offerings remain low and there is a continuedrapid rise in pension fund and insurance contributions, these institutions may be expected toplay an increasingly large role in financing corporate expansion, in part through increasingdemand for the FML-supported financial innovations. Signs of growing interest on the part ofthe pension funds in the closed-end real estate and risk capital mutual funds and REICs point,in fact, in this direction.

5.3 Deepening the Securities Markets. The increase in the value of share issues and therise in the number of companies participating in the stock and bond markets indicates that themeasures supported by the FML aimed at deepening the securities market have had the desiredeffect. Companies now have better access to equity and loan funds, lowering their costs ofinvestment. The growth of leasing companies and the increased numbers of closed-end mutualfunds and REICs are also signs of deepening capital markets. This deepening process appearslikely to continue and accelerate, as noted above, and to include the new bank-packagedsecuritized and collateralized loans supported by the FML.

5.4 Strengthening the Banks. Fears that the banks would lose part of their businessthrough disintermediation of the financing requirements of large firms and would be hurt bythe liberalization of the pension funds were partially realized. Despite this, Chile's stronggrowth has meant that short-term deposits have grown at only a slightly slower pace than priorto 1989. Moreover, sales of mortgage-backed securities did not decline as expected but rosestrongly. Furthermore, the banks have been able to finance the recent sharp expansion ofprofitable short-term lending by increasing external borrowing and continuing to liquidatedomestic investments.

5.5 The financial performance of the banks has improved markedly since the mid-1980sand particularly over the past two years. This trend appears likely to continue. However, the

40

FML contributed little to the improvement, which is attributable primarily to Chile'smacroeconomic development. Nonetheless, the provisions of the FML relating to the sale ofsecuritized and collateralized bank loans appear likely to make an important contribution to thefurther strengthening of the banking system in the years ahead which highly desirable in viewof the persisting burden of the banks' subordinated debt.

5.6 Providing Credit for Leasing Operations. The credit component addressed a clear caseof market failure. First, the leasing companies, prior to the loan, had inadequate access toterm financing. Second, SMI also had inadequate access to term financing through thecommercial banks, which they could potentially side-step via leasing. The demand for, andprofitability of (unsubsidized) leasing, which has attracted many new companies, attests that itfilled a real need. It mainly financed the acquisition of productive assets in a sound financialand trade policy environment and played an increasingly important role in filling theinvestment financing needs of SMI. The incorporation of the auction mechanism into thedesign of this component was appropriate and highly successful. In short, the creditcomponent of the FML must be judged an unqualified success.

5.7 Balance-of-Payments Support. Neither the Bank nor Chilean authorities could havebeen expected to accurately forecast the future course of copper prices, the reversal of Chileancapital flight and a return of international confidence in Chile, therefore, the fact that the firsttranche of the policy component was not needed, and the second cancelled, should notinfluence the performance rating of the loan.

5.8 Reforms without the Loan? Both Bank and country officials involved with the FMLagree that most of the FML-supported financial reforms would eventually have beenintroduced even without the Bank's involvement, indicating that balance-of-paymentconsiderations were not the paramount consideration in the Government's preparedness toinitiate the reforms. At the same time, both Bank officials and Chilean authorities argue thatthe FML bundled and accelerated a series of needed reforms in a package that wouldotherwise have likely taken much longer to implement, and some parts may never have beenimplemented. In addition, the loan provided critical leadership in providing a successfulmechanism for channeling funds to the leasing sector, without which other programs, includingIDB's use of the auction mechanism to provide funds to leasing companies and banks, mightnot have been conceived.

5.9 Technical Assistance. The technical assistance provided by the JGF in conjunctionwith the FML was well conceived, targeted, implemented and supervised, and appearsgenerally to have met its objectives.

Audit Ratings

5.10 The FML may be considered to have been successful to date and to hold the promiseof contributing to the further deepening of Chile's capital markets. The loan is therefore ratedsatisfactory. Institutional development impact is rated substantial, particularly with respect toCORFO and its transition to a successful second-tier lending institution (See Annex IX) aswell as the supervisory agencies of the capital markets which increased their ability to analyzeand regulate the capital markets considerably. Finally, sustainability of the both the policy aswell as the leasing component is rated as likely.

41

Lessons -f Experience

5.11 The main lessons of the FML are as follows:

(a) Lessons which confirm previous OED findings (see Report No. 12128 onKorea Industrial Finance and Report No. 13257 on Mexico SMT operations).

* It is appropriate to support emerging financial market reforms when they are wellconceived and designed; such support strengthens them and gives them momentum.

* A highly complex, hybrid financial sector development project with a large number ofdetailed technical assistance sub-components can be successful provided: (a) themacroeconomic, financial and industrial policy framework is sound; (b) theGovernment "owns", and is fully committed to, the project and its implementation is inte hands of !ompetent officials and institutions; (c) there is close Bank/Governmentcooperation; (d) the Bank and the Government are able to draw upon a sound base ofprior sectoral and institutional knowledge; and (e) the Bank devotes adequate resourcesto loan preparation and supervision.

* Simultaneously supporting the liberalization of financial markets, and providingdirected credit for an activity such as leasing, on the other, are not necessarilyincompatible, provided the directed credit addresses clear market failure and does notimpede the evolution of private sector financing alternatives.

(b) Lessons which are new but cannot be viewed yet as definitive.

* Slow legislative and regulatory processes, coupled with conservative attitudes on thepart of financial institutions, tend to delay the realization of desirable changes infinancial policies, even where there is a firm government commitment to implementthem.

* Asymmetrical demand- and supply-side responses to financial reforms can lead tounintended side-effects (e.g., the bidding up of stock prices).

* International capital flows have a major impact on domestic capital marketdevelopments. While they boost demand for domestic securities as foreign funds areincreasingly placed on domestic capital markets, they adversely affect supplies asdomestic companies increasingly issue securities in foreign capital markets.

* Leasing can provide a very useful and practical supplement to other approaches to theproblem of providing SMI adequate access to investment financing.

Auctioning off longer-term loans can be a useful means of allocating such credit in thecontext of an underdeveloped longer-term capital market not providing reliable andcompetitively determined interest rates.

43 Annex I

Macroeconomic Indicators

w

Table 1: Basic Indicators

GDP Gross Inv. Gr. Nat. Say. Private Cons. Unempl. CPI Peso Value of Wage, Salary Stock Market

Growth (%) (%GDP) (%GDP) Growth (%) Rate (%) Growth (%j Unidad de Growth (%) Capitalization

Fomento (UF) (JS$B.)

1970 16.5 14.6 0.01971 9.0 14.5 12.3 13.11972 -1.2 12.2 8.1 7.41973 -5.6 7.9 5.0 -5.51974 1.0 21.2 20.3 -14.31975 -12.9 13.1 7.2 -11.21976 3.5 12.8 1.4 0.2 211.81977 9.9 14.4 10.0 13.8 11.8 91.91978 8.2 17.8 11.7 7.4 14.1 40.11979 8.3 17.8 11.8 6.9 13.6 33.41980 7.8 21.0 13.8 4.2 10.4 35.1 46.91981 5.5 22.7 6.3 12.2 11.3 19.7 30.31982 -14.1 11.3 2.1 -13.5 19.4 9.9 9.71983 -0.7 9.8 4.4 -5.8 14.6 27.3 13.7 2.61984 6.3 13.6 2.9 1.8 13.9 19.9 2,230 20.0 2.11985 2.4 13.7 5.4 -1.1 12.0 30.7 2,818 25.1 2.01986 5.7 14.6 7.8 4.9 8.8 19.5 3,299 22.0 4.11987 5.7 16.9 12.7 4.8 12.7 19.9 4,044 19.7 5.31988 7.4 17.0 16.3 4.6 11.0 14.7 4,484 22.2 6.81989 10.2 20.3 10.5 5.3 21.4 5,432 19.2 9.61990 3.0 24.7 22.0 2.8 5.7 27.3 7,043 28.3 13.61991 6.1 22.2 22.6 7.5 5.3 18.7 8,286 27.7 28.01992 10.3 23.7 22.3 10.1 4.4 12.7 9,424 20.7 29.61993 6.0 26.5 7.7 4.5 12.2 10,623 11.4 44.6

Sounces World Baic World Table. Worl Debt Tables, Reports 500WCH. 6726-CH. 8549-CH. 9051-CH. 12903-CH; IMF: Internatona Financial Steigest

Table 2: External Sector

Export Import Nominal Real Ex.Rate Average Share of Exp. Balance of Long-Term Foreign Debt (US$M.) Debt ReductioGrowth (%) Growth (%) Exch. Rate (1980=100) Tariff (%) Copper (%) Payments Public Private Total Share of Operations

(Peso/Dollar) (US$ M.) GDP (%) (cumul. US$M1970 45.9 86.01971 0.8 8.5 41.1 73.0 -309.01972 -15.1 3.2 40.4 78.7 -509.0 2556 495 3.0501973 2.8 -5.4 60.0 82.2 -367.0 2767 508 3,2751974 45.9 3.4 83.6 76.8 -656.0 3875 647 4,5221975 2.3 -3.9 113.4 105.0 57.3 -605.0 4016 746 4,7621976 24.4 4.3 103.0 57.0 59.5 411.0 3966 882 4,8491977 11.9 35.5 27.9 101.7 38.0 54.2 126.0 3925 1.095 5,020 57.01978 11.2 17.6 33.9 115.4 24.0 49.9 730.0 4576 1,697 6,273 51.31979 14.1 22.7 39.0 115.2 24.0 47.8 952.0 4839 2,888 7.726 47.31980 14.3 18.7 39.0 99.8 11.8 45.7 1245.0 4700 4,822 9.521 43.81981 -9.0 15.7 39.0 86.0 10.1 43.9 67.0 4411 8,263 12,675 44.41982 4.7 -34.3 73.4 98.2 10.1 46.7 -1358.0 5143 8,834 13,977 98.61983 0.6 -15.1 87.5 117.1 10.1 47.9 -4285.0 7101 8,228 15,329 101.51984 6.8 14.5 128.2 118.8 20.6 46.7 -2075.0 11287 6,536 17.823 133.61985 6.9 -11.0 183.9 132.6 36.5 47.0 -2750.0 13923 4,793 18,716 141.7 3301986 9.7 204.7 173.7 30.9 41.8 -2806.0 15970 3,486 19,456 134.0 1,3141987 5.8 17.0 238.1 183.6 20.6 43.7 -1922.0 16983 2,490 19,473 111.4 3,2921988 12.1 247.2 193.9 20.6 48.2 448.0 15006 2,374 17,380 88.5 6,0631989 15.9 24.5 294.6 185.7 15.5 51.9 427.0 12125 2,934 15,059 69.1 8,7461990 8.5 2.0 335.0 196.8 15.0 45.7 2334.0 11574 4,271 15,845 67.9 9,8411991 10.0 6.3 371.9 185.6 11.0 40.5 1235.0 11022 4.726 15,748 55.9 10,6691992 16.8 22.5 380.2 170.6 11.0 38.9 2499.0 10295 5,351 15,646 49.3 11,0541993 4.4 11.5 425.7 169.4 11.0 35.3 585.0 9011 7,167 16.178 48.2 11,352Not: The Balance of Paynantsa Item I the overall balence.'

Sources: World Bank: World Tables, World Debt Tables, Reports 50-CH. 6720-CH. 8549-CH. 9851-CH, 1003-CH: IMF: Internallonal Financial Statistica

47 Annex ITable 3: Public Finance

Current Current Current CurrentRevenue Expenditure Balance Revenue Expenditure Balance(Bill. Pesos) (Bill. Pesos) (Bill. Pesos) (%GDP) (%GDP) (%GDP)

1972 0.07 0.08 -0.01 29.8 34.0 -4.31973 0.32 0.31 0.01 27.8 27.0 0.91974 2.57 2.10 0.47 27.9 22.8 5.11975 12.30 9.74 2.56 34.7 27.5 7.21976 39.70 33.10 6.60 30.8 25.7 5.11977 89.10 81.40 7.70 30.9 28.3 2.71978 154.00 136.00 18.00 31.6 27.9 3.71979 252.00 195.00 57.00 32.6 25.3 7.41980 359.00 272.00 87.00 33.2 25.2 8.11981 406.00 341.00 65.00 32.0 26.9 5.11982 368.00 395.30 -27.00 29.7 31.9 -2.21983 429.04 462.99 -33.95 27.5 29.7 -2.21984 544.11 563.03 -18.92 28.8 29.8 -1.01985 745.90 725.81 20.09 28.1 27.4 0.81986 914.33 861.52 52.81 26.7 25.2 1.51987 1194.04 1064.42 129.62 26.3 23.4 2.91988 1534.29 1413.76 120.53 25.9 23.9 2.01989 1595.23 1368.19 227.04 21.3 18.2 3.01990 1903.07 1674.06 229.01 20.7 18.2 2.51991 2678.74 2237.26 441.48 22.5 18.8 3.71992 3491.00 2740.00 751.00 23.4 18.4 5.01993 4110.61 3389.45 721.16 22.8 18.8 4.0

Sources: World Bank: World Tables, Repos 5 -CH, 67-CH, N49-CH, 651-CH, 12103-CH.

m

=

49 Annex II

The Policy Component of the Loan

I . Modernizing securities market infrastructure involved the establishment of: (a) acomputerized stock exchange; (b) a central securities depository system (to eliminate the needfor physical transfers of stocks and bonds, etc.); and (c) a risk classification monitoring unit inthe Superintendency of Stocks and Bonds (SVS) (to ensure the consistency and reliability ofthe risk ratings issued by private risk assessment companies).

2. Increasing the supply of private sector securities entailed: (1) simplifying theprocedures governing, and disseminating information concerning, the issuance of stocks andbonds; (2) fostering the creation of closed-end mutual funds specializing in (a) risk capital, (b)real estate, and (c) st.cks and bonds registered by the SVS; (3) encouraging the formation ofreal estate investment companies; and (4) supporting the establishment of a private company,possibly in conjunction with IFC, separate from other insurance companies, to guaranteecorporate bonds.

3. Providing additional outlets for pension funds and insurance companies involved: (1)giving pension funds permission to invest in real estate investment companies; (2) legalizingpension fund investments in the new, specialized closed-end mutual funds; (3) permittingpension fund investments in certain listed equities without obligation to meet the requirementsof the Risk Assessment Commission (RAC) and permitting increased investment in equitiesmeeting the requirements of the RAC; (4) permitting pension funds to invest up to 10 percentof their assets in short-term commercial paper; (5) submission of legislation to (a) permitcommercial banks to securitize and collateralize part of their loan portfolios and sell themwithout the authorization of the SBIF and (b) permit pension funds to buy securitized orcollateralized securities from the banks; (6) the submission of legislation to permit insurancecompanies to invest in the new specialized closed-end mutual funds and real estate investmentcompanies and liberalization of the rules governing insurance company investment in corporateequities; and (7) submission of legislation permitting insurance companies to purchasesecuritized or collateralized securities from the banks.

4. Strengthening and improving the profitability of the commercial banks involved: (1)legal changes (see previous para.) to permit banks to sell securitized or collateralizedsecurities; (2) relaxation of the condition that banks limit the value of their guarantees to theamount of their capital and reserves; (3) permission for banks to issue subordinated bonds anduse at least half as part of their capital base up to a limit of 20 percent of their capital andreserves.

5. Strengthening the leasing sector entailed: (1) establishing a regulatory framework forleasing companies that were subsidiaries of commercial banks; and (2) issuing regulatoryamendments permitting leasing companies to issue bonds to a value equal to twice their capitalinstead of merely equal to their capital.

Annex II 50

6. Second Tranche Release Coniditions. While the majority of the policy measures werealready in place or were conditions of effectiveness, there were several second tranche releaseconditions. They consisted of (1) issuance of regulations governing the Central DepositorySystem and establishemnt by the Central Bank of incentives and a timetable for the transfer ofpension fund administrators to transfer securities from the CB to the new Central DepositorySystem; (2) satisfactory Bank review of legislation and regulatory framework relating to theestablishment of REICs; (3) amendment to pension fund law to allow them to invest in closed-end mutual funds and up to 10% of their assets in short-term commercial paper; (4)submission of legislation authorizing pension funds and life insurance companies to purchasesecuritized and collateralized loans issued by banks; (5) submission of legislation permittingbanks to securitize and collateralize loans and to issue subordinated bonds to improve theircapital base; (6) raising the global limit on guarantees granted by banks.

51 Annex III

Pension Funds

a) Background

1. In 1981, Chile introduced a privately-run, compulsory pension fund scheme requiringevery employee to contribute 10% of gross income. Since the sy.tem is fully funded, thecontributions are accumulated until retirement (instead of being paid out to the currently agedas in a pay-as-you-go system). As a result, savings of the pension funds rose dramaticallyfrom US$ 0.3 billion in 1981 to US$17.5 billion in March of 1994 (Table 1). In fact, thegrowth of holdings of the pension funds has far outpaced expectations of the SAR to the pointthat holdings in 1994 were 100% higher than expected (see Table 1). A favorable overalleconomic developmet, increasing membership, and high real rates of return are the mainfactors accounting for this higher than expected growth of assets.

2. P:ior to the FML, pension funds were restricted to investing their resources ingovernment bonds, bank deposits, mortgage securities and a very limited number of corporateequity end bonds. They could only invest in companies that met the stringent conditionsspelled out in the pension fund law (DL 3500) requiring high capitalization and a widelydispersed ownership. In practice, this meant that the funds were only allowed to invest in lessthan a dozen recently privatized companies.

3. These restrictions were projected to generate a dearth of satisfactory outlets for themounting savings of the pension funds. It was held that the restrictions on investing incorporate equity and bonds would, together with slow growth in mortgage-backed securities,force pension funds to invest ever-larger shares of their portfolio in government bonds andbank deposits (see Table 2b). This would reduce the returns to the pension funds, stiflepotential investment in the private sector, and place an unduly large amount of investible fundsin private banks.

b) The FML

4. The specific measures included in the FML were:

* i) a change in regulations to increase the number of eligible companies for investment(allowing limited investments in companies that did not follow the rules set out in DL3500).

* ii) permission to invest in the newly established closed-end mutual funds. Three typesof funds were set up, one investing in real estate, one in corporate securities, and onein risk capital in non-listed companies.

* iii) permission to invest in commercial paper.

* iv) permission to buy shares of real estate investment companies.

Annex III 52

v) permission to invest in securitized and collateralized loans issued by banks. Basedon these changes, the SAR projected an investment profile that would includeinvestments in these new outlets and significantly reduce reliance on Treasury bonds,bank deposits, and mortgages (see Table 2c).

c) Implementation

5. Legislation authorizing measures i)-iv) had either already been approved prior to loaneffectiveness of were approved by March of 1990. Condition v) was also included in theMarch, 1990 legislation but has not led to any investments in these instruments as theaccompanying legislation authorizing these new instruments was passed only in March, 1994and has yet to be implemented. In addition, an amendment to the pension fund law passed inMarch, 1994 law increased the share of holdings that may be invested abroad from 1% to 14%of holdings and further eased restrictions on companies that may sell bonds and equity to thepension funds, hoping to boost the number of companies that can the pension funds can investin directly to about 150.

d) Outcome

6. The actual development of the investment profile has been somewhat different thananticipated in the SAR. Tables 1, 2a),b) 3, and 4 detail the changes. First, it has to be notedthat an important change was that the holdings of the pension funds increased much faster thananticipated. In 1994, the holdings were at about twice the level anticipated in the SAR, or anastounding 35% of GDP (Table 1). Thus it is to be expected that in the face of thisunexpected growth, the investment profile shifted. It must also be noted that large relativedeclines in holdings of the pension funds do not necessarily mean large absolute declines inholdings. For example, although deposits in financial institutions dropped from 28.5% ofholdings in 1988 to less than 6% in 1994, the absolute amount of holdings in bank depositshas only dropped by about 20% between 1989 and 1994.

