Report No. 772.1BR

BrazilSelected Issues of the Financial Sector

March 26, 1990

Country Department ICountry Operations DivisionLatin America and Caribbean Regional Office

FOR OFFICIAL USE ONLY

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CURRENCY EQUIVALENTS(Annual Averages)

1982 US$1.00 - 0.18 Cruzados1983 US$1.00 - 0.58 Cruzados1984 US$1.00 = 1.85 Cruzados1985 US$1.00 M 6.20 Cruzados1986 US$1.00 - 13.66 Cruzados1987 US$1.00 - 39.23 Cruzados1988 US$1.00 - 262.00 Cruzados1989 US$1.00 = 2,838.00 Cruzados

GLOSSARY OF ACRONYMS

BANCO HERIDIONAL - Federal Commercial Bank Located in Rio Grande do SulBANCO RORAIMA - Federal Commercial Bank Located in RoraimaBB - Bank of BrazilBNCC - National Credit CooperativeBNDES - National Economic Development BankCDB - Bank Certificate of DepositCDI - Industrial Development Council (Interbank Certificate

of DepositCEE - State Savings BanksCEF - Federal Savings BanksFDPE - Export Protection FundFCVS - Fund for Compensation of Salary VariationFGTS - Private Sector Unemployment Insurance and Pension FundFINAM - Amazonia Investment FundFINEX - Export Financing FundFINOR - Northeast Development FundFINSOCIAL - Social Investment FundFISET - Fund for Sector DevelopmentFMM - Merchant Marine FundFND - National Development FundFUNA6RI - Agricultural FundIOF - Financial Operations TaxIPEA - Institute of Economic ResearchLBC - Central Bank LettersMCR18 - Rural Credit Manual Guideline 18OFND - National Development Fund BondPAPP - Agricultural Program for Small ProducersPIS/PASEP - Social Integration Program/Public Employees'

Pension FundPROAGRO - Guarantee Program for Agricultural ActivitiesPROASAL - Support Program for Producers of Sugar AlcoholPROINVEST - Agriculture Investment ProgramSEPLAN - Planning SecretarySTN - The National TreasurySUDAM - Amazonia Development SuperintendencySUDENE - Northeast Development SuperintendencyUNDHAB - Housing Development Fund

FOR OFFICMIL USE ONLY

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TITLE: BRAZIL: SELECTED ISSUES OF THE FINANCIAL SECTOR

COUNTRYs Brazil

REGION: Latin America and the Caribbean

SECTOR: Country Economic

REPORT: TYPE CLASSIFICATION MM/YY LANGUAGE7725-BR SRA Official Use 02/90 English

DATE: February 1990

ABSTRACT: This report examines selected featuires of the Brazilianfinancial system that prevent it from attaining its role inthe efficient allocation of financial resources. Thefeatures examined are market structure and concentration inthe banking sector, directed and subsidized credit programs,inflation tax, required reserves, barriers to entry and exitfrom the banking sector, and prudential regulation. Inaddition, annexes contain a macroeconomic overview of theperiod covered in this report, a survey of the major typesof directed and subsidized credit programs, and analyses ofthe interaction between money supply and federal bonds.

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

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TABLE OF CONTENTS

PLe

Esecutive Summary......... ......... .. ..... ..1

Conclusion ........................................... .64 4 .0............7

Chapter Is Market Structure and Concentration in the BrazilianBanking Sector ... ..... .#. . . . . . . .10

A. Institutional Overview ........ . ....... ................ . 10B. Concentration of Banking Activities ....................... lS

Chapter 2: Directed and Subsidized Credit Programs ....................... 24

A. The Nature of Directed and SubsidizedCredit Programs ...... ................................. . 24

B. The Size of Directed & Subsidized Credit Programs ......... 25C. Economic Effects of Directed and Subsidized Credit ........ 27D. Recommendations ................... , . .... 29

Chapter 3t Inflation Tax and the Banking System ..................... 31

A. Introduction .... .......................................... 31B * The Inflation Tax and Inflationary Transfers to

the Banking Sector ............. .. ......... 33C. Conclusion............. #.. . .. .44

Chapter 4s Required Reserves .............................................45

A. Introduction ........................ 4SB. The Rationale for Reserve Requirements ....................45C. Brazil vs. Chile........ 47D. Summary and Conclusions .............. ... .... . 48

Chapter 5t Entry and Exit .......................... O

A. Entry Into the Market.. .... 50B. Exit from the Market ............ . .... .. .... 55

Chapter 6: Prudential Regulation. 57

A. Banking Supervision ........... . .......... 57B. Loan Diversification............. 57

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Annexes

1: Functions of an Efficient FinancialSystem and Macroeconomic Overview ........................... 62

A. Microeconomic Role of the Financial System ............... 62B. Macroeconomic Role of the Financial System ............... 64C. Other Macroeconomic Concerns ............................. 65D. Macroeconomic Overview 1980-88 ......................... 66E. Overview of Some Financial Variables ..................... 69

2: Money Supply and Federal Bonds . ............................... 78

3s Major Types of Directed and Subsidized Credit Programs . .84

A. Defining Directed Credit ................................. 84B. Description of the Major Programs . . 86C. The Programs: Detailed Analysis . . 89D. Funds and Programs Administered by the

National Treasury .... 94E. Directed Credit Programs Applied to Commercial

Banks .................................................. 99F. Directed Credit Programs Applicable to Savings

Banks .............. 102G. Directed Credit Programs Funded by the Central Bank ..... 104H. Directed Credit Programs for Non-banking

Financial Intermediarief . ....... ....... 106

4: Quantification of Implicit Subsidies of DirectedCredit and Their Economic Effects ............................ 108

A. The Size and Composition of Directed CreditPrograms ........................... 108

B. Measuring Implicit Subsidies .......................... .. 110C. Quantifying Implicit Subsidies . ................ 114D. Economic Effects of Directed Credit . . .15.................. l

Appendices

I. Market Structure and Concentration . ............... 122II. The Inflation Tax .......... . .................... 125III. Reserve Requirements ....................... 131IV. Indexation of Financial Instruments . . .143V. Date Series and Bibliography . .............. 147

PREFACE

This report is the product of eFonomic sector work initiated bythe Trade Finance and Industry Division of the Brazil Department in June1988. The authors are Valeriano Garcia (task manager), Thomas Glaessner,Mauricio Larrain, Daniel Artana, Roberto Mosse and Samuel Talley. ChristoeKostopoulos and Tracy Mincey provided efficient research assistantship.Lauren Stanley and, in second stage, Robin Gaster edited the report.Carmen Lazcano provided very competent secretarial support.

The report consists of six chapters followed by four supportingannexes and five supporting appendices. These are the following: Chapter1, Market Structure and Concentration (Daniel Artana); Chapter 2, InflationTax (Valeriano Garcia and Christos Kostopoulos); Chboter 4, ReserveRequirements (Valeriano Garcia); Chapter 5, Entry and Exit (Daniel Artana);Chapter 6, Prudential Regulations (Mauricio Larrain and Samuel Talley);Annex 1: Functions of an Efficient Financial System and MacroeconomicOverview (Valeriano Garcia); Annex 2: Money Supply and Federal Bonds(Valeriano Garcia); Annex 3: Major Types of Directed and Subsidized Credit(Thomas Glaessner): Annex 4: Quantification of Implicit Subsidies (ThomasGlaessner). The appendices ares Appendix I, Market Structure andConcentration; Appendix II, Inflation Tax; Appendix III, ReserveRequirements; Appendix IV, Indexation of Financial Assets (Roberto Mosse)and finally Appendix V, Data Services and Bibliography.

The authors are grateful to many officials of the Central Bank ofBrazil and other Brazilian authorities that openly provided all the data.

Sx8cU WJE SUMIARY

SUO4ARY AND CONCLUSIONS

1. Some of the most striking characteristics of the Braz4lian bankingsystem in the 1980's were the following areass

(a) Reserve Recuire6nts. There wass (i) an extraordinarilylarge number of effective average requirements on demanddeposits, (by 1989 each individual bank had a differenteffective rate due to the imposition of marginal reserverequirements duriAg the *summer plan'); (ii) a largevariation in the legal reserve ratios for demand deposits,ranging from a low of 8Z to a high near 50Z; (iii) a largegap between average reserve requirements on demand depositsand those required for savings and time deposits.

(b) Interest Rates. There were myriad controlled interest rates.On the liabilities side of the banks' portfolio, interestrates were forbidden on demand deposits and fixed in realterms for saving deposits. On the asset side, a large shareof the loans vat controlled.

(c) Directed Credit. Coupled with interest rate controls, alarge share of the financial sector credit was directed togovernment priotities through the extensive network of stateand federal baaks. This process of intense governmentcontrol and regulation, combined with macroeconomicinstability, chanmeled an increasing share of total credit tothe public sector.

(d) Prudential Regulatioas. There lacked an adequate system ofloan portfolio classification and loss provision according torisk of default. Regulations of loan portfoliodiversification and information disclosure were inadequate.

(e) Barriers to entry. Prom 1985 to 1988 the number of banks inBrazil was frozern'. A new bank could enter the business,or expand branches, only if it bought a licence from another:ank releasing its share of the market. Licences had animportant market value and were actively traded.

(f) State Banks. During this period many state banks becameinsolvent and were bailed out by federal authorities withimportant effects on monetary aggregates and resourceallocation.

(g) Housing Finance Slstem. The Housing Finance System has beenextremely regulgted and those regulations have caused itspotential insolvency.

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2. The background of Brazil's high and increasing rate of inflationhas to be considered when analyzing its financial system. Under conditionsof uncertainty generated by high and variable inflation rates the termstructure of loans is reduced, real interest rates are high, banks receivetransfers due to inflation expanding their rent seeking activities, and theinvestors' portfolio is frequently switched causing financial instability.

3. By the end of 1987, the Brazilian authorities were willing tobegin their financial sector reform in areas (a) to (e), discussed above.The other areas, Housing Finance System and state banks, will be addressedin future financial sector reports.

4. Both the Housing Finance System and the state banks are in need ofreform. Resources for the Housing Finance System come mainly from savingsaccounts and compulsory private sector unemployment insurance funds. Thegovernment fixes interest rates on both assets and liabilities. In severalinstances, regulations required that indexation of the system's liabilitiesbe different than the indexation of its assets. This and other largeconcessions to borrowers will result in a large deficit for the system.

5. Most of the state banks are in serious financial difficulty. Theyhave financed their State treasuries beyond their means. In the process,the state banks raised overdrafts on their legal reserves, obtained accessto large rediscounts, and sold certificates of deposit at rates well abovethose offered by private banks. The result is that many state banks havenegative equity.

6. Chapter one discusses market concentration and the legal frameworkthat has esgmented the Brazilian financial system. Financialintermed'aries were restricted as to the type of deposits they could acceptand the loans they could make, while entry into the system was extremelydifficult. Such institutional segmentation led to the emergence offinancial conglomerates; while this type of segmentation has recently beeneliminated with the passage of the multiple service banking law, and entryinkto the market has been eased through the abolition of licensingrequirements ("cartas patentesn), important market segmentation due todirected credit, priced por..folio allocation and interest rate controlsstill remains.

7. Figures related to market concentration are the following: whenthe Bank of Brazil is included, the four largest banks own 59? of totalassets. The four largest private banks own 33Z of the total assets held bythe system excluding those of the Bank of Brazil. This concentration hasbeen increasing: in 1965, the 20 largest commercial banks (excluding theBank of Brazil) owned 51? of total assets; by 1987 they owned 84Z.

8. As far as competition is concerned, barriers to entry and exit arethe crucial issues, rather than the number of firms. The current highlevel of concentration seems to have resulted not from market forces butfrom government regulations. If these regulations are eliminated, thereare no grounds to fear oligopolistic behavior.

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9. The gross inflation tax may also help to explain the concentrationof the Brazilian financial system. If Brazilians had concentrated theirdemand deposits in those banks considered 'safe" and with a large branchIngnetwork, the inflation-induced transfers to the banking system would havebeen distributed unevenly and mostly to large banking conglomerates, makingthem more profitable than the small independent banks. This could alsoexplain the Brazilian policy of imposing higher reserve ratios on largerbanks; however, while such a policy may have reduced the transfers, alsoincreased the variability of the money multipMier.

10. Chapter two discusses directed and subsidized credit and interestrate policy. It describes the sources of funds that directed and the typesof intermediaries or other institutions that collected, administered, andapplied these funds; the types of restrictions applied to the allocation ofthese funds; the definition and measurement of directed and subsidizedcredit programs, and their quantitative importance; and, finally, thegeneral economic effects of directed and subsidized credit programr.

11. Regulations or laws often result in price and quantityrestrictions on both the liability and asset sides of the balance sheets offinancial intermediaries. In Brazil, these restrictions vary according tothe sector, region, and city to which resources are applied or, in somecases, according to the source of the capital. Also, restrictions applyaccording to the type of borrower and the size of the lending institutionadministering the resources.

12. In 1986-87, the major directed credit programs were 802 of theaverage outstanding balance of public and private sector credit. Excludingcredit extended for housing, 57Z of the average stock of credit wasdirected.

13. The implicit subsidy realized by some of the largest directedcredit programs, including the Housing Finance System, amounted to morethan Cz$1 trillion in 1987, equivalent to 802 of Treasury revenue and about72 to 82 of GDP. This subsidy was at its peak due to the high amount ofcredit outstanding as a consequence of the Cruzado Plan. We estimate thatthe subsidy had halved by 1989.

14. Inflation and the inflation tax are discussed in Chapter three andAppendix II. Inflation has deleterious effects in any financial system.This is especially true for Brazil because its financial system hasfeatures amplifying the effects of inflation. These features include theimplicit prohibition of interest payments on demand deposits,1 the myriadsubsidized interest rates and directed credit flows, and the widelydiffering reserve requirements on different types of deposits.

1/ By January 1989 this prohibition has been lifted.

1S. The non-banking public pays the inflation tax on H12 by expandingits nominal balance in order to keep them at a given real target. Part ofthis taz is cashed in by the Federal Government and part is a transfer tothe banking system which expands to compete for those rents. The parttransferred to the 4inancial sector has been an important source ofdistortions within the banking sector and between banking and othereconomic sectors.

16. Variable rates of inflation cause variable inflation tax receipts,because the short-run elasticity of base money and demand deposits relativeto inflation is less than unitary. As the experience of the Cruzado Planhas shown, a substantial fall in the inflation rate seems to be associatedwith a less-than-proportionate increase in real demand deposits. Thus, fora given structure of required reserve ratios, a fall in the inflation ratereduces inflation-induced transfers to the banks, while a rise ininflation increases them. Also, if price changes are unexpected, the taxproceeds will still be more variable as the tax base responds with a lag tothe tax rate change.

17. The inflation tax has led to an important gross transfer of re-sources to the banking system (from the private sector and from the Govern-ment, since the Government also holds demand deposits). The 1985-87 annualaverage transfer is estimated at US$7.5 billion, with a minimum of US$5.3billion in 1986 and a maximum of US$11.2 billion in 1987. In addition, itshould be stressed that the transfer's variability is as important as itslevel. The minimum quarterly transfer received by private commercial bankswas US$34.8 million in the second quarter of 1986, and the maximum wasUS$3,863 million in the first quarter of 1987. Payment of interest ondemand deposits become common practice since then and was authorized by theCentral Bank in 1989.

18. The impact of inflation on the banking sector is striking. Forexample, during the first phase of the Cruzado Plan, interest rate spreadsof large private banks, net of reserve requirements costs, fell dramati-cally to the 32 to 42 range. With the inflationary upsurge in the firstand second quarters of 1987, the inflation adjusted spreads increased to12.91 and 202 during the first and second quarter of 1987 respectively.

19. Banks, during the period in which they were not allowed to payinterest on demand deposits, engaged in non-price competition -- which ismuch less elastic than interest rates with respect to sudden changes indemand. Nevertheless, private banks reacted swiftly to the lowerprofitability of demand deposits during the low inflation phase of the

21 The inflation tax is paid only on the real monetary base. We includein this discussion demand deposits because inflation related transfersto the banks are closely associated with the real quantity of non-interest bearing demand deposits.

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Cruzado Plan, closing many branches and thus avoiding major losses. Asgovernment banks actually expanded their branch networks during the CruzadoPlan, they all had large losses in at least one quarter of 1986. Asinflation rebounded, their policy of opening more branches may not havebeen entirely bad in the medium term.

20. Chapter four discusses issues related to the instability of finan-cial flows caused by the Government's policy of maintaining multiple re-serve requirements. The primary problem with such an approach is that itleads to radical changes in the money supply. The methodology of the chap-ter is based on the traditional monetary base cum multiplier model, and theconclusions reached are consistent with the hypothesis that, for the periodunder analysis, the large variability of the money multipliers have ac-counted for substantial changes in the growth rate of the money supply.This variability was caused by endogenous switches in the public's desiredrelative portfolio composition. 'hile the average rate of growth in themoney stock has been mainly determined by fiscal deficits, private sectorrediscounts and external accounts, the large variability around that growthrate seems to be mainly endogenous and multiplier-induced.

21. The hypothesis that the multiple reserve requirements policy hascaused instability in the supply of money through portfolio compositionwsitches is tested in Chapter four. Strong evidence emerges in support ofthe argument. For example, during 1983-9?, the ratio of savings depositsto total deposits explains 52Z of the variability of the rate of change inM4,3 and the ratio of total term deposits to total deposits explains 64Zof the same variable. The same tests were carried out for Chile, a countrywith minimal reserve requirement differentials, and the results areopposite to those for Brazil. As expected, portfolio switches in Chilehave had little effect on money supply.

22. The traditional reasons for reserve requirements are reviewed inChapter four. Manipulation of reserve requirements is usually justified byclaims that such actions (i) make the system *safer' by making it more'liquid"; (ii) sterilize undesired changes in money supply; (iii) helpsmall banks vis-&-vis large conglomerates; (iv) increase the flow of creditto underdeveloped regions; and (v) obtain cheaper financing of publicsector deficits. Under closer examination, we will find that there areother, more efficient, instruments available for achieving those goals.

23. Money multipliers in general, and reserve requirements in par-ticular, also affect the profitability of the banking sector and influenceinterest rate spreads. These effects made the variability of reserve re-quirements both a monetary problem and a source of instability in theBrazilian banking industry.

/M4 is defined as demand deposits (excluding the government) plus savingdeposits, plus time deposits plus federal bonds outstanding.

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24. Chapter five discusses barriers to entry and exit. The highbarriers to entry and government regulations were more likely to protectbankers' profits than social welfare. The recent elimination of "cartaspatentes' liberalizing entry to the banking system is a welcome move.Nevertheless, there are still important restrictions on branching, such asminimum demand deposit requirements per branch wvhich should be eliminated.If this restriction is maintained it may become an important barrier tocompetition.

25. Market exits in the form of bankruptcies or liquidation have beenrare in the Brazilian financial sector. If entry is to be made more flex-ible, adequate mechanisms have to be put in place to facilitate exit, mini-mizing its negative side effects. One alternative is to establish apartial deposit insurance fund that would either pay off small depositorsin case of liquidation or, if less costly, support restructuring. There isalready pending legislation in Brazil addressing this issue.

26. Bankruptcy protection procedures -- the so-called "concordata" --need to be streamlined to recognize the effect of inflation on liabilities.The procedures in place freeze the non-collateral liabilities of a companyfiling for bankruptcy protection in nominal terms, thus providing an easyway to reduce indebtedness at the expense of financial intermediaries.This weakens payment discipline and, depending on the size of a company'sdebt, may affect the solvency of the creditor institution. In addition itpromotes only the type of lending that can be secured by good collateral indetriment to rates of return guidelines to allocate credit.

27. Tariffs and fees established by the Central Bank are in most casesnegligible, causing uneconomic increase in the demand for certain bankingservices. This increases operating costs which in the end are passed on toborrowers in the form of higher lending interest rates. Tariffs and feeson banking services thus have to be deregulated, especially if banks areauthorized to pay interest on their current accounts.

28. Chapter six discusses prudential regulations. Although bankingsupervision has improved in the last two years, there are still importantshortcomings. Improvements have 'come from an increasing focus on theanalysis of the overall solvency condition of intermediaries. The majorshortcomings in banking supervision are: (i) lack of a good system of loanportfolio classification according to risk of default; (ii) absence of anadequate system of provisions for possible loan losses; (iii) the practiceof recording as income the interest accrued on doubtful loans; (ivinadequate regulation of loan portfolio diversification and capitaladequacy; and (v) poor information disclosure by the Central Bank offinancial intermediaries' balance sheets and income statements. Inaddition, troubled state banks simply ignore most Central Bank regulations.

29. The sequencing of reforms is important. For instance, improve-ments in market entry have to be preceded by strengthening of supervisionand prudential regulations. Reforms to facilitate entry and payment of in-terest on demand deposits will reduce banks' profitability by increasingcompetition, which will, in turn, increase pressure on the banks, espe-cially those already experiencing loan portfolio problems. Most of thesereforms are being carried out with little noise or disruption.

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Conclusion

30. This report examines some of the features of the Brazilian bankingsystem that prevent it from achieving its potential as an efficient toolfor economic development. It discusses important reforms that would pro-tect t.t system from macroeconomic shocks, and help to create the basis fora miore independent monetary policy. En addition, the reforms suggestedbelow would channel savings toward sectors of higher social productivity,avoiding regressive income redistributions, stabilizing and deepeningriaancial intermediation, and reducing real rates of interest.

31. The an.alses in Chapters One, Five, and Appendix I, lead us toconcluee that the Brazilian banking system has contestable features, andthat market forces will be able to discipline any non-competitive behaviorin a liberalized environment.

32. Supervision of financial intermediaries does need to be improvedL-d focused on credit risk analysis and assessment of the intermediaries'overall solvency. That would put the Central Bank in a better position totake timely actions to stop unsound financial practices, or, if necessary,to force insolvent institutions to leave the market at an early stage ofinsolvency--thus reducing potential losses for both depositors and theCentral Bank.

