FROM THE OFFICE OF PUBLIC AFFAIRS

Introduction

I am pleased to join you today in a discussion of a critical component of any growth strategy - mobilizing financing for private investment.  This is a subject of considerable interest to the U.S., and at Treasury in particular, as we analyze key challenges for raising growth in both countries.  And it is fitting that we consult closely with those who know best the barriers to access to credit - you, the private sector.  We see problems with financial intermediation being at the heart of growth outcomes that are currently well below their potential. 

Any investor or bank lender wants both a stable macroeconomic environment and a predictable, competitive business environment at the microeconomic level.   Brazil’s authorities face challenges on both fronts.  But I want to take a moment to highlight real progress on macroeconomic stability in recent months.

 Macroeconomic Outlook

 Macroeconomic conditions have turned the corner following a particularly challenging period beginning last year and continuing into 2003.  This Brazilian government, like its predecessor, has already established a well-deserved, solid reputation for making effective use of fiscal and monetary tools in pursuit of a stable macroeconomic environment.  Financial markets have reacted positively to policy actions of the Lula administration, as well as to strong fiscal and external performance.  The real has strengthened 20% on the year-to-date while spreads on Brazilian bonds have narrowed more than 700 basis points.  And thanks to the support by the Lula Administration of the Central Bank’s continuing efforts to meet inflation targets, general inflation is falling rapidly.  Clearly, recent good news on inflation justified yesterday’s decision by the Central Bank to cut the overnight rate by 50 basis points to 26%. 

Brazil’s export sector has outperformed even the most optimistic expectations: Exports have grown 43.5% over the past year, resulting in an $8 billion trade surplus for the first five months of 2003 and a $19 billion trade surplus over the last twelve months.  Even more compelling is the fact that these results have been achieved largely through export expansion rather than import contraction.     

The Finance Ministry’s Economic Policy and Structural Reform Agenda released earlier this year calls for primary surpluses sufficient to reduce Brazil’s debt-to-GDP ratio.  The authorities have clearly put that agenda into practice.  Brazil far exceeded first quarter fiscal targets - generating a primary surplus of nearly 6% - through March of this year.  As the Finance Ministry’s Policy and Reform Agenda highlights, reducing Brazil’s debt-to-GDP ratio will, in itself, be growth-promoting.  Other measures, such as the Government’s announced plans to reduce the share of foreign exchange-linked public debt and extend average debt maturities will enhance stability. 

Recent progress may very well represent the start of a “virtuous cycle” - one that rewards sound fiscal and monetary policies with price and exchange rate stability, which in turn, feeds back into lower debt levels.  Such stability will allow for the gradual reduction in interest rates, which in turn will fuel growth and further improve Brazil’s outlook. 

This period of rising confidence creates a window of opportunity for looking beyond short term financial concerns and focus on longer-term priorities, in particular, economic growth.  Despite the strong performance of Brazil’s export sector and favorable financial market conditions, overall economic activity remains depressed.  Real GDP growth this year is expected to reach only 1.9%, following 1.5% growth last year.  A sustained and consistent effort to establish conditions necessary for private sector investment and productivity growth will allow Brazil to achieve the sustained, high growth of which it is capable.

A key vulnerability, not just in Brazil but in emerging markets globally, has been an imbalance in sources of affordable credit.  Businesses that are able to do so actively tap external sources of financing, but domestic financial intermediation has not played the role it should in financing investment and growth.  My comments today are focused on domestic sources of credit, in particular, bank credit. 

 Bank Credit

Bank credit plays a critical role for firms, especially in countries where capital markets aren’t fully developed.  If access to bank loans is restricted, potentially profitable projects cannot be undertaken and economic activity will suffer.

While Brazilian bank assets are roughly three times that of Mexican banks, the two banking systems provide the same amount of direct lending to the private sector.  The relatively low level of lending is coupled with high intermediation spreads and high lending rates to businesses and individuals.  Intermediation spreads have declined substantially since the beginning of the Real Plan, and again since the floating of the exchange rate; however, bank credit remains prohibitively expensive for most small and medium-sized firms and even large companies.  Current spreads are 56% for loans to individuals and 24% for loans to firms; this compares roughly with intermediation spreads of 1-2% for loans to firms in the U.S.  With such high rates, firms are frequently forced to finance investment through retained earnings and/or the savings of family and friends, delaying if not eliminating larger scale or longer term projects. 

In recent years, Brazil’s Central Bank has made active efforts to lower lending rates and improve financial intermediation.  With the establishment of the new payments system in 2002, the Central Bank began publishing basic information on loan rates to improve data-sharing.  The Accounting Statements of Financial Institutions were revised to be consistent with international norms.  And the scope of the Credit Risk Data Center was widened, lowering the threshold of loan size that banks are required to report from $50,000 real to $5,000.  All of these measures work to strengthen reporting in the banking sector and enhance the sector’s stability as a result.

Nonetheless, high interest rates persist.  Both macroeconomic and microeconomic factors are clearly in play.