7. In contrast to projections, the share of holdings in state institutions grew and stabilizedat a much higher level thqn anticipated. In absolute terms, pension funds more thanquadrupled their purchases of government papers. This means that the government continuesto have a relatively cheap and reliable source of finance. An important factor in thisdevelopment was the sharply rising issuance of debt instruments by the Central Bank to stemthe effect of the sharply rising inflows of foreign capital. The Central Bank was determined toprevent both the appreciation of the peso and the inflationary impact of monetizing theinflows. Instead it accumulated foreign capital reserves (from 5.4b. US-$ in 1990 to I lb. inJune 1994) and, at the same time, sharply increased its issuance of debt instruments in order torestrict domestic money supply. This in turn led to much higher than anticipated investmentsby the pension funds in government papers.

8. Similarly, the relative decline in holdings of mortgage-backed securities wasconsiderably smaller than anticipated. This may in part be due to the improved capitalposition of the banking system which was held to be one of the constraints limiting the growth

53 Annex III

of mortgage-backed securities. Moreover, favorable economic conditions improved theperformance of t&e construction sector, thereby giving a further boost to the mortgage market.

9. At the same time, the projected fall in bank deposits was much more dramatic thananticipated. Pension funds reduced the share of holdings in bank deposits from 28.5% to lessthan 6%. Here, she low rate of return offered by the banks compared to other outlets arelikely to be the most important cause for this relative decline.

10. Investments in equity, on the other hand, moved in the opposite direction with pensionfunds -ncreasing their share of holdings in company equity from 8% in 1988 to 32% in 1994.In fact, by 1993 pension funds accounted for about 12% of the very high stock marketcapitalization in Chile. Thus the pension funds have been a very important driving force inthe rapid developmen+ of the stock market and the improved access to finance for large-scaleenterprises (see Annex VIII). An important factor accounting for the much larger thananticipated investment in shares is a much larger than anticipated number of eligiblecompanies. The SAR assumed that only 17 more companies would become eligible forinvestments as a result of easing the restrictions (i.e. allowing investments in companies thatdid not meet DL 3500 conditions) while in reality 63 more companies have received equityinvestments (Table 4, 5). In addition, the value of the shares held by the pension funds hasincreased considerably as a result of sharply increasing share prices over the past few years.This large rise in share prices has been due to a combination of favorable macroeconomicdevelopments, rising foreign portfolio investments, and the rising demand of the pensionsfunds and life insurance companies themselves (see Annex V).

11. Corporate bonds have developed in line with projections. The bond market grewrapidly aided by the entry of increasing number of eligible firms into the bond market (Table4). In the past two years, investments in bonds have stagnated, due mainly to stagnatingissuing activity (see Annex V). Particularly noteworthy is the increasing investment in bondsof leasing companies which total US$42.5 million in 1994 and have thus contributedconsiderably to financing the growing leasing sector (Annex VII). Bonds and subordinatedbonds (issued to strengthen the capital base of banks, see Annex VI) issued by banks and otherfinancial institutions play a negligible role in the portfolios of the pension funds.

12. The new instruments introduced with the support of the FML have not played animportant role in the portfolio of pension funds. All three types of closed-end mutual fundshave only captured about 0.6% of the portfolio by July of 1994. Equity in Real EstateInvestment Companies account for 0.4% of the portfolio suggesting that there has beenrelatively little activity on this front (see Table 4). Finally, the commercial paper market hasnot developed at all yet (see Annex V). As mentioned before, securitization andcollateralization of loans has not taken place yet.

13. It is difficult to determine the factors influencing the limited use of these instruments.An important factor appears to be the time it takes to develop these new instruments.Although legal for a few years, it took a considerable amount of time for such the closed-endfunds to actually come into existence. As of March, 1994, twelve funds were in operation andinvestments in eight of them have risen rapidly in the past few months (Table 4). The pension

Annex III 54

funds have expressed considerable interest in these new instruments and are awaiting theirfurther development. The prospects for Real Estate Investment Companies may not be sopromising. Two REICs came into existence already in 1991, but there have been no newadditions since then and the holdings of the pension funds have not increased by much (Table4). One factor accounting for the absence of a commercial paper market is the important rolebanks continue to play in the provision of short-time finance to companies.

e) Assessment

14. The liberalization of the Pension Funds was clearly a success. Real rates of return in1990-94 have averaged 16.6%, considerably above earlier periods (Table 1). These highreturns have helped solidify the confidence in the system and have contributed to itsastounding growth. Since the returns are reinvested, the high real returns have alsocontributed to an increase in savings.

15. The liberalization has contributed in a major way to the development of the stock andbond markets. The number of companies listed has increased considerably and the ability toattract funds from the pension system has been a major factor in this development (see AnnexV). Moreover, the development of the bond market has been stimulated by the pension funds,although recently the supply of domestic bonds has stagnated, partially due to the increasedissuance of bonds and stocks in foreign capital markets (Annex V). As a result of theseliberalizations, large companies have considerably better access to long-term finance in thestock and bond markets,-thereby lowering their investment costs and improving theirprofitability (Annex VIII).

16. At the same time, the portfolio of the funds stuck much more to traditionalinstruments. Government and mortgage securities make up more than half of the totalholdings. The continued high reliance on government instruments is due to the determinationof the Central Bank to prevent an appreciation of the peso. Moreover, most of the expansionoccurred in traditional equity and bond instruments, while the more innovative instrumentshave not played an important role, although they are clearly on the rise.

17. Clearly, further diversification of the portfolio is still needed. Pension funds continueto rely too much on government bonds and mortgage-backed securities. Moreover, they buydisproportionate amounts of equity in the largest and former state-owned companies (those thatmeet the conditions of DL 3500) to the point that they own between 12 and 50% of equity ofChile's largest enterprises (mostly utilities and telecommunications), with an (unweighted)average of 30.3% (Table 5).' This represents an increase over 1991, suggesting that moreoutlets are still needed.'

1. Those companies are in accordance with the stricter regulations of the pension fund laws regarding capitalization and widedispersion of ownership. In Table 5, they are referred to companies meeting DL 3500 requirements.

2. At the same time, investments in other companies (not meeting DL 3500 requirements) have progressively increased and now makeup 20% of shareholdings. Also, the share of these companies held by pension funds increased to 5% which is still far below the shareowned of the largest companies (Table 5).

55 Annex III

18. As the Central Bank's policy of accumulating foreign reserves at such a rapid pace isunsustainable in the long run, the issuance of debt instruments is likely to fall, therebyreducing the pension funds' high reliance on state-issued securities. This, combined with moreheavy use of the new instruments introduced in conjunction with the FML and the newliberalizations passed in 1994, is likely to lead to further diversification of pension fundholdings. Such developments would particularly help medium-sized companies improve theiraccess to term financing via the stock and bond market as well as the risk capital funds, unlesspension funds diversify mostly into foreign assets after the recent raising of the ceiling onforeign investments.

19. Thus the FML clearly achieved its substantive objective regarding pension funds, i.e.channeling the resources of the pension funds to more productive uses. It is likely (but tooearly to determine), however, whether many of the new instruments that were introduced aspart of the loan will have the desired effect of further diversification of the pension fundportfolio and improved access to investment funds for corporations.

Annex III 56

Table 1: Basic Data on Pension Funds

Number Act Holdings SAR Real Rate of ReturnFunds (US-$ b.) Projections (%)

1981 12 0.30 12.6

1982 12 0.61 28.8

1983 12 1.14 21.3

1984 12 1.24 3.5

1985 12 1.53 13.4

1986 12 2.12 12.3

1987 12 2.71 5.4

1988 13 3.58 3.58 6.4

1989 13 4.47 4 6.9

1990 13 6.66 4.8 15.5

1991 13 10.06 5.6 29.7

1992 13 13.00 6.4 3.1

1993 22 15.94 7.2 16.2

1994 21 17.54 8 18.3

Average 81-94 13.9

Average 90-94 16.6

Note: 1981 return data are July-December only, 1994 return data are January-July only, 1994 volume is for April1994.

Source: Staff Appraisal Report(SAR); SAFP: Boletin Estadistico Mensual No.95, 108, 121, 124, Report 6728-CH

57 Annex III

Table 2: Investment Profile, 1988-1994

a) Actual Development (Billions of 1993 Pesos)

Financial Institutions Companies

State Foreign DisposableInstitutions Deposits Mortgages Other Stock Bonds Other Investment Assets

1988 747.8 602.0 456.3 0.0 171.1 135.2 0.0 0.0 0.0

12/89 1085.5 543.3 462.1 18.3 263.7 237.3 0.0 0.0 0.5

12/91 1855.1 569.1 647.6 74.6 1140.7 537.2 14.5 0.0 4.8

3/94 2869.0 435.6 947.1 98.5 2336.4 497.6 71.5 46.0 5.1

7/94 3078.6 455.7 984.1 91.9 2396.2 499.3 75.0 74.3 3.1

b) Actual Development (Shares of Portfolio)

Financial Institutions Companies

State Stocks Bonds Other Foreign DisposableInstitutions Deposits Mortgages Other (%) (%) (%) Investments Assets

(%) (%) (%) (%) (%) (%)

1988 35.4 28.5 21.6 0.0 8.1 6.4 0.0 0.0

12/89 41.6 20.8 17.7 0.7 10.1 9.1 0.0 0.0 0.0

12/91 38.3 11.8 13.4 1.5 23.6 11.1 0.3 0.0 0.1

3/94 39.3 6.0 13.0 1.4 32.0 6.8 1.0 0.6 0.1

7/94 40.2 6.0 12.9 1.2 31.3 6.5 1.0 1.0 0.0

c) Projections Staff Appraisal Report Without Changes

1993 40.8 37.0 9.9 0.0 7.6 4.7 0.0

1998 50.0 32.9 6.0 0.0 6.5 4.6 0.0

d) Projections SAR With Changes supported by FML

1991 28.1 24.3 11.9 0.0 15.7 5.8 14.1

1994 23.2 24.3 7.7 0.0 13.7 6.1 24.9

Note: see SAR for assumptions used to derive projections.Source: SAR, SAFP: Boletin Estadistico Mensual No. 95. 106, 121, 124.

Annex III 58

Table 3: Financial Institutions (Percentage of Total Pension Fund Assets)

Number Deposits Mortgages Bonds Subord. bonds Shares Total(%) (%) (%) (%) (%) (%)

12/89 38 20.8 17.7 0.7 0.0 0.0 39.212/91 37 11.8 13.4 1.4 0.1 0.0 26.73/94 33 6.0 13.0 1.0 0.3 0.1 20.37/94 6.0 12.9 0.8 0.3 0.1 20.0

Table 4: Investments in Companies

Number of Companies Closed-End Funds Total Commercial

Stocks Bonds Of which REIC Closed- Shares Shares- Bonds Real Risk Securities Closed- PaperLeasing End (%) REIC (%) Estate Capital (%) End (%)

Funds (%) (%) (%) (%)

1988 12 9.1 0.0 6.4 0.0 0.0 0.0 0.0 0.0

12/89 24 19 2 10.1 0.0 9.1 0.0 0.0 0.0 0.0 0.0

12/91 43 26 7 2 23.6 0.3 11.1 0.0 0.0 0.0 0.0 0.0

3/94 73 43 8 2 8 32.0 0.4 6.8 0.2 0.2 0.0 0.4 0.0

7/94 31.3 0.4 6 5 0.3 0.2 0.1 0.6 0.0

SAR Projections

1991 20 15.7 3.1 5 8 5.1 6.0

1994 29 13.7 4.9 6 1 10.0 10.0

REIC-Real Estate investment Companies, the column leasing refers to bonds only.Smurce: SAFP: Botctin Estadisico Mensual 95. 108. 121. 124. SAR

Table 5: Diversification of Shareholding

Companies meeting DL-3500 Share of Investments Proportion of Companies Held by Pen.Funds

Yes No DL3500 (%) Others (%) DL3500 (%) Others (%)

12/89 8 16 93.0 7.0

12/91 9 34 87.1 12.9 26.8 2.3

3/94 10 63 79.9 20.1 30.3 5.2

Note: DL 3500 sets out the criteria permitting investments by the pension funds.Source: SAFP: Boletin Estadistico Mensual 95, 108. 121. 124. SAR

59 Annex IV

Life Insurance Companies

a) Background

1. Life insurance companies fulfill two important functions in the structure of Chile'sprivate compulsory pension plan scheme. First, all members of the pension plan system arerequired to pay 3.75% of their earnings to purchase disability insurance from life insurancecompanies. As the number of participants has grown, so has the premiums received by thelife insurance industry (see Table 1). Second, life insurance companies offer the possibility forpension plan holders to transfer their pension savings to the life insurance company which willpay it out to the beneficiary in the form of an annuity. Since this form of retirement benefit issafer than to keep the funds in the pension plan (and hope that one will not outlive one'spension fund savings), the vast majority of beneficiaries have chosen the annuity optionleading to very rapid growth in the assets and investible funds of the life insurance companies,reaching more than US$4b. or 11% of GDP in 1993 (Table 1). While this is considerablysmaller than the assets of the pension funds (US$17b. in 1994, see Annex III), the assets ofthe life insurance companies represent the second most important pool of domestic savings.

2. Since over 95% of the rapidly growing assets of the life insurance companies areinvested in securities (see Table 2), they were facing similar regulatory constraints that alsorestricted the pension funds (see Annex Ill). In particular, they were relying heavily ongovernment and mortgage-backed securities as well as bank deposits for their investments.Given the continued growth of the life insurance companies, it was feared that the continuedreliance on government securities and bank deposits would lower the returns to life insurancecompanies. At the same time, the growth of the life insurance companies presented a uniqueopportunity to deepen Chile's financial markets and channel these savings into much-neededproductive investments.

b) FML Loan

3. The measures supported by the FML loan consisted of a range of liberalizationsregarding the investment possibilities of life insurance companies. More specifically, theywere allowed to:

i) invest in shares of real estate investment companies and closed-end mutualfunds as well as purchase securitized and collateralized instruments emitted bybanks.

ii) invest in companies that did not meet the strict ownership diversificationguidelines established in the insurance company law.

Annex IV 60

c) Implementation

4. With the exception of allowing companies to invest in securitized and collateralizedassets which has not been implemented to date, all measures had already been implementedprior to board approval. In 1994, further changes in the insurance company law continued theliberalization effort by allowing insurance companies to invest in fixed-income mutual funds,endorsable mortgage loans, and up to 18% of their portfolio abroad.

d) Outcome

5. In many ways, the changes in the portfolio of life insurance companies mirror thedevelopments of the pension funds (see Annex III). Investments in state securities continuedto increase, both in absolute terms as well as in shares of the portfolio, approaching 40% ofoverall investments in 1993. Mortgage-backed securities also grew in absolute terms but madeup a slightly declining share of total investments. Deposits with banks stay flat in absoluteterms and fell considerably as a share of total investments.' Stocks investments increasedmore than three-fold and investments in corporate bonds rose as well, although they representa declining share of the portfolio.'

6. There are also important differences between changes in investments of the pensionfunds and life insurance companies. Life insurance companies have concentrated much moreon corporate bonds than on corporate equity, although prudential regulations did not require it.While they have expanded equity holdings to 9% in 1993, this is far below the 30% ofportfolio held by the pension funds. Conversely, life insurance companies held 20% of theirportfolio in coportate bonds in 1991, while pension funds held only 9%. Since the bondmarket expanded much less rapidly than the equity market in the past few years (see AnnexesIII, V) and since pension funds and life insurance companies hold about 85% of corporatebonds outstanding (see Annex V), life insurance companies have been constrained much moreby their higher reliance on the bond market than pension funds. In fact, the share of theportfolio invested in the bond market declined, while their share of total corporate bondsoutstanding actually increased from 28% in 1990 to 30% in 1993.

7. Table 3 shows two profitability indicators. The first shows the returns on investments.These returns are measured on UF and are thus real rates of return. They are quite high,averaging slightly below 10% a year. They are slightly lower, but considerably less volatilethan the returns earned by the pension funds (see Annex III) which is a reflection of theirmore conservative investment practices (esp. the higher reliance on bonds rather than equity).Nominal return on net worth (capital plus reserves) is more volatile, but also significantlypositive in real terms.

1. These figures include deposits as well as bonds emitted by financial institutions. It is not possible to disaggregate the data andtell the precise magnitude of these two components, although deposits likely constitute the majority of this category.

2. It was not possible to disaggregate the data further to see whether there was significant investments in REICs and closed-end funds.Given that these funds have only developed recently, it is unlikely that they represent a significant share of the portfolio held by thelife insurance companies.

61 Annex IV

e) Assessment

8. Similar to the pension funds, the life insurance companies have been able to managetheir rapid growth without facing declining returns or too heavy reliance on state instrumentsfor their investments. While their holdings of state instruments is high and grew considerably,they have successfully diversified their portfolio into stocks, bonds, and other investments(including real estate). The FML loan clearly helped in supporting the relaxation of rulesregarding equity investments which has been the fastest-growing component of their portfolio.

9. As with the pension funds, the diversification of the portfolio was mainly restricted totraditional investment vehicles such as stocks and bonds rather than the new instruments(closed-end funds, REICs, etc) that were introduced with the FML. As the life insurancecompanies are slowly reaching the limits of the capacity of these instruments, in particular thelimited volume of the bond market, it is likely that the new instruments will soon play a moreimportant role in their portfolio. Moreover, a new round of liberalization included in theMarch 1994 law allows for further diversification of the portfolio, including more foreigninvestments, and should therefore ensure that the life insurance companies will continue toearn high returns and provide much-needed industrial finance.

10. The changes supported by the FML were clearly a beneficial and important step in theongoing process of liberalization of institutional investors. They have increased the amount ofindustrial finance available (see Annex VIII), have allowed institutional investors to continueto earn impressive returns on their investments, and have contributed considerably to capitalmarket deepening.

Table 1: General Indicators

Real Growth in Real Assets Share of Security MarketPremiums (%) (B. 1993 Pesos) Capitalization (%)

1989 20.8 703.2 6.8

1990 31.5 879.0 6.7

1991 23.6 1149.9 5.4

1992 10.4 1383.3 6.4

1993 12.9 1716.1 6.3

Source: Anuario Seguros 1993.

Annex IV 62

Table 2: Investment Profile of Life Insurance Companies(Billions of 1993 Pesos and Shares of Portfolio)

Government Mortgages Deposits, Stocks Corporate Other TotalBonds Financial Bonds Investments

Bonds

1993Pesos (B.)

1989 214.3 115.8 78.4 41.1 136.5 83.1 669.2

1990 320.5 127.8 51.7 43.4 177.5 132.6 853.6

1991 400.5 156.3 68.2 100 225.6 172.6 1123.2

1992 513.7 176.9 71.6 126 234.0 212.8 1335.0

1993 660.6 257.0 82.1 147.1 242.3 265.7 1654.8

Shares ofPortfolio(%)

1989 32.0 17.3 11.7 6.1 20.4 12.4 100

1990 37.6 15.0 6.1 5.1 20.8 15.5 100

1991 35.7 13.9 6.1 8.9 20.1 15.4 100

1992 38.5 13.2 5.4 9.4 17.5 15.9 100

1993 39.9 15.5 5.0 8.9 14.6 16.1 100

Note: Other includes cash, real estate investments. and loans to clients.Source: SVS: Anuario Seguros 1993.