33. Better supervision would also allow the Central Bank to improvethe quality of the information provided to savers. Specific areas forimprovement include: the loan portfolio classification system; the pro-visioning system to cover potential loan losses; interest accrual on doubt-ful loans; regulations on loan portfolio diversification and capital ade-quacy; information disclosure; and supervision of state banks.

34. Directed and subsidized credit, from any source, impedes theoperations of capital markets and the efficient resource allocation. If itwere allocated as intended, these resources would not be applied toprojects with the highest social rate of return. As money is fungible, ashare of the fu- is would probably not be channeled to those sectorstargeted by the Government. The fact that there is an income transfer dueto the subsidy element, directed credit may have implications regarding thepattern of the consumption-investment choice. Also directed creditincreases the cost of intermediation as reflected in interest rates of thenon-regulated segment.

35. The policy of directing and subsidizing credit has segmented themarket, allowing arbitrate operations to absorb large quantities of highquality human capital. These hidden subsidies have also amounted to asignificant part of the Brazilian budgets, contributing to inflation andmacroeconomic instability. The income distribution curve has been furtherskewed, both because inflation is a regressive tax and because some of thecompulsory savings funds have fallen on real wages. Furthermore, adminis-tered interest rates may have distorted the relative price of capital vis-a-vis labor, favoring capital-intensive projects despite regionalunemployment.

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36. The Central Bank should also explicitly allow banks to pay compe-titive interest rates on demand deposits. This recommendation has alreadybeen implemented through a Central Bank circular. It is designed toachieve important goalss first, to reduce the variability in thecomposition of the public's financial portfolio; and second, to decreasesubstantially the inflation related transfers to the banking system thusreducing the incentive to 'excessive' branch expansion.

37. Interest rates should be liberalized because they will then mirrorexpected inflation rates. Once liberalized, high and variable rates ofinflation will cause small changes in relative ex-ante real rates acrossdifferent financial instruments. If portfolio holders respond mainly toexpected changes in real returns, they will devote fewer resources decidingon switches in portfolio composition; transaction costs will thus bereduced, releasing resources for more productive endeavors. Also, the lessvariable the portfolio composition, the more stable the money multipliersand other monetary and credit magnitudes. In short, Brazil's previousprohibition of payment of interest on demand deposits and otherinterferences in market interest rates raised transaction costs and were asource of financial and monetary instability. The interest rateliberalization on demand deposits will become operative as reserverequirements are lowered. Meanwhile these paymentr, are made throughspecial arrangements with government bonds.

38. Liberalization of interest rates on demand deposits should helpeliminate the share of the inflation tax appropriated by the bankingsystem, this appropriation has a number of undesirable features: it isnon-transparent: it is large and quite variable; it implied non-desiredincome redistributions; it was not evenly distributed among banks; itproduces interest groups which may wish continuation of inflationarypolicies; and it misallocates resources as rent-seeking banks expandedbranch networks.

39. This report defends and recommends: (a) equalization of reserverequirements on all types of deposits; (b) phasing out forced savingsschemes and their especial' c._erest rates, thus reducing interest ratedisparities which are not associated with risk or term structure; (c)ending mandatory allocation of commercial banks' portfolios, leaving thebanks' free to choose their own portfolio mix; (d) upgrading prudentialregulations to cope successfully with the challenge of deregulatedfinancial markets; (e) facilitating exit with a partial deposit insurancescheme.

40. The reduction of reserve requirements on demand deposits should begradual, so as to avoid inflationary pressures. Our estimates show that,ceteris paribus, a one percentage point reduction of the average legalreserve ratio on demand deposits would increase money supply (M4) by

roughly 1.52. This would not threaten any stabilization effort, as itsexpansionary effect could easily be offset by increasing the legal reserveratios on time deposits or savings deposits--both zero by the end of 1989.A one percentage point increase in the legal ratio on time deposits wouldreduce money supply (M4) by 2.12 and a one percentage point increase thelegal ratio on savings deposits would reduce money supply (M4) by 7.70Z.4

41. Simulation models carried out in supporting background papers(Carvalho, et. al.) suggest that a uniform reserve requirement of 62 to 72for demand, savings and time deposits would be consistent with the averagemultipliers realized in 1987, for M3 and M4. Naturally, the reduction indemand deposit-reserve ratios will not be a windfall gain to banks becausebanks would now be paying interest on demand deposits.

42. The Central Bank has already implemented some of these recommenda-tions, namely elimination of the 'cartas patentes" system, permitting banksto pay interest on demand deposits, and introducing the multiple servicebanks as a means of eiiminating institutional segmentation, and we expectthat the remaining recommendations of this report be received in afavorable manner.

43. Certainly, the Brazilian financed system would still face otherimportant problems. The housing finance system, state banks, and capitalmarkets are currently being studied, and will be the subject of futurereports.

41 These calculations are done with end of period January 1989 data. Fordetails on methodology, see Appendix III.

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CHAPTER 1

MARKET STRUCTURE AND CONCENTRATION IN THE BRAZILIAN BANKING SECTOR

1.1 The goal of this chapter is to measure the degree of concentrationof the Brazilian banking system, and to discuss whether high concentrationimplies higher market power and lower economic performance. The degree ofconcentration of banking activities is appraised using indexes that calcu-late market shares. However, before that, a brief overview of Brazil'sfinancial institutions seems useful.

A. Ins itutional Overview

1.2 Brazilian financial institutions are developed and diversified,and the financial system consists of several sectors: commercial banking,development banking, housing finance, credit cooperatives, securities ex-changes, insurance, and commodities and futures. The financial system'smost important component is clearly the banking sector, which is mixed,with large federal financial institutions, which provide the bulk of in-vestment finance and agricultural credit operating alongside federal, re-gional, state commercial, and state development banks along with a moreflexible (and profitable) private financial system. Table 1 gives asummary description of the financial system.

1.3 The structure held until 1988, dates from 1964, when several lawsleading to institutional segmentation were passed. Separate financialinstitutions were created to provide for the financial needs of each sectorof the economy, and differentiation mechanisms were introduced to ensurethat each received an adequate flow of funds.

1.4 Even though several types of institutions were created, manyestablished themselves into privately owned conglomerates centered aroundcommercial banks. These conglomerates provided all the main financialservices through companies which were separate in legal and accountingterms, but which had strong operational ties -- often sharing staff, sup-port services, and headquarters. This institutional segmentation waseliminated by the end of 1988 with the 'multiple service banking resolu-tion" which also eliminated the licences that regulated entry.

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Table 1

FINANCIAL SECTOR INTERMEDIaRIES(As of June 1987)

Type of institution Number Branches Deposits Loans(2 type of (2 totalinstitution) fin. sector)

BANKING SECTOR (Demand)1. Commercial Banks 103 14415 100 47

. Bank of Brazil 1 2284 18 13

. Public federal 4 598 3 2

. Public state 24 2628 23 13

. Private national 56 8830 55 16

. Private foreign 18 77 1 3

2. Investment Banks 41 142 8

3. Consumer Finance C -inanies 112 488 7

VELOPM T BANKING4. Development Banks 15 58 17

• Public federala 2 41 10• Public regional/state 13 17 7

HOUSING FINANCE (Savings)5. Savings Banks 59 2437 100 18

. Public federalb 1 75 14

. Public state 4 25 4

6. Savings and Loan Companies 79 606 3

7. Savinas and Loan Cooperatives 12

COOPERATIVES8. Credit Cooperative 586

TOTAL 953 14415 100

a/ Includes BNDESbI Caixa Economica Federal.

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1.5 The financial intermediary institutions can be divided into sevensectors. A brief description of each is provided belowt

1) Banking Sector

a). Commercial banks. Until recently Brazil had three types ofdomestic and foreign commercial bankss large conglomerateswith national networks; mid-sized regional banks; and localbanks. Commercial banks provided traditional banking serv-ices, mainly short-term lending, and also operated in theforeign exchange market, when licensed by the Central Bank.They were active in *Ahe short-term securities markets butwere not allowed to operate in the savings and loan busi-ness or to engage in stock exchange transactions.

b) Investment banks. These mostly privately owned domesticand foreign banks primarily engaged in banking with largecompanies, and also acted as intermediaries for BNDES.They were allowed to perform an array of stock exchangetransactions, also offered leasing services. Investmentbanks provided the same services as commercial banks, ex-cept that they did not accept deposits with maturities ofless than 60 days.

c) Consumer finance comanies concentrated on personal lendingfor the purchase of durable goods or for general purposes,with funds from the sale of acceptance bills. These com-panies were not allowed to undertake foreign borrowings.

d) Leasing comanies provided medium- and long-term credit forthe purchase of fixed assets. With limited access to localfunds, they were basically financed through foreigncurrencies.

2) Development banking

Brazil has regional federal and state owned developmentbanks which act primarily as intermediaries of BNDES forlong-term investments in both public and private enter-prises. Development banks take capital participation incompanies, both directly and through their ownsubsidiaries.

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3) Housing finance

a) Savinas banks. All savings banks are owned either by thefederal or state governments. They lend for private re-sidential property, and finance government urban develop-ment programs. They provide some of the same servicesfound in commercial banks such as accepting demand depositsand offering short-term lending. The Brazilian savings andloan system is in serious difficulty as a result of infla-tion and indexation arrangements.

b) Housing finance comDanies raise funds through deposits andlend to both individuals and real state companies. How-ever, they can only perform these operations in the regionsfor which they have been licenced.

c) Savings and loan companies are privately owned co=paniesspecializing in housing credit. They finance both indivi-duals and construction companies with funds from passbooksavings accounts and the proceeds of mortgage bills. Theycannot accept demand deposits and are restricted to savingsaccounts.

d) Savings and loan cooveratives. Similar to savings ard loancompanies, except that they can only lend to their members.

4) Credit Cooperatives

Cooperatives provide credit and related services to theirmembers with funds from capital contributions and otherborrowing from private and public sources.

5) Securities Exchanges

a) Stock exchanges. The first Brazilian stock exchange wasestablished in Rio de Janeiro in 1845 (BVRJ). Later, in1890, the stock exchange of Sao Paulo (BOVESPA) wascreated. Since then, financial services have concentratedin those two cities. There are secondary stock exchangesin other state capitals, but they only carry 3Z of totaltransactions.

The importance of stock exchanges was raised in the latesixties by the introduction of special governmentincentives. Law No.4728 (1965) laid the institutionalfoundations for regulating capital markets in Brazil. Itmade the registration of securities mandatory, createdsecurities firms and brokerage houses, defined functions ofthe stock exchange, and most importantly, created tax

- 14 _

incentives for companies to open their capital, In 1976,the 'Comissao de Valores Moviliarioso (CVM) was created bythe National Monetary Council to further regulate thismarket in a fashion which, in theory, is similar to theSecurities and Exchange Commission in the United Strates.

b) Brokerage firms own stock exchange seats, intermediateforeign exchange transactions, buy and sell securities forthemselves and other parties, and manage mutual funds.

c) Securities dealers perform most of the transactions ofbrokers, but they can not act on the stock exchangethemselves.

6) Insurance

Licensed insurance companies, if not independent institu-tions, are controlled either by financial conglomerates,Brazilian companies, or state governments. With the excep-tion of reinsurance, they can undertake all types ofbusiness.

7) Commodities and futures ExchanRes There are three exchangeswhich undertake dealings in commodities and futures. Almostall of the trade, however, is in futures. Two of these ex-changes are linked to the major stock exchanges, and the otheris independent. They all are self-regulating and responsiblefor their own membership admission procedures.

1.6 Parallel to these financial institutions is the structure of offi-cial regulation and control. The National Monetary Council (CMN), estab-lished in 1964, creates and regulates monetary and credit policies, and isresponsible for the control and development of the financial system. Seveninstitutions implement the CMN's policies. The CMN may bypass the chainand exercise direct authority.

1.7 The relative importance of the main fini.acial intermediaries isshown, through various measures, in Table 1. Besides those institutionslisted in Table 1, there are also; 434 dealer firms, 277 brokerage firms,56 registered representatives, 9 institutional investors, 9 stock ex-changes, and 3 commodity and futures exchanges.

1.8 The major institutions deserve a slightly closer look. First,there is the Central Bank, which is the main regulatory agent and executesmost of the CMN's macroeconomic policies. Besides its normal central bank-ing activities, it also regulates changes within the banking system, actsas the Federal Government's agent in borrowings, and regulates privatesector housing finance institutions. The Security Exchange Commission(CVM) regulates Brazil's stock exchanges, and issues accounting and report-

- 15 -

ing rules. The National Private Insurance Council (IRBISUSEP) supervisesreinsurance, and insurers rarely place more than is required with the IRB.The SUSEP supervises private sector insurance. The Bank of Brazil (BB) isthe largest commercial bank, dominating agricultural financing from federalearmarked funds, its own deposits, and federal budget allocations. The 3Bdiffers from other commercial banks in that it alone accepts deposits fromother banks and performs clearing house activities, issues import and ex-port licences, and provides export financing. The National Economic andSocial Development Bank (BNDES) finances most of Brazil's long term capitalspending, generally at subsidized interest rates, from government earmarkedfunds, budget allocations, and domestic and foreign borrowings. It ac-counts for roughly half of total development loans outstanding. TheFederal Savings and Loan Bank (CEF) is Brazil's largest savings bank, andfinances, at preferential rates, most new and existing housing. TheNational Bank of Cooperative Credit (BNCC) extends subsidized credit toagricultural cooperatives. Only a small part of its activities are relatedto the financial sector.

B. Concentration of Banking Activities

1.9 There is a strong feeling in Brazil that its financial systemshould not be liberalized because the market is highly concentrated andliberalization will be followed by oligopolistic behavior. The literatureon banking activities has analyzed the effects of concentration on theperformance of the banking industry. As in other fields of the industrialorganization literature, different authors have been interested in theeffects of market structure on industry behavior. Does concentration meanmore "market power"? Does it mean poorer performance? The answer has beenno, in both cases. Several arguments show that concentrated industries donot necessarily perform more poorly. The contestable-market literatureshows that a single firm could service an entire market and still be heldto normal profit levels as long as there were firms outside the marketready to enter if economic rents were positive. That in turn requires theexistence of low barriers to entry (and exit), which is precisely whatderegulation means.

1.10 Several tests have been conducted for the US economy in the1950's.4 They found a positive correlation between more concentratedindustries and profits, apparently corroborating the oligopoly hypotheses.However, Demsetz (1973) proved that concentration is in fact a proxy forsize. He argued that if a concentrated industry earning higher than aver-age profits was in fact protected by barriers to entry,5 all firms in the

4/ See Bain (1951).

5/ Note that these barriers must be self imposed by the incumbent firms.If barriers are imposed by the Government the best way to get rid ofthe monopoly rents is not to intervene in the market, but to changegovernment policy.

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industry, large and small, should be earning rents. If only large firmsearn higher than normal profits, the best explanation is not that a con-centrated industry leads to a poorer performance, but that large firms aremore efficient. In fact, Demsetz provides some evidence to support hisview.6 Moreover, Brozen (1970) has shown that higher than normal profitstend to disappear in the long run, which means that there are market forces'regulating the industry.

1.11 There have been several tests of the market-concentration hypo-thesis for the banking industry.7 These studies correlated dieferent meas-ures of concentration (in general the concentration of deposits) with meas-ures of bank performance (profits, interest rates on loans, interest rateon deposits). According to Gilbert (1984), approximately half of thestudies found a positive correlation between concentration in the bankingindustry and poorer performance, but in thess cases the impact of an in-crease in concentration on performance was not very important. Moreover,the few studies that tested Demsetz's hypothesis found that it helped toexplain higher proffts in more concentrated banking areas.

1.12 Other studies have analyzed the cost curves of the financial sys-tem. trying to detect possible economies of scale. If economies of scalewere relevant for banking activities, an unregulated market would be in-consistent with competitive prices. Empirical studies for the US show thatthe average cost curve is U shaped (although the diseconomy is not veryimportant).8

The Brazilian Case

1.13 Several authors have measured the concentration of the Braziliancommercial banking system, but none attempted to test the market concentra-tion hypotheses, or to extend the analysis to other financial intermedia-ries.9 Clearly, a great deal of information would be necessary to makesuch an analysis.

6/ See however, the discussion between Demsetz and Weiss (1974).

7/ When the study is made for several industries, concentration iscorrelated with profits in each industry. For a single industry, likebanking, the hypothesis is tested correlating concentration and ameasure of bank performance in different markets (generally localareas). This raises the problem of defining the relevant market andthe relevant measure of performance, because there is competition fromnon-banking services and there are banking activities which have anational market. See Schmidt (1984).

8/ See Gilbert (1984).

91 See for example Portocarrero de Castro (1981), Carvalheiro (1982) andda Silva Marques (1982). These studies also summarize previous work onthe subject.

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1.14 First, the author would have to determine the relevant market forfinancial activities (local, regional, or national). For deposits, it isvery likely that a local measure would be necessary since the possibilityof investing their funds in other areas is remote for small depositors (andprobably also for some large depositors). However, a local measure wouldlikely be not necessary for loans, since firms usually have connectionswith large financial centers, and are thus able to compare the interestrates charged by different institution.

1.15 In any event, such regional information is not readily availablein Brazil; the information that does exist but is not very reliable becausebanks tend to add their operations from different areas together. Second,the relevant financial unit would have to be determined. Most studies dealwith commercial banks and do not take into account the existence of finan-cial conglomerates that own commercial and investment banks and other fi-nancial institutions. These conglomerates avoid legal restrictions ondeposit and loan segmentation, and, in essence, give a complete servlce totheir customers. However, regional information on the consolidated figuresof conglomerates is practically-non-existent.

1.16 Given the limited data, the empirical analysis of this sectionwill be organlzed as follows. First, different measures of concentrationcalculated by other authors will be updated. These calculations serve onlyto describe how financial concentration has evolved in receut Brazilianhistory; they have no pollcy relevance because they are not related to anymeasure of bank performance. Second, the analysis will be extended tofinancial conglomerates. Finally, balance sheet data will be evaluated toobtain some economic conclusions about the behavior of the Brazilian finan-cial system.

Measures of concentration

1.17 There are several measures of concentration. As the purpose hereis to illustrate changes in concentration over recent years, the calcula-tions below have been made for indexes already calculated for previousyears in other studies.

1.18 Table 2 provides two simple measures of concentration, showingchanges from 1965 to 1987 in the shares of total assets, total deposits-and equity held by the four largest and twenty largest coamercial banks(excluding the Bank of Brazil). Table 3 shows data from 1987, includingthe Bank of Brazil.

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Table 2

Market Share of the Largest Commercial Banks(Percentages)

Year 1965 1975 1980 1987

Total assets

- 4 largest 17 41 n.a. 33- 20 largest 51 89 n.a. 90

Total deposits

- 4 largest 15 29 30 35

Equity

4 largest 11 22 27 41

_/ Excludes Bank of Brazil.

Sourcess For 1965 to 1980 Portocarrero de Castro (1981) and da SilvaMarques (1982). For 1987, Central Bank of Brazil, the GazetaMercantil Review, and the Austin-Asis Report.

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Table 3

Market Share of the Largest Commercial Banks in 1987(Average of the year in percentages)

Total Assets Total Deposits EquityI1 II I II I II

4 largest 33 59 35 59 41 63

8 largest 55 69 50 69 56 73

10 largest 62 72 56 73 63 76

20 largest 84 90 78 86 81 88

1/ The column marked I excludes the Bank of Brazil, the column marked IIincludes the Bank of Brazil.

Sources Central Bank of Brazil, the Gazeta Mercantil Review and theAustin-Asis Report.

1.19 Table 2 snows that concentretion in the Brazilian commercial banksystem increased sharply from 1965 to 1975; this process stopped from 1975to 1980, but continued in the period 1980 to 1987. In 1987, the 20 largestcommercial banks held 90Z of all assets held by commercial banks (federal,state-owned, and private). When the Bank of Brazil is excluded from thedata, the share held by the four largest banks decreases to approximately30-401; however, more than 80S is still held by the 20 largest banks. Wecan conclude that assets, deposits, and equity are more evenly distributedamong the 20 largest banks when the Bank of Brazil is excluded from thecomparison, which shows the importance of the Bank of Brazil in the finan-cial system. It alone holds about 441 of total assets and equity.

1.20 The process of increasing concentration in the Brazilian bankingindustry is confirmed by analysis using the Herfindahl index and estimatesof the variance of the logarithm of deposits. These analyses show thatconcentration proceeded rapidly from 1965 to 1975, and are described infull in Appendix I. Further, the total number of commercial banks (publicand private) decreased from 336 in 1964 to 106 and 105 in 1976 and 1987respectively -- which reflects the concentration of Brazilian-owned privatebanks. The number of foreign banks increased, with bilateral agreementsallowing the opening of branches of Brazilian banks abroad.

* 20

Table 4

Number of Comuercial Banks ig. the Industry(Annual Data, 1976, 1987)

Type of Bank 1964 1976 1987

Public Banks 24 27 31Private banks 312 79 74- National 304 69 56- Foreign 8 10 18TOTAL 336 106 105

Sourcest 1964 and 1976: Carvalheiro (1982).1987S Bank of Brazil. SistemaFinanciero National, December 1987.

1.21 Finally, we should note that the share of bank branches owned byprivate commercial banks declined from 74Z in 1968 to 55Z in 1987. How-ever, the loss iS less severe in less developed regions (where the percent-age declines from 572 to 46: in the same period), because the number ofbranches owned by private banks in these regions increased by 1782 comparedto only 162 in the most advanced regions.

Table 5

Branches of Commercial Banks in Brazil(Annual Data and Percent, 1968, 1975, 1987)

1968 2 1975 Z 1987 2

More developed regionsl 6241 82 622u 80 9425 67- Private banks only 4871 4474 5651- S of private banks 78 72 60

Less developed regions 1346 18 1574 20 4662 33- Private banks only 769 757 2141- 2 of private banks 57 48 46

Total cf the country 7587 100 7794 100 14087 100- Private banks only 5640 5231 7792- Z of private banks 74 67 55

1/ More developed regions include the South and Southeast of Brazil.