•  Government borrowing from banks crowds out loans to the private sector.  Balance sheet data indicate that large banks are more invested in securities - mostly government debt - than loans.  Brazil’s top 20 banks hold roughly one-quarter of their assets in public debt. 
   
• To fight inflation, reserve requirements are high.  Reserve requirements of 60% on demand deposits and 10% on time deposits reduce potential income for the banking sector, making it necessary for banks to charge higher rates on capital that is put to productive use. 
   
• Furthermore, Brazil’s history of high real interest rates - which averaged 11% in recent years - reflects an uncertain macroeconomic environment.  Persistent fears of high inflation force banks to raise interest margins a priori to offset potential erosion of capital.

 But we are not convinced that macroeconomics tells the whole story.

• High operating expenses and taxes absorb a significant portion of intermediation income.  Overhead costs at Brazilian banks have been double the average for Latin America, and triple the average for upper middle income countries.  High payroll costs stem, in part, from the need to maintain substantial collection and legal departments given cumbersome legal and judicial processes. And finally, taxes on banks have historically been more than double the Latin American and upper-middle income country average.
• Public ownership in the banking sector and directed lending may also play a role in the preservation of high intermediation spreads.  Public banks have lower returns on assets, higher non-performing loans and higher operating expenses than private banks.  This means higher average interest rates across all loans.  Directed lending is on a declining trend but remains as high as 40% of total credit. 
•  A weak bankruptcy code and inadequate judicial infrastructure also lead to higher interest rates.  Creditor rights are considered weak.  Court judgments can take as long as five years due to case backlogs and generous rights to appeal.  There is also considerable variation in court decisions across Brazil, increasing the risk to lenders.  Creditors or creditor committees have little to no role in the process of liquidation.  And once proceedings are completed, tax claims, wage arrears, and administrative expenses are paid first, leaving little for creditors.  There is no legislation which facilitates informal workout procedures to reduce the burden on the court system.
• I should add that a law designed to modernize the bankruptcy code and address many of these issues has been in discussion in the Brazilian Congress since 1993. Congress recently began debating amendments to the legislation, which is a significant step forward.  I understand an informal commission is reviewing whether the legislation can be sent to a vote in the House, which could happen in the near future.  Passage of bankruptcy legislation would represent significant progress toward increasing creditor rights and lowering intermediation spreads.
   

The significant public sector presence and weak bankruptcy law result in high credit costs and lower asset quality.  For the six months ending December 2002, allowance for bad credits was 30% of net interest revenues, and Brazil’s historical rate of write-offs is 4% to 5% of total credits, compared with 0.4% to 1.4% in developed countries.  The majority of non-performing loans are in public bank loans to industry and housing, and private bank loans to individuals.  One conclusion is that substantial directed public lending to riskier borrowers, combined with the inability to seize on those loans, is an important source of inefficiency in the banking system.

To summarize, high bank spreads clearly stem from macroeconomic factors, including crowding out.  But they also follow from a raft of microeconomic factors, including high operating expenses, the burden of inefficient public sector banks, and weak creditor rights. 

The Lula Administration is already tackling a number of these areas, and these efforts should result in increased access to affordable credit for the private sector. No single factor will have a greater impact in spurring growth than lower interest rates.  And no single factor will have a greater impact on interest rates than a stable macroeconomic environment.  A sound fiscal picture will allow for the gradual reduction of public sector debt and free-up bank resources for private sector lending.  The Lula Administration has already announced intentions to lower debt-to-GDP; continued strong fiscal performance, combined with passage of key tax and pension reforms, should make this attainable. 

Furthermore, a commitment to meet inflation targets, as has been demonstrated by the Central Bank, will eventually lead to lower inflation expectations.  Eliminating persistent fears of high inflation will result in lower lending rates.

But, in addition to this macroeconomic progress, the agenda must include steps to address microeconomic and structural problems.  Certain provisions of the pending tax legislation, if passed, would lower banks’ overhead costs by reducing their payroll burden.  Likewise, reducing the amount of directed lending and under-performing loans by public banks would free up capacity for more productive uses of bank resources at lower rates of interest.  Finally, passage of bankruptcy reform legislation will go far in boosting banks’ willingness to lend, and would help banks streamline collection and legal departments.

 Conclusion

The United States has one of the most open and, therefore, competitive banking sectors in the world.  The access to capital that it provides to the private sector and individuals alike has been a key driver of economic growth in the U.S.  Small businesses are the primary driver of economic growth in the U.S., and in most other countries.  They provide roughly three out of every four new jobs and about half of the nation’s private sector output.  Small businesses also represent 99% of all employers and employ 50% of the private work force. 

The ability of small businesses to get financing is critical to their success.  Commercial banks are the most important source of financing for small businesses, and the competitive and deep banking system in the United States ensures sufficient credit for small businesses across a wide range of sizes, industries, and locations.

We want to engage with Brazil’s authorities and with you in the private sector on these issues. We all seek the policy, legal and regulatory environments that make it possible to expand access to affordable financing to creditworthy, productive borrowers.  I am looking forward to an informed and spirited panel discussion and to ongoing engagement on these issues in the future.