Table 3: Profitability of Life Insurance Companies

Real Return on Nominal Return on Net Worth (Equity plusInvestments (%) Reserves, %)

1989 9.6 38.8

1990 10.1 14.9

1991 11.6 32.8

1992 7.3 8.4

1993 8.0 10.6

Source: SVS: Anuario Seguros 1993.

63 Annex V

Securities Markets

a) Background

1. After the severe financial crisis of the early 1980s, the securities markets recoveredrelatively quickly and began a moderate expansion, albeit from a very low level (see Annex I,Table 1). This expansion was fuelled by the privatization of a number of large state-ownedenterprises and the increased demand for securities by the pension funds and life insurancecompanies.

2. In spite of this growth, the securities markets were facing considerable bottlenecks.Among the specific bottlenecks identified were shortcomings in security markets infrastructure,in particular the absence of a depository system, the lack of reliable risk classification, and theabsence of electronic trading. In addition, the supply of securities was curtailed bycumbersome informational requirements for securities issuers, the lack of bond guaranteeschemes and specific credit insurance companies, as well as the absence of mechanisms tosecuritize and collateralize non-mortgage loans assets and trade them in the securitiesmarkets.'

3. These bottlenecks were believed to hold back further expansion of the supply ofsecurities. In addition, strict regulations governing the investments of pension funds and lifeinsurance companies depressed potential demand for securities (see Annexes III, IV). Thesefactors combined lowered the capital channeled through the securities markets, therebyreducing the amount of long-term funds available for investment and lowering the rates ofreturns earned for the rising savings generated by the pension funds and life insurancecompanies.

b) The FML Loan

4. The specific measures included in and supported by the loan were:

i) establishment of a computerized stock exchange.

ii) establishment of a depository system for all types of securities.

iii) creation of a risk classification monitoring unit at the securities marketregulatory agency SVS (Superintendencia de Seguros y Valores), withtechnical assistance provided (see Annex X).

1. Securitization of loans refers to selling a loan on the securuties market, with the new purchaser being entire responsible for thecredit risk. Collateralization involves selling a loan that is backed by a specific real collateral on the securities markets with the bankstill bearing the credit risk, i.e. the loan is turned into a guarantee.

Annex V 64

iv) reduction of information requirements for securities issues and informationalseminars to publicize the new regulations and encourage more issuingactivities.

v) establishment of three types of closed-end mutual funds specializing in riskcapital, real estate, and securities, respectively.

vi) establishment of Real Estate Investment Companies (REIC).

vii) changes in legislation to encourage establishment of a bond guarantee scheme.

viii) permission to banks to securitize and collateralize loans and sell them on thesecurities markets.

In addition, several measures to liberalize the investment possibilities of pension funds and lifeinsurance companies were also included (see Annexes Ill, IV).

c) Implementation

5. Items i) as well as iii) through vii) had either already been enacted or were enactedbefore Board Presentation in December 1989. The legislation permitting the establishment ofa private depository system was enacted prior to loan effectiveness in March 1990. Thesystem is being tested and will become operational in early 1995.

6. Submission of legislation to permit the securitization and collateralization of loans wasrequired for second tranche release. Although the second tranche was canceled (since therewas no longer a need for balance of payments support), the legislation was submitted inJanuary 1993 and passed in March of 1994. It is still awaiting implementation, pending asolution to the subordinated debt problem of banks (see Annex VI).

d) Outcome

7. Data on securities emissions and stock market capitalization show unprecedented levelsof growth (Tables I and 2). Particularly impressive is the rapid and accelerating pace of stockemissions, which nearly tripled in real terms in a mere three years. Similarly, mortgage bondissues more than doubled. The increase in capitalization is even more impressive. Overallsecurities market capitalization more than doubled. Also here, stocks and mortgage bondsoutperformed other securities instruments.

8. Apart from the rapid overall growth of securities markets, there has been a dramaticshift in the importance of the private sector in the capital markets. The private sector

2. Note that mortgage markets were functioning well already prior to the FML. None of the measures supported with the FML dealtwith mortgage markets and the securitization of mortgages by banks (see Annex VI).

65 Annex V

increased the share of total emissions from 27% in 1990 to 68% in 1993." In terms ofcapitalization, the private sector captured 83% of total securities markets capitalization in1993, up from 69% in 1990. This shift has been caused by a combination of a reduced capitalrequirements of the state and an increased presence of the private sector in the securitiesmarkets.

9. A key element in the growth of the securities markets has been the impressiveperformance of the stock market. Expressed in US$, stock market capitalization more thanquadrupled between 1989 and 1993, rising from 9.6 billion to 44.6 billion in 1993 (see AnnexI, Table 1). This represents 110% of GDP, by far the highest level of stock marketcapitalization in Latin America. The price/earnings ratio tripled between 1990 and 1993 andnow stands at a high 21, suggesting that a sharp increase in share s is a major factor in therising stock market capitalization (Table 3).

10. Three factors combine to account for this rapid growth of the stock market. On thesupply side, there is the increase in the number of new issuers. Between 1990 and 1994, morethan 100 new companies have entered the stock market, bringing the total number ofcompanies traded to 350 (Tables 3, 4). Another 25 to 30 are in the process of going public,partially induced by the high presence of the pension funds in the stock market (see Annex III,and Table 4). On the demand side, foreign capital has flown in at a very high rate. Fundsheld by Foreign Capital Investment Funds (FICEs) account for 3.4% of market capitalizationin 1993, up from 2.7% in 1990 (Table 5).4

11. The second and by far most important factor influencing the demand for stocks is theincreasing involvement of the pension funds and life insurance companies in the stock market.Their share of stock market capitalization rose from 6.2% in 1990 to nearly 12.7% in 1993(Table 4). In 1994, the share has continued to rise. The liberalization of pension fund andlife insurance investments clearly was the dominant force behind Chile's stock market boom.

12. While the supply factors are important, a comparison of Tables 1 and 2 as well as thesharply rising P/E ratio clearly demonstrate that share increases, driven by sharply risingdemand from FICEs, pension funds, and life insurance companies, are a much greater factor inthe sharp rise in stock market capitalization. Thus demand increases, induced by favorablemacroeconomic conditions as well as the measures liberalizing investment opportunities of thepension funds and life insurance companies, is outpacing supply increases, suggesting that theFML was more successful in boosting demand than in increasing the supply of securities.

3. The numbers are slightly deceptive. For the public sector and financial bond issuers, the figures refer to net emissions (i.e.emissions of bonds minus repayments). Thus, the public sector and financial bond issuing figures are understated. While this affectsthe levels, it should not affect trends in issuing activity.

4. At the same time, an increasing number of Chilean companies (around 70 in 1994) are able to place equity directly on US stockmarkets (via American Depository Receipts-ADRs) so that the foreign capital invested in Chilean companies is much larger than theactivities of foreign capital investment funds on the Chilean securities markets would suggest.

Annex V 66

13. In spite of the large increase, the pension funds and foreign portfolio investorscombined only hold 16% of market capitalization. At the same time, annual trading in stocksonly amounts to less than 10% of total capitalization, suggesting quite thin trading activities(Table 3). This low trading volume indicates that most companies are willing to place only arelatively modest proportion of their shares in the market, and prefer to keep the majority ofshares closely held, so that the seemingly low share of pension funds and FICEs in overallcapitalization suggests that these two institutions dominate the traded portion of the shares andthus have a major influence on rising shares.'

14. The bond markets have also grown, but a much slower pace (Tables 1, 3). Between1990 and 1993, the value of bond outstanding only increased by about 40% in real terms, andthe number of companies emitting bonds rose from 26 in 1990 to 43 in 1994. After a boomof in 1991, bond emissions have dropped considerably. The majority of bond emissions isfrom industrial companies, with banks and other financial institutions (mainly leasingcompanies) playing a smaller role.

15. On the demand side, pension funds and life insurance companies entirely dominate thebond market (Table 4). Their share in non-financial bonds outstanding grew from 65% in1990 to 89% in 1991, before it fell to 85% in 1993. At the same time, the share of financialbonds held by pension funds increased from 23% in 1990 to 67% in 1993.' Clearly, thepension funds and life insurance companies are the predominant customers and the slowdevelopments in the supply of bonds in recent years is not due to a lack of demand. Thedecline in importance of corporate and financial bonds in the investment portfolio's of pensionfunds and life insurance companies also suggests that there would have been sufficient demandfor a more active bond market development (see Annexes III, IV).

16. The most important factor restraining the supply growth of corporate and financialbonds appears to be the increasing ability of Chilean companies to directly tap internationalcapital markets at more competitive rates than those available domestically. Since 1991, muchof the issuing activity with regard to stocks and bonds has moved abroad, thereby constrainingissuing activity in Chile, particularly bond issues (see Annex VIII).

17. The new products supported by the FML have up to now played a negligible role inthe securities markets, accounting for less than 0.2% of securities market capitalization.Twelve closed-end mutual fund management companies are listed with the Superintendency ofSecurities, and ten funds were in operation at the end of 1993. Four risk capital funds had

5. If one excludes the recently privatized companies whose shares are dispersed and traded widely, the share of market capitalizationheld by pension funds and foreign investors shrinks by about two-thirds suggesting that many of the new companies that entered thestock market are willing to sell less than about a quarter of their shares. In that sense, the high market capitalization (and the highP/E Ratio) may partially be an effect of this behavior which leads to an undersupply of shares in the face of high demand, therebydriving up stock prices. If all shares of all companies listed were actually tradeable, the market capitalization might well beconsiderably lower.

6. This is also true for the mortgage-backed securities and government bonds, where the share of securities held by pension fundsand life insurance companies rose considerably between 1990 and 1993, clearly suggesting that the increases in demand haveoutstripped increases in supply (Table 5).

67 Annex V

combined assets of 11.3 billion pesos, the five real estate funds have about 35 billion pesos inassets, and the one securities funds had just started operation in November 1993. Table 6summarizes the assets structure of these funds.

18. After some activity in 1990, the commercial paper market remained undeveloped. Itappears that industrial companies continue to rely on banks for short-term financing needs andhave not used this vehicle. On the other hand, open-end mutual funds play a more importantrole, accounting for about 2% of securities markets capitalization in 1993.

19. The real estate investment companies have also played only a small role so far. Thereare twenty-five real estate companies listed with the Superintendency of Securities (Table 4).They commanded about 78 billion pesos of assets in 1993, the vast majority of which isaccounted by the biggest three companies. The pension funds have, so far, invested in two ofthe largest real estate companies (Table 4).

20. On the other hand, the one innovation supported by the FML in securities marketsinfrastructure that has played a very important role in recent years, is the electronic stockexchange. By now, 29% of all stock market transactions, 59% of fixed income securities and11% of closed-end mutual fund activity is handled by the electronic stock exchange (Table 7).Since both exchanges (as well as the small securities market in Valparaiso) trade the sameproducts, the competition between the exchanges has led to considerable gains in efficiencyand drops in commissions charged.'

e) Assessment

21. Clearly, the securities markets development of the past years exceeded expectations.Particularly the development of the stock market has been phenomenal. The question arises,however, to what extent the measures supported by the FML can account for these extremelypositive developments.

22. As far as the securities markets infrastructure is concerned, the two items that wereimplemented, the electronic stock exchange and the risk rating classification system, appear tohave been a success and contributed to the rapid development of the securities markets. Theelectronic exchange is playing an ever-important role and has contributed to increasingefficiency and lower transactions costs.

23. Interviews with the Superintendency of Securities suggest that the risk classificationmonitoring unit has also contributed to improved securities market development. The numberof risk classification agencies dropped from eight to four and the differences between theirassessments have narrowed. Both is likely to have reduced uncertainty and improvedefficiency of the bond market.

7. The traditional Bolsa still lists more companies, but that difference is narrowing.

Annex V 68

24. The central depository system has yet to open. Even without it, the stock market wasable to flourish. Nevertheless, all participants agree that the opening of the depository systemis likely to further reduce transactions costs and thus increase the efficiency of the securitiesmarkets.

25. The supply of securities has improved markedly. In particular, many more companieshave rushed to the stock market. It is difficult to determine whether the removal of obstacleson the supply side (mainly regarding informational requirements for issuers) or whether thepromise of easy access to pension fund capital was the main factor in increasing the number ofsecurities issues. Table 4 shows the number of companies listed and those whose shares havebeen bought by the pension funds. The pension funds have holdings in a third of productioncompanies which suggests that the promise of pension fund capital might have been animportant influence (see Table 4 and appendix III). Similarly, the arrival of foreign capitalinvestment funds is likely to have fuelled issuing activity.

26. The bond markets have not developed nearly as well in spite of growing demand fromthe pension funds and life insurance companies. Here, external factor, esp. the ability to emitbond internationally, is likely to have been the most important factor accounting for this slowdevelopment.

27. The specific new products introduced by the FML have not played an important roleto date. But it has to be noted that the closed-end funds were set up recently and the RealEstate Investment Companies are also a relatively recent phenomenon. The number ofcompanies that have entered the field suggest that these aspects of the securities business hasvery high promise (Table 6). The increased interest of the pension funds in these products islikely to provide a further stimulus for their development in the coming years (see Annex III).Similarly, it is likely that the securitization and collateralization of loans will be well receivedby the securities markets.

28. It thus appears that the securities market provisions included in the FML certainlyhelped promote the securities markets. At the same time, other provisions in the FML, mostnotably the liberalization of the pension funds, as well as macroeconomic and internationaldevelopments have probably played a more important role in the rapid increase in securitiesmarket activities, particularly the stock market. Nevertheless, the loan has done much tomodernize the securities markets in Chile and has introduced a range of new products that arelikely to fuel further growth and development.

69 Annex V

Table 1: Primary Securities Market (Billions of 1993 Pesos)

1990 1991 1992 1993

Private Sector 500.3 604.2 609.7 850.5

Stocks 128.1 86.0 205.3 348.7

Corporate Bonds 147.3 172.8 65.2 120.1

Financial 31.8 57.2 22.6 10.6Institution Bonds

Commercial Paper 37.1 0.0 0.0 2.3

Mortgage Bonds 144.9 273.4 294.7 343.2

Endorsable 11.1 14.8 21.9 25.6Mortgage Loans

Public Sector 1343.9 1236.1 1780.6 395.5

Total 1844.2 1840.3 2390.3 1246.0

Share Private (%) 27.1 32.8 25.5 68.3

Share Public (%) 72.9 67.2 74.5 31.7

Note: Financial Institution Bonds and all Public Sector Emissions refer to net emissions (emissions minusredemptions); all others refer to gross emissions. Mortgage bonds and financial bonds emitted by the Banco delEstado are included in the Mortgage Bonds and Financial Instit. Bonds categories.Source: SVS: Revista Valores 1993.

Annex V 70

Table 2: Securities Market Capitalization (Billions of 1993 Pesos)

1990 1991 1992 1993

Private Sector 8752.1 15077.0 14959.4 21925.0

Stocks 6778.4 12601.8 12280.1 18898.4

Corporate Bonds 617.9 767.7 781.1 819.3

Financial Inst. Bonds 158.9 178.4 187.9 156.1

Commercial Paper 11.9 0.0 0.0 0.0

Mortgage Bonds 942.1 1090.0 1246.1 1437.6

Endorsable Mortgage 23.5 38.1 60.5 86.7Loans

Mutual Funds 219.4 401.0 403.7 526.9

Public Sector 3903.6 5562.2 5963.7 5487.1

Total 12656.0 20639.2 20923.1 26280.2

Share Private (%) 69.2 73.1 71.5 83.4

Share Public (%) 30.8 26.9 28.5 16.6

Note: Figures for financial bonds and mortgages are as of November 30, 1993; for all others they are as of December31, 1993.Source: SVS: Revista Valores 1993.

Table 3: Stock and Corporate Bond Market Indicators

Stock Market Indicators Corporate BondMarket Indicators

Companies Capitalizati Amount New PIE Companies Newon (B. 1993 Traded (B. Issues Ratio Issues

Pesos) 1993 Pesos)

1990 245 6778.4 448.4 23 7.1 26 151991 253 12601.8 1086.5 32 14.7 41 241992 281 12280.1 1218.2 31 14.3 39 12

1993 312 18898.4 1754.4 39 21.0 39 41994 350 43

Note: 1994 data refer to June, 1994.Source: SVS: Revista Valores.

71 Annex V

Table 4: Corporations Listed on Stock Markets (December, 1993)

Companies Listed Shares Purchased by PensionFunds (March, 1994)

Production 161 54

Telecommunication 6 4

Utilities 29 13

Real Estate Companies 25 3

Services 38 0

Investment Companies 25 0

Investment Funds 12 8

Leasing Companies 5 0

FICEs 5 0

Pension Funds 6 0

Mutual Funds 13 0

Total 325 82

Services: Sports Clubs, Stadiums, Tourist Associations, Hotels, Fairs, Ports, Stock Markets; Investment Funds refer toclosed-end mutual funds; Production refers to manufacturing, agriculture, resource extraction and processing; RealEstate Companies include real estate managements and investment companies. Note that mutual funds are excluded inTable 3.Source: SVS: Revista Valores 1993.

Annex V 72

Table 5: Shares of Pension Funds, Life Insurance Companies, and FICEs in Security Markets Capitalization byInstrument (Percentages)

1990 1991 1993

Capitali- Share Share IUfe Share Capitali- Share Share Life Share Capitali- Share Share Sharezation Pension Insurance FICEs zation Pension Insurance FICEs zation Pension Life FICEs

Funds Funds Funds Insurance

State 3903.6 38.2 8.7 1.0 5562.2 33.4 7.7 0.3 5971.9 45.2 11.8 0.1Institutions

Mortgages 965.6 46.5 10.9 0.0 1128.1 32.5 11.2 0.1 1526.4 58.4 16.8 0.0

Corporate 617.9 60.8 28.7 0.1 767.8 68.7 29.4 0.1 819.3 55.1 29.6 0.0Bonds

Financial 158.8 23.4 n.a. n.a. 178.4 47.5 n.a. n.a. 156.1 67.1 n.a. n.a.Bonds

Shares 6778.4 5.6 0.6 2.7 12601.8 9.2 0.8 3.3 18898.4 11.9 0.8 3.4

Mutual 219.4 0.0 0.0 2.0 401 0.0 0.0 2.6 526.9 0.0 0.0 1.3Funds

Total 12655.6 22.0 5.4 1.8 20639.2 19.5 4.4 2.1 27898.9 22.9 4.8 2.4

Note: Data for pension funds in 1993 are estimated by proportionally adjusting data from March 1994. There are no disaggregated data on life insurance and FICE investments in financial bonds.Sources: SVS: Revista Valores 1993, Anuario Seguros 1993; SAFP: Boletin Estadistico.

Table 6: Assets of Closed-End Funds (Billions of 1993 Pesos)

Risk Capital Funds

Cash 0.02 0.02

Shares in Traded Companies 2.59

Variable Rate Assets 0.63

Debt Titles 4.91 9.00

Risk Capital Investments 3.71

Real Estate Investments 24.32

Land 3.27

Building 12.52

Leased Assets 6.05

Endorsable Mortgages 2.47

Other Assets 0.07 0.37

Total 11.3 34.33

Source: SVS: Revista Valores 1993.