Sources: Data for 1968 and 1975 from Portocarrero de Castro (1981). Data forCentral Bank of Brazil. Sistema Financiero Nacional, December, 1987.

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1.22 All banks (private and public) increased their branches in lessdeveloped regions more than proportionally. This is consistent with theCentral Bank policy of imposing less severe restrictions on the opening ofnew branches in pioneer regions.

1.23 We should also note that the number of commercial banks decreasedtwvu thirds from the mid-1960's to mid-1970's, but the total number ofbranches remained more or less constant, which indicates increasing concen-tration. From the mid-1970's to 1987, the number of banks changed little,but the total number of branches doubled (increasing the average size ofcommercial banks).

Financial Conglomerates

1.24 Table 6 shows the market share in total deposits and equity of theten largest commercial banks and their associated financial companies (in-vestment and development banks, and finance companies (private and public,but excluding the Bank of Brazil). In all periods, the share was lower forthe conglomerates than for the c oercial banks, although the difference isnot very relevant.

Table 6

Market Shxare of the Ten LarRest Financial Conglomerates(Percentages at the End of Each Period)

(Annual Data, 1986 - 1988)

1986 1987 1988 (I sem.)

Only comm rcial banks- Total depositsl 57.6 49.8 53.6- Equity 57.9 57.4 55.0

Financial conglomerates- Total deposits2 54.1 45.9 47.0- Equity 53.3 51.2 50.1

11 Demand and time deposits.2/ Demand, savings and time deposits plus acceptance bills of

com rcial, development and investment banks and of consumerfinance companies.

Sources Balance sheet data provided by the Central Bank of Brazil.

CONCLUSIONS

1.25 The Brazilian financial system has been undergoing continued con-centration since 1965 as a result of a deliberate policy of the monetary

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authorities. The system has been segmented by law; financial intermedia-ries have been restricted as to the type of deposits they could accept andthe loans they could make. As Chapter 5 will show, entry into the finan-cial system was extremely difficult. To overcome this institutional seg-mentation, participants evolved in large conglomerates. This type of seg-mentation has recently been eliminated through the multiple service bankinglaw. Nevertheless, important market segmentation still remains.

1.26 The Brazilian banking sector is highly concentrated. When theBank of Brazil is included, the four largest banks own 592 of total assets.The four largest private banks hold 33Z of all assets held in the systemexcept those of the Bank of Brazil. Furthermore, this concentration hasbeen increasing: in 1965, the 20 largest commercial banks (excluding theBank of Brazil) owned 512 of total assets; by 1987 this share had increasedto 842.

1.27 From the mid-1960's to the mid-1970's the number of commercialbanks decreased from 336 to 106, but the number of branches remained moreor less constant, with an increasing average number of branches per bank(i.e., increasing concentration). From the mid-1970's to 1987. the numberof commercial banks did not change much, but the total number of branchesdoubled, increasing the average size of commercial banks. However, privatecommercial banks owned 74Z of the total branches in 1968; by 1987 theyowned only 552.

1.28 All banks (private and public) increased their branch networks inless developed regions more than proportionally. This is consistent withthe Central Bank policy of imposing less service restrictions on theopening of new branches in pioneer regions.

1.29 As far as the extent of competition is concerned, barriers toentry and exit are the crucial issue,rather than the number of firms in agiven market. If concentration was the result of economies of scale therecould be grounds for concern. Nevertheless, the current high concentrationhas not resulted from market forces but from government regulations. Ifthose regulations are eliminated, tbere are no grounds for fearing oligo-polistic behavior if the system is liberalized.

1.30 While we have made no econometric test for the existence of econo-mies of scale in the Brazilian banking industry, academic studies acceptthe hypothesis that while there are economies of plant and economies ofscope, there are no economies of scale in that industry. Naturally, con-stant returns to scale do not necessarily imply survival of small banksduring a liberalization process.

1.31 Barriers to entry and, probably, regulations obstructing paymentof interest on demand deposits have contributed to market concentration inBrazil. In fact, the latter have already been abolished, and barriers toentry have recently been relaxed. As these are the key supports for oligo-poly, we do not expect that implementation of the liberalization processadvised elesewhere in this report will generate oligopolistic behavior.

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1.32 Overall, ve conclude that the Brazilian banking industry does looklike a contestable economic activity and that, within a liberalized con-text, market forces will be able to discipline any non-competitivebehavior.

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CHAPTER 2

DIRECTED AND SUBSIDIZED CREDIT

2.1 Official credit programs in Brazil were very substantial. Theysegmented the credit markets and resulted in an inefficient allocation ofresources. This chapter will describe the funding of these programs, theinstitutions that collect and apply the funds and the restrictions imposedon credit applications. It will also discuss methods of measuring directedand subsidized credit programs, and draw some conclusions as to theirquantitative importance. Finally, it will analyze the general economiceffects of directed and subsidized credit programs.

A. The Nature of Directed and Subsidized Credit Programs

2.2 Hany of these programs are mandated by decree laws rather than byregulations issued by the Central Bank or the National Monetary Council.This is particularly true of taxation that supports long-term investments(e.g., FGTS, PIS/PASEP, FND, FINSOCIAL, and the FMM), and the funds admin-istered by the National Treasury.

2.3 Over the period reviewed, 1985-87, the primary sources of fundssupporting Government-directed credit -~perations have been (i) variouspayroll, sales, financial transactions (IOF), or income taxes; (ii) pass-book savings accounts and demand deposits; (iii) Central Bank sources thatinclude rediscount and overdraft facilities as well as outright advances insupport of official programs; (iv) insurance premiums and private pensioncontributions; and (v) foreign borrowings including loans extended by mul-tilateral lending institutions.

2.4 A variety of different institutions collect the funds for officialcredit programs. Often, the institution charged with administering theresources does not collect them--which sometimes leads to disputes betweenthe collection and administration agents.

2.5 Various institutions allocate credit funds, including federalfinancial institutions, the National Treasury, numerous government agen-cies, and, until the end of 1987, the Central Bank. Many credit programs,particularly those administered by BNDES, CEF, and the Bank of Brazil,constitute virtually the only source of domestic, cruzado-denominated,long-term financing currently available in Brazil. By contrast, the offi-cial credit administered by the Treasury provides borrowers with short- andlong-term funds to support prices of agricultural commodities, purchaseagricultural products, provide subsidized credit to agricultural producersin the Northeast, and promote exports.

2.6 Various directed credit programs affect the freedom with whichcommercial banks, savings and loans institutions, private insurance com-panies, short-term mutual funds and pension funds manage their assets.Amongst other effects directed credit programs have been linked to reserverequirement policies applied to demand deposits; the commercial banks'

- 25 -

required reserves have been allocated outrigk: to support either credit tosmall enterprises or debentures issued by financially distressed corpora-tions; a certain proportion of passbook savings accounts have been al-located to support the Housing Finance System- regulations have also forcedinvestments in government securities by private pension funds, insurancecompanies, and short-term mutual funds; and leverage restrictions haveconstrained the use of privately issued securities as collateral in repur-chase transactions--a restriction which tends to create incentives to holda larger portfolio of government securities.

2.7 Rediscount lines administered by the Central Bank also have func-tioned as a means of directing credit, because the Central Bank has capi-talized interest on these lines, and has imposed different interest chargeson discount window advances or different eligibility requirements onfederal, state, and privately owned commercial banks respectively. Inaddition, there were periods in 1987 when the base rate used in computingcharges on discount window advances was not adjusted in line with inflationon a daily basis, creating incentives for banks to obtain discount windowadvances.

2.8 Current credit budgeting procedures followed by the Treasury donot include coverage of a number of large directed credit programs orfiscal incentive schemes funded wholly or in part through compulsory sav-ings schemes. These funds are primarily administered by BNDES, CEF, andthe Bank of Brazil.

2.9 Existing regulations or laws often result in price and quantityrestrictions on both the liability and asset sides of financial intermedia-ries' balance sheets. These restrictions vary according to the sector,region, or city in which resources are applied-- or in some cases, in whichthey are obtained. Restrictions also apply according to the type of bor-rower, and with regard to the size of the lending institution administeringthe resources.

B. The Size of Directed & Subsidized Credit Programs

2.10 The overall extent of government intervention in the financialmarkets has increased steadily. As of 1987, about 61Z of the total liabi-lities of the financial system were under the direct or indirect control ofthe Government -- 41Z was in the portfolio of government-owned institu-tions, while the remaining 20Z represented mandatory government applica-tions of demand deposits or passbook savings accounts in the form of re-quired reserves or directed credit. Including direct government debt oper-ations, the proportion of total liabilities regulated by the Governmentrises to almost 80Z. Over the period reviewed, government debt grew from25Z to almost 40Z of total private and public sector banking liabilities.The only resources fully available for unregulated lending are time de-posits, which constitute a relatively large source of funds for commercial

- 26 -

banks and investment banks.10 Roughly 202 of saving balances and 402 ofdemand deposits are also sources of funds to be freely applied.

2.11 Official credit programs were a substantial proportion of totalcredit in 1986-87, with the major directed credit programs accounting for802 of the total average stock of credit. The size of these programs ishigh even in relation to other developing countries that either have had orhave extensive directed credit programs such as, Pakistan, India, Turkey,Yugoslavia, Malaysia, Philippines and even Korea (in the past).11 Ifcredit extended to housing is excluded, 572 of the average stock wasdirected. Moreover, compulsory savings schemes represented 292 of theaverage stock of credit to the public and private sectors; earmarking ofpassbook savings to the housing sector 242; credit operations directed bythe Central Bank about 152; forced investments required of non-bankingfinancial institutions 72; and the directed credit operations undertaken bycommercial banks 22 to 4Z.

2.12 Official credit programs combined with reserve requirements re-sulted in increased constraints on the financial system's portfolio. inthe case of savings banks, 802 of passbook savings accounts (virtually theonly source of funds for such institutions) could not be applied freely tothe borrower or sector of choice: 152 h&d to be held as government bondswhile the remaining 652 had to be applied to housing finance under termsindicated by the Central Bank. In the case of private (non-official)pension funds, insurance companies, and short-term mutual funds, 252, 502,and 302 respectively of assets had to be invested in government securities.Leverage restrictions on the use of private securities as collateral inovernight or term repurchase contracts also created similar incentives forfinancial institutions to carry a larger portfolio of government securi-ties. The types of restrictions noted above have provided a convenientmeans for creating a captive market for government debt, particularly forlonger maturity issues placed at non-market rates. Finally, mandatoryapplications of demand deposits to agriculture and industry (excludingreserve requirements) amounted to roughly 102 to 152 of the total depositliabilities of the commercial banking system (excluding Bank of Brazil).

2.13 The implicit subsidy associated with a sample of the largest di-rected credit--programs including the housing finance system--amounted tomore than Cz$1 trillion in 1987, equivalent to 802 of Treasury revenue, and

10/ Very recently, some banks have begun to issue short-term interest-bearing accounts ('conta remuneradam). However, these liabilities arenot yet very large. Similarly, investment banks and broker/dealershave legally been able to operate what amount to short-term moneymarket mutual funds offering overnight deposits at unregulated interestrates. However, limits on applications and withdrawals out of theseaccounts were Cz$100,000, thereby not making such accounts asattractive an option as holding non-interest-bearing sight deposits.

11/ See Chapter 4 of the 1989 World Development Report entitled, "FinancialSector Issues in Developing Countries' for a further discussion of thispoint.

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about 72 to 8 of GDP.12 More than one-third of this subsidy resulted fromdirect Central Bank advances to the Bank of Brazil or to state commercialbanks, either through discount window operations or through the so-calledMonetary Reserve Fund. The large subsidies in 1987 occurred, in part,because balances still existed in the conta de movimento" account whichhad been provided to the Bank of Brazil at a zero interest rate. In addi-tion, the correction factor used to index the principal value of loan con-tracts (i.e., OTN) did not at times keep up with the rate of domestic priceinflation or with the rate of cruzado depreciation. Also, the slowness toreindex loans after the failure of the Cruzado Plan contributed to thelarge implicit subsidy. We estimate that by 1989 subsidies have halvedsince the 1987 peak.

C. Economic Effects of Directed and Subsidized Credit

2.14 Official credit has reduced the efficiency with which resourcesare allocated among competing investments. The cost of capital is dif-ficult to ascertain given the large degree of government intervention inboth the liability and asset sides of the portfolio of financial institu-tions. This, combined with macroeconomic policies that have resulted inhighly variable inflation rates, made for an environment in which a yieldcurve as such does not exist. As the information content in interest ratesis reduced, there is an increase in search, screening, and other transac-tion costs for borrowers and lenders -- with a consequent reduction in realcapital formation.

2.15 The development of long-term capital markets has been discouragedboth by constraints on the balance sheets of prospective institutionalinvestors (e.g., pension funds, mutual funds and insurance companies) tofinance government programs, and by the provision of credit to fund long-term investments at non-market determined rates mandated by the Government.Intermediaries may also have been encouraged to expend resources to exploitinconsistencies in regulations or to obtain special advantages bymaximizing the rents associated with repassing or diverting this credit touses other than those intended.

12/ The implicit subsidy described here is computed by multiplying theaverage outstanding balances for a particular official credit programover the 1986187 period times the difference between the actual averagerate charged on the credit and a nominal "market' rate. The resultpresented is very sensitive to the choice of 'market' rate chosen. Theresult shown is based on using a 'market rate' as proxied by OTN + 15Zor the IGP-DI which increased by 415Z during 1987. Note that the IGP-DI (although not the official price index) was used, because itrepresents the yield an investor could obtain if he held the broadestbasket of goods as the IGP-DI, by contrast to the IPC, includes goodsthat make up part of the construction price index, as well as goodsincluded within the IPC. Finally, the estimates reported do notreflect coverage of a variety of other types of possible subsidiesassociated with the foreign exchange operations of the Central Bank.For a further discussion, see Annex 3.

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2.16 Disintermediation has tended to increase with inflation to theextent that rates on key liabilities on the balance sheets of certainspecialized intermediaries have been fixed in nominal terms or have beenlegally fixed in real terms via an unrealistic price index. Evidence ofincreased disintermediation lies in the growth of illegal intercompanylending, particularly in 1987.

2.17 Segmentation of deposit and credit markets has been maintained bygovernment regulations that limit the amount and pricing of credit offeredto particular sectors, regions, or types of borrowers; and throughregulations on the pricing of liabilities. Also, operating costs offinancial intermediaries have increased due to the frequency of changes inregulations that affect the pricing and allocation of earmarked funds.

2.18 Directed credit programs, in many instances, have resulted in aregressive redistribution of income. For example, in the context of sometypes of credit programs (e.g., compulsory savings schemes like FGTS),taxes on payroll and other forms of taxes on labor or sales tax revenuesfund subsidized credit operations that often benefit the vrbari populationmore than the rural poor. Often, this subsidized credit is diverted toeconomic agents with higher incomes, thus increasing income inequalities.

2.19 The process of accurately measuring and controlling governmentexpenditures has been complicated under conditions of high inflationbecause the implicit subsidies associated with a substantial number ofofficial directed and subsidized credit programs are not taken explicitlyinto account in the credit budget. Thus, the implicit subsidies add to thestructural deficit to be financed in future periods. Moreover, futuregovernment revenues will probably be adversely effected by the decline inthe efficiency of government investment that tends to be associated withthese programs.

2.20 The process of controlling the growth in monetary aggregates hasalso been complicated. The Central Bank and the Bank of Brazil have beenpermitted to fund their directed credit operations through money creation,because there was neither an adequate means nor a willingness on the partof the Government to force the Central Bank to sterilize the full value(inclusive of implicit subsidies) associated with these credit operations.The recent reform of the fiscal budgeting process that also redefines thefunctions of the Treasury and the Central Bank will tend to mitigate thisdifficulty. Under this reform, the lunds and programs administered by theCentral Bank were transferred to the control of the National Treasury atthe end of 1987, and the open line of credit between the Central Bank andthe Bank of Brazil (i.e., the 'conta de suprimento especial') was closed.In addition, the Central Bank was no longer permitted to issue domesticdebt on its own account.

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D. Recommendations

2.21 Directed and subsidized credit programs should be gradually phasedout according to an agreed upon timetable.

2.22 The taxes earmarked for long-term investment by government decreeor laws and administered by federal financial institutions need gradualelimination. However, as a first step, the transparency of these programsshould be enhanced and directed credit operations priced so as to shift theprice of long-term credit toward market determined rates. Such actionswould enhance the prospects of reducing future structural governmentdeficits.

2.23 Measures taken under the budgetary reform to close the 'conta demovimento' and 'suprimento' accounts -- thereby eliminating this source ofautonomous directed credit from Central Bank and Bank of Brazil control --should be supported, since this has been one of the most important sourcesof directed and suosidized credit available over the period reviewed.

2.24 Restrictions on applications of passbook savings accounts, par-ticularly with regard to pricing, should be removed as part of any effortto reform the Housing Finance System in Brazil. As passbook savings ac-counts represented 302 of total financial system liabilities in June 1987,and as the implicit subsidy associated with this form of compulsory lendinghas been large (see Annex 3 for details), this reform is particularlyimportant.

2.25 The compulsory applications of demand deposits held by commercialbanks that have been lent in support of agrict2lture (MCR18) and industry(Resolutions 695, 1335, and 1408) should be phased out. Although stepshave been taken to price these loans closer to market rates, forced lendingof these funds should be discontinued, so as to enhance the efficiency ofthe financial intermediation process and to reduce the spread required onfree loans to compensate for the implicit tax associated with such forcedinvestments. Similarly, compulsory applications of required reservesshould be phased out, while leverage restrictions on the use of privatesecurities in repurchase transactions should be relaxed.

2.26 Forced investments in government securities required of insurancecompanies, pension funds, and short-term mutual funds should be reducedwhere there is clear evidence that these restrictions exceed those calledfor under reasonable and prudential diversification guidclines. This isparticularly important for pension funds, since development of a privatepension system may begin to provide a useful alternative to the existingGovernment social security system (SINPAS)--which is in need of reform.

2.27 The Government should account for all credit programs in theNational Treasury, inclusive of all direct loan obligations and loan guar-antee commitments of federal agencies or federal financial institutions netof various intragovernmental transactions. The Government's recentlystated intention to create a manual providing basic information on thefunds and programs administered by the Treasury, Bank of Brazil, CEF,

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BNDES, Bank of Amazonia, Banco of the Northeast, Bank of Roraima, andH4eridional Bank is an important first step in this process.

2.28 Information disclosure and the quality of information provided tothe Treasury by all federal financial institutions and government agenciesthMt presently administer directed credit programs need to be improved.Such disclosure is required if the Treasury is to assess budget appropria-tion requests properly, particularly those from federal financial institu-tions such as the Bank of Brazil. The number of institutions that collectresources earmarked by the Government needs to be reduced and penaltiesimposed on collection agents (e.g., public sector enterprises) that do notremit funds to the Treasury promptly.

2.29 The transparency of the present credit budget prepared by theNational Treasury needs to be improved. This can be done through theprovision of detailed tables that present the average terms (rate andmaturity) for each major directed credit program, obligations or commit-ments under the program, and estimates of the present value of the subsidystream implied by the program. If the Government wishes to confer subsi-dies on particular borrowers, it would be preferable to do this directly(i.e., through provision of lump-sum transfers that are authorized andappropriated in the budget) rather than by restricting the balance sheetsof financial institutions as has often occurred in the past.

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CHAPTER 3

INFLATION TAX AND THE BANKING SYSTEM

A. Introduction

3.1 Inflation is a pervasive phenomenon which regressively affectsincome distribution, blurs the difference between relative and absoluteprice changes, and thereby undermines the effectiveness of the price sys-tem. Government intervention to halt inflation often complicates matters,as is the case with price controls, interest rate controls, or foreignexchange ceilings, particularly when these are enforced without properadjustment of the sources of growth of the money supply.

3.2 It is important at the outset to adopt precise definitions of theinflation tax rate and of the revenue from that tax. In the steady state,the inflation tax rate is the rate of inflation itself. The nominalrevenue from the inflation tax is the monetary base times the rate ofinflation, less the interest--if any--that is actually paie on commercialbank reserves by the Central Bank; this magnitude consitutes thesustainable flow of resources that the Central Bank can supply to thetreasury by generating inflation.

3.3 The effects of inflation on the financial sector have been dis-cussed extensively in economic literature, but although the idea of aninflation tax is well known, its effects on the banking industry havereceived little policy attention. Part of the tax is paid by depositorsand part by borrowers. When depositors receive no interest payments eitherin kind or in money then they fully bear the tax. Also, if there iscompetition in the banking business, the sector will earn only competitiverates of return no matter how much transfer it obtains from the inflationtax.

3.4 When banks are barred from paying interest on demand deposits theywill engage in non-price competition which implies the use of resources toexpand branching and other mechanisms to compensate lenders. From a socialpoint of view, the result is over-investment in the financial sector. Ifthere are barriers to entry, but some degree of competition exists amongunits, rent-seeking behavior will also lead to over-branching and resourcemisallocation. Many of the distortionary effects of inflation on resourceallocation are reduced when banks are allowed to engage in pricecompetition. Naturally, the incidence of the inflation tax would still bean issue. 13

3.5 The incidence of the tax is a complicated matter. Before 1988banks were not allowed to pay interest on demand deposits and, naturally,found other imaginative ways of attracting deposits, such as increasing the

13/ Rent seeking transforms what otherwise would be mere income transferinto resource cost.

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number of branches, offering more services and the like. Whether or notbanks pay monotary interest on demand deposits it can be shown thatinflation will reduce the real rate of return on deposits, but by less thanit reduces the real rate of return on currency ( which is the negative ofthe inflation rate). It is in this way that depositors pay some of the taxon commercial bank reserves.

3.6 Whether or not borrowers from the banking system are damaged byinflation or benefit from it depends upon the effect of inflation on thereal quantity of credit. If the supply of real bank credit to the privatesector increases as a consequence of inflation, the expected real rate ofinterest on that stock of credit will decline, and borrowers from thebanking system will benefit. If that supply declines, then the real rateof Interest on the stock of credit increases, and borrowers will be damagedby inflation. The final result will depend on reserve and cash depositratios and the degree of substitution between various monies in the system.