73 Annex V

Table 7: Share of New Electronic Exchange in Trading Volume (Percentages)

Stocks Fixed Promissory Investment Other TotIncome Notes Funds al

1990 8.2 47.7 80.8 20.3 63.3

1991 14.7 54.3 76.8 1.7 35.8 63.9

1992 24.1 51.6 55.1 15.8 48.0 47.7

1993 28.8 58.8 62.9 11.2 62.1 60.3

Note: Other consists mostly of spot trading in US$.Source: SVS: Revista Valores 1993.

s

75 Annex VI

Banking System

a) Background

1. After the severe economic and financial crisis of 1982-84, Chile's banks' emergedonly slowly from their state of virtual bankruptcy. In order to shore up the banks, the CentralBank had purchased the non-performing loan portfolio of the banks and provided credit linesfor the reprogramming of other problem loans.2 Part of the agreement was that the bankswould be required to repurchase the loan portfolio, once their financial situation improved.After -everal revisions, in 1989 this obligation was turned into subordinated debt requiring thebanks to repurchase their loan portfolio out of profits. Since the rate of repurchase has beenvery slow and is expected to last up to 100 years for some banks, there are continueddiscussions on how tc deal with the subordinated debt issue. In particular, the question hasarisen whether banks should be forced to repurchase their portfolio in a specific time period(e.g. 40 years) with the repayment schedule depending on the banks' profitability. Thesediscussions are still ongoing.

2. As a result of the crisis and the unresolved problem of subordinated debt, the bankspursued very coaservative policies to slowly improve their balance sheets. In particular, theywere slow to increase their medium-and long-term lending portfolio. Instead, they reliedheavily on more profitable short-term lending, some of which was rolled over. Thus, thebanking system did not play an important role in providing term finance for productiveinvestments.

3. Given the continued fragility of the banking system, any strategy aimed at improvingthe securities markets had to ensure that the banks would not be hurt in the process and ideallybenefit from the reforms. This would be particularly important since it was expected thatgrowth of non-bank mortgage intermediaries as well as further development of the corporatebond and commercial paper market would potentially reduce the role of banks in the financialsector and, at the same time, undermine their financial recovery. Moreover, any reform aimedat deepening the financial system should provide incentives for the banking system to providemore term finance for productive investments without hurting their viability or profitability.

b) The FML Loan

4. The specific measures regarding the banking sector included in the FML loan were:

* i) allowing banks to securitize loans and sell them on the securities markets.

1. Note that banks hold 98% of assets of the financial system. The other 2 percent are held by other financial companies.

2. Moreover, banking supervision was improved to forestall a similar financial crisis.

Annex VI 76

* ii) allowing banks to collateralize loans and sell them on the securities markets.'

* iii) increasing the global limit on guarantees from one to two times the amount ofcapital and reserves.

* iv) allowing banks to issue subordinated bonds', fifty percent of which could becounted as capital up to a limit of 20% of capital and reserves.

Thus the strategy would be to allow the banks to gain greater access to the securities marketsthrough the securitization and collateralization process. The removal of the global limits onguarantees would facilitate collateralization of loans and improve the banks flexibility tomanage their assets, while allowing subordinated bonds would help recapitalize the bankingsector. At the same time, amendments to the pension fund and life insurance company lawwas included in the loan to allow pension funds and life insurance companies to buy thesesecuritized and collateralized assets (see Annexes III, IV).

c) Implementation

5. All four measures were conditions for second tranche release. Since the secondtranche was canceled, there was no obligation on the part of the Chilean government toinstitute these changes. However, the government did implement the changes in guarantees aswell as the permission to emit subordinated bonds to increase the capital base of banks.Moreover, a law to allow securitization and collateralization was submitted to the legislature inJanuary 1993 and was approved in March 1994. It has yet to be implemented, pendingsatisfactory resolution of the slow repayment of the subordinated debt.

d) Outcome

6. Table I shows a summary balance sheet of the banking sector. Especially noteworthyis that between 1986 and 1993, total assets of the banking system fell slightly. At the sametime, there has been a considerable shift within the asset structure of the banks. In particular,short-term lending has more than doubled and the emission of letters of credit for mortgageshad doubled. At the same time, medium- and long-term lending has stagnated and financialinvestments have fallen considerably.

7. On the liabilities side, long-term deposits and bonds nearly quadrupled while short-term deposits increased by more than 70%. This is not due to the involvement of the pensionfunds whose real level of deposits with the banking system fell slightly (making up about 10%

3. The difference between securitization and collateralization is that in the latter case, a specific collateral is attached to the loan andthe bank continues to carry the credit risk even after selling the loan (i.e. the loan becomes a guarantee), while in the former case thebank no longer bears the credit risk.

4. Subordinated bonds differ from subordinated debt. The FML permitted to issue subordinated bonds to increase their capital base.Subordinated debt is the non-performing portfolio that was taken over by the Central Bank as part of the financial rescue package inthe 1980s. Banks are obliged to service this subordinated debt out of their profits.

77 Annex VI

of total deposits in 1993). Similarly, business in letters of credit (mostly mortgages) nearlydoubled in value. These increases came at the expense of domestic and foreign liabilities.'Thus there has been a healthy shift away from reliance on Central Bank and foreign debt toincreased deposits by the private sector and institutional investors.

8. The deciining provisions indicate clear improvements in the health of the lendingportfolio, which is also reflected by sharply rising profits (see Table 1). At the same time,capital and reserves have stagnated throughout the period, suggesting that the banking systemhas not expanded much in the past years, but made more profitable use of its resources.

9. Table 2 concentrates on the long-term portion of the banks' portfolio to determinewhether there has been an increase in long-term intermediation. New Long-term commercialloans as well as long- term promissory notes and export/import credits have increasedconsiderably in the past seven years. At the same time, reprogrammed loans are making up anincreasingly smaller share of the banks' portfolio. Thus the stagnating overall long-termportfolio (para 5) masks increases in new lending that have replaced reprogrammed loans.

10. On the liabilities side, a disaggregation of long-term deposits indicates that the increasein long-term savings deposits is even more dramatic, from 0.5% of assets in 1986 to 5.5% in1993 suggesting increasing confidence in the banking system. Bond emissions also increasebut not nearly as fast as deposits. Reprogramming bonds have disappeared by 1990.

11. Subordinated bonds, supported by the FML to increase the capital base of banks, cameon line in 1990 increased to 64.3 billion pesos in 1993. They still make up only 5% of thebanks' capital suggesting that banks have not used this instrument to the full extent possible(20% of capital) although capital and reserves have stagnated in real terms in the last sevenyears.

12. Subordinated debt, i.e. the debt to the Central Bank as part of their obligation torepurchase their bad loan portfolio has fallen by little more than 10% in real terms between1986 and 1993. It still makes up about 10% of assets and 150% of capital and reservessuggesting that the subordinated debt problem has not been solved yet. Consequently, thebanking system remains vulnerable to changes in government policy regarding the repaymentof this subordinated debt.

13. The Banco del Estado, the only state-owned bank in Chile, continues to play animportant but somewhat declining role in the financial sector (Table 3). Its assets make up16% of total assets of the banking system, down from 21% in 1986. Particularly noteworthyis that the Banco del Estado lends proportionately more long-term than private banks. At thesame time, it hardly attracts any long-term deposits while it dominates the emissions offinancial sector bonds. This dominance of the bond market has been declining as privatebanks have slowly increased bond emissions in the last three years, starting from a very low

5. Domestic liabilities mainly consist of lines of credit and loans from the Central Bank to shore up the banking system, and muchof the foreign liabilities dates back to the debt and banking crisis of the early 1980s.

Annex VI 78

level. The Banco del Estado also continues to be unusually profitable earning 21% of profitsin 1993 while holding only 14.2% of capital. This is due to a combination of high profitsfrom its banking relations with the government as well as the fact that it escaped the bankingcrisis of the early 1980s unscathed and is not facing subordinated debt problems.

14. One of the growing sectors in the banks' portfolio is the mortgage business. Mortgageloans outstanding have more than doubled between 1986 and 1993, with its share of assetsrising from 2.7% to 6.6% (Table 4). The vast majority of these mortgage loans are securitizedand subsequently traded on the stock market. Data from the pension funds suggest that theyincreasingly dominate the securitized mortgage business and now buy about 80% of allsecuritized mortgages traded on the securities markets (Table 4). Thus in contrast to fearsexpressed in the SAR that the mortgage business would slowly dry up for banks due tosaturation and heightened competition, it has played an increasingly important role. One ofthe factors accounting for this development is that the life insurance companies have notdisplaced the banks in the offering of mortgages (yet), and that the demand for mortgage-backed securities by the pension funds has remained very strong.

15. Table 5 shows the development of guarantees. Although banks have increased theamount of guarantees they offer, short-term as well as long-term, the banking system as awhole has not reached the global limit of one times their capital and reserves, that existedprior to the FML.' One of the factors accounting for this is that collateralization of loan hasnot taken place yet. Once banks are allowed to collateralize loans, they will treat them on thebalance sheets as contingent assets, thereby likely approaching or surpassing the previous limiton guarantees.

16. Table 6 reports on the capital adequacy and profitability of the banking sector. Whilecapital and reserves have not increased by much in real terms, the loan-capital ratio suggeststhat only in 1993 banks may slowly be facing capital constraints.' As mentioned above,profits have more than doubled since 1986. In real terms, however, profits were highlynegative in the mid-1980s, and only turned positive in real terms in 1993." Given that thesubordinated debt continues to make up 150% of capital, even years of high profitability areunlikely to eliminate the subordinated debt problem.

e) Assessment

17. After the severe crisis of the early 1980s, the banks have come a long way in theimprovement of their portfolio and profitability. They rely less and less on government creditlines, they have pared their foreign debt, the reprogrammed loans have largely disappeared

6.Individual banks may have surpassed the limit.

7. The low loan-capital ratios in the mid-to late 1980s are deceptive since the loan portfolio was much worse then and thereforeneeded a stronger capital base to sustain it.

8. Compared to other Latin American countries, this is a very good record indeed. Data from Venezuela, Colombia, Ecuador, andothers point to sharply negative real rates of return in the banking system (Revista Perspective Economica No. 60, 1992).

79 Annex VI

from the balance sheets, and they have been able to attract growing private deposits,particularly long-ierm deposits, and they posted positive real profits for the first time in 1993.Thus whatever might have happened in the absence of the FML, the banking sector's recoverywas not hindered much by the strengthening of the securities markets and the ability ofcompanies to bypass banks and issue securities directly at home or abroad. If it were not forthe continued subordinated debt problem, the banking system could be regarded as problemfree.9

18. The avenue envisaged by the FML to allow greater access to the securities markets(securi ization, collateralization) and thus access to the savings of the pension funds did notmaterialize yet. Also, the stagnation of assets and capital suggest that banks did not benefitmuch from the phenomenal growth of institutional and private savings. On the other hand, thebanks did get access to increasing amounts of pension fund investments via their expandingmortgage-backed securities business, which was projected to fall due to the entry of lifeinsurance companies in the mortgage business. Thus one unexpected development (the tardyimplementation of the securitization, collateralization legislation) appears to have been partiallyoff-set by another unexpected development (the continued growth and preeminence of banks inthe mortgage business). This suggests that securitization and collateralization might becomevery important vehicles for banks to access securities markets once their predominant role inthe mortgage business is being challenged. Thus there is a continued need to implement thechanges envisioned by the FML.

19. The banks have not played an important role in the provision of term credit toindustrial companies. As they slowly ridded themselves of their reprogrammed loan portfolio,they have replaced it with new lending without increasing the total amount of funds lent tocommercial enterprises. They have, however, provided sharply increasing amounts of short-term funds, backed by increasing short-term deposits. Thus banks have continued to play theirrole as short-term financial intermediary, without expanding much their total assets, capital, orlong-term intermediation.

20. In summary, although the banks have not benefitted much from the growth ininstitutional and private savings, they were not hurt much either. Instead they continued torely on their core business, short-term intermediation, got some access to the securities marketsby increasing their mortgage-backed business, and used the last few years to improve thestructure and profitability of their portfolio.

9. Under the current legislation, the subordinated debt is actually not a major problem for banks and represents nothing more thana tax on profits. If, however, the government decided to force higher repayment rates, then the subordinated debt could directly affectthe portfolio of the banking system and potentially endanger its sustainability.

Annex VI 80

Table 1: Summary Balance Sheet-Banking System (Billions of 1993 Pesos)

1986 1987 1988 1989 1990 1991 1992 1993

Assets 21076.4 19527.9 18538.5 17692.6 17331.0 15423.3 16492.9 18589.6

Disposable Funds 835.0 914.2 951.4 957.6 1014.4 1255.5 1613.4 1594.9

Short-Term Lending 2169.2 2481.6 2986.3 3465.3 3081.1 3423.6 4512.6 5407.6

Long-Term Lending 2974.6 2913.0 2956.7 3157.5 2801.1 2550.1 2715.5 2973.7

Letters of Credit 750.3 739.7 780.1 848.9 893.0 1051.6 1192.9 1421.1

Investments 6788.1 5910.5 4827.4 3639.7 3882.4 3974.6 3276.8 3112.3

Fixed Assets 316.6 336.2 347.0 380.9 420.7 469.1 513.6 554.6

Other Assets 7242.5 6232.6 5734.7 5224.7 5238.3 2698.8 2668.1 3525.4

Liabilities 21076.4 19527.9 18583.5 17692.6 17331.0 15423.3 16492.9 18589.6

Short-Term Deposits 4157.1 4638.8 5169.0 5551.8 5459.0 6534.5 7030.8 7407.9

Short-Term 311.7 490.7 647.7 602.5 702.8 689.0 972.6 1186.1Dep.Bonds

Letters of Credit 806.7 773.4 821.3 887.4 946.7 1104.8 1251.6 1482.9

Domestic Liabilities 3766.8 3145.2 2284.4 2048.6 1593.2 1401.6 1248.8 1260.7

Foreign Liabilities 4030.9 3143.1 2487.8 1835.7 1580.6 1057.8 1582.7 1636.1

Other Liabilities 6227.8 5695.7 5542.6 5113.4 5376.3 2988.3 2766.2 3910.7

Provisions 611.5 540.6 567.4 519.8 483.8 448.3 394.2 387.3

Capital and Reserves 1119.7 1054.2 1012.0 1039.0 1084.1 1112.7 1140.9 1171.9

Profits 44.1 46.2 51.4 94.3 104.4 86.4 105.0 146.0

Long-term lending includes consumer, commercial, and real estate loans. Investments includes all investments (not only financial). Other assets main refers tocontingent assets, adjustments, and miscellaneous assets. Domestic liabilities mainly refer to debts to the Central Bank, the Banco del Estado, and Credit Lineswith the Central Bank. Other liabilities refers mainly to contingent liabilities, due interest, and adjustments. Due to the differences in definitions, some numbersdo not match with later tables on long-term assets and liabilities.Source: SBIF: Annual Reports.

Table 2: Banking System- Long-Term Items on Balance Sheets

a) Billions of 1993 PesosLong-Term Lending FaMkM Total Assets Long-Term Liabilities AlbwdWwledConmm Loans Iteprigrned Loans Loans to Fl. hInt k lmtposis &nds R"to-SBn Subord. Benam Centk Linas D CO ard BE DoM t Fot Banks obt

1986 1356.4 1169.9 250.5 5053.3 21076.4 105.9 51.8 148.5 0.' 1681.3 378.7 3474.1 206;.31987 1478.4 929.4 262.4 4743.9 19527.9 282.4 89.6 114.0 0.0 1596.6 ki7. 2551.0 2139.91988 1672.0 702.9 295.9 4074.8 18583.5 466.7 111.3 66.8 0.0 1191.3 338.0 1731.7 2038.91989 1784.3 513.1 278.5 3152.6 17692.6 444.3 122.0 34.0 8.0 902.3 442.3 9498 1872.11990 1616.2 353.1 256.3 3495.5 17331.0 559.1 149.0 0.6 17.0 709.9 373.7 654.7 1d04.91991 1650.2 211.4 92.4 3647.1 15423.3 518.3 165.4 0.0 25. 546.5 293.5 398.3 1754.81992 1834.8 126.1 34.6 3192.3 16492.9 795.3 171.0 0.0 39.2 395.7 220.5 314.1 1748.71993 2043.8 75.5 27.7 3009.8 18589.6 1025.6 155.2 0.0 64.3 237.6 166.6 303.3 1734.5

b) Share of AssetsLong-Term Lending W..bi Total Assets Long-Term Liabilities SbOWCOMMn. LOWn* Ra d Lfft Loans Is Fi. Inot. Eguly, Socurwe DpasS Bond Rprog. BondA Subod. Onw Crdf Lns Do to CB and BE DM b For. Banks Debt

1986 6.4 5.6 1.2 24.0 100.0 0.5 0.2 0.7 0.0 8.0 1.8 16.5 9.81987 7.6 4.8 1.3 24.3 100.0 1.4 0.5 0.6 0.0 8.2 1.1 13.1 11.01988 9.0 3.8 1.6 21.9 100.0 2.5 0.6 0.4 0.0 6.4 1.8 9.3 11.01989 10.1 2.9 1.6 17.8 100.0 2.5 0.7 0.2 0.0 5.1 2.5 5.4 10.61990 9.3 2.0 1.5 20.2 100.0 3.2 0.9 0.0 0.1 4.1 2.2 3.8 10.41991 10.7 1.4 0.6 23.6 100.0 3.4 1.1 0.0 0.2 3.5 1.9 2.6 11.41992 11.1 0.8 0.2 19.4 100.0 4.8 1.0 0.0 0.2 2.4 1.3 1.9 10.61993 11.0 0.4 0.1 16.2 100.0 5.5 0.8 0.0 0.3 1.3 0.9 1.6 9.3

18 LO7TM Ofke umf"da m Vda I .8E 1.30 24 i aft. 10n. 1oodmnhyM . 0.5io 0a.

CAno Lesa Noduft bass. MomMdad - pOss wAmpd Imod Vapost adh aft neoO above saou aw amft ne Lbwr

SWAM hamdf 19889.03.81.6 1.9 1000 25 0. 0. 0. 6.41.89.3 11.1989 10. 2.9 1.6 17. 1000 25 07 0. 0. 5. 2.55.4 10.1990 9.32.0 1.5 0.2 1000 32 0. 0. 0. 4.12.23.8 10.

Annex VI 82

Table 3: Share of Banco del Estado in Banking Sector (Percentage)

Share Assets Share Capital Share Profits Share LT Lending Share LT Deposits Share Bonds

1986 20.8 23.1 59.9 26.8 0.2 69.6

1987 20.0 24.8 48.9 29.3 0.0 76.3

1988 18.4 15.4 43.8 30.8 4.7 71.1

1989 16.5 15.2 15.3 32.6 0.4 76.4

1990 16.9 14.7 14.2 34.3 3.2 63.9

1991 17.1 13.0 19.6 29.1 0.1 51.5

1992 16.4 14.5 27.0 24.9 1.7 45.4

1993 15.7 14.2 21.0 23.2 1.6 44.1

Source: SBlF: Annual Reports.

Table 4: Securitized Mortgage Business (Billions of 1993 Pesos)

Mortgage Loans Share of Total Assets Traded on Stock Bought byOutstanding (%) Market Pension Funds

1986 576.1 2.7

1987 593.2 3.0

1988 632.3 3.4

1989 927.3 5.2 462.1

1990 960.9 5.5 759.4 559.0

1991 1014.6 6.6 860.0 647.4

1992 1097.0 6.7 971.5 827.2

1993 1220.4 6.6 1135.0 962.5

Source: SBIF: Annual Reports; SVS: Revista Anuario 1993: SAFP: Boletin Estadistico.

83 Annex VI

Table 5: Contingent Assets (Guarantees, Billions of 1993 Pesos)

Short-Term Long-Term Total Share of Capital & Revenue

1986 392.2 113.0 505.3 45.1

1987 412.7 99.8 512.5 48.6

1988 544.6 126.0 670.6 66.3

1989 547.9 146.3 694.2 66.8

1990 500.9 158.5 659.4 60.8

1991 581.3 148.6 729.9 65.6

1992 658.3 159.7 818.1 71.7

1993 619.8 225.6 845.4 72.1

Source: SBIF: Annual Reports.