3.7 In this chapter we shall not attempt to study the incidence of theinflation tax. We shall describe the quantity of the total tax on demanddeposits that has been administered by the banking sector and the quantitythat different sources of demand deposits have contributed to the tax.Section B provides different tables with measurements of the inflation taxpaid and received by different sources. Finally, Section C summarizes themain conclusions. Appendix II provides background information for themajor arguments developed in this Chapter.

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b. The Inflation Tax and Inflationary Transfers to the Bankinh Sector

Prevailing Economic Conditions

3.8 Table 1 provides a broad view of the existing conditionsrelative to inflation, demand deposits, and legal reserves in the periodcovered.

Table 1

Statistics Relevant to the Inflation Tax(Std. Deviation in parentheses)

(USS millions)(Quarterly Data, Mar. 1985 - Dec. 1987)

Variable 1985 1986 1987

Inflation Rate 30.2 12.5 41.0(Quarterly 2) (5.8) (16.1) (18.4)

Total 6,612.1 17,502.2 9,262.7Demand Deposits+ (1,143.4) (4,113.8) (2,657.8)

Private 4,546.9 12,832.3 6,057.2Demand Deposits* (432.3) (4,680.4) (1,670.0)

Average Legal 39.4 37.3 41.0Reserve Rate (2) (3.6) (0.3) (3.5)

t/ Totals for this variable includes private and official commercialbanks, and Bank of Brazil & BNCC.

+/ Central Bank definition (includes savings banks).

Sources Central Bank of Brazil.

3.9 Table 1 verifies that suitable conditions en lsted for a high andvariable inflation tax. The quarterly average inflation rate in all threeyears was very high: 30.22 per quarter In 1985, 12.52 in 1986, and 412 in1987; most importantly, the variability in the inflation rate is also veryhigh. 37ven though the high average inflation rate implies a low level ofreal demand deposits, a sizable subsidy was still received by the bankingsector because no interest was paid on the deposits.

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Inflation Tax

3.10 Table 2 presents a breakdown of the total inflation taxes paid bythe bank customers in Brazil.14

Table 2

Statistics of inflation Tax(Std. Deviation in parentheses)

(US$ millions)(Quarterly data, Mar. 1985 - Dec. 1987)

Quarterly Average** 1985 1986 1987

Inflation Tax PaidBjy Private customers* 1,382.1 1,136.7 2,387.9

(339.7) (1,045.7) (899.5)

Inflation 'Tax" Paidthrough GovernmentDemand Deposit 632.9 618.6 1,356.8

(295.5) (870.6) (736.1)

Inflation Tax Paid 2,524.3 2,080.7 4.581.1on M1+ (503.2) (2,141.0) (1,903.6)

ANNUAL Total GrossInflation Tax 10,097.3 8,322.8 18,324.3

_ Totals for these variables include private and officialcommercial banks and Bank of Brazil & BNCC.

+1 Central Bank definition (includes savings banks).

Source: Central Bank of Brazil.

3.11 We assume that private customer. who are demand deposit holdersprobably paid most of the inflation tax which equaled nearly US$1.4 billionper quarter in 1985, US$1.1 billion in 1986, and US$2.4 billion in 1987.In terms of GDP, the annualized average inflation tax paid by bankcustomers in 1985, 1986, and 1987 was 4.32, 2.22, and 7.26Z, respectively;for the same three years, the Government's annualized average transfer tothe banking system was 0.52 of GDP 1985, 0.32 in 1986, and 1.03t in 1987.The annualized average total tax paid by Ml holders was 7.78t, 4.092, and13.92 of GDP respectively. On an annual basis, total inflation tax paid byM1 holders was US$10.1 billion in 1985, US$8.3 billion in 1986, and US$18.3billion in 1987.15

14/ Inflation tax paid by M1 holders consists of inflation tax paid byprivate bank customers, transfers through Government demand depositsand inflation tax paid by currency holders.

15/ In current prices, GDP in 1985, 1986, and 1987 was Cz$1,406 billion,Cz$3,687.5 billion, and Cz$12,305 billion, respectively.

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3.12 Table 3 examines the percentage contribution of private andGoverrment demand deposit holders, as well as currency holders, to thetotal inflation tax paid on Mi.

Table 3

Statistics of Inflation Tax:Contributions By Holders of M1(Std. Deviation in parentheses)Percent of Total Inflation tax

(Annual Averages of End of Quarter Data, Mar. 1985-Dec. 1987)

Variable 1985 1986 1987

Private DemandDeposit Holders 55.5Z 60.1? 53.21

(4.4) (9.6) (4.4)

By Gov't DemandDeposit Holders 24.4Z 24.5? 28.0?

(4.4) (10.8) (5.4)

Currency Holders 20.11 15.3? 18.8?(1.2) (2.1) (2.4)

Sources Central Bank of Brazil.

3.13 Private customers (mainly demand deposit holders) paid the largestproportion of the tax in 1986. This was the year of the Cruzado Plan and alarge portion of the private sector's assets were kept in the form ofdemand deposits. In 1987 the private sector paid roughly the sameproportion of the tax as in the pre-Cruzado Plan year.

Estimation of Transfer to the Banking Sector from Inflation Tax

3.14 Table 4 indicates the banks' gross receipts from inflation. Itshould be emphasized that these receipts have not been netted to accountfor the banks' expansion to appropiate these rents. The estimates of thistransfer and its major components were obtained using the model developedin Appendix II; pi is the inflation rate; ddp is demand deposits of theprivate sector; r is the average legal reserve ratio, in percentage terms,on all private demand deposits; ddg is demand deposits of the governmentsector; Bt is total transfer to the banking sectors; and Bt/Tt the bankingsector's transfer as a percentage of the total inflation tax on MI.

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Table 4

Annual Gross Inflation Related Incomeof the Bankina Sector

(US$ millions)(Annual Data, 1985 - 1987)

Year Pt ddp rl* ddg Btl (Bt/Tt)2

1985 30.23 18,187.9 39.41 8,260.1 5,908.2 58.51986 12.52 51,329.0 37.47 18,679.8 5,317.2 63.91987 41.02 24,228.9 41.00 12,821.9 11,145.5 60.8

W 1 Quarterly average.Ti Bt is total transfer to banking sector.Z/ Tt is inflation tax on MI.

Sources Central Bank of Brazil.

Graph 1Inflationary Transfer to the Banking Sector*

(Quarterly Data. Sept. 1984 - Dec. 1987)(in millions of USS)

K)

1-I

,94 ."4.2 ."M I_W 111 I"512 I_M I_M *m 112t la 190 ."a .997.

Mel~~~~~~~~~VA.1..

Note: 198409 refers to the third quarter of 1984.Source: Central Bank of Brazil.

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3.15 The banking sector has received about 60? of the annual inflationtax on MM collected in the past three years. Furthermore, as expected, thepercentage of the tax going to the banking sector moves inversely with theaverage legal reserve ratio. In 1985, 1986, and 1987, the banks' inflationrelated transfers were 4.62, 2.62, and 8.52 of the GDP respectively. Thehigh level and variance of these figures is striking. Naturally, thesefigures represent gross receipts. Banks' rates of return might still havebeen in line vith the rest of the economy because the banking sector hasprobably invested large amounts to appropriate these rents. Otherinflation related transfers to the banking sector also are not included;for example, the lags between collecting and delivering some taxes.

3.16 Table 5 illustrates the proportion of the transfers to the bankingsector that comes from private demand deposits, and also the transfer tothe same sector flowing from Government demand deposits.

Table 5

Bankina Sector Revenue By Origin of Deposits(Percent)

(Su-mation of Quarterly Data, Mar. 1985-Dec. 1987)

Year Private GovernmentDemand Deposits Demand Deposits

1985 57.2 42.81986 53.5 46.41987 51.3 48.7

Source3 Central Bank of Brazil.

3.17 Clearly, inflation-related transfers to the banks from the privatesector declined relative to those from the public sector during the period.

3.18 This analysis can be carried further, to estimate the inflationarytransfers that accrues from private demand deposits to private and publiccommercial banks. The Bank of Brazil and BNCC are treated separately.

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Table 6

Transfer to Banking Institutions:Quarterly Averane of Inflationary Transfers From Private Demand Deposits

and its Components(US$ millions)

(Std. Deviation in parentheses)(Quarterly Data, Sept. 1984 - Dec. 1987)

Private Demand Average LegalDeposits Reserve Ratio(Z) Subsidy

Private CommercialBanks 4,695.8 40.44 661.6

(2,797.9) (3.21) (339.9)

Official CommercialBanks 1,313.1 38.20 176.2

(806.6) (3.22) (100.2)

Bank of Brazil& BNCC 1,329.6 38.90 178.0

(798.7) (2.52) (107.6)

Sourcc: Central Bank of Brazil.

3.19 Table 6 shows that private banks hold a larger proportion of totalprivate demand deposits, and hence are in a position to benefit more fromthis source of transfers. On the other hand, official banks (official com-mercial banks and the Bank of Brazil & BNCC) have an actual level of re-serves on private demand deposits that is lower than those required ofprivate banks; this allows official banks to retain a higher proportion ofthe subsidy than private banks.

3.20 The high variability of demand deposits is also important. Itmakes for an unstable transfer whose consequences affect banking policy.For example, the lower inflation rate of the Cruzado Plan in the secondquarter of 1986 forced many banks to close some of their branches due tolosses, transferring the consequences of instability to the public. Demanddeposit variability, along with variability in savings deposits and largeswitches in portfolio holdings, set the framework for the the large vari-ability in financial flows, described in 'bapter 4.

3.21 The changes in the inflation transfer administered by the bankingsector were due mainly to changes in the inflation rate and in the realstock of demand deposits because reserve ratios on demand deposits wererelatively less variable. Table 7 offers a quarterly picture of the aver-age transfers shown on Table 6.

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Table 7

Inflationary Transfers from Private Demand DepositsBy Type of Institution

(US$ millions and Percent)(Annual Data, 1985-1987, Quarterly Data, Mar. 1986-Dec. 1987)

Private Official Bank of BrazilCommercial Banks Commercial Banks & BNCCLegal $ Tot. Z of Legal $ Tot. X of Legal $ Tot. Z ofReserve transfer* Reserve subsidy* Reserve subsidy*Ratio to total to total to total

Banking Banking BankingYear Sector Sector Sector

1985 40.0 2,193.4 64.9 37.5 615.3 18.2 39.0 566.8 16.8

1986.Q1 37.7 926.5 66.9 35.5 267.7 19.3 37.2 189.6 13.71986.Q2 37.8 13.7 62.1 36.2 3.9 18.4 37.0 4.2 19.61986.Q3 38.0 190.4 64.1 36.4 55.2 18.6 36.8 51.1 17.21986.Q4 38.5 723.2 63.4 36.6 209.6 18.4 36.5 208.1 18.21986 38.0 1,853.2 65.2 36.2 536.1 18.9 36.9 452.9 16.0

1987.Q1 38.4 1,278.0 63.6 36.8 372.0 18.5 37.2 359.0 17.91987.Q2 38.7 1,111.0 61.3 36.3 318.0 17.6 36.9 383.0 21.31987.Q3 44.8 392.0 57.7 42.7 122.0 18.0 42.8 165.0 24.31987.Q4 45.2 689.0 56.6 43.5 233.0 19.2 42.3 294.0 24.21987 41.7 3,407.7 60.7 39.8 1,046.9 18.3 39.8 1,202.9 21.0

Transfer from private demand deposits.Source: Central Bank of Brazil.

3.22 In addition, Table 7 shows a large variability of the grosstransfer within a given year; aggregating the transfers we see that thegross inflation tax rendered to the banking sector from private demanddeposits was about U5$5.7 billion in 1987, or 4.3Z of GDP.16 Table 7also shows a decreasing proportion of the total transfers emerging fromprivate demand deposits being received by private commercial banks. Thiscould be the result of the decreasing proportion of private demand depositsheld by these banks. The next table illustrates this point. Table 8 showsthe ratio of the transfers captured by private banks from private demanddeposits to the transfers received by official banks from the same source.

16/ This figure can be compared to the comments following Table 2 whichestimate annualized quarterly inflation tax paid by demand depositholders to be 7.6Z of GDP; together with a legal reser've ratio of41.7Z, we also get the approximate figure of 4.3X.

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Table 8

Ratio of Transfers to PrivateBanks from Private Demand Denosits

to Transfers Received by OfficialBanks from the Same Source(Quarterly Data, 1986, 1987)

Year Ratio

1986.Q1 2.021986.Q2 1.6319&6.Q3 1.791986.Q4 1.73

1987.Q1 1.741987.Q2 1.581987.Q3 1.361987.Q4 1.31

Sources Central Bank of Brazil.

3.23 The transfers from private sector demand deposits to privatecommercial banks has consistently declined relative to the transfers toofficial banks. From the first to the final quarter of 1986, the ratiofell from 2.02 to 1.73. In 1987, the ratio fell from 1.74 to 1.31. Sincethe legal reserve ratios of the two types of institutions have been movingin the same direction. larger shares of private demand deposits should havebeen placed in official banks. This was particularly noticeable during thelaunching of the Cruzado Plan, in the second quarter of 1986.

3.24 Table 9 indicates the growing contribution of the governmentsector's demand deposits to the total inflationary transfers to the bankingsector.

Table 9

Transfers due to Government's Demand Denosits as Percentof Transfers from total Demand Deposits

(Quarterly Data, 1986, 1987)

Bgt lYear Bt

1986.Q1 57.81986.Q2 39.31986.Q3 29.8*986.Q4 27.7

1987.Ql 47.91987.Q2 52.91987.Q3 39.31987.Q4 47.3

Sources Central Boak of Brazil.

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3.25 Although no clear trend emerges in 1987, it is evident that in thelast three quarters of 1987, total government demand deposits' contributionto inflationary transfers to the banking sector was substantially higherthan its contribution in the last three quarters of 1986.

3.26 Both Tables 8 and 9 indicate a growing Government presence in thebanking sector. Table 8 illustrates a larger role for official banks inaccepting a higher proportion of the private sectors' demand deposits thanprivate banks in the last two years, and Table 9 illustrates that theGovernment's demand deposits -- legal reserve requirements being roughlyunchanged -- are a growing proportion of total demand deposits. This wasno surprise.

Government Revenue From Inflation Tax.

3.27 Table 10 shows estimates of the Government's revenue from theinflation tax.

Table 10

Government's Annual Inflation Tax Revenue*(USS millions)

(Annual Data 1985-1987, Quarterly Data Mar. 1985-Dec. 1987)

_ G~~~~~~Rt

Year Pt ht GRt Tt

1985.Q1 33.53 3148.8 1056.0 46.551985.Q2 22.01 3122.4 687.3 40.281985.Q3 30.38 3329.7 1011.7 39.631985.Q4 34.99 4141.3 1449.2 40.301985 * 235.10 13742.3 4204.2 41.53

1986.Q1 35.71 4463.0 1593.8 33.371986.Q2 0.26 7663.0 19.9 36.091986.Q3 3.05 9239.7 281.4 39.861986.Q4 11.09 9872.8 1094.7 39.291986 * 65.04 31238.4 2989.7 35.92

1987.Q1 38.53 6352.1 2447.8 40.601987.Q2 65.67 3310.5 2173.9 35.701987.Q3 21.03 5125.5 1078.1 52.071987.Q4 38.86 4974.6 1933.0 46.741987 * 415.99 19762.7 7632.8 41.65

_t For annual tata, the Pt is the annual (December to December)inflation rates ht and GRt are sums of the relevant quarterlyestimates; and GRt/Tt is a ratio of annual data. ht ismonetary base as defined by the Central Bank. Tt is theinflation tax on Ml.

Source: Central Bank of Brazil.

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3.28 From Table 10 we can infer that the proportion of the inflationtax going to the Government sector remained almost unchanged before andafter the Cruzado Plan, at approximately 40?. In addition, the drop in thelegal reserve ratio was partly responsible for the Government receiving asmaller part of the inflation tax in 1986. The inflation tax received bythe Government was about 3.3?, 1.52, and 5.8? of GDP in in 1985, 1986 and1987, respectively.

3.29 Additional evidence about the effects of inflation on banks' in-terest rate spreads is given below in Table 11.

Table 11

Coruercial BanksInterest Rate Svreads and Inflation

(Quarterly Data, 1986 - Kid 1987)

Private Banks Public Banks

1986 Inflation L M S L M S

I 0.357 15.4 18.4 13.4 7.2 7.5 10.2II 0.003 3.2 2.4 2.5 1.1 3.4 -4.0

III 0.031 3.5 3.7 3.5 2.2 1.3 1.1IV 0.111 7.9 7.3 7.0 6.1 4.3 4.7

1987I 0.39 17.9 15.0 13.8 12.0 12.2 5.1II 0.66 20.0 13.6 14.7 11.6 11.3 12.0

Note: L,M,S refers to large, medium and small as stated inCentral Banks regulations. Relative to stock creditoutstanding, small banks are defined as those having lessthan US$5 million, medium banks as having less than US$57million and large banks if they are above US$57 million.The Bank of Brazil was excluded from the above table dueto non-availability of data. The quarterly interest ratespreads on free loans, obtained from income statements andbalance sheets provided by the Central Bank, werecalculated as follows: (numbers in parenthesis representCentral Bank codes)

Interest income on free loans (7010300) Cost of Deposits (8010000)net of irovisions (8187500) and borrowings (8030000)

Average value of stock of free Average value of stock ofloans (1920700) net of deposits (4010000) andprovisions (1024900) borrowings (4050000)

Sources Estimates made by Tracy Hincey (LA1TF), based on Central Bank ofBrazil data.

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3.30 The relationship between inflation and interest rate spreads isstriking. While we expect spreads to move with inflation as banks shiftthe burden from the implicit tax on non-interest bearing required reserves.we also expect that those spreads will rise with inflation if banks collecta share of the inflation tax. During the third quarter of 1986, the pricelevel increased 3Z, and large private banks had a spread of 3.5Z; asinflation soared to 66Z during the second quarter of 1987, the spread alsosoared, reaching 20Z.

3.31 The next table shows the relative contribution of the spread com-ponents disaggregated by: a) Net Income; b) Required Reserves; c) OperatingExpenses; d) Forced Investments; and c) Taxes.

Table 12Spread Components (X)

Private and Public Commercial Banks(Annual Data 1986, Quarterly Data 1986)

1986Ouarter Inflation Net Income Rea. Res. Operating ExS. Forced Inv. Taxes

Pvt. Publ. Pvt. Publ. Pv.t Publ. Pvt. Publ. Pvt. Publ.Large Banks

I .35 7.6 6.3 17.9 11.1 56.4 57.3 2.4 0.7 15.6 24.7II .002 7.2 -28.4 7.8 4.0 63.1 89.5 3.2 2.0 18.8 32.9III .03 1.9 -1.9 13.3 5.6 63.1 68.2 3.9 0.8 17.8 27.4IV .11 13.3 0.7 19.4 16.1 39.5 52.9 8.8 9.2 19.0 21.2

Medium

I .35 7.5 5.7 11.6 5.3 61.6 67.3 1.9 1.8 17.3 19.8II .002 3.4 -122.0 5.0 7.9 69.2 156.3 1.9 3.8 20.5 54.2III .03 8.8 -18.2 6.9 2.2 57.1 87.2 1.9 0.2 25.3 28.6IV .11 14.3 6.8 10.6 10.1 47.2 54.5 4.3 5.4 23.5 23.3

Small

I .35 11.5 26.5 8.2 2.5 61.8 31.9 0.5 3.5 18.1 35.6II .002 -122.0 -211.9 8.9 n.a. 175.0 241.5 1.7 n.a. 35.5 70.4III .03 14.4 6.3 4.8 0.7 54.0 63.7 1.3 0.1 25.5 29.1IV .11 7.6 -13.8 12.7 7.1 52.7 72.5 3.8 7.9 23.2 26.3

Source: Central Bank of Brazil data. Public Banks include all commercialbanks except Bank of Brazil. These tables were taken from abackground paper written by Cesar Fort for which researchassistance was provided by J. Saettone.

3.32 Sharp changes in the inflation rate during the Cruzado Plan alsoallow us to draw conclusions about the effect of inflation on spreads, themost important being that the share of interest rate spreads explained bynet income moves in the same direction as the inflation rate.

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3.33 PrivAte banks, except for small ones, ended 1986 with a higherrelative share of net Income than at the beginning of the year, as iftrying to compensate for the hard mlddle quarters of that year. In thosequarters the absolute spread vas lower, and operating expenses also rose asa proportion of outstanding loans. Table 12 also shows that private banksadjusted swiftly to changing conditions. By closing branches they avoidedthe huge losses experienced by the public banks. All government banks hadimportant losses in at least one quarter of 1986, as they actually expandedtheir branching networks. Given the fact that inflation rebounded, thispolicy may not have been entirely bad in the long run.

3.34 Small banks, whether private or public, seem to have been quitesensitive to changes in the inflation rate. Private banks were obviouslymore efficient than public banks, as can be ascertained from the statisticsshowing the relative importance of operating costs in the interest ratespreads. They also depended heavily on inflation-related profits.

C. Conclusion

3.35 Instability and social overexpansion of the banking sector arisebecause the banking sector relies on inflationary related transfers as partof its revenue. This revenue is subject to large fluctuations which causephases of expansion and contraction. The most dramatic contraction occuredin 1986 when private banks closed many branches. Thus banks in Brazilobtain large transfers but must operate in a very uncertain environment.

3.36 Until 1988, Government regulations indirectly subsidizedcommercial banks by either forbidding or discouraging the payment ofinterest rates on demand deposits; banks borrowed from demand depositholders at a negative real interest rate, equal to the rate of inflation inabsolute terms, and lent at positive rates. Whereas this could beincerpreted as Implying that the Brazilian inflation resulted in largetransfers from depositors (private and government) in the banking system tothe shareholders of that system, we cannot rule out the possibility of aneven more adverse outcomes those transfers may have been subsequentlyreturned (in part) to depositors, but in a highly wasteful manner, e.g.excesive branching and other services.