Table 6: Health and Profitability of Banking Sector

Capital Capital and Profits Return on Return on Sub.Debt/Adequacy Reserves Equity (%) Assets (%) Capital

1986 5.9 1119.7 44.1 3.94 0.21 1.84

1987 6.5 1054.2 46.2 4.39 0.24 2.03

1988 7.5 1012.0 51.4 5.08 0.28 2.01

1989 8.0 1039.0 94.3 9.07 0.53 1.80

1990 7.0 1084.1 104.4 9.63 0.60 1.66

1991 7.1 1112.7 86.4 7.77 0.56 1.58

1992 8.2 1140.9 105.0 9.20 0.64 1.53

1993 9.2 1171.9 146.0 12.46 0.79 1.48

Capital Adequacy. Ratio of Debt (including contingent assets) to capital and revenues.Source: SBIF: Annual Reports.

85 Annex VII

Leasing Sector

a) Background

1. Leasing companies have existed in Chile since the 1970s. After the severe financialcrisis of the early 1980s, they recovered only slowly. A change in the banking lawimplemented in 1986 allowing banks to set up leasing subsidiaries led, combined withimproving overall conditions, to a rapid expansion of the leasing sector. The growingpopularity of leasing was due to its considerable advantages vis-a-vis bank lending, i.e.simpli -ity of the contract, the absence of onerous collateral requirements, much reduced own-finance requirements, the attached service contracts, and the tax advantage of acceleratedwrite-offs of equipment purchases via leasing. Moreover, leasing presented a particularlypromising avenue for small an6 medium companies who, for a variety of reasons including theabsence of collateral, poor record-keeping, and little bank experience with the sector, had littlechance to obtain term credit from banks.

2. This rapid growth soon hit considerable constraints as leasing companies were facingdifficulties in obtaining term finance for their operations. Bond emissions for purchase frompension funds and insurance companies were limited to one times capital, no bank wasallowed to lend more than 5% of its capital to any one leasing company (or any othercompany), and leasing had not benefitted from the IDB credit lines, so that the three mostimportant avenues for term finance could not be increased much further. This occurred at atime (1988) when the leasing sector, despite its impressive growth, accounted for only 5% ofcapital formation, which is considerably lower than in comparable developing countries.

3. Projections by the SAR suggested that the demanded volume of the two largest leasingcompanies alone (Leasing Andino and Santiago Leasing which controlled about 70% of theleasing sector in 1988) would climb from US$ 160 million in 1990 to $304 million in 1993.Given the prevailing limits on financing, a gap of $25 million would appear in 1990 and climbto $133 million in 1993, suggesting a cumulative financing gap of the total leasing industry ofabout $350-400 million between 1990 and 1993. Without new sources of term finance, thisdemand would likely be unmet, thereby severely reducing the access to investment capital toindustry, particularly the SMI sector.

b) The FMIL Loan

4. The FML loan was designed to support the leasing sector in two different ways:

* i) establishment of a regulatory framework for leasing companies that are banksubsidiaries as well as a regulatory change allowing leasing companies to emit bondsfor purchase by pension funds and insurance companies up to twice the level of theleasing company's capital.

* ii) a $50 million line of credit component to be auctioned to leasing companies atperiodic auctions organized by CORFO, the state development bank. At these

Annex VII 86

auctions, leasing companies could submit bids for loans denominated in UF pesos anddollars. The bids were to include a proposed amount and currency, interest, term, andrepayment structure and a detailed list of projects to be financed by the credit.CORFO was to set an interest rate floor to insure it was in line with the prevailinginterest rate regime and had the right to reject bidders based on institutional eligibilityand other pertinent factors.' The funds would be allocated based on the bids with thehighest bidder receiving priority allocations. This auction process was a novelcomponent never tried in Chile (or elsewhere in developing countries) to allocate fundsto leasing companies.

The innovative auction mechanism was chosen in order to establish a market-based interestrate in an environment where there were no other reliable reference rates. Another advantageof the auction system is to award funds at differentiated s based on the actual willingness-to-pay rather than a fixed applicable to all, thereby ensuring an efficient allocation of scarceresources. CORFO planned to hold auctions of about US$3-6 million every few months;participating companies would be first be evaluated for eligibility criteria, and no companywas allowed to raise more than 35% of its financing through the auction mechanism.

It was also known at the time that 1DB was in the process of putting in place a $600 millioncredit line for industrial finance targeted at banks and possibly leasing companies ($360million loan plus $240 million counterpart and beneficiary funds). If the funds in the IBRDleasing component were to exhaust quickly, some of the IDB credit line could also be accessedby leasing companies using the same auction mechanism.

c) Implementation

5. The regulatory framework governing leasing companies that are bank subsidiaries wasalready in place by the time the loan was negotiated. The limit on bond emissions waschanged as a condition of effectiveness (March 1990), so that both policy measures were inplace by the time the loan started disbursing.

6. Several coordination issues appeared during implementation of the leasing credit linecomponent. They are discussed in great detail in the PCR and will only be briefly repeatedhere:

After approval of the FML, but before the first auction, the IFC approved anddisbursed a $10 million to Leasing Andino, the largest leasing company in the sector.Intervention by IBRD staff to delay this action on the grounds that it could endangerbidding in the first auction proved fruitless as the IFC went ahead with theirdisbursement.

1. The subsidiary of the state-owned Banco del Estado was not allowed to participate in the auctions. Nor was Banco del Estadopermitted to participate in the parallel auctions of IDB funds to banks.

87 Annex VII

In spite of earlier agreements to coordinate disbursement, IDB decided to auctionfunds to leasing companies and banks before IBRD was ready to hold its first auction.In two auctions held in June 1990, IDB auctioned $39.8 million to leasing companiesand $5 million to banks, thereby also putting in question the continued need for theIBRD leasing component. Subsequently, it was agreed to coordinate auctions anddraw more heavily on IBRD funds until they are exhausted.

7. In the event, neither the interference by the IFC nor the 1DB proved to be problematicsince the demand for leasing funds far exceeded the supply. Although IDB continued todisburse some funds to leasing companies in 1990 and 1991 (and more funds subsequently),the IBRD credit line component was exhausted after only five auctions in November of 1991,far ahead of schedule.2

8. Table 1 shows the interest rates offered by the companies that entered successful bidsin the five auctions. While they are considerably below a reference long-term retail lendingrate charged by banks, they are quite a bit above a comparable deposit rate. All the rates arereal rates since the loans were denominated in UF, the inflation-adjusted monetary referenceunit.' To date, CORFO has maintained a 0% arrears rate on repayments.

9. CORFO has continued to auction large amounts of 1DB funds as well as required owncounterpart funds to leasing companies. Repaid funds from IDB and IBRD loans have beenadded to the counterpart funds and auctioned off again. By 1994, US-$369.6 million of IDBfunds and counterpart funds have been auctioned off to leasing companies which, combinedwith the $50 million from IBRD brings the total of funds made available to the leasing sectorin the past four years Lo $419.6 million (Table 2). Thus any outcome and assessment will bebased on the combined involvement of IDB and IBRD.

d) Outcome

10. Table 3 chronicles the development of the leasing sector as a whole and three of thesector's largest companies. The number of leasing companies doubled from 13 in 1989 to 28in 1993, 19 of which are subsidiaries of domestic (14) or foreign banks (5). The volume ofactivity grew at phenomenal rates. The value of outstanding contracts is estimated to havegrown more than sixfold from $180 million in 1989 to $1270 million in June of 1994. In1993, leasing activity amounted to about 15% of gross domestic investment, up from 5% in1988.

2. Due to the high demand, the amounts auctioned were quickly raised from the initially projected 2-4m. to US-$ 7-13m. per auction.

3. Interestingly enough, in the two joint auction held by IDB for banks and leasing companies (which were held prior to the firstIBRD auction), leasing companies outbid banks and therefore received nearly all the funds. The reason was that leasing companieswere facing considerably higher financing costs than banks and thus were willing to pay more to get long-term CORFO funds. Toalleviate the problem and allow banks to get access to IDB funds, IDB and CORFO decided to hold separate auctions for leasingcompanies and banks. The leasing companies have paid higher rates throughout the past four years although the gap has narrowedrecently suggesting improved access of leasing companies to other attractive sources of finance.

Annex VII 88

11. At the same time, the number of contracts was rising rapidly. Leasing Andino andSantiago Leasing, the two largest companies of the sector, more than tripled the number ofleasing contracts in the past five years and the total sector combined had 25,800 contractsoutstanding in 1993. Beneficiaries of leasing operations cited overall economic conditions, thetax advantage of leasing over bank loans (accelerated write-off), the ease of access(particularly for small and medium enterprises), the absence of onerous collateral requirements,and a downward trend in interest rates charged on leasing operations as the main factorsinfluencing this growth in demand.

12. The CORFO auctions played a key role in this impressive growth performance. Rightfrom the start, companies heavily participated in the auction program, with some leasingcompanies (including Leasing Andino) relying on CORFO for up to two-third of their long-term liabilities. Overall, all leasing companies solicited funds to cover up to a third of theirtotal liabilities from CORFO. In fact, some companies reached the limit of funds they wereallowed to seek from CORFO (35% of total liabilities).

13. In the past two years, the share of CORFO funds in total liabilities has decreased fromabout 31% in 1992 to only 15% in 1994 (Table 4). The factors accounting for this decline arethe reduced volume of auctions that have driven up interest rates and thus reduced the interestof some leasing companies, the ability of leasing companies to better access the bond markets,and the continued growth of the leasing sector that has reduced the relative importance of theCORFO auction system.'

14. Table 5 shows the 1993 balance sheet for the leasing sector as a whole as well as thetwo largest companies. Although the role of CORFO has declined considerably, it continuesto account for 15% of short-term and nearly 25% of long-term liabilities of the sector. Atthe same time, bonds have become more important as a source of long-term finance. In fact,leasing companies are now emitting bonds at a level close the amount of their capital. Forsome companies, such as Leasing Andino and Santiago Leasing, the level of bond financinghas in fact surpassed the amount of capital, suggesting that raising the limit of bond financingto twice the level of capital (supported by the FML) has indeed been an important step toimprove access to long-term finance of leasing companies (see para. 2, 4, Table 5).

15. The relative decline of CORFO financing has had a potentially problematic effect onthe soundness of the leasing companies' financial management. Santiago Leasing, forexample, has stopped participating in the CORFO auction due to the high interest rates that itwould have to offer in order to be allocated funds. Partially it has made up for it byincreasing bond emissions. At the same time, however, it is financing much of its additionallong-term leasing activity with short-term bank lending so that, in 1993, long-term assets areabout 20% larger than liabilities, capital, reserves, and profits put together (Table 5). This

4. The main factor for the reduced allocation is the effort by the Central Bank to reign in domestic credit.

5. Although all CORFO funds are medium-to long-term funds, those that come due in a given year are included in the short-termliabilities.

89 Annex VII

mismatch problem has is apparent on the 1993 balance sheets of ten of the 18 companies thatare members of the Association of Leasing Companies, with some companies having long-termassets that are 60% larger than long-term liabilities.6 This term mismatch could generateliquidity problems, especially in the case of adverse economic or financial shocks.

16. After documenting the impressive growth performance of the leasing industry, thequestion arises as to the beneficiaries of this growing form of equipment financing. Table 6documents the type of equipment that is purchased via leasing as well as the sectors ofbeneficiaries. In both years for which data is available (1992, 1994), transport, industrial, andoffice equipment make up about 50% of the leased goods. Around 15% is in real estate andabout 10% in private cars. Among the sectors of beneficiaries, commerce, industry,telecommunication, transport, and construction receive nearly three quarters of the value of allleasing contracts, clearly suggesting that productive sectors of the economy are the primebeneficiaries of leasing. Moreover, the beneficiaries of the IBRD auctions closely match thegeneral sectoral distribution of beneficiaries (Table 6).

17. Table 7 documents the relation between leasing and the SMI sector. With rapidlyincreasing volume of operations and the number of contracts surpassing 25000 in 1993, thequestion arises how much of leasing is targeted at the SMI sector and might thus be alleviatingan important market failure that limits this sector's access to other sources of term finance.Unfortunately, the leasing companies do not provide direct information on the beneficiaries butonly on the size of the leasing contracts. Table 7 shows that among the contracts of LeasingAndino, for example, 83% are below 2000 UF (around $50,000) in 1993 suggesting that smalland medium industries may be the prime beneficiary of leasing equipment. Moreover, theaverage size of contracts for another company, Santiago Leasing, has dropped by 50% in realterms in the last four years. In 1993, it stood at a relatively low 1200 UF (around $30,000),suggesting that the growth of leasing has increasingly involved the SMI sector in its business.

18. A third piece of evidence comes from a CORFO study on the SMI sector which alsosuggests that SMIs have growing access to leasing. 76% of all contracts in 1993 are withmicro, small, and medium enterprises. In amounts, however, the large companies continue todominate, receiving about 84% of the value of all leasing contracts (Table 7).'

19. In contrast to the group of beneficiaries in the overall leasing sector, large companiesgot most of the IBRD funds. Micro, small, and medium companies received only 34% of the

6. Leasing Andino and a number of other leasing companies have not followed this path but have been willing to pay the higherinterest rates of the CORFO auctions to avoid this type of term structure mismatch. Banestado Leasing has, as a subsidiary to the state-owned Banco del Estado, been barred from the auctions and relied 100% on bank loans for their long-term finance. They were ableto grow at about the same rate of all the other leasing companies, but are currently also suffering from a term structure mismatch ontheir balance sheet.

7. The total number of beneficiaries in the CORFO study is much smaller than the number of contracts reported by the Associationof Leasing. If the two data sets are compatible, this suggest that in 1993, the average beneficiary company had four leasing contracts.

Annex VII 90

contracts and 24% of the funds with large companies receiving the rest. The average size ofcontract was considerably above the contract size observed in Santiago Leasing (Table 7).

e) Assessment

20. Both the regulatory as well as the credit component have been a resounding success.Clearly, the IBRD and IDB credit lines have played a major role in this impressive growthsince they provided the much needed term finance to expand the leasing operations.

21. The regulatory change as well as the general improvement of the securities marketshave helped to provide greater access of leasing companies to the capital markets. Theincrease in bond finance is a promising development and may soon be able to fully replace thedirected credit. At this point, however, the term mismatch on the balance sheets of someleasing companies suggests that the sector is not quite in the position to totally rely on itsdirect access to term finance in the capital market. By the time the IDB program ends in1995, however, they may very well be.

22. The interest rate structure as well as the repayment rate show that the directed creditcomponent of the loan was providing market-based finance rather than subsidized loans.CORFO has not made a loss on the operation and in fact, it stands to gain given that theinterest rate differential between the subborrower rates and the World Bank interest rate isconsiderably larger than the devaluations of the peso vis-a-vis the dollar.

23. The auction mechanism was an important and extremely valuable innovation. Itprovided a market-based interest rate where it was difficult to find an appropriate referencerate, it allowed CORFO to successfully differentiate and award funds based on the truewillingness to pay of the bidders, and it took interest rate determination out of the hands of aninstitution that could potentially be influenced by non-economic considerations. It paved theway for years of continued auctions to leasing companies and banks via the IDB, and recentlyChile has begun to auction off subsidies.

24. The beneficiaries of the leasing companies have indeed been the productive sectors ofthe economy who have used the funds to buy much-needed capital goods, mostly machineryand transport equipment. Although large companies continue to get more funds throughleasing than other companies, the SMI sector has been the major beneficiary of the growth ofthe industry. This has contributed to a partial alleviation of an important market failure inChile, namely the absence of term finance for micro, small, and medium enterprises (seeAnnex VIII).

91 Annex VII

Table 1: Real Interest Rates on Auction

Auction Comparable Bank Rates

Auction Rate Deposit Rate Loan Rate

1 (9/90) 9.2-9.7 8.7 12.5

2 (1/91) 8.01-8.02 6.8 9.4

3 (5/91) 6.87-8.46 6.2 8.7

4 (8/91) 6.45-6.66 6.0 8.9

5 (11/91) 6.41-6.65 5.8 8.2

Note: In the fifth auction, Leasing Andino also bid for USS6 million at LIBOR+2.61%

Source: CORFO, Banco Central.

Table 2: CORFO Auctions for Leasing Banks 1990-1994 (US-$ MV.)

1990 1991 1992 1993 1994 Total

Leasing 47.2 86.6 121.0 84.1 80.5 419.6

World Bank 7.4 42.6 50.0

IDB 39.8 44.2 121.0 84.1 80.5 369.6

Banks

IDB 21.2 26.0 96.9 44.3 17.4 205.8

Source: CORFO

Annex VII 92

Table 3: Leasing Sector ActivityLeasing Andino Santiago Leasing Banestado Leasing Total Leasing Sector

Contracts Value Contracts Value Contracts Value Contracts Value Companies(Pesos) (Pesos) (Pesos) (US-$M)

1989 2439 73.8 180 13 (9)1990 2867 65.1 1234 31.4 1801991 3836 84.5 2084 36.5 4001992 6376 107.0 3490 52.7 580 22.5 7301993 9357 135.1 5976 70.6 1042 36.0 25814 1070 28 (19)1994 1270

Note: Banestado contracts refer to new contracts, all others to all outstanding contracts. When expressed in pesos, the value refers to billions of 1993pesos. The unbrackcted number of companies refer to the total number of leasing companies, while the number in brackets refers to the number ofleasing companies that are subsidiaries of foreign domestic banks.Source: Annual Reports for Leasing Andino. Santiago Leasing. Banco del Estado,and Association of Leasing Companies.

Table 4: Sources of Finance for Leasing Companies (Millions of US-$)1992 1993 June 94

Amount Share Amount Share Amount Share(%) (%) (%)

Banks 92 35.1 560 48.6 600 44.7Bonds 21 8.0 ill 9.6 170 12.7CORFO 81 30.9 199 17.3 197 14.7Other Liabilities 43 16.4 141 12.2 200 14.9Net Worth 26 9.9 143 12.4 175 13.0

Total 262 100.0 1153 100.0 1342 100.0

Source: Association of Laming Companies

93 Annex VII

Table 5: Balance Sheet for Leasing Sector and Largest Companies (Billions of 1993 Peso)

Total Sector Leasing Andino Santiago Leasing

1993 1993 1992 1993

Total Assets 497.1 138.2 54.9 70.7

Short-Term Assets 219.9 63.6 26.0 33.3

Leasing Contracts 190.6 50.2 20.5 27.9

Other 29.3 13.4 5.5 5.4

Long-Term Assets 273.1 73.2 28.4 37.0

Leasing Contracts 272.5 73.2 28.3 36.9

Other 0.6 0.0 0.1 0.1

Fixed Assets 4.1 1.4 0.5 0.5

Total Liabilities 497.1 138.2 54.9 70.7

Short-Term Liabilities 245.2 63.1 26.2 38.9

Banks 160.5 35.3 8.9 25.5

Bonds 9.2 3.3 1.8 0.8

CORFO 38.7 12.7 7.3 6.9

Other 37.0 11.8 8.2 5.6

Long-Term Liabilities 190.3 58.7 21.6 22.9

Banks 80.7 16.4 6.0 2.7

Bonds 38.6 12.0 3.8 11.7

CORFO 47.0 21.0 9.7 5.8

Other 23.9 9.3 2.1 2.7

Capital Reserve 49.6 13.1 5.5 7.2

Profits 12.0 3.3 1.7 1.8

Source: Association of Leasing Companies, Annual Report for Santiago Leasing, Leasing Andino.

Annex VII 94

Table 6: Use of Leasing Fund

a) Type of Equipment Financed (Share of total value of contracts)

Total Leasing Sector (%)

1992 1994

Transport 22.3 21.1Industrial 15.4 15.4

Office 13.8 10.4

Earth Moving 11.3 8.9Printing 3.2 3.6Medical 2.7 3.4Agricultural, Forestry 2.8 2.9Load Moving 2.6 2.7Real Estate 14.2 17.7Cars 8.5 10.9Other 3.3 0.9

Total 100.0 100.0

b) Sectors of Beneficiaries (Share of total value of contracts)

Total Leasing Sector World Bank(%) (1990-1991)

1992 1994

Commerce, Industrial Services 23.4 26.0 18.8Industry, Manufacturing 21.2 20.9 22.4

Telecom, Transport 16.7 17.1 19.0Construction 10.5 9.8 16.6Communal & Personal Services 9.7 8.4 9.3Agriculture, Fishery 6.3 8.2 7.1Minerals, Earth Movement 6.3 4.4 1.7Forestry 3.2 3.2 0.0Financial Services 2.4 1.7 0.0Utilities 0.3 0.2 0.0

Total 100.0 100.0 100.0Source: Association of Leasing Companies, CORFO

95 Annex VII

Table 7: Leasing and SMI

a) Contract Size, Leasing Andino (1993) b) Average Contract Size, Santiago Leasing

< 2000 UF 83% 1993 Pesos (M.) UF

2000-5000 UF 12% 1990 23.99 2460

> 5000 UF 5% 1991 17.50 1795

1992 15.1 1549

1993 11.8 1210

c) Debt with Leasing Sector by Company Size

Annual Sales Number of Amount Share of Share of Total(UF) Companies ('000 UF) Companies (%) Amount (%)

Micro <:2400 1173 1627 16 2

Small 2401-25000 3322 7099 47 9

Medium 25001-50000 927 3278 13 4

Large > 50000 1700 63119 24 84

Total 7122 75122 100 100

d) Size of Beneficiaries of IBRD Funds e) Average Leasing Contract:IBRD Auctions

Share of Share of Auction AverageContracts (%) Amounts (%) Contract (UP)

Micro 3.4 1.6 1(9/90) 7605

Small 19.2 13.3 2 (1/91) 5964

Medium 11.7 9.7 3(5/91) 10749

Large 57.6 66.6 4 (8/91) 5559

Not classified 8.1 8.8 5 (11/91) 3332

Note: 2000 UF = US$50,000. One million 1993 pesos - US$2,400.

Source: Annual Reports for Leasing Andino, Santiago Leasing, CORFO

97 Annex VIII

Industrial Finance

a) Background

1. During the severe recession of the early 1980s, Chile industrial sector faced acombination of a high foreign debt burden, much reduced export and internal demand, and afinancial system that was technically bankrupt. In order to overcome the crisis and improvethe liquidity position of companies, the government allowed banks to reschedule theircorporate debt (and refinance themselves at the Central Bank at favorable rates), purchased thenon-performing portfolio of the banking system, and established a preferential exchange ratefor foreign debt service of corporations.

2. These measures, combined with a favorable external environment, forward-lookingtrade and exchange rate policies, and a sharp reduction in the corporate tax rate, enabled theindustrial sector to recover quickly from this crisis and surpass pre-recession levels of outputby 1986. Output increases were aided by rapidly rising exports, both traditional (copper) andnon-traditional (but also resource-intensive) goods. Investments also rebounded from a low of9.8% of GDP in 1983 to 17% in 1988.

3. After the recovery from the crisis of the early 1980s was complete, further expansionof the industrial sector soon faced considerable constraints. These constraints which arediscussed in detail in a World Bank Industrial Finance Report (7737-CH), will only besummarized here briefly. In particular, the possibility of protectionism in OECD countries,stronger competition from other export producers, rising labor costs, and insufficient privateR&D could potentially threaten Chile's export-led growth. In addition to these external andmacroeconomic factors, the Industrial Finance Report estimated that to maintain a 5% realgrowth rate per annum, investment levels would have to rise from 17% in 1988 to above 20%in the following years. While domestic savings was rising rapidly, mainly due to rapidexpansion of the perision fund and life insurance system, and could therefore provide theneeded investible funds, it was feared that the financial sector would not be able to channelthese funds to finance rising levels of medium- and long-term investment.

4. The main factors in this shortage of investible resources in the face of rising savingswere the legacy of the banking crisis that had led to a more vulnerable and more cautiousbanking sector (see Annex VI), an underdeveloped equity and bond markets that wereproviding funds only to the very large companies, the absence of other forms of securitizationof assets, the absence of risk capital, and an underdeveloped leasing sector (see Annexes V,VII). The underdevelopment of these portions of the financial sector was due to supply andsecurities markets infrastructure constraints as well as tight regulations of the pension fundsand life insurance companies that prevented the channeling of long-term savings to long-terminvestments (see Annexes III, IV).

Annex VIII 98

b) World Bank Strategy in the Financial Sector and FM[L Loan

5. The World Bank was pursuing a dual strategy to alleviate the shortage of industrialfinance. One element focussed on structural reforms to improve the functionings of the capitalmarkets while the other provided directed credit to industrial companies as an interim measureuntil the reforms of the financial sector yield the desired results.The structural reform element of the World Bank strategy included three structural adjustmentloans (2625-CH 1986, 2767-CH 1987, 2892-CH 1988) that supported the rescue of thefinancial system (SAL 1,11), macroeconomic adjustment (SAL I), and initiated some financialsector reform including improvements in prudential regulation and some liberalization on theinvestment regulations of institutional investors (SAL 1II).

In addition, the Bank supported three directed credit operations to provide finance toindustrial enterprises until the capital markets would provide sufficient resources on their own:

* Industrial Finance Restructuring Project (2606-CH, $100 million 1986-1991) whichwas initially designed to assist in the financial restructuring of ailing industrialenterprises but was later changed to provide term finance for investment to large-scaleindustry (see concurrent audit).

* Second Industrial Finance Project (3053-CH, $75 million 1989-92) which was afollow-up project to channel resources to large-scale enterprises (see concurrent auditand Box 1 below).

* Small and Medium Industry Project (2613-CH, $40 million 1986-92) which waschanneling credit to small and medium-sized companies (see Box I below).

6. The FML loan continued the two-pronged approach of the World Bank in dealing withfinancial sector and industrial finance issues. On the structural front, the FML included:

* further liberalization of pension fund and life insurance investments (Annexes III, IV).

* improvements in supply of securities and introduction of new instruments (closed-endfunds, real estate investment companies, securitized and collateralized loans, see AnnexV).

* improvements in securities market infrastructure (electronic exchange, depositorysystem, improved risk classification, see Annex V).

* strengthening capitalization of banks and introducing securitized instruments (seeAnnex VI).

* increasing ability of leasing companies to emit bonds (Annex VII).

At the same time, it included a directed credit component of $50 million to provide a one-timesupport to jump start the leasing sector in order to promote term investment in small andmedium companies, until the capital markets would provide sufficient financing to this sector.

99 Annex VIII

The IDB has continued this program so that more than US$400 million have been channeledto leasing companies in the last four years.

c) Implementation

7. Implementation is discussed in detail in the relevant Annexes. Securitization andcollateralization has not been implemented yet. Moreover, closed-end mutual funds have onlystarted to develop in the past two years.

d) Outcome

8. The outcome of the specific measures are discussed in the various Annexes. Thequestions to be examined here are whether the totality of the FML package did much toimprove access to term finance for industrial companies, which measures were most importantin the development of industrial finance of the past few years, and what, if any, are theremaining constraints to industrial finance.

9. Table I shows the level of long-term corporate debt and equity outstanding. Clearly,all components of industrial finance show considerable improvements over the past few years.The importance of the various components differs considerably. The market value of equityoutstanding increased most rapidly. Most of this increase, however, is due to the rising valueof shares rather increased emission of equity. Table 2 shows the number of new placementsof equity at the issuing price. They also nearly tripled between 1990 and 1993, but accountfor only about 2% of the increase in capitalization.

10. The value of domestic corporate bonds outstanding also increased but at a muchslower pace. The flows in Table 2 suggest that, in fact, the number of new issues of corporatebonds have decreased in the past few years so that corporate bonds do not account for much ofthe considerable increase in corporate finance. An important factor accounting for thisdevelopment is the increasing ability of Chilean companies to access more competitiveinternational capital markets which has reduced their interest to place bonds on the domesticmarket.

11. Commercial long-term debt held by banks increased by about 20% in the past fouryears, while the rescheduled loans that date back to the financial crisis of the early 1980s haveslowly disappeared from the balance sheets. When the two are taken together, total long-termdebt to banks increase by only about 10% in real terms in the past few years. Leasing hasgrown very rapidly. The debt outstanding to leasing companies has nearly tripled, and theflows in Table 2 suggest an accelerating pace of lending by the leasing sector.

12. Risk capital investments funds have played a very minor role for industrial finance upto now, allocating only 3.5 billion pesos (about $10 million) in 1993. Since this is a very newform of investment, it remains to be seen whether it will be play a more important role inraising capital for industrial companies.

Annex VIII 100

13. Finally, corporate foreign debt has also increased tremendously over the past fouryears. In fact, Table 2 suggests that the increase of foreign long-term lending and theplacement of bonds on international capital markets are the most important factor in theincrease in corporate debt. In addition to increased foreign lending and increased bond issuingactivity, American Depository Receipts (ADRs), a mechanism that allows Chilean companiesto place equity directly on US stock markets, has also been an extremely important factor inraising capital for industrial companies, particularly in 1993 when Chile received investmentgrade rating by both major rating agencies. So far, seven large Chilean companies havebenefitted from this scheme, placing a total of more than US$800 million on US capitalmarkets.

14. Table 5 in Annex V shows the major sources of domestic industrial finance. Thecorporate bond market is entirely driven by the pension funds and life insurance companieswho, by 1993, hold 85% of corporate bonds outstanding. Pension funds and life insurancecompanies account only for a nearly 13% of stock market capitalization. But this small shareis mostly due to the fact that many shares of closely-held companies are not traded (see AnnexV, Table 5). In fact, the share of pension funds and life insurance companies among tradedshares is much higher. It is important to note that foreign investors also play an important rolein the growing stock market capitalization. Thus in addition to the increase in long-termforeign lending, foreign capital has provided increasing funds to industry via the equitymarket.

15. It should also be noted that these three sources of industrial finance increased rapidlyin the past four years, both in absolute as well as in relative terms. Pension fund, lifeinsurance, and foreign investors' funds that have been made available for industrial financeincreased rapidly in real terms and made up an increasing share of securities marketcapitalization. Thus the liberalization of pension fund and life insurance company investments(see Annexes Ill, IV) have, combined with the favorable macroeconomic and externalenvironment, contributed significantly to the improvement in access to long-term industrialfinance.

16. Table 3 shows the impacts of World Bank and IDB lending on the long-term lendingof the Chilean banking system as well as leasing sector activity. Of the estimated new long-term loans given by banks, IDB and IBRD provided about 12% in 1990 which declines to lessthan 3% in 1993. This indicates a moderate overall, and sharply declining influence ofmultilateral directed credit in the provision of term finance.' IBRD and IDB involvement inthe leasing sector, however, has been much more important than their involvement with thebanks (see Annex VII). Between 1990 and 1992, IDB and IBRD disbursements account for25-30% of the value of new leasing contracts. But also here the rate drops sharply to less than15% in 1993.

1. For details on the estimate, see notes below Table 5. It should be noted that in contrast to the average term of regular bank lending(2-4 years), IDB and IBRD funds were onlent at a maturity of up to 15 years with several years grace so that these funds were muchlonger-term than average bank loans.

101 Annex VIII

17. Another way to assess the improvements in the access to industrial finance is toexamine how the sources of funds for industrial enterprises changed over time. While there isno overall company survey available, the audit mission for the two industrial Finance Projects(2606-CH, 3053-CH) assembled financial data on the companies that received funds fromthese two projects, which is able to shed some light on the question (see concurrent audit).While this sample may not be representative of the industrial sector in Chile, it gives a goodoverview of the changes that occurred in the late 1980s and early 1990s.2

18. Table 4 shows consolidated balance sheets for the companies of the sample. Since thenumber of companies included in the sample is changing over time, it is best to examine theper company panel (bottom half) and focus on the time period from 1987 to 1992. The leftside presents nominal, the right side real (millions of 1993 pesos) figures. In this time period,the companies in the sample increase their fixed assets by about 60% in real terms, suggestingconsiderable expansion in investments. While the IBRD funds play a considerable role in thisexpansion (particularly as a share of long-term liabilities), IBRD never provided more than15% of total debt. Moreover, the share of IBRD financing declines from 15% in 1988 to6.5% in 1992, clearly suggesting that the enterprises are able to access alternative sources offunding. Also, as the share of IBRD funds declines, other long-term sources of long-termfinance appear and replace these funds, suggesting that these companies have increasing accessto long-term lending, even without IBRD assistance.

19. The most important factor in the increase in fixed assets financing is equity, whichalso increases by about 50% in real terms between 1987 and 1992. This increase in equity isnot mainly due to retained earnings. In fact, profitability of industrial enterprises is not veryhigh and actually declining towards the beginning of the 1990s, leaving little room to expandequity via retained earnings. This leaves the issuing of equity as the only other possibleoption to increase their capital base.

20. The ratios in Table 4 suggest that these industrial enterprises are, as a whole,financially viable. The current ratio is declining but still significantly above minimum levelsand the capital structure is adequate. Long-term and total-debt to equity levels remain low,mainly due to the rapidly expanding equity base of the companies. Equity as a share of totalliabilities remains at a high 60% throughout the period, comparable to levels prevailing inindustrialized countries. Similarly, the share of long-term debt to total liabilities in this sampleis at a high level, leaving only a small percentage of short-term borrowing, which is also afactor contributing to the good liquidity position.

21. Table 4 presents an aggregate picture. When dividing the sample into corporationswhose shares are not traded on the stock market, corporations whose shares are traded on thestock market, and smaller limited liability companies, a few important differences emerge (notreported here). First, companies active in the stock market have even higher levels of equity-

2. The companies include a wide variety of sectors ranging from food processing via textiles to metal, mining, and agriculture. Thecompanies included were likely to be in better financial position than the average. Also, they are representative of large companiesand do not include small and include only very few medium companies (see Box 1 below).

Annex VIII 102

finance (60-70%) and rely only very little on short-term borrowing (less than 10% ofliabilities). They have even more favorable current and debt-equity ratios suggesting that theiraccess to the stock market has done much to improve their financial structure in spite of theirrapid growth. Moreover, they relied little on IBRD funds (less than 10% of total lending) andin 1992 IBRD funding has virtually disappeared from the balance sheets.

22. Corporations whose shares are not traded have a lower proportion of equity finance(50%), have good access to long-term debt (25%), rely more on short-term borrowing andhave consequently less favorable current and debt-equity ratios. Smaller limited liabilitycompanies also even less access to long-term finance (15%), they rely more on short-termfinance, and their equity base is much more volatile since much of the changes in equitydepend on retained earnings and thus profitability.

e) Assessment

23. Access to term finance has improved substantially over the past four years.Furthermore, the measures supported by the FML have had a considerable impact in bringingabout this change. In particular, the development of the equities and corporate bond marketcan be directly linked to the liberalization of the pension fund and life insurance portfolios aswell as the improvements in the changes of securities market infrastructure and supply ofequities (see Annexes ill, IV, V). More and more companies have come to receive equity andbond finance, as the number of companies listed, including some medium-sized ones, increasedfrom 245 in 1990 to 350 in 1994, and the number of issuers of corporate bonds increased to43. At the same time, it should be noted that a considerable portion of the improvements inindustrial finance came from abroad and is due to improved macroeconomic conditions, andchanges in international capital flows.'

24. While the expansion of traditional instruments has fuelled the growth of the financialmarkets, the range of new instruments proposed in the FML has so far done little to improvecorporate finance. Securitization and collateralization of loans has not occurred yet, and therisk capital and securities closed-end mutual funds have just started up and have not providedmuch capital to industry. As these instruments develop, further improvements in corporatefinance are likely.

25. Bank lending has provided some, but not very much more finance to industry. Itappears that banks continued to improve their profitability (with support of the FML) andexpand their short-term lending, but have not done much to increase their portfolio of long-term lending.

26. Credit to the leasing sector has proved to be invaluable. Estimated new leasingcontracts tripled in real terms between 1990 and 1993 and the joint involvement of IDB and

3. Although capital inflows have risen considerably, there does not appear to be a new debt crisis on the immediate horizon. As apercentage of GDP, foreign capital inflows are still far below the levels of the early 1980s. Moreover, the Central Bank hadaccumulated foreign reserves of more than US-S II b., equivalent to one year of imports or 75% of total medium and long-term debt,so that it is likely to withstand short-term reversals of international capital flows.

103 Annex VIII

IBRD clearly helped to jump start the sector. At the same time, it appears that the leasingsector has expaneed beyond these sources of directed credit and is slowly increasing its accessto other sources of finance (see Annex VII)."

27. A sample of industrial companies clearly indicates that companies surveyed have beenable to considerably increase their equity base as well as their access to term finance. Whilegrowing at very high rates, they were able to maintain a sound financial structure and have, atthe same time, become less dependent on directed lines of credit. At least large and somemedium industrial companies benefitted from the measures supported by the FML, and now nolonger need to rely on directed credit schemes to expand or improve their financial health.

28. While clearly improved, the question invariably arises whether industrial companieshave, by now, "sufficient" access to term finance or whether more financial market reformsand/or directed credit may be needed. A first indication on this questions was alreadyprovided by Table 5 in Annex V. The extremely high proportion of corporate bonds andtiaded shares held by pension funds and life insurance companies clearly suggest that there issufficient demand for corporate equity and bonds so that these markets could easilyaccommodate further growth. Unless there are severe supply constraints to more issuingactivity, this suggests that those companies that can go to the stock market for finance (mostlylarge and larger medium companies) have access to sufficient term finance from other sourcesso that they do not need to tap the equity and bond markets to the full extent possible.

29. Table 5 below takes another approach to answer this question by comparing the actualprovision of long-term finance by the financial sector with an indicator of financial need. Thetop of the table provides data and estimates on all new long-term capital provided every yearto the productive sectors of the economy. It differs from Table 2 by replacing net flows of thebanking, leasing, and foreign sector with estimates of gross flows. In this way, they can becompared with the level of actual gross private investment which is taken to be a measure offinancial need by the corporate sector.'

30. Gross financial flows to the productive sectors have risen by 150% between 1990 and1993. Equity markets, leasing, banks, as well as foreign lending (and ADRs in 1993) grew thefastest and account for this impressive increase in the availability of investible funds.'

31. The bottom panel of the table then compares these flows to estimates of gross privateinvestment to determine the share financed by long-term instruments of the financial system.Gross private investment has increased by more than 25% in real terms between 1990 and

4. A caveat to this is that as the sector moves away from 1DB and IBRD funding, it is increasingly relying on short-term lending tofinance medium-term lending, which could generate liquidity problems in future.

5. For details of the estimate, see note below the table.

6. The reason why banks appear to grow much more dynamically than in Tables I or 2 is twofold. One is that the level in 1990 isunusually low and due to a sharp curtailment in bank lending. The other is that banks have indeed provided more lending by replacingold rescheduled loans with new lending (see Annex VI).