3.37 We have, therefore, shown that the effect of inflation on thebanking sector is very Important. We can conclude that the authorizationof interest payment on demand deposits was a very important step towardsstabilizing the banking sector and enhancing monetary control.

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CHAPTER 4

REQUIRED RESERVES

A. Introduction

4.1 This chapter is an attempt to ascertain the relative importance ofmultiple compulsory reserves in generating uncertainty -- more variablemonetary and credit flows -- in the Brazilian financial and monetary sce-nario. Appendix III provides empirical support to the major arguments de-veloped in this chapter.

4.2 Any business sector would be subject to instability in output andprices if its taxes, or subsidies, were to change frequently, or if itsproduction function were forced, by exogenous forces, to change unex-pectedly and substantially.19 Thus the financial sector will sufferinstability if: (a) there are multiple compulsory reserves; (b) theinflation rate is high and variable; and (c) there are restrictions onpaying interest on demand deposits, along with other interest ratecontrols. All conditions applied fully to the Brazilian financial sector.The remainder sections of this chapter will focus on the instabilitygenerated by multiple compulsory reserves.

B. The Rationale for Reserve Requirements

4.3 It is, to begin with, not entirely clear why reserve requirementsregulations are needed at all. The usual rationale is that legal reserveratios are, inter alia, an instrument to safeguard the financial system,forcing banks to hold some of their assets in cash or in Central Bank de-posits, so as to make lank portfolios more liquid; a device to be mani-pulated, or fine-tuned, in order to attain some interest rate (price) goalsand some quantity goals (simultaneously); an instrument to sterilize otherchanges in the source of base money or the money multiplier; a way to dis-criminate, through multiple compulsory reserve ratios, in favor of smallbanks and against powerful conglomerates; an instrument to increase theflow of credit to poor or priority geographical areas; and a mechanism forproviding cheap financing of Treasury deficits by requiring banks to hold apercentage of their reserves in government securities. These points de-serve further discussion.

I9/ The production function of the banking "industry' can be written asfollows:(1) L - (l-r)D; (2) D - f(K, L, W); where L - bank loans,r - compulsory ratios, D - Deposits; K - Capital; L - Labor, U - Others(interest rates, inflation, etc.). In (1) the 'fixed, coefficient ofproduction is subject to permanent shocks if the system has, like inBrazil, multiple compulsory ratios. These exogenous shocks in theproduction function causes instability in the industry and also causesunforeseen changes in the inflation tax paid by the public to thebanking system.

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4.4 Reserve requirements are not really instruments for safeguardingthe financial system. For any commercial bartk, there are no assets moreilliquid* than the legal reserves held with the Central Bank. They can

draw over the legal limit on such deposits only under harsh penalties, anda continuous deficit position with the Central Bank is bound to produceintervention or liquidation. The unfortunate worldwide tradition of fixingdifferent legal reserves ratios on demand and savings deposits is a livingexample of this misconception.

4.5 Some monetary authorities around the world try to control interestrates, the stock of money, the real exchange rate, the gap between theofficial and black market exchange rates, and the quantity of foreignreserves--simultaneously.20 Economic principles and, most importantly,experierce, attest to the impossibility of achieving such ambitious goalssimultaneously. 2 1

4.6 In general the best way to cope with undesired changes in thedeterminants of the multiplier or in the monetary base is not throughmanipulation of compulsory reserve ratios, but with open market operations.22If changes in the monetary base are determined endogenously, it would becounter-productive to try to compensate for those movements. For example,if credit is changing because of seasonalities in the endogenous componentsof the multiplier, it would be unreliable to change reserve ratios to com-pensate for them, as there is an inside and variable lag in the effect ofsuch a policy. Also, and most importantly, these policy changes in reserveratios are an additional source of uncertainty and increased risk, becausethose ratios have a crucial bearing on the profitability of commercialbanks. A risky activity requires a higher-than-average return, and thesector surely will obtain it through higher interest rate spreads. Becauseof these deleterious side effects, there should be uniformity and rules,not discretion, in the policy concerning compulsory reserve ratios.

4.7 In Brazil, smaller banks have much lower required legal reserveson demand deposits than do large banks. Although the official rationalefor this policy is that small banks could not survive with higher ratios,there is no hard evidence of economies of scale in the banking business.Even if there were, no subsidy to uneconomic-sized firms would be justifiedon these grounds. There may be economics of plant size, but surely thisdoes not justify subsidies to banks that may be so small that they cannotabsorb their fixed costs. If the preferential treatment granted to smallbanks is a consequence of political bargaining, a direct subsidy from theTreasury would be a better alternative.

20/ Sometimes this menu ever, includes the real interest rate and the realstock of money.

21/ Friedman's 1968 address to the AEA demonstrated that it is impossibleto attain via monetary policy targets based on real magnitudes.

22/ Brazil faces serious problems with open market operations becausefederal debt is immediately monetized through overnight re-purchaseagreements. This does not mean that reserve requirements are a bettersubstitute.

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4.8 In Brazil, banks also have different compulsory reserve ratios ondemand deposits according to their geographical location. Those banksestablished in poor, or priority areas, have lower requirements. Thisattempt to increase the real flow of credit to these regions is futilebecause in Brazil there are no controls on domestic capital flows. Theselower reserve ratios may be an advantage to those banks but surely make anegligible contribution to regional development.

4.9 Banks are sometimes allowed to hold their compulsory reserves ininterest-bearing government bonds, largely to increase demand for thosebonds, which reduces financing costs to the Treasury. However, allowingthe banks to hold part of their legal reserves in interest-bearing assetsincreases the subsidy which they already receive from the inflation tax.On the other hand, if banks are paying full competitive interest rates,allowing them to hold interest-bearing government bonds in lieu of legalreserves would be equivalent to reducing the tax that, otherwise, is beinglevied on financial intermediation.

C. Brazil vs. Chile

4.10 It is interesting to compare the behavior of money supply compo-nents (baseimultipliers) in Brazil with that in Chile. The latter providesa good comparison because it has had a theoretically correct policy forrequired reserve ratios. In Brazil, the difference between legal reserveratios on time and demand deposits has varied between 10 and 40 percentagepoints, and this gap is nov wide. In Chile, the difference has been only 5percentage points and has been constant, at least during the period of thecomparison. The following table compares the monetary base and the multi-plier as explanators of monetary growth in Brazil and Chile.

Table 1

Determinants of Monetary GrowthCorrelation Coefficients

(Monthly Data, Jan. 1983 to Dec. 1987)

Rate of GrowthCorr. with Growth of M3 Base Multiplier

Brazil 0.13 0.29

Chile 0.32 0.13

Corr. with growth of M4

Brazil -0.03 0.43

Chile 0.28 0.08

Sourcest Central Bank of Chile and Central Bank of Brazil.

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4.11 The results above are striking. In Brazil, the endogenous multi-plier was much more important than the monetary base in explaining monetarygrowth. In fact, for the sample period, the monetary base was statis-tically irrelevant in the case of M4. Exactly the opposite is true forChile, where the base was highly significant and the multiplier had anegligible contribution to monetary changes. These results also hold for asample period excluding the Cruzado Plan period.

D. Summary and Conclusions

4.12 Legal reserve requirements have been a favorite instrument bywhich the authorities have attempted to control credit and monetary flows.Compulsory reserve ratios on demand deposits have been tailored to helpsmall banks and poor regionst thus the lowest legal ratio, 82, applied tosmall banks in (poor) priority regions and the largest, 43Z, applied tolarge banks in non-priority areas. There were 42 different ratios alto-gether, and since the introduction of 802 marginal reserve requirements inJanuary 1989 there are as many different averase reserve requirements asnumber of banks, namely 103. The treatment of savings deposits has alsovaried widely. At present, savings banks have no reserve requirements, butthey are forced to direct 152 of their saving deposits to the Government asthey are required to buy interest.bearing government bonds. Time deposits(CDs) have also been subject to different reservco ratios through time,although they are currently zero, since mid 1989.

4.13 Hence, while reserve requirements on demand deposits are, on aver-age, very high, those oD. t4me and saving deposits are now zero. Thus thereis a wide gap between these ratios. The public's desired portfolio com-position has varied substantially over time, which implies wide swings inthe ratios of cash, demand deposits, saving deposits, time deposits andfederal bonds to total deposits. In addition, banks were not allowed topay interest on demand deposits.

4.14 Economic analysis suggests first, that the reserve requirement onall types of deposits is an important variable in explaining the bankingsector's share in the money creation mechanism, and the level of the moneymultipliers. If this average is very variable it also will cause variabi-lity in all financial flows relevant to banking business and monetaryanalysis.23 Secondly, if all reserve requirements are equalized and banksare allowed to pay interest on demand deposits, the money multipliers wouldbe much more stable.

4.15 The empirical evidence assembled in this chapter is cczsistentwith these propositions, and allows us to conclude that the money multi-pliers have been highly variable in Brazil; this variability reflectsendogenous switches in the public's desired portfolio composition; therelative importance of those portfolio switches is so large that they haveovershadowed the monetary base in explaining short-term changes in monetary

23/ If banks are not allowed to pay interest on demand deposits, they sharethe inflation tax proceedings with the Central Bank. Furthermore, ifinflation is high and varies, the level of this revenue becomesunstable. This problem is the subject of Chapter 3.

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aggregates; and when the same tests are carried out for Chile, a countrywith less distortion in compulsory reserves, they show a striking dif-ference from Brazil, thus reinforcing our arguments about the importance ofdistorted reserve ratios.

4.16 A simple but important policy recomuundation, based on economicanalysis and empirical evidence, stems from this analysist the CentralBank should equalize all legal reserve requirement ratios. Simulationmodels carried out in supporting background papers (Carvalho, et al.) sug-gest that a level of 6Z to 72 for reserve requirements on demand, savingsand time deposits, would be consistent with the average multipliers for1987, regardless of the money supply definition.

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CHAPTER 5

ENTRY AND EXIT

5.1 We saw from the discussion of market structure and concentrationin chapter 1 that free entry and exit remains the key to curbing oligopolyin a liberalized environment, rather than regulation. However, in Brazil,neither entry nor exit has been easy for financial intermediaries.

A. Entry Into the Market

5.2 Historically, legal restrictions on the opening of new banks al-lowed expansion only through branching; the relevant legislation onbranches apparently favored the creation of large banking firms via fiscaland credit incentives.24 Moreover, new branches were usually allowed onlyin promoted regions of the country.

The 1985 Point System

5.3 In 1985 three financial conglomerates were liquidated by theCentral Bank (Auxiliar, Cominco, and Massonave). The Central Bank guar-anteed the payment in full of demand deposits and was obliged to transfer alarge amount of money to these bankrupt institutions. In November 1985Resolution 1060 created a point system with the idea of allowing theCentral Bank and other creditors of the failed banks (e.g. the holders oftime deposits) to receive quick income from the realization of the banks'assets.

5.4 Authorization to open new financial institutions of any kind (in-cluding new branches) was suspended, and the value of the whole financialsystem was fixed at 75142 points. The houses and branches of all financialinstitutions were assigned a fixed number of salable points that apparentlyreflected their market value (e.g. 132 points for the house of commercialand investment banks, and 0.25 points for a branch in a promoted region).In this way, the Central Bank, by closing entry into the financial system,raised the goodwill value of financial institutions and obtained more re-venue from the sale of the bankrupt conglomerates assets.

5.5 The only exception to the freeze was the granting of new chartersto foreign banks on the grounds of reciprocity. If a country allowed oneor more Brazilian banks to operate in its markets, Brazil allowed the samenumber of banks from that country to operate in Brazil as well. In thelast few years, a number of foreign banks have entered the Brazilian marketthrough this mechanism.

5.6 In 1988 the point system became irrelevant because the newconstitution forbade the sale of points. From different interviews with

241 In 1967, new legislation allowed the opening of new branches to bankscharging interest rates below one percent a month. As interest ratecontrols tend to discriminate against small banks (because they chargehigher interest rates when the market is not regulated) this policyfavored the concentration of banking activities.

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Central Bank officials and private sector managers it could be establishedthat each point sold for approximately US$45,000 (at the official exchangerate) in 1985 and 1986. Its value decreased to US$29,000 in 1988 when thebusiness community assigned a higher probability to the elimination of thepoint system. After the new constitution was approved, the market value ofpoints went down to zero.25

5.7 The value of points was paid in addition to the intrinsic value ofthe assets. It represented the goodwill value of the financial system,artificially augmented by the decision of the Central Bank to close themarket to new competition. Thus the value of a point represented the dis-counted value of expected economic rents. For the whole financial systemthis expected rent was equal to almost US$3.4 billion -- approximatelyequal to 13 percent of the value of the total equity of the financialsystem.26

Multiple Service Banks

5.8 The point system was eliminated in 1988. New institutions will beallowed to enter the system, subject to previous approval from the CentralBank. There have been about 90 requests pending to open multipurpose banks(Bancos Multiplo); this desire to enter the financial market confirms thatthe legal restrictions on entry were protecting economic rents. It is notyet clear whether the Central Bank will eliminate all ladministrativerestrictions on entry, although Central Bank officials have emphasized thatentry will be allowed to any bank satisfying minimum capital requirements.

5.9 Resolution 1,524 specified the rules applicable to BancoMultiplos. Under these rules, commercial banks, investment banks, develop-ment banks, housing credit societies, and credit, financing, and investmentsocieties are allowed to establish Banco IMultiplos, subject to prior au-thorization by the Central Bank. The rules also specify minimum capitalrequirQments for forming a Banco Multiplo, as well as leverage limits foron-going Banco Multiplos. Banco Multiplos also are required to be membersof the new depoeit insurance system now being established in Brazil.

25/ The value of points fluctuated according to changes in theprofitability of financial activities. In 1987, it decreased forfinance companies because they were in serious financial conditions;after the Cruzado Plan commercial banks closed many branches and holdmany points in stock. The Central Bank itself also held some points instock and consequently was able to regulated the market for points, atleast to some extent.

261 Alternatively, the annual market interest rate is 1O in dollars, andthe flow of economic rents is expected to last for ever, banks willearn an extra 1.3S over the "normal' rate of return. Note that tocompensate for these rents, the corporation income tax applied to thebanking industry is S higher (45? compared to 401) than that appliedto other activities.

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5.10 Authorizing the creation of Banco Multiplos should improve finan-cial intermediation in Brazil in several ways. First, it will allow exist-ing financial conglomerates to merge their various units into one organiza-tion. This reorganization should result in at least some modest efficien-cies. Second, it would tend to reduce the circumvention of prudentialleverage limits now occurring in various parts of the Brazilian financialsystem.

5.11 In authorizing the creation of Banco Multiplos, the Brazilianconstitution prohibited these organizations from engaging in insurance.While apparently based on other reasons, this decision would have the de-sirable effect of avoiding the combination of banking and insurance opera-tions in the financial statements of Banco Multiplos -- a combination thatwould make it difficult for the Central Bank to monitor the banking opera-tions of Banco Multiplos, and could result in some slippage in the CentralBank's supervisory control over banking operations. It could also signi-ficantly reduce the effectiveness of the Central Bank's s off-sitemonitoring.

5.12 As of end-1988, the Central Bank was reviewing applications fromvarious financial organizations to become Banco Multiplos. By lateNovember, the Central Bank had approved 91 applications. Of the 102 com-mercial banks in Brazil, 25 have already been authorized by the CentralBank to convert to Banco Multiplos.

5.13 In short, the Brazilian Government's decision to allow the crea-tion of Banco Multiplos should help to reduce the existing segmentation ofthe Brazilian financial system. Moreover, by giving financial institutionsgreater flexibility in organizing their operations, Banco Multiplos shouldproduce at least some modest gains in efficiency. Finally, the creation ofBanco Multiplos does not appear to pose any new threat to the stability ofthe banking system. The activities in which Banco Multiplos can engage donot appear to be unduly risky. Moreover, many commercial banks that willconvert to Banco Multiplos are already engaged in these activities throughtheir subsidiaries.

5.14 The minimum capital requirements for Banco Multiplos are quitecomplex, but are essentially based on the number of offices that the BancoMultiplo operates and the types of activities conducted at each office.For a Banco Multiplo that has only a head office and engages only in com-mercial banking, the minimum capital requirement is 1.2 million OTN.27 Ifthe Banco Multiplo also engages in investment banking and housing financeat the head office, it must have additional capital of 1.2 million OTN and600,000 OTN respectively. Still more capital would be required for eachbranch operated by the Banco Multiplo, with the amount varying depending onthe number and types of activities conducted at each branch.

5.15 In addition to the minimum capital requirements, new commercialbanks and Banco Multiplos must demonstrate to the satisfaction of theCentral Bank that they have competent management. The Central Bank in-dicates that it generally expects senior management to have at least five

27/ An OTN was roughly US$7.50 (OTN were eliminated in January 1989).

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years of experience. The Central Bank also reviews the past record ofsenior management to be sure that there is no history of dishonesty.

Maximum Debt Equity/Ratios

5.16 Financial companies must also comply with maximum debt/equityratios. For commercial banks this ratio can not exceed 15s1, while forfinance companies the limit is 12:1.

5.17 It is presumed that some institutions are avoiding this restric-tion by manipulating relation with their financial conglomerate.28

However, on average, Central Bank data shows that the ratio is not eluded.Moreover, if we assume that only the equity is genuine (which is clearly anextreme assumption), the debt/equity ratio of commercial banks amounts to6.73, while that of private commercial banks is 6.54.

5.18 When a bank seeks to open a new branch in any city, the CentralBank checks whether the ratio of total deposits to the number of branchesin the city would decline to below a minimum pre-established ratio. If so,the new branch is not authorized (this restriction does not apply to themain house of a bank).

5.19 These new entry requirements constitute a considerable improve-ment. By reducing the barriers to entry, the new approach should increasecompetition and stimulate banking innovation. In addition, by focusing oncapital adequacy and management competence and integrity, Brazil will beemploying the same protective devices that other countries have used suc-cessfully to ensure that new entries do not undermine banking stability.

5.20 At present, existing financial conglomerates can avoid leveragerestrictions placed on certain financial subsidiaries by engaging in so-called "double leverage". In a double leverage operation, the parent com-pany (typically a commercial bank in Brazilian financial conglomerates)issues debt in the market and then downstreams the proceeds to its subsi-diaries in the form of equity. This equity injection reduces the leverageof the subsidiaries, thereby allowing them to meet prudential leveragerequirements. However, as a result of the parent's debt financing, theleverage of the conglomerate, viewed on a consolidated financial statementbasis, has been increased, thereby exposing the conglomerate to greaterrisk than before. When tiered financial conglomerates convert to non-tiered Banco Multiplos, all financing will be conducted in a single entity.Consequently, these organizations will not be able to engage in doubleleverage in order to circumvent prudential leverage limits because doubleleverage requires a tiered organizational structure.

Evaluation of Restrictions on Entry Into the Brazilian Financial System

5.21 The major shortcoming with the new entry provisions relates to theminimum capital requirements. Minimum capital requirements and maximum

281 A way to elude this restriction is to finance the equity of theinvestment bank or finance company if the conglomerate with a loan fromthe coumercial bank. For the consolidated operation of theconglomerate this practice leads to a higher debt-equity ratio.

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debt/equity ratios are standard practices in many countries. They act asscushions' when the firm goes to bankruptcy. The higher this amount, thelower the losses of the Government (for its payments to insured depositors)and of uninsured depositors will be.

5.22 Capital requirements in Brazil are based in substantial part on abanking organization's number of offices. The problem is that the numaerof offices may not be a very reliable guide to the bank's asset size or theamount of risk that the bank will assume once it begins operations. Banksthat have a large amount of assets per office may end up being signifi-cantly undercapitalized. A better way to set minimum capital requirementsis to require a bank to have sufficient capital to support the bank's pro-jected volume and type of business during its early years of operation.

5.23 Restrictions on the minimum amount of deposits per branch aredesigned to protect incumbent firms against excessive pressure from poten-tial entrants. In a sense, they act as an antidumpit.g restriction, protect-ing established firms from a 'ruinous competition" which could end in thefailure of several firms and consequent monopolization of the market.However, economic theory and empirical evidence from banking industries inother countries both show that this barrier to entry should be abolished.

5.24 From a theoretical point of view, a firm dumping its products inthe market should not be seen as selling below its cost; rather it shouldbe viewed as investing to obtain a monopoly position. In the meantime,consumers are benefitted from the highly competitive environment. More-over, it is practically impossible to distinguish a reduction of pricesaimed at creating a monopoly position from a similar reduction forced by'sane" competition (originated for example in technological advances).Empirical estimates for the US experience2 9 also show that dumping was notrelevant in the context of regional financial activities.

5.25 The market value of the points transacted among financial inter-mediaries showed that there were significant restrictions on entry. Onlyin this way it is possible to obtain an economic rent for such a longperiod of time.

5.26 In other words. if economic rents cannot avoid massive frauds, itis better to allow competition. In any case, if competition also Impliessome bankruptcies, at least we have saved the extra cost to depositors andcreditors imposed by a protected banking industry.

5.27 Under Brazilian banking law, on going banks and Banco Multiploscannot have liabilities that exceed 15 times the institution's equity.This 15:1 limit, however, excludes three types of liabilities from cover-age: (1) federal government credit pass-throughs ('repasses'); (2) inter-bank certificates of deposit; and (3) guarantees.

5.28 These regulations raise several concerns. First, the three excep-tions by definition dilute the leverage constraints, and, in some cases,could permit banking organizations to operate with very high debt/equity

29/ See for example Pyle (1986) and White (1986).

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ratios. Second, and more fundamental, there is the form taken by presentcapital adequacy regulations. For some years, bank supervisors have re-cognized that risk in banking is largely associated with the types of as-sets that banks hold. Some assets, such as cash and government securities,add little or no risk. Other assets, such as loans, can involve signi-ficant risk. Capital adequacy regulations that focus on debt/equityratios totally ignore the potentially wide range of risk that bank port-folios can contain. In addition, other forms of bank risk, such as asset/-liability maturity mismatches and off-balance sheet banking, are not cap-tured by a debt/equity ratio.