Annex VIII 104

1993, reflecting a rising need for term finance by the corporate sector." At the same time, theshare of this increasing investment levels that were financed by the financial markets increasesdramatically from 41.5% in 1990 to 84.6% of gross private investment in 1993. This is to saythat companies have had to rely less and less on short-term finance (including rolled over shortterm loans) and own funds to finance their increasing levels of investments. This suggests thatthe combination of increased domestic as well as foreign medium and long-term funds are nowbeing channeled to the productive sectors at a level where most of the investment needs of thecorporate sector appear to be met.8

32. This last observation can only be made while recognizing an important caveat. Whilethe total amount of industrial finance has substantially increased and may be sufficient as awhole to finance even the high investment and growth rates prevalent in Chile, this does notmean that the distribution of industrial finance ensures that all viable investment projectsreceive the necessary funding. Most of the improvements in the financial markets havebenefitted large companies. They receive almost all of the foreign lending, including ADRs,they are the ones that have easy access to the domestic and international stock and bondmarkets, and they continue to receive the bulk of bank lending (including the IDB and IBRDdirected credit schemes). For small and some medium companies (see Box 1 below),however, access to term finance continues to be more difficult (see also concurrent SMI-audit).They have to rely mostly on leasing, some bank lending, and new instruments such as riskcapital mutual funds. While leasing is expanding rapidly into the SMI sector, banks are stillquite reluctant although they are increasingly turning to the SMI sector to make up for losingmany of their larger clients that no longer rely on the banks for their financing needs.'

33. It is important to note that recent developments have led to considerable improvementsfor small and medium enterprises. The rapid expansion of the leasing sector as well asincreased bank lending to the sector have done much to improve their access to term finance.As the stock market continues to expand and new securitized instruments become available,there should be further improvements in the access to term finance, particularly for medium-sized companies. At the same time as large and some medium companies increasingly rely ontheir direct access to domestic and foreign capital markets for their financing needs, banks arelikely to further expand their involvement in the SMI sector.' 0 It is too early to tell whether

7. Incidentally, this represents 26.5% of GDP in 1993, allowing Chile to grow faster than the projected 5% real growth rate, for whichinvestments of about 20% of GDP would have been needed.

8. Another indicator that suggests that companies are not facing grave difficulties in obtaining funds are real interest rates. Realinterest rates charged by banks for 1-3 year operations have fallen from about 13% in 1990 to about 9% in 1993, which is level notmuch above real lending rates prevailing in developed countries. A caveat of the interest rate data is that not all companies have accessto funds from banks so that interest rates just measure price and not availability.

9. A study of the SMI sector concludes that in 1993 70% of microenterprises, 35% of small, and 23% of medium enterprises haveno access to bank lending, and those that do get mostly short-term credit at relatively high costs. This does, however, represent animprovement over earlier years where the rates of no access were much higher.

10. At the same time, they are also turning increasingly abroad and are in the process of increasing their presence in other LatinAmerican countries.

105 Annex VIII

Box 1: Defir ing Small, Medium, and Large Enterprises

The methodology used to define small, medium, and large enterprises is notuniform and may influence the conclusions about credit access in important ways. Inparticular, it.dustrial finance projects, including the IFRP and IFP projects auditedconcurr3ntly, tend to use a much larger definition of small, medium, and large enterprisesthan the definitions used by SMI projects. Below, the definitions used by the IFRP andIFP audits, compatible with the usage in the respective SARs and PCRs, and the SMI andF1*L audits, which itself is based on CORFO's definition, are compared. In the IFRP-IFPdefinition, the threshhold between small and medium companies, expressed in annual sales,is already far above the threshhold for large companies using the SMI and FML definitions.

Consequently, the conclusions of the four audits should be viewed with thesedifferences in mind. For example, using the IFRP-IFP definition, the IFP loan intendedto serve medium-sized enterprises, while the FML-SMI definition would imply that it wasserving large companies. Similarly, the finding in this audit and the SMI audit that (usingthe FML-SMI definition) small and smaller medium companies, particularly those notaffiliated to a large industrial group, continue to have difficulties in getting access tomedium and long-term bank credit is perfectly consistent with the concurrent observationof the IFRP and IFP audits that larger small and medium-sized companies have muchimproved access to credit and may need no further support.

Annual Sales (US-$) Annual Sales (US-$)SMI-FML-CORFO IFRP-IFP

Micro <65,000 n.a.Small 65,000-675,000 <2,000,000Medium 675,000-1,350,000 2,000,000-10,000,000Large >1,350,000 >10,000,000

these encouraging developments will be sufficient to provide adequate term finance to smalland some medium enterprises or whether further involvement may be needed."

II. It has been noted that there is also an important difference among small and medium companies that are affiliated with anindustrial group and have little problems in getting access to industrial finance, while those companies that are independent are facinggreat difficulties (see World Bank Report 7737-CH, and concurrent IFRP, IFP audits). Due to data limitations, the audit is unableto bring any additional evidence to bear on this question.

Annex VIII 106

Table 1: Stock of Corporate Long-Term Debt and Equity Outstanding (Billions of 1993 Pesos)

1990 1991 1992 1993

Securities MarketsEquity 6778.4 12601.8 12280.1 18898.4Corporate Bonds 617.9 767.7 781.1 819.3Risk Capital 3.7Investment

Total 7396.3 13369.5 13061.2 19721.4Bank LendingCommercial Loans 1616.2 1650.2 1834.8 2043.8Rescheduled Loans 353.1 211.4 126.1 75.5

Total 1969.3 1861.6 1960.9 2119.3Leasing 173.7 254.1 351.3 463.1Total Domestic 9539.3 15485.2 15373.4 22303.8Without Equity 2760.9 2883.4 3093.3 3405.4Private Non-FinancialLT Foreign Debt 1830.5 2018.8 2170.3 2765.4ADRs 34.4 34.4 362.5Total Foreign 1830.5 2053.3 2204.8 3127.9

Total 11369.8 17538.5 17578.2 25431.7Without Equity 4591.4 4936.7 5298.1 6533.3

Source: SVS: Revista Valores 1993, SBIF: Annual Reports, Banco Central: Evolucion de la Econmia en 1994, Association of LeasingCompanies

Note: Non-financial private foreign debt was obtained by subtracting foreign debt of the private banking system from the stock ofprivate, long-term foreign debt reported by the Central Bank.

107 Annex VIII

Table 2: Flows of Long-Term Debt and Equity (Billions of 1993 Pesos)

1990 1991 1992 1993

Securities Markt ts

Equity 128.1 86.0 205.3 348.7

Corporate Bonds 147.3 172.8 65.2 120.1

Risk Capit.l Invest. 3.7Total 275.4 258.8 270.5 472.5

Banking Lending -166.1 34.0 99.3 158.4

LeasiUg 35.0 80.4 97.2 111.8

Total Domestic 144.3 373.2 467.0 742.7

Private Non-Financial

LT Foreign Debt 55.0 188.3 151.5 595.1

ADRs 34.4 0.0 333.1

Total Foreign 55.0 222.7 151.5 928.2

Total 199.3 595.9 618.5 1670.8

Note: Bond emissions are gross flows. The flows of bank lending are net flows and arrived at by subtracting the stocks reported in TableI.

Source: SBIF, SVS, Association of Leasing Companies, Banco Central.

Table 3: 1DB and IBRD Support for New Lending of Banks and Leasing Companies(Billions of 1993 Pesos)

1990 1991 1992 1993

BanksTotal Outstanding 1969.3 1861.6 1960.9 2119.3

Annual Change -166.1 34.0 184.6 209.0

Estimated New Loans 280.0 438.1 597.2 667.7

World Bank 23.0 12.4 3.0 0.0

IDB 10.7 12.4 41.5 18.9

Total Disbursements 33.8 24.8 44.5 18.9

Share of New Loans 12.1% 5.7% 7.5% 2.8%

LeasingLeasing Outstanding 173.7 254.1 351.3 463.1

Annual Change 35.0 80.4 97.2 111.8

Est. New Leasing 91.0 145.6 190.4 250.6

World Bank 3.7 20.3 0.0 0.0

IDB 20.1 21.1 51.8 35.8

Total Disbursements 23.8 41.4 51.8 35.8

Share of New Contract 26.2% 28.4% 27.2% 14.3%

Note: For details of estimates, see table below.Source: CORFO, World Bank, Leasing Andino, Banco del Estado. SBIF

Tabb 4: Summary Balancc Shets of Sample of Induatrial Com~panm

Noinal (ffdlns of current pesos) Real (Miliona of 1993 Penbe)

el Total a) Total1985 1906 1987 1988 1989 1990 1991 1992 1985 1986 1987 198 1989 1990 1991 1992 >

M~Qdecmp 2 6 12 21 24 26 20 19 Num~be Icompan, 2 6 12 21 24 26 26 19C n A~ 24130 5262 61018 110918 147259 165742 213005 216226 c~nnt A~s. 90952 16946 160283 262756 287974 249980 273604 254630 F~dA.. 60066 9817 129283 237126 380199 579213 759157 762650 F~sd Ase 226403 31615 339614 561733 743503 873597 973683 900438Totao Assot*Jabnd.a 88381 15546 200442 393354 545351 786340 1054835 1072812 Tota Assas~ai. 325590 50065 526542 931825 1066468 1185996 1353504 1263263Cun~n Lime 23500 4983 30414 59509 61049 101895 139829 136796 cuncnm .u 80577 16047 79095 141162 119385 153603 179049 161244LngTnumbLAMN 17447 4392 40983 66665 183960 236758 305118 291661 LeTumbLhMe 65762 14144 107658 157924 320634 357090 391366 344198Wedd sank Leen 0 1002.594 5642.706 19620.15 24613.67 29968.55 34324.85 28461.68 Wedd Sank L~an 0 3229 14823 46479 48134 45200 44063 32893

36293 6140 120703 266018 317723 440197 0n96r2 644062 Equlr 136797 19773 317075 630176 621327 872976 781923 757475Pro~ls 2277 1153 28067 56176 40223 31195 31206 39667 Profis 8583 3713 73729 133077 78659 47050 40011 46495Raio RadosCurent Rao 1.03 1.08 2.01 1.86 2.41 1.63 1.52 1.58 Curnt Ratio 1.03 1.08 2.01 1.86 2.41 1.63 1.52 1.58LT D~b-Equiy Rado 0.48 0.72 0.34 0.25 0.52 0.53 0.50 0.45 LT DoM-EquitykRad 0.48 0.72 0.34 0.25 0.52 0.53 0.50 0.45T D~-Equky Rao 1.13 1.53 0.59 0.47 0.71 0.76 0.73 0.67 T Debl-Equfty Rao 1.13 1.53 0.59 0.47 0.71 0.76 0.73 0.67ShareSTDobt~b. 27.2% 32.1% 15.2% 15.1% 11.2% 13.0% 13.3% 12.8% ShareSTODebtlab. 27.2% 32.1% 15.2% 15.1% 11.2% 130% 13.3% 12.8%ShareLT~ilab. 20.2% 28.3% 20.4% 16.9% 30.1% 30.1% 28.9% 27.2% ShareLTDebt~Lab. 20.2% 28.3% 20.4% 16.9% 30.1% 30.1% 28.9% 27.2%Shwe EquyiJab. 42.0% 39.5% 60.2% 67.6% 58.3% 56.7% 57.8% 60.0% Share Equ~iyALlb. 42.0% 39.5% 60.2% 67.6% 56.3% 56.7% 57.8% 60.0%Shara WB/Tol Dt 0.0% 10.7% 7.9% 15.5% 10.9% 8.8% 7.7% 6.6% Sha WB/Total Dob 0.0% 10.7% 7.9% 15.5% 10.9% 8.8% 7.7% 6.5%

b) Pör Co~mpay b) Per CompanyCun~ Am~ 12065 877 5085 5282 6138 8375 8193 11300 c~mAntA.. 45476 2824 13357 12512 11999 9615 10523 13402F~udA 30033 1836 10774 11292 15842 22277 29198 40139 FkdAsA~ 113201 5289 28301 26749 30979 33600 37449 47391Tota AssalL&abfits 43191 2591 16704 18731 22723 30244 40571 56464 TOta Assät.Uabli~i 162795 8344 43878 44373 44436 45615 52058 66488CUnLM~S 11750 831 2535 2838 2544 3919 5378 7200 cu~ ntubm 44288 2675 6650 6722 4974 5911 0917 8407LangT.qn,uSaemm 8724 732 3415 3175 6832 9106 11735 15351 LengTnm mI•• 32881 2357 8972 7520 13360 13734 15053 18116ananan 0 167 470 934 1026 1153 1320 1498 wéddS.ngLoen 0 538 1235 2213 2006 1730 1695 1731

Equer 18147 1023 10059 12668 13238 17161 23446 33898 EquAa 6396 3298 26423 30008 25889 25884 30074 39067Pr~fits 1139 192 2339 2675 1676 1200 1200 2008 Proffs 4291 619 6144 6337 3277 1810 1539 2447Rads RasCurrot Rao 1.03 1.08 2.01 1.86 2.41 1.63 1.52 1.58 CurrTrd Rado 1.03 1.06 2.01 1.86 2.41 1.63 1.52 1.58 00LTDObt-EquityRato 048 0.72 0.34 0.25 0.52 0.53 0.50 0.45 LT DoM-Equity RaO 0.48 0.72 0.34 0.25 0.52 0.53 0.50 0.45TDobt-EquityRado 1.13 1.53 0.59 0.47 0.71 0.76 0.73 0.67 TDobt-Equty Rao 1.13 1.53 0.59 0.47 0.71 0.76 0.73 0.67Share ST D0 bb. 27.2% 32.1% 15.2% 15.1% 11.2% 13.0% 13.3% 12.8% Share ST DetMlab. 27.2% 32.1% 15.2% 15.1% 11.2% 13.0% 13.3% 12.8%SharoLTDobl~ab. 20.2% 28.3% 20.4% 18.9% 30.1% 30.1% 28.9% 27.2% ShareLTDbtab. 20.2% 28.3% 20.4% 16.9% 30.1% 30.1% 28.9% 27.2%Shar EqutyJab. 42.0% 39.5% 60.2% 67.6% 58.3% 56.7% 57.8% 60.0% Share Equityiliab. 42.0% 39.5% 60.2% 67.6% 58.3% 56.7% 57.8% 60.0%Shara WBTota DoM 0.0% 10.7% 7.9% 15.5% 10.9% 4.8% 7.7% 6.6% Share WB/Total Db 0.0% 10.7% 7.9% 15.5% 10.9% 88% 7.7% 6.5%

9m~: kan cal de Chk nd F~unc Prje pw*e UnJL

109 Annex VIII

Table 5: Long-Term Financing of Private Domestic Investment (Billions of 1993 Pesos)

1990 1991 1992 1993

Securities Markets

Equity 128.1 86.0 205.3 348.7

Corporate Bonds 147.3 172.8 65.2 120.1

Risk Capital 3.7Invest.

Total 275.4 158.8 270.5 472.5

Bank Lending 280.0 438.1 597.2 667.7

Leasing 91.0 145.6 190.4 250.6

Total Domestic 646.3 842.4 972.7 1340/2

Private Non-Financial 467.5 645.9 656.2 1137.7LT Foreign Debt

ADRs 34.4 0.0 333.1

Total Foreign 467.5 680.3 656.2 1470.8

Total LT Finance 1113.8 1522.8 1628.9 2810.9

Gross Dom.Inv. 3438.9 3371.8 4001.8 4440.3

Housing 156.0 288.3 316.6 368.9

Public Sector 598.8 588.7 656.3 687.0

Private Sector 2684.2 2494.8 3029.0 3384.4

Share of PrivateInvestment financed 41.5% 61.0% 56.6% 84.6%

Note: Equity, Corporate bond, ADRs, Capital Investment represent annual flows to these instruments and are basd on dinct dat homethe supervisory agencies. New bank loans to enterprises are estimated by adding the change in loans outstanding and the presumedrepayment of 25% of the loans outstanding in the previous year. This estimate, which suggest an average mamuity of four years isbased on the term structure of loans to the Banco del Estado. The term structure is held to apply for loans from abroad. New lasingcontracts are estimated based on Leasing Andino data adjusted for their market share. Gross investment figures a take fm WorldTables and Central Bank data. Housing investment is estimated by using new emissions of mortgage bonds and public sector inve ntis estimated using internal World Bank figures.

Source: SBIE,SVS.Association of Lasing Companies,Banco Central,Leasing Andino.Banco del Estado, World Tables.

Ill Annex IX

CORFO

a) Background

1. Corporacion de Fomento de la Produccion (CORFO) is the only state developmentbank of Chile. h combines the functions of a holding company for state-owned enterprises, aprovider of development finance in the form of equity, loans, and guarantees, and a supporterof research and development activities by public R&D centers and the private sector.

2. As Chile continued with privatization of state-owned enterprises throughout the 1980s,the importance of CORFO as a holding company decreased (see Table 1). Theseprivatizations involved considerable book losses. The cash flow generated from theprivatizations was transferred to the Treasury. Continuing efforts at privatization are likely tofurther reduce the holdings of CORFO.

3. CORFO's development finance activities had been primarily as a first-tier lender toindustrial enterprises. In that capacity, CORFO's lending operations had received strongsupport from several consecutive IDB and World Bank credit lines since the 1960s. CORFO'slending portfolic had, for a long time, been burdened by high rates of non-performing loans.Throughout the 1980s, non-performing loans were on the order of 20% or above.'Conditionalities imposed by IDB-Loan 509 to reduce the percentage of non-performing loansto 14% by 1988 were not met.

4. As a result of the poorly performing loans, CORFO ran significant losses throughoutthe 1980s in spite of charging positive real interest rates. Provisions against losses and othercosts associated with the poorly performing components of the portfolio eroded theconsiderable profits from the performing loan portfolio (see Table 1). In addition, poorauditing and unclear accounting made any assessment of the financial viability and profitabilityof CORFO extremely difficult.

b) The FML Loan

5. In spite of its past difficulties, CORFO was chosen as the financial intermediary forthe FML loan. The project files explain that no other institution was available to act asintermediary for this project. In addition it was argued that the leasing component of the FMLloan was purely a second-tier operation and should therefore not be hampered by many of theproblems of the past. In order to ensure the success of the second-tier lending operation, afinancial intermediation unit was established within CORFO with the help of the technicalassistance component of the FML (see Annex X). Furthermore, the loan came at a time whenefforts by the government and IDB to clear up the CORFO loan and holding portfolio were

1. Some of CORFO's lending was to support government policies regarding certain industries and regions and was often forunprofitable activities. TMis, among other things, led many of CORFO's clients to believe dia loans from CORFO did not need tobe repaid since the government would find it politically diffmcult to collect on them.

Annex IX 112

underway. In conjunction with these effort, IDB required CORFO to lower its arrears rate tobelow 10% by 1990 as a condition for its newest loan (IDB-576, $240 million).

c) Implementation

6. The details of the operation of the leasing component are discussed in Annex VII.With the exception of continued problems regarding late and insufficient auditing of CORFO'soverall financing activities, the implementation of the leasing component proceeded flawlessly.The financial intermediation unit has proved capable of handling the auction process as well asthe collection of past loans. As discussed in Annex VII, the auction process has since alsobeen used to auction IDB-funds to leasing companies and banks.

d) Outcome

7. Since 1990, CORFO has ceased to be a first-tier lender and has concentrated onsecond-tier operations, mostly using the auction process to allocate funds (see Table 1). Infact, by June 1994, CORFO's second-tier portfolio, for the first time, makes up more than50% of CORFO's total lending portfolio (Table 2).2 Thus the auction process has been veryhelpful in facilitating this move from first-tier to second-tier institution. As a second-tierinstitution, CORFO has no arrears (see Table 2). Thus the second-tier operations did not haveany of the problems associated with the first-tier operations.