5.29 The Central Bank is aware of these deficiencies in existing capi-tal adequacy regulation and is now in the process of reviewing alternativeapproaches. It is expected that it will move towards recent capital ade-quacy guidelines adopted by the Basle Group. These guidelines specifydifferent capital requirements for asset groups with different degrees ofcredit risk, and also specify capital requirements for various types ofoff-balance sheet items.

5.30 Of course, the ultimate value of capital adequacy guidelines de-pends crucially on the integrity of bank financial reporting. Even rig-orous capital requirements may have little value if banks are allowed toinflate their capital accounts by not making adequate provisions for loanlosses or by accruing interest on loans long after actual interest paymentshave ceased. However, an examination of the quality of financial reportingby Brazilian banks was beyond the terms of reference of this mission.

B. Exit from the Market

5.31 Exit from the market in the form of bankruptcies or liquidation ofbanking intermediaries is not common in Brazil. As an exception, fourbanks were liquidated in 1985, but no liquidation has taken place sincethen. In the case of these liquidations, the Central Bank covered 10OZ ofthe demand deposits of the institutions being liquidated. Time depositswere covered up to 25Z of their value.

5.32 Several factors may explain the lack of bankruptcies. An economystrongly growing for about 20 years certainly helped banks to make enoughprofits to clear non-performing loans. The Government has also indirectlyhelped financial intermediaries by limiting entry and by restricting banksfrom paying interest rates on demand deposits, thereby allowing them tocollect a substantial inflation tax. Neverthsless, this situation maychange if the system becomes more competitive or growth slows. In eithercase, financial intermediaries will be squeezed and the weaker ones will beforced to leave the market.

5.33 At present, there is no mechanism in place to reduce the negativeexternalities associated with the liquidation of financial intermediaries.30

There are also no clear mechanisms to support the rehabilitation of

30/ The exception is a deposit insurance scheme for savings up to a limit(3,500 OTN) placed with savings and loan companies. The scheme, whichis mandatory and financed by premia paid by these companies, isadministered by the Central Bank and has operated well in the past.

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troubled intermediaries. However, in December 1987, the President au-thorized the establishment of a deposit insurance scheme to partially coverdepositors for losses resulting from the liquidation of financial interme-diaries. The rules and regulations of this scheme have yet to be issued.

5.34 Before such a scheme is put into place several questions must beaddressed: These includes eligibility, voluntary or compulsory member-ship, the liabilities to be covered and the limit on tnat coverage,charges, government financial contributions, and the scheme's role in reha-bilitation as opposed to liquidation.

5.35 A deposit insurance scheme could reduce the negative effects as-sociated with the liquidation of financial intermediaries, especially thenegative impact on small depositors' confidence which may lead todisintermediation.

5.36 Currently, a borrower facing debt problems can file for bankruptcyprotection (Iconcordata*) and from that date on, its obligations are frozenin nominal terms. The borrower has to repay its debt within two years andwith a 12Z nominal interest rate per year. Debts secured by collateral areexcluded. Considering Brazil's current high rates of inflation, concordata-- which was established in a time when inflation was not a problem --provides an easy way to reduce indebtedness at the expense of financialintermediaries.

5.37 Concordata procedures not only weaken payment habits but, depend-ing on the size of a borrower's debt, could affect the creditor institu-tion's solvency. In addition, these procedures distort credit allocationsince they cause financial institutions to concentrate their lending onborrowers who provide collateral. Monetary correction should be allowed,and the maturity and interest rate of a borrower's debt under concordatashould be freely agreed by the borrower and its creditors according to theborrower's repayment capacity.

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CHAPTER 6

PRUDENTIAL REGULATION

6.1 As we have seen, Brazil clearly needs to reduce economic regula-tions in its financial sector--such as controls on interest rates, restric-tions on the allocation of credit, subsidized credit and reserve require-ments. Along with this liberalization process, Brazil should alsostrengthen supervision and prudential regulation. Financial liberalizationwithout both proper supervision and prudential regulation to discourageunsound financial practices has proven to be an explosive mix in some coun-tries of the region (especially in Argentina and Chile).

A. Banking Supervision

6.2 Although banking supervision has improved in the last two years,there are still important shortcomings. Improvements have come from anincreasing focus on the analysis of the overall solvency condition of in-termediaries. The major shortcomings in banking supervision are: (i) lackof a good system of loan portfolio classification according to risk ofdefault; (ii) absence of an adequate system of provisions for possible loanlosses; (iii) the practice of recording as income the interest accrued ondoubtful loans; (iv) inadequate regulation of loan portfolio diversifica-tion and capital adequacy; and (v) poor information disclosure by theCentral Bank of financial intermediaries' balance sheets and income state-ments. In addition, troubled State Banks simply ignore most Central Bankregulations.

B. Loan Diversification

6.3 Brazilian banking now prohibits a bank from lending more than 30percent of its portfolio to its ten largest borrowers. While this lawforces banks to diversify their portfolio to some degree, it would notprevent a bank from making a loan to a single borrower in an amount equalto several times the bank's equity. If such a loan went into default andwas not well-secured, the bank could fail.

6.4 The Central Bank is aware that existing banking law does not con-tain effective lending limits. Moreover, the National Monetary Commissionrecently required the Central Bank to undertake a study of lending limits.The Central Bank is now conducting the study, which it expects to completewithin a few weeks.

6.5 The following suggestions should be considered in formulatinglending limits:

1. Lending limits should apply not only to loans, but to otherforms of credit extensions and guarantees as well.

2. In order to prevent evasions of the intent of the law, lendinglimits should apply not only to the borrower, but to allparties related to the borrower. This provision, for example,

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would prevent a corporation from setting up numerous subsidia-ries for the purpose of expanding its ability to borrow from asingle bank.

3. Lending limits should be based on a bank's eouitv (net equityin Brazil), rather than the bank's assets portfolio, as equityis the most meaningful measure of a bank's ability to absorbloan losses.

4. The lending limit in Brazil should be set at no more than 25percent of an institution's net equity.

5. The same lending limit should be set for all financial insti-tutions under the Central Bank's supervisory authority.

6. The Central Bank should have authority to define all terms inthe lending limit statute.

7. While banks and borrowers would need time to adjust to the newlending limits, the grace period should not exceed two years.

6.6 The Central Bank has indicated that it will consider a resolutionon lending limits at its December 1989 meeting. Moreover, the Central Bankagreed with the mission that the lending limit should be set at no morethan 25 percent of net equity, and that banks would have a grace period ofno more than two years. If tha Central Bank adopts a resolution dealingwith lending limits at the December meeting, it will pwomptly forward acopy of the resolution to the World Bank.

6.7 At present, Central Bank examiners classify loans as either 'cur-rent' or 'doubtful*. The criteria for classifying loans as doubtful arequite complex, but are essentially based on the period during which in-terest or principal payments have been in arrears, and whether the loan issecured or guaranteed. Banks are generally required to make a provision ofIOOZ for loans that are classified as doubtful. Loans that are overdue ayear or more are generally have to be written off.

6.8 The present system for classifying loans has several shortcomings.First, there are no intermediate loan classification categories (such asusubstandard") for loans that could have some loss potential, but do notyet represent probable losses. Second, the procedure for classifying loansbased on interest or principal arrears could result in troubled loans notbeing adversely classified where interest has been capitalized or the loanhas been rolled over.

6.9 The Central Bank is aware of these deficiencies, and will consideramending its procedures in December. During the mission, World Bank staffrecommended that the Central Bank consider establishing three adverse clas-sification categories--substandard, doubtful, and loss -- requiring provi-sions of 20Z, 50Z, and 100? respectively. The Central Bank viewed thisrecommendation favorably and indicated that it would be adopted at theDecember meeting. The three adverse classification categories and as-sociated provisioning percentages have been recently adopted by other

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countries as part of a program supported by financial structural adjustmentloans.

6.10 Although financial intermediaries are required to publish detailedfinancial statements in local newspapers on a semiannual basis, informationdisclosure by the Central Bank is extremely poor. This increases the costof information for depositors and makes comparisons between financialintermediaries more difficult.

6.11 Troubled State Banks usually do not comply with reserve require-ments, loan portfolio diversification rules, and timely publication regula-tions. For example, seven State Banks, whose administrations have beentaken over by the Central Bank, concentrated about 702 of their loan port-folio in single borrowers: state Governments.

6.12 A program to improve supervision of banking intermediaries shouldinclude: (i) establishment of a loan classification system according torisk of default; provisions and interest accruals should be based on therisk determined by the loan portfolio classification system; (ii) stringentregulations on loan portfolio diversification and capital adequacy; fi-nancial intermediaries should not lend more than a prudent proportion oftheir equity to a single borrower and capital adequacy requirements shouldbe based on risk-adjusted assets; (iii) reliable and timely information onthe financial condition of intermediaries provided on a periodic basis bythe Central Bank; and (iv) subjecting state banks to the same regulationsas private intermediaries.

Recent Reforms

6.13 During the past three years the Central Bank has been engaged inan extensive review of its prudential regulation, supervision, and examina-tion policies and procedures. While this extensive review is still goingon, it has already produced notable achievements.

6.14 This year, the Central Bank produced an impressive new charter ofaccounts for banks and other financial institutions under the CentralBank's supervisory jurisdiction. This charter will guide financial insti-tutions in preparing financial reports for the Central Bank. The financialdata contained in these reports constitute an important source of informa-tion for the Central Bank in carrying out its regulatory and supervisoryresponsibilities.

6.15 Within the last two years, the Central Bank also has developed acomputer-based, off-site monitoring system. This system is 'state of theart, for such systems in the developing countries and appears comparable tosystems used in the developed countries. The Central Bank employs thissystem to track the financial condition of financial institutions over timeand to detect deterioration in their condition at an early stage. Thissystem also permits the Central Bank to use its examiner resources moreeffectively by focusing particular attention on problem or deterioratinginstitutions. More efficient use of examiner resources is important be-cause budgetary constraints have forced the Central Bank to cut back on itsexamination force in recent years, even though the Central Bank'ssupervisory responsibilities have expanded.

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6.16 A series of recommendations are also deserved from other areascovered in this reportt

1. Entry into the financial market was restricted through the so-called ucarta-patentew licensing system. This system wasmodified by the new 1988 constitution to increase competitionand reduce spreads. Exit from the financial market in theform of bankruptcies or liquidation is rare in Brazil. If theentry system is to become more flexible, adequate mechanismshave to be put in place to facilitate exit, minimizing itsnegative side effects. One possible alternative is to estab-lish a deposit insurance scheme that would pay off small de-positors in case of the liquidation of an intermediary orwould support its restructuring, if this is tqe less costlyalternative.

2. Bankruptcy protection procedures--the so-called aconcordata"--need to be streamlined to recognize the effect of inflationon borrowers' liabilities. By freezing the liabilities of abusiness filing for bankruptcy protection in nominal terms,present procedures provide an easy way for borrowers to reduceindebtedness at the expense of financial intermediaries. Thisnot only weakens payment habits but, depending on the size ofa borrower's debt, can affect the solvency of the creditorinstitution.

3. The fees on banking services should be deregulated, especiallyif banks are authorized to pay interest on their current ac-counts. The Central Bank usually sets very low fees, causingan artificial increase in the demand for certain banking serv-ices, especially current accounts. In the end, this increasesoperating costs, which are passed on to borrowers in the formof higher lending interest rates.

4. Generalized payments of interest rates on demand depositsreduces banks' profitability by limiting their ability tocapture the inflation tax, and competition will be increasedby new entry rules. Lower profits will increase pressure onbanking institutions, especially on those already experiencingloan portfolio problems. The Brazilian authorities will haveto be ready to determine the magnitude of the potential pro-blems, and decide whether troubled intermediaries should beliquidated or recapitalized and restructured. horeover,without better supervision and prudential regulations it willbe hard to stop unsound financial practices which may proli-ferate in a less regulated environment.

5. The Central Bank regulates the fees on banking services. Thisrestricts price competition and, since maximum fees areusually set at a low level, demand for certain banking serv-ices is unduly encouraged. A good example is the maximum feefor checks which does not even cover the actual cost of the

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check. In the end, these extra costs Increase spreads and arepassed on to borrowers in the form of higher lending interestrates. Ceilings on banking fees should be lifted. In orderto compensate current account holders for the adverse effectof inflation on their current account balances, the existingrestrictions on the payment of interest on these balances alsoshould be lifted. This would also help to eliminate distor-tions in the size and structure of the banking system, bankinginstitutions' attempts to capture an increasing proportion ofthe inflation tax.

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ANNEX 1

FUNCTIONS OF AN EFFICIENT FINANCIAL SYSTEW: ANDMACROECONOMIC OVERVIEW

Al.1 Assessment of the policy-related issues discussed in this reportdepend on the background paradigm used. Hence, in the next section weprovide our paradigm, which shows that the Brazilian financial system haslarge inefficiencies. The resiliency and neutrality of this system havebeen tested by large economic shocks recently experienced in Brazil; faultyand excessive regulations and unstable macroeconomic environment havecaused the financial system to fail to fulfill its more important roles.

A. Microeconomic Role of the Financial System

A1.2 The most important microeconomic functions of a financial systemare:

(a) To intermediate between different economic units. The finan-cial system intermediate between the supply of capital pro-vided by saving-surplus economic units and the demand forcapital by other investment-deficit economic units.

(b) To transform the term structure of debts. The time profile ofinvestors' funding demand is usually different from the timeprofile desired by savers; benks and other intermediariesperform the task of accommodating the different time profileswhich savers and investors desire. To perform this function,the financial system transforms the term structure of itsliabilities into a different term structure of assets by issu-ing indirect securities.

(c) To reduce risk. Financial systems reduce savers' risks bypooling large batches of primary securities (different typesof deposits) and issuing indirect securities (loans), thuscreating a diversified portfolio. By reducing risk, the fi-nancial system also reduces the real interest rates for in-vestors, generating a larger demand for investment.

(d) To unify markets. Financial intermediation, if undistorted,eliminates the market segmentation that would prevail in itsabsence, thus increasing the efficiency of savings. Directedlines of credit or the lack of an organized financial systemare often reflected in market segmentation t-hat prevents theuse of resources so as to obtain their highest marginal pro-ductivity. Because interest rates are the signal of inter-temporal scarcities and preferences, unified markets matchsavers and investors in a time-efficient path.

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(e) To reduce transaction costs. This function, related to theprevious one, is very important because, in the absence of anorganized financial system, savers and investors have to matcheach other and thus face very high transaction costs. Thecentralization process carried out by financial systems sub-stantially reduces transaction costs, thus reducing interestrate disparities and market fragmentation.31

(f) To spread information. A financial system that is functioningwell allows universal knowledge of the term structure of in-terest rates, providing helpful information to those insideand1 outside the financial system. This information is crucialin creating the *right" expectations; by reducing predictionerrors the efficiency of the economy will be increased, unem-ployment reduced, and the economy made more stable.

A1.3 All these functions can be carried out in the market place freefrom any government regulations, except possible prudential regulations.Nevertheless, the rapidity of the transition toward liberalization remainsopen for discussion.

A1.4 The interest rate Is the crucial price of financial intermedia-tion, and as such should be freely determined by the market for both de-posits and loans. Banks should be free to pay market interest rateR ondemand deposits; this is very important in Brazil because of its high andvariable rate of inflation. Payment of interest on demand deposits willlower commercial banks' profits from high inflation rates. Inflation-basedprofits provide variable and hidden transfers to the commercial banks,transfers which are inequitable and a source in instability to the bankingindustry. They also generate inefficiencies by providing incentives toexpand branching beyond the social optimum.

A1.5 Average minimum reserve requirements should be the same for allbanks, and should not be determined by bank size or region. Since theserequirements constitute a tax on financial intermediation, differential taxtreatments distort bank decisions, driving resJurces to inefficient sizesor low productivity areas.

A1.6 The financial system should freely allocate its issues of secon-dary securities (loans). Portfolio allocation forced by the authoritieschannels resource flow to low profitability investments, crowding out otherventures with higher rates of return and thus preventing maximum economicgrowth. These problems are shared by all types of directed credit schemesscompulsory allocation of portfolios, earmarked taxes, forced savings, oroutright rediscount.

31/ Banks would accomplish the function of reducing transaction costs moreefficiently if reserve requirements were zero. Non-interest bearinglegal reserves are a tax on financial intermediation; the higher thereserve requirements the higher the wedge that will be driven betweenlending and borrowing rates, thus increasing interest rate spreads.

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A1.7 Often these regulated schemes involve regressive income redistri-butions, as is the case when forced savings bear negative or below themarket interest rates and subsidies are applied to wealthy industrialistsor farmers. This is also the case when subsidies are financed with a re-gressive inflation tax.

A1.8 According to this description the financial sector Is viewed as animportant economic unit whose efficiency is judged according to microeco-nomic considerations -- of which the key factor is the interest rate, whichis a relative price. The financial system is also closely related to themoney creation mechanism, and thus its performance has macroeconomic impli-cations. Therefore, maximum efficiency from a monetary point of view Im-plies that the financial system should be as neutral as possible. Itshould not disrupt monetary policy, nor should it amplify exogenous macro-economic shocks.

B. Macroeconomic Role of the Financial System

The most important macroeconomic roles for a financial system arethe following:

(a) To ranidly transmit the chanRes experienced by the monetarybase to the monetary stock

A1.9 An ideal financial system will have a short inside lag in trans-mitting changes in the monetary base to the money stock. This will beachieved when most banks target profits instead of political goals, so thatprofits become the driving force of the industry. The system must also befree from uncertainties derived from frequent changes in regulations, be-cause banks will react faster to disequilibria generated by changes in themonetary base if they are operating in a stable environment . Faced withstock or flow disequilibria, the banking system will adjust faster if itperceives those disequilibria to be generated by 'permanent* changes.

(b) To transmit chanies experienced by the monetary base to themonetary stock with little variability

Al.10 If MI was the relevant32 monetary aggregate, the goal of havingthe money stock exactly reflect changes in the monetary base would beattained by imposing a lOOZ reserve requirement. With 10OZ reserves, themoney creation and administration process would be tightly separated fromthe saving-investment process. The Central Bank would be the only sourceof money creation and the banking system would administer the means of pay-ment, while saving and investment would be carried out through medium- andlong-term contracts. The intermediation instruments would be bonds,stocks, and promissory notes bearing market risk.

A1.11 If the relevant rsonetary aggregate is comprehensive enough toinclude government bonds (Y4), the difficulties of separating the adminis-tration of the means of payments from the saving-investment process would

321 The 'relevant, monetary aggregate is the financial asset compositewhose demand is more stable vis-a-vis other financial assetscomposites.

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be very large. In this type of environment, where the money creationmechanism is inextricably linked to the saving-investment intermediationprocess, and bonds have zero reserve requirements, the 0optimum" level ofreserve ratios is zero for all types of deposits.

A1.12 To achieve this 'neutrality.' it is important that all legal re-serve requirements on all types of banks and deposits be equal. Equalreserve requirements would prevent shifts from one type of deposit tomnother from having meaningful effects on money supply. If, in addition,reserve requirements are zero, government bonds are also prevented fromaffecting money supply through endogenous portfolio shifts.33

(c) To provide credit to productive enterDrises

A1.13 The provision of banking credit to productive enterprises wouldnot be of any macroeconomic concern if the economy had a well developedcapital market. The reason to emphasize money, and not credit, is that theCentral Bank and the banking system have a monopoly in the creation ofmoney, but they do not have a monopoly in the creation of credit.

A1.14 The irrelevance of banking credit, from this point of view, doesnot hold if capital markets are underdeveloped, i.e. banking credit haspoor substitutes. In that case unexpected cuts in banking credit wouldhave a negative effect on production. This is an additional reason forequalization of reserve requirements on all types of deposits, as en-dogenous changes in the money multiplier would otherwise also affect thereal flow of banking credit.

C. Other Macroeconomic Concerns

A1.15 To reduce the portfolio shifts that cause undesired chaages in themoney stock and in the real quantity of banking credit, banks should beallowed to pay free market interest on all deposits. In particular, banksshould be allowed to pay interest on demand deposits. The public chooses aportfolio according to the relative return of its components. If interestrates on demand deposits are fixed and equal to zero, the real return willfluctuate, and will be equal to the negative of the inflation rate.

A1.16 If, as in Brazil, the rate of inflation is large and variable,non-interest bearing demand deposits will cause large portfolio shifts.These portfolio shifts are bad in themselves because they bear large trans-action costs; we have also already seen the resultant increased monetaryinstability.

A12.17 Since January 1989, banks in Brazil have been explicitly allowedto pay interest on demand deposits. This is an important step forwardbecause it reduces the possibility of indexed government liabilities caus-ing hyperinflation. By the end of 1988, 42Z of Brazil's monetary stockconsisted of indexed federal bonds. These highly liquid bonds are part ofthe money supply because they are traded intensively in the open marketwith overnight repurchase agreements.

33/ Naturally, differential excess reserves will prevent completeinsulation form portfolio shifts.

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A1.18 The higher the proportion of tovernment indexed or interest bear-ing money (bonds) in the total money stock, the higher the risk of hyper-inflation because these bonds ir.troduce an automatic and increasinQ *realbills'34 effect. In this scenario, today's money issue is dependent onyesterday's prices, implying a model under which today's inflation willdepend on yesterday's inflation. This is not necessarily explosive, but itcould well be.

Al.l9 The payment of interest on demand deposits would cause stabiliz-ing shift from government indexed money to private interest bearing money.This shift would increase in importance as the level of reserve require-ments declined, as the latter would allow banks to pay higher interestrates. In such a case, the Central Bank should not yield to the temptationof increasing the rate that it pays on its new debt; it should in factgradually reduce its financing from monetary bonds and rely more on directmoney issue until a "true" bond market can be developed.