8. The remaining first-tier portfolio continues to be burdened by extremely high arrearsrates. CORFO did not meet the conditionality imposed by the IDB loan in 1990. In fact, byAugust 1994, of the remaining first-tier portfolio, 89.3% are in arrears (Table 2).3 Thisarrears rate on first-tier lending is so large that CORFO continues to have a 42% arrears rateon its total lending portfolio (i.e. including the arrears-free second-tier portfolio). To rid itselfof the problems associated with its first-tier lending portfolio, CORFO continues to sell itsportfolio (at a substantial discount) to private institutions for collection. By the end of 1994, itplans to have sold off the entire first-tier lending portfolio, thus concentrating purely on itsmuch more successful second-tier lending activities.

9. While the high arrears rate in the first-tier portfolio has considerably reduced profits inthe past, it no longer poses a risk to profitability in coming years given that provisions for allfirst-tier operations cover nearly 90% of the remaining first-tier portfolio.

10. CORFO's non-lending operations have also shown considerable improvements (Table1). While the privatization program has proceeded much more slowly in the 1990s than it didin the 1980s, CORFO has been able to continue to reduced its liabilities and assets.

2. Development loans and old development loans refer to first-tier operations in the balance sheet in Table 1, while auctioneddevelopment loans as well as 1DB, IBRD loans (auctioned off by CORFO) represent the second-tier portfolio.

3. This number refers to the total amount of all loans in arrears and not just the actual repayment quotas that are late. For about 80%of the loans in arrears, there are still scheduled payments to be made in the future. Thus if only the late portion of all the arrearportfolio were counted in the arrear percentage, this percentage would be much lower.

113 Annex IX

Particularly noteworthy is the rapid decline of external debt, both in absolute terms as well asa share of liabilities. Moreover, CORFO registered profits in 1992 and 1994 for the first timein decades, thereby stemming the slow erosion of CORFO's equity base.

11. The net position with the treasury turned from positive to negative in the time period.This number is daceptive, however, since the positive asset position stemmed from theprivatizatioas of the late 1980s whose proceeds were transferred to the treasury. Also, itshould be noted that in 1994 the net position with the treasury has stabilized. If this trendcontinues, the combination of positive profits and no increases in indebtedness to the treasurysignals the end of loss-making and subsidization and the beginning of sustainability forCORFO's operations.

e) Assessment

12. Given CORFO's past performance, it was risky to assign it the function of apexinstitution for the leasing component of the FML loan. It turned out, however, that CORFOwas able to deal with this new role well and has been very successful as a second-tier financialintermediary. The FML loan as well as continued IDB-lending were instrumental in makingthis transition.

13. This transition, combined with efforts to reduce and improve the efficiency ofCORFO's holding operations, have improved CORFO's overall financial viabilityconsiderably. In fact, by 1994 CORFO appears to be on a path towards financial self-sustainability and moderate profitability without heavy reliance on state subsidies. This hasnot only reduced potential financial burdens for the state, but also ensured that Chile now hasa mechanism to efficiently and effectively transfer funds to industrial enterprises via thedomestic financial system using CORFO as the apex institution. This is quite an impressiveturn around. However, promoting second-tier operation is only part the institutional changesnecessary. The transformation of CORFO will be complete only when other aspects of its newstrategic plan will be implemented. The most pressing one are the sale of the remaining non-performing loan portfolio and the sale of remaining non-profitable affiliated enterprises.

Table 1: Summary Balance Sheet of CORFOBifions of 1993 Pesos

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

Assts 2340.9 2439.7 2405.4 1899.7 1555.8 1601.5 1647.8 1549.6 1490.4 1414.1 1370.1

Curren Assets 56.2 113.5 199.0 223.0 219.9 142.2 127.0 189.9 182.6 170.8 136.3C~ 12.4 13.2 4.8 8.9 7.1 18.8 7.2 9.0 12.7 10.0 2.2Drm n t^ 20.0 56.9 40.3 49.1 48.1 51.4 40.3 23.6 17.2 17.8 14.4Au*n D^pm L~ 0.0 0.0 0.0 0.0 0.0 0.0 4.8 52.6 71.6 17.0 0.0OB ud SRD Lo n 0.0 0.0 0.0 0.0 0.0 0.0 0.0 23.8 32.0 53.6 30.0

m- n hrbød -1.9 0.0 0.0 0.0 0.0 -1.2 -0.8 -0.5 -32.7 -18.0 -0.6~s lsan" or p~ak 0.0 0.0 0.0 0.0 0.0 0.0 -2.9 -11.0 0.0 -1.1 0.0

Ou.om sae ocpenÉse 3.3 7.9 125.3 115.1 101.4 3.1 24.4 53.1 49.7 60.6 68.0cr currnAdsen 22.4 35.4 28.7 49.9 63.3 70.0 53.8 39.4 32.0 30.9 22.4

Long-Tørm Asa~ta 242.9 279.0 313.3 326.5 337.6 549.1 487.9 277.8 264.0 234.7 217.0Duvelopmb U LM 119.6 119.5 158.7 170.2 180.5 230.2 166.2 79.1 57.4 36.1 10.5O6. ORD~Lons 0.0 0.0 0.0 0.0 0.0 0.0 54.9 48.5 101.0 110.2 128.4~ass dIowno r bed d*t -31.0 0.0 0.0 0.0 0.0 -5.5 -4.4 -2.3 -2.7 -2.4 -2.2

Dm fem at cmpn 40.0 37.7 42.2 60.2 72.3 100.5 73.5 46.9 29.2 20.8 17.2o Long.Tum A~ 114.3 121.8 112.4 96.1 84.8 223.9 197.7 105.6 79.1 70.0 63.1

Investments in Affillted Companis 1730.2 1828.7 1713.7 1139.0 720.7 618.2 828.5 899.2 915.6 885.0 893.6Fbæd Assets 20.0 19.2 20.6 25.7 24.2 21.9 14.9 13.3 13.2 12.6 12.4Other Ases 278.7 186.2 148.1 175.2 240.5 257.0 189.4 169.5 115.0 111.0 110.9

Ow ODAøome Lone 164.8 176.0 134.0 117.7 115.6 121.6 151.4 163.3 99.4 121.8 131.7~u: -n ,r boddebM -127.7 -135.0 -121.1 -141.6 -129.1 -130.2 -117.5 -127.7 -98.6 -123.3 -134.1

Tr r ~ Traury 0.0 14.3 16.7 43.1 133.4 167.8 63.8 54.5 47.9 42.5 40.80o~r 241.5 130.8 118.5 156.0 120.6 97.8 91.7 79.4 66.3 70.0 72.5

LMbi~s and Equty 2340.9 2439.7 2405.4 1899.7 1555.8 1601.5 1647.8 1549.6 1490.4 1414.1 1370.1

Current L.bll s 43.8 44.9 87.3 127.9 146.9 124.4 146.8 132.6 86.0 82.6 76.3D~c DeM 21.0 18.5 47.3 59.1 76.3 29.5 61.2 51.5 19.7 9.5 9.4E*ern o~ht 18.6 24.5 37.4 65.1 67.5 91.7 60.1 74.4 56.4 44.4 40.1

b to Treamury 0.0 0.0 0.0 0.0 0.0 0.0 0.0 2.4 3.8 24.7 19.4mer cufent Lb.. 4.3 1.9 2.6 3.7 3.1 3.1 5.4 4.2 8.1 4.0 7.4

Long-Trm Lifbilities 202.9 293.7 637.6 624.4 518.6 783.2 690.7 611.1 580.6 567.5 530.7cm~ ~c0. 42.9 60.7 414.7 65.7 35.5 123.0 73.8 33.3 51.6 72.2 73.4

Forgn Deb 160.1 233.3 222.8 556.7 463.1 660.2 563.7 486.6 372.9 316.9 281.0D~bt a Trsury 0.0 0.0 0.0 0.0 0.0 0.0 53.4 71.7 144.3 166.2 166.5OUwr Long-Trm U~bi 0.0 0.0 0.0 0.0 0.0 0.0 0.0 17.6 11.8 12.2 7.8

Total Liabilities 246.8 338.5 724.8 752.3 665.5 907.6 837.4 743.7 668.7 650.1 607.0

Equity 2094.6 2100.9 1680.6 1147.4 890.5 692.5 810.4 805.9 821.7 763.9 763.1capita 1968.8 1968.5 1959.1 1904.2 1800.3 1745.8 1808.3 1893.4 1893.7 1884.6 1800.5Røs 114.8 191.1 -13.2 -47.0 -47.1 -68.4 114.8 114.9 115.2 114.6 113.5RetinedEaing 0.0 10.9 -58.9 -204.9 -602.5 -687.8 -976.8 -1115.5 -1192.0 -1180.0 -1166.6Trians D Trøsury -4.8 0.0 -61.2 -107.4 -174.6 -100.1 0.0 0.0 0.0 0.0 0.0curr~nt Proft 15.2 -69.7 -145.5 -397.4 -85.5 -214.9 -136.0 -86.9 5.0 -55.3 15.7

Memo: Net Position with Treasury 4.8 14.3 77.9 150.5 308.0 267.9 10.4 -19.6 -100.2 -148.4 -147.1

Nat: 1994 det arm up to June.Saurce. CORFO

115 Annex IX

Table 2: Loan Portfolio, First and Second-Tier (Billions of Pesos in 8/94)

First Tier Second Tier Total

Number of Operations 2936 646 3582

Amount Outstanding 154.0 173.4 327.4

Performing Portfolio 10.7% 100.0% 58.0%

Arrerr Portfolio 89.3% 0.0% 42.0%

Source: CORFO

s

117 Annex X

Technical Assistance

a) Background

1. Limitations in the regulatory oversight of the financial system have contributed to theseverity of the economic and financial crisis in Chile in the early 1980s. Consequently,alongside the economic and financial recovery, the state institutions and agencies that dealwith regulating the financial markets needed strengthening.

2. The need for technical assistance was reinforced by the measures supported by theFML which entailed a significant deepening and liberalization of Chile's financial markets.These measures could only work and generate the confidence necessary for further growth ofthe financial system i.' the supervisory bodies as well as the ministries in charge of regulatingfinancial markets were able to successfully implement these measures and carefully monitorthe progress without running the risk of another financial crisis.

3. In addition, there was a need to examine the technology development and SMI policyof the Chilean government to determine whether any changes in strategy were needed toimprove technological development and better promote SMIs in Chile.

b) The FMIL Loan

4. The FML loan included a US-$ 1.96 million (260.5 million Yen) Technical Assistancecomponent financed by the Japanese Grant Facility. The T.A. had originally 14 componentsplus a remainder of unallocated funds (Table 1). Later, a fifteenth component was added andthe remaining funds reallocated. The individual components are discussed in the outcomesection; a summary is provided in Table 1.

5, In addition, the Japanese Grant Facility had supported project preparation bycommissioning and paying for three studies on financial intermediation, the leasing sector, andtechnology financing, respectively. The projected amount spent on these three studies was 4.5million Yen (US-$ 0.035 million).'

c) Implementation

6. No major issues appeared during implementation. Project files show that great carewas taken on every supervision mission to discuss the progress and benefits of the technicalassistance components. As part of these discussions, a new component was added to the T.A.(CORFO's financial intermediation unit). As with many T.A. components, disbursement wasrelatively slow and lagged behind the disbursements for the leasing component. But bySeptember, 1993, all funds were allocated and by the end of FY 94 they were disbursed.

1. Only 2.15 million Yen were spent The remainder was later reallocated to the other technical assistance components, therebyincreasing the funds available from 260.5 m. Yen to 262.85m. Yen (Table 1).

Annex X 118

d) Outcome

7. Flow of Funds Matrices. In order to provide the Central Bank, the Ministry ofFinance and the regulatory agencies with a more accurate and reliable overview of financialmovements in the economy, this component was supposed to set-up the process of flow offunds accounting and provide the accounts for an initial year. By now, flow of funds tableshave been created for 1986-1990. For 1990, a more disaggregated version has been producedand currently the Central Bank is in the process of providing flow of funds tables for 1991-1994. Thus this component has initiated an ongoing process of producing a coherentframework of financial analysis that will provide crucial insight to policy-makers andresearchers.

8. Institute of Banking Studies Courses. The purpose of this component was for theInstitute of Banking Studies to organize four seminars for high and medium-level bankingexecutives on new financing techniques and one seminar for entrepreneurial management. Inaddition, a study on the availability of financing was done in conjunction with the BankingRegulators (SBIF).

9. Ministry of Finance: Development of Information Systems. This component wasdesigned to update the computer systems of the Budget Directorate. In order to providesufficient complementary equipment, this item was increased considerably.

10. SBIF: Banking Statistics Information System Development and Studies. The fundsallocated to this component were used for studies on regulatory issues relating to credit cards,money desk operations, banking mergers, venture capital, and securitization as well asinformation systems for banking surveillance and consultant support for the working group onhousing finance. The high quality of the statistical information as well as the expertise of theSBIF on regulatory issues suggests that these components clearly had a beneficial outcome onthe capabilities of this crucial supervisory body (see Annex VI).

11. SVS: Risk Rating and Information Systems Development. One crucial aspect ofimproving securities markets infrastructure was to improve the quality and reliability of riskclassification (see Annex XX). This component supported the creation of a risk classificationunit within the Securities Markets Regulatory Agency (SVS) and provide the necessarycomputer systems and technical capabilities to enable them to analyze and reconcile divergingratings by private risk classification. In addition, a seminar to disseminate information onsecurities issuance techniques was organized to increase the number of securities issuers. Thegrowth of the stock and bond markets as well as the smooth functioning of the four privaterisk classification companies are testimony to the smooth functioning of risk classification aswell as the wider availability of information regarding securities issues (see Annex V).

12. Pension Fund Regulators (SAFP): Study on Investment Possibilities. Since a majorportion of the legislation supported by the FML consisted of liberalization of the regulationsgoverning the investments of pension funds, a study to analyze the investment possibilities andthe issues arising from such liberalization was commissioned. Clearly, such an analysis was

119 Annex X

timely and important to ensure the maintenance of a delicate balance between liberalizationand prudential discipline.

13. Treasury: Systems Development. In order to enhance the efficiency of the Treasury (adepartment within the Ministry of Finance), this component finances the acquisition andinstallation of computer equipment and accompanying software.

14. Technology Development Seminar. This seminar was designed to bring togethergovernment officials, academics, entrepreneurs and invited national and foreign experts todiscuss a range of technology related issues and thus help structure the new government'stechnology development strategy. The seminar took place in June, 1990 and was attended bythe task manager of the FML loan. The seminar was judged to be an overall success instimulating productive discussions on Chile's technology policy and produced a number ofongoing initiatives on specialized issues. One drawback reported was the low attendance ofprivate entrepreneurs and the absence of representation from IDB. Although funds had beenbudgeted to finance this component, the Chilean government absorbed the cost of thiscomponent and did not ask for disbursement of the funds.

15. Study of Demand for Funds for Technological Investigation. In order to provide morebackground for the governmen's deliberations on its technology policy, this study identifiedfactors that influence the demand for technological activities. The study also proposed adesign for a National Technology Development Fund.

16. Study on Modernization of Technological Institutes. This study examined the structureand operations of CORFO's technology institutes and suggested ways to modernize them.

17. Study of Long-Term Financing for Small and Medium Sized Companies. This studyaddressed the question on how the private capital markets could ease the existing constraintsfor long-term funds for SMIs. This study was an important ingredient in the reformulation ofthe government's SMI policy in 1993 which moved away from directed credit to subsidizedtechnical assistance, help with loan applications, credit guarantees, and other mechanismsdesigned to ease SMI's access to financing from the formal financial sector and the capitalmarkets (see concurrent SMI audit).

18. Strengthening of Control Systems in Internal Revenue Service. This component, whilesomewhat unrelated to the goals of the FML loan, should be seen as part of two parallel publicsector management operations that targeted the improvement of tax collection and auditingprocedures at the Internal Revenue Service (Loans 2504-CH and 341 1-CH). This componentfinanced studies as well as equipment and training.

19. Study on the Impact of Lines of Credit. This study was designed to analyze the impactof multilateral credit lines on the Chilean capital markets and investigate in particular whetherthese forms of directed credit might impede indigenous capital market development.Unfortunately, this study was canceled when the reallocation of funds took place in early1994. Given the importance and relevance of the topic, it is unfortunate that this particularcomponent was cut.

Annex X 120

20. Strengthening of CORFO's Financial Intermediation Unit. In conjunction with theleasing credit component and on-going reform efforts at CORFO, it was recognized that it wasnecessary to establish a separate unit within CORFO that would concentrate solely on second-tier operations. This component supported the financial intermediation functions of this unitand clearly was a factor contributing to the overall success of the leasing credit linecomponent.

21. Consultant Services in Administrative Unit. Instead of the projected 5% of totalexpenditure, the consultant services used to manage the T.A. component used 13% of totalexpenditure. While this amount is considerable, the complexity of the program as well as itsoverall success appear to justify these high expenditures.

e) Assessment

22. The T.A. included in the project and the studies commissioned for project preparationmet their objective and were successful in supporting the FML. The T.A. directly supportedand assisted the key institutions that were charged with implementing and supervising thechanges in the financial markets. While some unrelated components were also included in theT.A., the thrust of the T.A. was focused and addressed very specific and immediate needs ofinstitutional strengthening, technology development, and SMI policy.

121 Annex X

Table 1: Technical Assistance, Projected and Actual Spending(Million Yen)

Planned Actual

1. Flow of Funds Accounts 49.925 43.124

2. Institute of Banking Studies Courses 11.658 14.670

3. Ministry of Finance: Information Systems 33.147 47.111

4. SBIF: Banking Statistics Information Systemsand Studies 24.795 19.185

5. SVS: Risk Rating and Information Systems 6.525 6.335

6. SAFP: Study on Investment Possibilities forPension Funds 2.175 7.950

7. Treasury: Information Systems 31.900 34.155

8. Technology Development Seminar 10.875 0

9. Study on demand for funds for technologicalinvestigation 8.700 8.046

10. Study on modernization of technologicalinstitutes 7.250 6.297

11. Study on SMI financing 4.350 4.116

12. Control systems in Internal Revenue Service 29.000 29.735

13. Study on impact of credit lines on Chileancapital markets 2.900 0

14. Consultant services in administrative unit 12.325 36.048

15. CORFO-Financial Intermediation Unit 0 6.076

16. Unallocated 24.975 0

Total 260.500 262.848

123

Annex XI

Translation of the letter from Corporacion de Fomento de la Produccion - Chile

Santiago, April 11, 1995

Mr. Manuel PenalverDivision Chief

Dear Mr. Penalver:

Re: CHILE - Financial Markets Loan (Loan 3143-CH)Draft Performance Audit Report

I was pleased to receive your above-mentioned draft report.

As regard to the section dealing with Corporacion de Fomento de la Produccion, I am pleasedto report that we do not have any basic comments. I only wish to bring to your attention animportant development that took place last March: the Corporacion offered for tender thetotality of its Portfolio of Development Loans that had been lent directly to finance investmentprojects, as well as its "Cartera de Deudores" (Portfolio of Debtors), both of which were soldto two commercial banks.

As we have indicated to officers of the IDB [sic] mission that visited us last year, it has beenthe policy of the Corporacion since the year 1990 to carry out its financial assistance functionto private sector investment projects exclusively through financial intermediaries, throughperiodic tenders of funds, that is to say, to perform exclusively as a second-tier bank. Thispolicy has been most successful inasmuch as up to now, there have been no overdue loans inany of the operations. This fact has been verified by the officers of the IDB [sic] mission.

Very truly yours,

Roberto Hempel H.Manager, Intermediacion Financiera

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Report No; 14575Type: PPAR