D. Macroeconomic Overview 1980-88

A1.20 The Brazilian economy during the 1970's experienced high rates ofgrowth, increasing rates of inflation, and increasing foreign indebtedness.The record has been mixed during the 1980's as inflation continued to in-crease, foreign indebtedness remained high, and growth stalled.

A1.21 A permanent feature of the Brazilian economy has been the largepresence of the state. Brazil's economy is highly regulated, with manydecentralized planning agencies without a central economic planning bureau.The presence of the state is also felt in outright ownership of capitalthrough a network of public enterprises.

A1.22 The economy was subject to large shocks in the last fifteen years.The oil price shocks were sidetracked by massive foreign borrowing, andBrazil continued to experience high sustained growth until 1980, despiteseveral years in which the terms of trade changed adversely and a commer-cial policy that favored regulations and restrictions over free trade. In1981, a sharp recession was triggered by sharp increases in the interna-tional interest rate to which external borrowing was tied. LIBOR in-creased, from a 1978 average of 9.4? to a March 1980 peak of 19.5Z. Bythen, debt service and petroleum imports accounted for 1002 of Brazilianexports.

A1.23 The debt shock implied a very dramatic adjustment, and during1981-83 Brazil experienced the first absolute fall in real income since thebeginning of national income accounting in 1947. The exchange rate wasdevalued by 30? in 1983 and, in the same year, increased taxes and cutsubsidies. Imports fell from a 1979-80 average of US$23.8 billion to a1983-84 average of US$15.8 billion; inflation surged to 142? in 1983, froma previous annual average of roughly 100X.

A1.24 To cope effectively with increasing inflation, monetary and fiscalpolicies should have been very tight, but that was not the case. The money

34/ The so-called 'real bills' effect should have been called 'nominalbill' effect.

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supply increased substantially, as M4 -- which grew 1062 in 1982 --in-creased 150S in 1983. The Federal Government increased its real domesticindebtedness dramatically by switching from external debt financing todomestic debt financing.

A1.25 Inflation continued to increase steadily in 1984-85 because therewas no meaningful adjustment in the sources of growth of the monetary base.M4 grew at an annual average of 300S and inflation followed suit, althoughat a somewhat slower pace. State enterprises and the Federal Government,excluded from external financing, did not reduce real expenditures butcontinued with their domestic debt financing strateg7; consequently, domes-tic debt as percentage of GDP increased from a 1980 low of 4.1S to a 1985peak of 10.4Z.

The Cruzado Plan

A1.26 When the Cruzado plan was launched, in March 1986, the economy wasin an expansionary boom: real income had increased 8.5? the previous year,while the monetary base had increased by 385, and real wages had beenadjusted upward. The Cruzado Plan was based on: a change of monetaryunit, the new Cruzado being equivalent to 1000 old Cruzeiros; a pricefreeze, including the exchange rate which was fixed at 13.80 Cz/$US; a realwage hike, with an 82 increase above the previous six months average andwith 15? bonus for minimum wage; and a substantial deindexation of allfinancial instruments and the exchange rate. The package also included awage trigger indexation clause with a threshold of 20?.

A1.27 Brazil experienced a consumer boom and a large reduction in infla-tion, without an increase in unemployment, during the first quarter of theplan. The monthly inflation rate declined from 222 in February to 0.62 inJune 1986. The substantially lower rate of expected inflation caused alarge increase in the demand for money, and the typical asset portfolioholder switched from savings and time deposits to demand deposits.

A1.28 This wheterodoxw shock had neither implicit nor announced goalsreiardina money supply and fiscal adiustment. In fact, the Central Bankresponded swiftly to the increased money demand. Between March and July of1986, the monetary base increased by 150S. A slice of the money supplyincrease went to desired money balances, the rest to an increasingly over-heated market. During the plan's first quarter, the market adjustedthrough quantities; retail sales expanded 362 in real terms relative to thesame 1985 quarter, without major shortages or black markets.

A1.29 Shortages and black markets did began developing by August 1986.After September the price adjustment gained momentum, and the number ofblack markets as well as the exchange rate premium increased. Capacitylevels had been reached, and, most important, the money market/stock dis-equilibrium had been closed.

A1.30 During the early March-July phase of the stabilization plan, norelevant fiscal adjustments were made. There were some fiscal gains as thelower rate of inflation reduced the fiscal lag loss, and as interest paid

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on federal debt also was substantially reduced. The overall fiscal defi-cit, however, remained high. Moreover, the increasing relative price dis-equilibrium forced by the price freeze caused further pressure on absoluteprices.

A1.31. The failure of the Cruzado plan became evident by the end Gf 1986.A wedge between actual and desired cash balances surfaced, as in the earlyphase of the plan, but now in the opposite direction. A proper adiustmentcalled for harsh fiscal discipline and a sharp reduction in the rate ofgrowth of money supply; this was necessary to buffer the Impact on pricesof the higher desired income velocity of money. The monetary contractionthat took place after November 1986 was too little, too late.

Bresser and the New Macroeconomic Adiustment Plan

A1.32 Consequently, the disequilibria forced by the price controlserupted forcefully in 1987. In the second quarter of 1987 inflation aver-aged 202 per month, reaching a high of 26Z in June; furthermore, there wereearly signals of recession. Minister Funaro announced an external debtmoratorium in February 1987, and two months later he resigned.

A1.33 Luiz C. Bresser Pereira became the new Finance Minister. On June12, he announced a new plan for macroeconomic control." Again, it was aOheterodox plan, based on a 90-day wage and price freeze, followed byadministrative price controls and new indexation rules. On the fiscal sidesome taxes were increased but there was no decisive overhaul.

A1.34 The Bresser Plan succeeded only temporarily in halting inflation,which reached 15 by December 1987. In 1987, the operational deficit in-creased from 3.7S of GDP to 5.5Z, while both the money supply and the in-come velocity of money increased substantially. The administration targetsfor 1987 also included a large balance of trade surplus (emphasizing verylarge exports) of US$26.2 billion, and an overall surplus on the balance oftrade of US$11.5 billion, then second only to the 1984 figure.

Mailson da Nobrega's *Bread and Butter Approach

1A.35 Bresser Pereira resigned in December 1987, and Mailson F. daNobrega took office on January 6, 1988. His stated goal was to achieve afiscal deficit of 42 of GDP in 1988 and 2Z in 1989. He said that he wouldfollow a "bread and butter approach, pursuing a gradualistic, down toearth policy of public deficit reduction. He took measures that imposedindebtedness ceilings to states, municipalities, and public enterprises,and a reduction of fiscal incentives and wheat subsidies. The new consti-tution, approved by the end of 1988, also granted substantial revenue-rais-ing power to the states vis-a-vis the Federal Government.

A1.36 This 'bread and butter3 approach failed, by the end of 1988, toachieve any sustained price level stabilization. The money supply con-tinued to increase substantially as measures to reduce the fiscal deficitwere too timid, the external accounts were expansionary, and there was aninsufficient reduction on rediscounts to the private sector. Inflation

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actually increased reaching a monthly peak of 28.792 in December and caus-ing a record inflation rate of 933.62 in 1988. The external sector faredvery well in 1988 when measured by the US$19 billion trade surplus. Butthis *very good' performance was achieved through quantitative restrictionson imports, large subsidies to exports and very low growth. In 1988, thegovernment ended the external debt moratorium, paying its arrears andinitiating a dialogue with the IMF and commercial banks.3 1

E. Overview of Some Financial Variables

Moneys Quantity Demanded

Al.37 The importance of any financial system in the saving-intermedia-tion process (also known as financial deepening) can be measured by thereal quantity of money.36 Graph 1 shows the evolution of the real quantityof money (Ml, M3 and M4) for Brazil 1982-1988. Figure 2 shows the inverse,namely the income velocity of money.

35/ The relationship with the IMF and the commercial banks has improvedsubstantially since Minister Funaro declared the debt moratorium in1987. Brazil signed a letter of intent with the DMP in mid 1988.Brazil requested a stand-by arrangement equivalent to SDR 1,096 millionfor a period of 19 months. This letter set target ceilings of 361 ofGDP for the nominal fiscal deficit and 42 for the operational fiscaldeficit. The Brazilian Government also signed an innovative agreementwith the commercial banks' steering committee, offering a menu ofoptions to reduce exposure. A projected balance of payment surplus ofUS$5.4 billion in 1988 was to be used to clear with commercial banksthe US$3.4 billion that *were in arrears by the end of March 1988.Brazil also reached an agreement with the Paris Club on therescheduling of US$5 billion of official debt. By the end of 1988 thetotal stock of outstandiig external debt was US$110 billion, which issmaller than the US$121 billion figure outstanding at the end of 1987.

361 This is really a stock concept, but that the flows pertaining to it areproportional to the stock size.

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Graph 1

Monetary Ratios to GDP.Annual Data. 1982 - 1988.

0.36

0.34 -

0.32 -

0.3-

0. 28

0.26

0.24

0.22

0.18

0.16 -

0.14 -

0.12

0.1

0.08

0.06

0.04

0.0282 83 84 85 86 87 88

O Ml/GOP + M3/GDP o M4/GOP

Notes December 1988 is a projection. See Appendix V for data.Source: Central Bank of Brazil.

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Graph 2

Velocity of Money.Annual Data. 1982 - 1988.

32 -

30/

28-

26-

24-

22

18

16-

* ~~~144

12-

10-

8

6

4

2

82 83 84 85 86 87 88

0 GDP/mtl + GDP/M3 o GDP/M4

Notet December 1988 is a projection. See Appendix V for data.Sourcet Central Bank of Brazil.

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A1.38 During 1982-1988, Ml attained a maximum value of 7.42 of GDP in1986, but the public reduced it to a minimum of 3.52 in 1988. M4., whichincludes the ouwstanding stock of government bonds under overnight re-purchase agreements, was increased by portfolio holders from a minimum of272 of GDP in 1983 to a maximum of 372, in 1988.

A1.39 Income velocity of Ml attained a minimum of 13 per year in 198b,increasing steadily to a 1988 peak of 28 per year. Meanwhile, incomevelocity of M4 decreased. The ratio of federal bonds to total money supplyincreased to a peak of 422 by the end of 1988. This is evidence of theincreasing crowding out of the private sector. The diminished ase for theinflation tax probably was one of the causes of this crowding out. Graph 3shows the evolution of the real monetary base.

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Graph 3

Monetary Base, Ratio to GDP.Annual Data. 1982 - 1988.

0.035 -

0.0340.033, 0.032 \0.031 \0.03

0. 0290.0280.027 -0.026 -0.025 -

0.024-

0.023 -0.022-0.021-0.02

0.0 19

0.018 0.017 0.016 60.0 15 0.0 14-

82 83 84 85 86 87 88

0 Base / GDP

Note: December 1988 is a projection. See Appendix V for data.Sources Central Bank of Brazil.

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A1.40 Except for the short-lived 1986 Cruzado Plan, the real monetarybase shows an important downward trend. By the end of 1988 the real mone-tary base was 50? lower than the low 1982 level.

Money SupYly

A1.41 Graph 4 shows the rate of change of the monetary base and moneysupply (M4). It has two striking featurest (a) the large variability ofby both variables; and (b) the large departures from each other.

A1.42 Between 1982-1988, the rate of change of the monetary base was atits minimum during the first quarter of 1987. In January 1987, the levelof the stock of base diminished in absolute terms, thus the rate of changeof the base was actually negative. Furthermore, the highest peak was at-tained in the third quarter of the same year, with an increment of 641.This large variability was not as disruptive as one might have expected,because federal bonds, whose use by the Central Bank caused these drasticchanges, weee also part of the monetary stock. Nevertheless, these opera-tions are not, as we will see without consequences.

A1.43 Brazil had a policy of legal reserve requirements that has beenvery destabilizing for monetary control (see Chapter 5). While the averagereserve ratio on denand deposits was very high, roughly 50X, the average

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Graph 4

Monetary Base & M4, Rate of Change.a.. Ouurtuu.n." Oa.t. 1082-1985.

0.7

0.U

5-

0.2

a.

82 234 83 2 3 4 84 Z 3 4 IS 2 3 4 57 2 3 4 8s 2 3 4

a AoS 4 AXM4

Notes: December 1988 is a projection. See Appendix V for data.Sources Central Bank of Brazil.

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ratio on saving and time deposits was zero, in 1988. Thus, portfolioshifts caused by large swings in relative profitability have caused largechanges in the money multipliers.

A1.44 The large differences between the rate of change in the moneysupply and the monetary base is explained by the instability of the moneymultiplier. The simple correlation coefiicient between the rates of changeof M4 and the monetary base is only .28 (the same coefficient for M3 isonly .38). Obviously, the money supply has been out of control for reasonsthat go beyond the fiscal deficit.

Credit: Private Sector vis-&-vis Public Sector

A1.45 The private sector was crowded out by the public sector in recentyears--evidence in the increasing ratio federal bonds to money supply andin the government sector credit's share in total credit outstanding.

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Graph 5

Distribution of Total Credit Between1 Govsenm. A PIl to ranPln. s ,,.

as

ma

82 23 3452 3 4 2S a2 4 2 3 452 4 a2 3 3 4 4 2 3 4

dufmflOata. 1952 U

Notes: (1) Total credit to the non-financial government sector and to the

non-financial private sector separately are an aggregation of

credit operations of financial institutions. Because the

timeliness of data collection varies by type of institution,

i.e. balance sheets of State Savings Banks (CEE) take longer

to be updated than those on Official Commercial Banks in the

Monthly Bulletin of the Central Bank of Brazil (Bolletim

Mensal), figures for some of the less important sources (per-

centage-wise) had to be projected from as far back a' June

1988.(2) June, September, and December 1988 are projections. See Ap-

pendix V for data.Source: Central Bank of Brazil.

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ANNEX 2

MONEY SUPPLY AND FEDERAL BONDS

A2.1 The effect of open market operations on monetary stocks and in-terest rates may have different implications when bonds, used in thoseoperations, are immediately monetized by the market through overnight re-purchase agreements.

A2.2 In an orthodox situation, when bonds are not money, the initialeffect of an open market operation is to create disequilibrium. Banks'excess reserve ratios become different from their desired ratios, and thepublic's cash/deposit mix also becomes different from the desired ratio.The final effect is a change in monetary flows equal to the rate of changein the monetary base, unlesz change occurred to the money multiplier.37

A2.3 A different final result might occur if the trade in the openmarket is made with bonds that are immediately monetized. Consequently, weadd federal bonds outstanding to the money stock definition and assume thatthe Central Bank enters the market selling bonds. The first order effectwill be a reduction in the monetary base, but, in this heterodox case,there may be an important compensation via increased multipliers.38 Theseeffects will come from an increment in the desired bonds/deposits ratio.The public voluntarily holds the new larger stock of bonds because of theinterest rate increase caused by the open market sale. It is even theore-tically feasible that the increment in the multipliers will more than com-pensate for the reduction in the monetary base.

A2.4 The Brazilian case indicates three very troubling problems stem-ming from this analysis: (a) the immediate monetization of public debt;(b) the inverse effect of open market operations on the money multipliers;and (c) the Operversea effect of interest rates on the government interestbearing money supply. These are very serious problems, so serious thatBrazil should reconsider its strategy regarding debt-financing vs. moneyfinancing of its public sector deficit, and should also reconsider themeaning and consequences of its open market operations.

A2.5 The following exercise will illuminate the analytic basis forthese points. Let F be the stock of federal bonds outstanding. Given thefollowing definitions,

371 If the open market operation caused an increment in interest rates, themultiplier might change either because of a reduction in the banks'desired excess reserves or of a change in the cash/deposit ratiodesired by the public. Ur-der normal situations these effects areusually very small.

38/ The model works was if" required reserves on federal bonds were zero.

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M : Money Stockm : Multiplier of Money StockB s Monetary BaseC : CurrencyDD : Demand DepositsTD : Time DepositsSD : Savings Deposits

Ml -C + DDM * =C + DD + FM2* C + DD + + TDM3* -M4 C + DD + F + TD + SD,

define the multiplier as follows:

ml* .41* (1)B

= (C + DD + F)I(C + DD)(C + R)I(C + DD)

c + d + f. (2)c + r-

Lower case denotes ratios to M1. Differentiating with respect to f,

& - 1 =M1l (3)6f c+r B

n = Ml B 6f (4)

=< Ml* 6f. (5)mlMl

By the same token,

bi . N1Ml 6f (6)m2 M2

and,I [gi -~~fm Ml 6f. (7)

m4 M4

Hence, the growth rate of the multiplier (of any money stock) due to achange in the ratio of federal bonds to money, is the change in this ratiotimes the relative share of Ml to the money stock definition.

Equation 5 may be viewed in the following ways

< * (8)ml -Ml,

6f Ml~

expressing the semi-elasticity of the multiplier with respect to changes inthe bonds to money ratio. As bonds become a larger proportion of the money

- 80 -

definition, the semi-elasticity drops and the rate of the change in themultiplier drops. The effect of changes in F/Ml are transmitted throughMl1HI to the multiplier. Graph 1 shows the size of MI relative to M1lM2*, and M4.39

Graph I

Wtth 2.tDeCt to a (0.1) Chanqe in F;rN,

0.65

0.55

0.350.35

0.25

002.

0.15

0.1

82.12 3 483.12 3 484.12 3 485.12 3 486.12 3 *87.12 3 485.12 3 489.-J

Quorerty Oata (52/1 - 88/l, Jan. 59)O M1/Mi1 Ml U/U2' < Ml/M4Sources Central Bank of Brazil.

The semi-elasticity of the multipliers with respect to the bonds to moneyratio has been decreasing steadily since the Cruzado Plan. In the fourthquarter of 1986, the semi-elasticity of ml* was 0.56. This means that overhalf of the change in the F/Mi ratio was transmitted to the change in themultiplier (this positive change in the multiplier would have dampened theeffect of an open market operation that reduced the base). In January 1989the semi-elasticity of ml* had dropped to 0.18. Although this figure ismuch smaller than 0.56, it leaves room for a potentially adverse effect ofan open market operation.

39/ The differential 6f has been calculated by:

6f- F + (0.1 * B) F FC + D - (0.1 * B) C + D

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A2.6 Once the growth rate of the multipliers has been estimated, theabove expressions, equations (5)-(7), may be used to estimate the percent-age changes in money stocks; this is more interesting in discussing infla-tion. In logarithmic terms, the growth rate of the money stock is the sumof the growth rate of the multiplier and of the base.40

dln(Hi*) - dln(mi*) + dln(B) for i - 1,2,3

Recall dln(mi*), for i - 1,2,3, has been calculated from equations (5),(6),and (7), and dln(B) - -0.10. The results are summarized in Table 1.

Table 1

Percentage Drop in the Money Stock Following a Ten PercentReduction in the Monetary Base Due to an Open Market Operation.

(End of Period January 1989)

M1* M2* M4

Drop InMoney Stock 4.682 5.53Z 7.192

Sourcet Central Bank of Brazil.

A2.7 The above table indicates that for Brazil in January 1989, a hypo-thetical open market operation reducing the monetary base by ten percentwould have reduced each of the money stocks defined above by less than tenpercent; namely, M1* would have been reduced by only 4.68 percent, M2* by5.53 percent, and M4 by 7.19 percent.

A2.8 Hence, when bonds are part of the money supply definition, theeffect of an open market operation with bonds is dampened. The dampeningis due to the offseting change in the multiplier. The net size of theeffect will depend on the interest elasticity of the bonds to money ratio.The existence of a more 'perverce' effect of an open market operation ispossible when the growth rate of the multiplier more than compensates forthe drop in the base. In that base, the money stock would actually in-crease if the Central Bank sold bonds.

A2.9 The following graph illustrates the percentage changes in themoney stocks due to an open market operation that reduces the base by tenpercent.

40/ Discrete changes have been applied to this formula for the purpose ofillustration.

- 82 -

Graph 2

%Drop n M When Base Falls by 10% Duoto Scal of Fed. fiends (82/I - 88/M.l

82.1 2 3 4 83.1 2 3 & 8 .. 3 4 5132 I3 486.1 2 ............. 1 3. 2 3 *88.9 3*3Ja

' ~~~~~~~~~~~~~Nourtety Data (tnti. Jan 139)I Cl be I e~~~~~~ + M2C- c 4u

A2.10 The graph shows that in the first quarter of 1988, a hypothetical

10 percent reduction in the monetary base through an ogen market operation,! ~ ~would have lead to only 3.9 percent reduction in Hl1 At the same tfime.

i ~~M2* would be reduced by 5.4 percent. and 1.4 by 7.2 percent. Although these

j *~~re an extreme cases, they illustrate the dampening effect of the multi-

j ~~plier on open market operations. For mid-1988 the results were less dra-

j ~~matic but dampening was still present; a 10 percent reduction in the base

! ~~through open market operations would reduce Ml* by S 0 percent. M2* by 6.0

j ~~percent, and M4 by 7.4 percent.

A2.11 Open market operations may have other important consequences: (1)

Federal bonds bear interest, and they imply further issue of money or

55

j ~~(2) Open market ogerations will cause short-term chanlge in interest rates.If the Central Bank sets interest rate targsts, it will love any control it

| ~mRy have on supply, as the interest rate targets will change the relative

! ~~composition of the money supply 'The higher the interest rate targeted,

the higher the proportion of bonds to total money supply; on both counts,

- 83 -

(higher rate of interest and higher quantity of bonds), money emission hasto be higher in the next round. Also, the *multiplier effect" discussed inthe previous paragraph would be operative. This policy could easily leadto hyperinflation.

A2.12 Notice the difference between the analysis above and the tradi-tional model in which money and bonds are clearly differentiated and bondsare not money. In this traditional model, if the Central Bank targets aninterest rate that is below the market's n'atural rate, it has to printmoney at an increasing rate -- thus risking hyperinflation.

A2.13 In the Brazil-an model in which bonds are money, targeting aninterest rate that is higher than the market rate could lead to hyperinfla-tion. If open market operations are aimed at targets below the marketinterest rate, the income velocity of money will increase and inflationwill rebound.

A2.14 The conclusion is that the interest rate should be freelydetermined in the market without Central Bank intervention. Also, as longas inflation and fiscal deficits are very high, the Central Bank shouldrefrain from using open market operations to manipulate money supply.

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ANNEX 3

MAJOR TYPES OF DIRECTED AND SUBSIDIZED CREDIT PROGRAMS

A3.1 This annex describes six major types of official credit programspresent in Brazil. In each case, the major sources of funds supporting agiven directed credit program are described, the institutions that collectand administer the resources directed are indicated, and the quantitativeand pricing restrictions applicable are discussed.

A. Defining Directed Credit

A3.2 Directed credit operations, if broadly defined, include any law orregulation that restricts a financial intermediary's ability to apply lia-bilities freely on the asset side of the balance sheet.41 In Brazil, suchrestrictions often require that a given source of funds be applied to aparticular sector (e.g., housing, agriculture, etc.), region, or type ofborrower. It is possible to view directed credit operations as a form oftax or subsidy that is either levied or conferred on financial intermedia-ries or borrowers.

A3.3 The Government has elected to create by law several X or fundsbased on the earmarking of taxes (e.g., payroll, sales, corporate income,and import taxes) that are primarily used for long-term investments inspecific sectors or for the provision of a variety of social services. Inlarge part, so-called second-tier federal financial institutions (e.g.,BNDES, federal savings banks, or the Bank of Brazil) are charged with ad-ministering these funds.

A3.4 The National Treasury also administers a variety of funds (for-merly administered by the Central Bank and the Bank of Brazil until the endof 1987) that direct primarily short- to medium-term credit to targetedsectors (e.g., FUNAGRI supports agriculture, and FINEX supports exports).In most cases these funds are repassed through public and private financialintermediaries to final borrowers. In addition to directing credit totargeted sectors, some of these programs fund outright government purchasesof agricultural products, provide crop insurance, or fund programs to pro-mote production or exportation of a particular good.

41/ It is important, however, to distinguish within such a broad definitionthose types of restrictions on the application of funds (e.g., leveragerestrictions or diversification guidelines) that may be viewed as formsof prudential regulation.

aiart 1

Directed Credit Pr */

Flow of funds Sector of finl bwrowerFugos/fntermrdiariei/ or

Or_g__of f__ ds Goverrunt agencies aplcato of funds

Gontral 8a~~~~~~ edvmCntra

1) & nd4 lows s lsz

3) Treasuryborr=si~4) Prrteion of Ps sbOvng *.

5) Ltmm (e.g.,Trsm

(zinz fo 1a ofoo f~mIe 1) fo incurit zia

Ce2 itd Bnk funds: _lm all- scale_InAst t y

1)tlml t wfmi btes orfacilitiessIlqatylrlser

Relets t r r t P8Pambo nBop2en beInvX esteI ~~~~3) Sw l ]OSI& of _lsd

PaIth cotial bM amb_i2)~~~~~~~~~~~~~~~ Redtl de S h ate1

*/Reletsth stuctue of t=s rgasPirt 9

- 86 -

A3.5 The Government has used the banking reserve requirement to financeits deficit as well as to encourage commercial banks to apply certain lia-bilities (e.g., demand deposits) to finance agriculture, small and medium-sized enterprises, and, more recently, financially distressed enterprises.The reserve requirements are linked to the directed credit operations intwo ways. In some instances (e.g., applications to agriculture), financialintermediaries that do not apply a certain proportion of their demand de-posits to certain sectors are forced to hold these amounts as non-interestbearing reserves with the Central Bank. In other cases, a portion of re-quired reserves can be lent to distressed industries at subsidized interestrates.

A3.6 Rediscount lines administered by the Central Bank as part of itsdiscount window function are directed to particular types of financialinstitutions. The Central Bank differentiates the interest rate applied todiscount window advances to federal, state and private commercial banks.42

A3.7 Substantial credit programs have been employed in order to supportthe housing finance system. This has primarily been accomplished via re-gulations that target a substantial portion of passbook savings accounts athousing finance.

A3.8 A final form of directed credit (see Chart 1) results from govern-ment regulations requiring various types of non-banking financial interme-diaries (e.g., pension funds, insurance companies and short-term mutualfunds) to purchase federal, state, or other Government-related securities(e.g.. bonds issued by the FND).

B. Description of the Major Programs

A3.9 The major types of directed credit programs present in Brazil arecomplex. Table 1 below provides a broad overview of the major types ofprograms. A wide range of banking and non-banking financial intermedia-ries, with the naotable exception of investment bank dealers and brokers,are subject to restrictions on the asset or liability side of their balancesheets which affects the pricing or the amount of their liabilities andassets.

A3.10 The third column of Table 1 indicates that for most officialcredit programs, the Government places some constraints on the return to bepaid on earmarked funds. Only in the -ases of non-banking financial inter-mediaries (i.e., pension funds, insurance companies, or short-term mutualfunds) are there no restrictions on the interest rate or other terms of-fered on those resources. However, in these cases, restrictions on theasset portfolio of these institutions effectively constrains the returnthat they can offer to pensioners or holders of money market accounts.

42/ In principle, differential charges on overdraft lines will of courae bewarranted since the regulations governing discount window policy oftenresult in different charges and penalty interest depending on the sizeand frequency of overdrafts. The Central Bank discount window policyis described in some detail in Annex 3.

Tabl I

Dmecricteon ef the Tvyes of Directsed Credit b. Type of Reerces SE rked ma of Janhmr. I

Restrition on Leglp (L) oradministering regulatory o.. of sset aide resrictioninst;tution'- (t) Typ, of lend- Fore d invest-

lnstitutions pricing of reotrietion ing institution wnt in ogvt.adaini-tering earmarked on Type of adminietering securities or

Resource, earerhtd the reoure funds appli cations Sector l Regional borrower reouree - maturity Pricing reed. reserves

1. Long-term compulsory Official v L Y v Y N Y Y Nsavings funds (FaTS, fin neail (varies huino (FCTS, (not unifor- Differ. byPIS, PAP. FD6OCIAL, institutions according to FtUdHA8, F'VS) for *11 funds) region. *ec-RV, F4M. Rd M, (MM/CEI/ administering Indut tor. nd byFaW). Source of Sanco do Brasil) inetitution, Aarieultur, type of bor-funds: ererked tates but appl ies to CPSI/PASEP. rower, incomeand fo-e d inveet_nts vittually oll FINSCIAIL, of boroer orby non-bank financluil co iusory RND, PAN) occupationinti;tution; svinag funds) Socil S_etor Jo

(fimacia l)Infrabiructure(FMTs)

2. Najor fun,d nd Treasury and y L Y 'V ' N Y Y Nprgrams eupportinag government agein- Funds Applied Northemst vs. (g.. Differs byshort-term working eise with funes in support of South Central depending on region acapital to sediu_u-ter- repassed through agricultural (mamunts the ty of ector e we I1credit (e.g.. p WRI, (1) comercial and industrial applied to sor.outural as by typ ofRtervs mneteri., banks (fedral, credit, regions lending) borrower ortROASAL, tORtO, ett and pri- eapors, etc. secified) income ofF1Il. RAicat. vate) and (2) borrowerFlPE). Source of developmentfunds: primarily banks (state andearmarked Trseury fedral)revenue nd CentralBSak advances

8. Sight dspwiteb or Federal, astae. Y R Y Y Y Y Y Y Yregui red resrve and private (Interest can- Agriculture Particularly Aewanta to be (var;ie *ith (under force

ceomrcial banks not be paid by and mdium- for _munte applied very regrd to lending pro-financial sad _ It- lent to the with size of rgion. sector grapm forinstitution scal industry Northest in '*cial and type of agricultureis uing the mo proportion conteet of bankg borrower) and ml I Id ieight depweitc of eight forced leading indium enter- ;1 k k

deposit. d to apriculture pri_ the lLending to aonwt notdistrosed a" lied mstenterpri es be hold s Oout oft ri'Wirdrequired resves) '

reervs

Restriction on L.gal (L) oradminiterinng regwl T ofasf et side ratrictieonint7tutlon- (. ) Type f lend- Fe inve

In titutioe priicing Of rctriction ine institution _nt in govt.mdeinietering er_rked an Typ of administerine *amwiti_e or

R_eeurces nermried the reuerce funds api licatine Sectonal Regieonl borrower reewrces Hoturity Pricing ro. rerwvs

4. Forein borrowing Cnm_rcial N R N N N N Y N N

bki n_neetmt (mini_ms of banka/other year.)el1gibleI ntitutle

S. P _owAkevinp Specialized Y R Y Y Y N V V V*ccouints svings, loans in fund

Inetitutisne I(SC7IA! FE TA. FMS)federal 4 abots ad.. nieteredD*a ing bankis by CF to ap-

port the ho.s-in, finmo

Inwura,ce pr_is Sneuranra N R N N N N N N Ycopean;om

7. oneloin catribution. Pienac funds N R N N N N N N v

S. Ptney mrktt accounts Short-term N R N N N V v N Ymutal funds

.Central ian funda Centr lBank Y R N Y V N v Y NBy type ofrecipient ememrcial bank

if Information is proe iminary. Alao coverae is not exhawetive in that the Fiecal Incentive Scb... (e.g., PFDR FIsE, Ft4tM. ed PIN/PUROTA were not xamined in depth, esSection C blege for a brief description of thee. echema or Report No. 6077-ER of February 1987 for a *e elaorate diecueion of tea fiecal incentive echin*

i Over the period examined mom directed credit program had applied to ti_ depoits which ere r_ervable. hwever. a of early 19s8r oll rewired re... eearcatned *ith timdosit. inclusive of fore d inveetents in governasnt securities had been eliminated. 1 4>

/ Recently mom com_ rcial bante have begun to imae interest-bearine short-ter- aceon c led cant. re r neDad.,ji Not* that in practice coepulsory landing in thew area is determined by application of a percentage to net eight depoits defined as grm eight deposit. *inre regired rewves. __

gvrnmet depmit. and a number of ema lor items. A

Sourcs: Central ibnk and LATTF.

- 89 -

A3.11 Table 1, column 4 shows differences across official credit pro-grams with regard to the legal or regulatory origins of the program. In-terestingly enough, many of the official credit programs shown in the Tablehave been mandated by Central Bank resolutions instead of laws. However, amore detailed look at the long-term compulsory funds and the Treasury-controlled funds and programs reveals that virtually all of these programshave been created by law.

A3.12 Table 1 also indicates that the most comon restrictions ap-plicable to all types of official credit programs indicated are sectoral,regional, and type-of-borrower criteria for the allocation of funds. Thesame criteria often affect the pricing of the funds applied, since rates onofficial credit granted to low-income borrowers in the Northeast in supportof agriculture will tend to be subsidized (e.g., PAPP). In other regionswhere borrowers earn larger incomes, this tends to be less likely. Theseprograms can thus be viewed as a means to redistribute income in partthrough cross-subsidization of poor farmers by farmers with higher incomes.

A3.13 Finally, Table 1 indicates that forced investments of demand de-posits, passbook savings accounts, and a variety of other privately issuedliabilities have also constituted an important means of directing credit.

C. The Programs: Detailed Analysis

The ComDulsory Savings Funds

A3.14 The broad overview of directed credit programs presented inTable 1 masks several characteristics of the different programs that can beseen more clearly by considering each in turn. Consider first the directedcredit programs that are furded through taxation -- the compulsory savingsfunds. Table 2 summarizes information on these funds.

A3.15 All programs shown in Table 2 have been established by law --which has often mandated that a certain minimum return on these resourcesbe obtained by the federal financial intermediaries administering them.For example, CEF must pay MC + 3.7 a.a. on FGTS resources and can at timesearn a negative spread these funds. Restrictions that do not permitsecond-tier federal financial institutions like BNDES to raise free fundsin the private money and capital markets make it increasingly difficult tophase out directed credit programs, since only taxes and foreign borrowingsupport the operations of these institutions.

~akDireeted Ciedit Deeratign Acied with t7b Iblor Forced Sevens P_Emes - pf janus, 1

Reetri ctlOaSan prieint o0

remrces by Finncialint ermdiary lintitutian intrmadiery PA*trictions an meelicatira

adeini;ering col l;eting adsinistoring TyP ofNose of Fud or Progrem Origin of reource fund reoures reeorce Soctal Reglnal borror Obturity Pricing

1) FCtS (or tine on job U eyroll tes levied on a1 eat- IC + a.T a.* Caso Cain Fun weet be Didelines pro batsd an hed on dcisions by thegurante fwnd) was ties subject to labor legisla- so mmdeted econo miCa kooice applied i n sup- estebliisled by decimims by Counc;i of Truetoe with CE.esebdlithed by Law tion. Contributioem are rvi_ed by Lb 6.107 Federal Federal port of (1) fee- the Councl of the Counci; Vories by sector. rgion. *d6.107 of Saptear mnthly. Fund are received frm ily hoasing, (2) Tr_te under of Trusts type of borrer * "wellw. ThIbis is *ll orkers carriod undr the refinanc;na Decree Loe by citypri;nrily a compulsory Social Security System (SZWAS) restructuring 2.407 and theun _ lopeent insranc associated with Comcil meetSyste. lmewer. with- soter and seer- apovr CEedranals of fund can ae projects or decisios

lso occur urAer a (8) in support Dvoriety of other of Commrcilmeventa that my not be conrtruction.coincident with on Decr La 2.407ploymnt. For eseuple, of Jon. S. low.fund can be atdrewn indicates that aupon mrriage deth council ofor even in th swent trstoeei w Ilof the purche of a determine b1hoems

PTFCIS funds llbe allocated inconsultstionwi th theNatinal Councilof Urban Devl-opmnnt (aO@)

2) P16 eteblis;hcd in 751 of receipts *ro a in Ninimue of MC coins There are <vc- Tere are There ere not Tere leding: Cannot srn aSestether 1970 under enterprise solea tas and 2S from 3 .51 a.m. onoica topnl restric- regional any omior re- moturity of proed ofLaw 7. This fund dir ect Treesry trnsfors of the Federal tion. on the restrictions strictions on landing mat more thn 2bprowide un ioyment corporate income teo. pltI i catioan of on the a loce- the uamnts be greter of theeand other form of the funds by Ue tion of funds that hays to ten I year. funds by Law.coverage to M-civi I (that r quir e at the di;cro- be lent to Th;a Guido- Pricing dif-service e loyee lending to tion of the Particular liine he been fers accord-industryq ODverne_t tsy of e ;e irg to fial 0

enterprioe given that borroer. W O 0 JIm111=is ae viinvemet-

developomt sent. TN *bank 103 ndustry.

OTM * h for 4

awleca_olt

niustry

Restrictionan pricing ofresoures by Financielinterdiasry lntlt.ution intermediary Retriction on olication

administering collecting administering Typo OfNrs of Fund or Progra Origin of reources funds reouresn resourees Sctoral Regional borronrr lhturity Pricing

8) PAEP created in DO- It is funded through a trarsfer Minim of C Banco do ae5 5ss as for P1S Sers as for Sees as for Smu as for Sossas forcamber 1M70 under daf 25 of oprating receipts of * 8.5a a.. bra; I PI5 PI5 PIS PIS7. This fund provides each level of gowern_ent.coerag" to civil Provides unemployment insuraneservie asOloysa to cav; I service ploysoe

4) FM or the thritlm Funded throuwh a 35 tax n the MDdES mt Portobras Reoures- ad- eOtS mstFund: Was created by value of iorte in excas of CIF pay 01T * OS minidtered I lnd >outLow in. of value, nd taxes on freight for use of controlled by thes funds

chargee. This include s 20a tex thes funde Ministry of at an *vera|gon the iWort freight bill and a Trnsport, of OIW * 6V101 tow on CT) .D1 acts *as

a fiduciary

Funded through (s) 0.5O to N.A. *ince Bnco do Obtior I The sectoral Regioal *ilo- ND quaentita- Since _jor- About 96 ofS) FINIICIAL wse croeted ivi ed on a l IwsIs of coeen ise most funds Brasil (col- Trea_ry (0 a allocation is cations are t;e alloce- it4 of appli- FDIIOCIAL

in 1902 under Decree (private or public) that produce ar* allocated lects fumde A sm1l *mount dstrsined by determined tiom by typ cations are reourc- areLos 1.940. This fund goods A (b) by 5b contribution to ministries rsits to repssd Decree Low 1.940 annually *gain of borrower grantse oetr- grante * thea" introduced to (of corporte in co ton chsrgs) as grant Treaury through OMQ) of 1902 whereby by Law ity restri- ramining )dS

support various social made by service companioo financing within 3 SIFLAN/IPI. tians not of the reprogram. The funds working days) BNl#i. S a the pplicable ources *rsare part of Treaury sectoral ainio- Subject toreven"s tris *agree on pricing

the allocation retrictioannually. Over1iee2-6 SO lltsupported foodaid. 21.73 s _lagriculturalproducers, 19.73heaslth, 11 pop-ular housing. 9neducation, A2.61e othersocial program . D I

Reat icti onan priciC2 of

resoure. by F1nncial

intermediry Inetitution iltereadiry _ Rtte;tion on mI;ct.ono

aMinistering Golt It;n adminietering Type of

Mano of Fund or Proraa Origin of resourew fund. reources reoure. SetoalI Regional borrower Iturity Pricifig

6) RD: This fund e IbJor ewmrcew af funds include: OTNI * 6.1 Petrobrfis Directive. of Sectrl rlloon- So t N.A. Toro st be Pricing

or sted in July 1986 (a) 2b t'e on the wevle of the n ount tht col 1ec tax the Presdent tion is detr- invet 3a1 of greater than restriction

by Dereew La 2=Z! alcohol a asol ine eonsmed. O par& revenue end & Superviory min d by a FM fune in 4 years on FW funds

and to relnted by (b) * graated te on the acqu;- out to the rmit. It to Soerds to the Suporvieory the worth t i TIs * 6.0

Decree 9o 1111S of sition price o' e cars shore Treesry to the Cent"al ibtinal Tree- i'd est_b-

July 1`16. The fund the rate upris bebhee s for wee a portion bn ewhichi ary. Also I Ibhd by La.became seratlonal in nem cae to 10S fpr core 4 yeros of these Invest liquid GM= act. as Sw o fod. are

196 old; CO) lumiae of 10-year ORD fond. belac. as the OS.' eIocated tobeads peybeg t .a. A principnl agent for ho agent 4 r on- pr_ue. there

indeed to ON. Interest pas bl- Trem_rp lending seoe caital of en-eowthly; * (O) Centerl 1nb eof t h terpries (e.g *

;_emd bonds paying SIN * SS with funda. A very Eletorbee).3-year mtrlity & Interet pay- amell a_mt other fin areaents paya on a _smetral Is onlont errksd tIbisi. Thean are to be serviced throuh te seifie sscto

uing fle of future tax collec- Sano do vie 11Mltioe that earn interest in Srael;Centsrl bA

N.A. a Nbt pplicable

k/ Doe not include *l iportent cospuloory saving errangets, such as t oieintd with the seial seurity system o(SDfS). or th Fiscal Incentive Fun4s (FRS. FIT. FTM.

PD/pROTWA).

Soures: Centratl ank. I S. Cb . aCnd SIM.

m x-Al

O) I

- 93 -

A3.16 Most of the officiaL programs are funded with explicit taxestpayroll taxes for FGTS; sales taxes and earmarking of the corporate incometax in the case of FINSOCIAL and PIS; earmarking of government revenue inthe case of PASEP; taxes on the value of imports in excess of CIP value forMM; and implicit taxes in the form of compulsory investments required of

closed pension funds and insurance companies, as is the case for the OFNDbonds issued by the National Development Fund (FND).

A3.17 No single financial institution acts as *.he agent of the Govern-ment in collecting these resources, which are administered by either fed-eral financial institutions or ministries in conjunction with the NationalTreasury. Even public sector enterprises (e.g.. Petrobras in the case ofFND or Portobras for the FMN) act as collection agents that pass on re-sources to a given fund. The current complexity of present administrativearrangements raises questions about the extent to which the Government andCongress actually control these funds, as well as the transparency of theexisting system for accounting for these resources in the budget.

A3.18 Allocation of these funds to particular sectors, regions, andborrowers often is not related to market conditions. For example, in thecase of FINSOCIAL, existing decree laws require that a committee composedof Government agencies (i.e., SEPLANIIPEA/BNDES/STN and sectoral minis-tries) determine how these funds will be applied across sectors. Simi-larly, in the case of FGTS funds, a council of trustees established underDecree-Law 2.407 determines all major CEF applications of these funds.Such arrangements have led to a wide dispersion in the pricing of housingcredit, particularly since CEF must earn a higher spread on very limitedfree resources to czmpensate for the explicit or implicit subsidies in-herent in restrictions on the application of funds.

A3.19 Usually, when the Government issues long-term debt to fund such acompulsory savings program (e.g., FND through issuance of 10-year OFNDbonds), a return is offered which requires that a captive purchaser befound (e.g., pension funds and insurance companies) this debt. This sug-gests that the Government either cannot or will not attempt to place long-term debt in the market to fund its long-term lending operations.43

A3.20 In sum, the directed credit programs associated with earmarkedtaxes act to segment the credit market and result in a wide dispersion oflong-term landing rates. Moreover, the responsibility for collection andallocation of these funds often resides with different government agenciesand federally-owned i nancial institutions.

43/ The description of the compulsory savings schemes above neglects todiscuss a variety of fiscal incentive schemes that have been designed(under Decree-Law 1376 of 1974) to promote the development of theNortheast (FINOR) and the Amazon region (FINAM) or to encouragespecific sectors (FISET). In addition to these fiscal incentive funds,others such as PIN/PROTERRA operated during the period reviewed butrecently have been phased out.

- 94 -

D. Funds and Programs Administered by the National Treasury

A3.21 The funds and programs now administered by the Treasury take avariety of forms, as can be seen in Table 3 below. Some of these funds areused to direct credit to particular sectors (e.g., FUNAGRI for agriculture)while a number of funds function as price equalization schemes (e.g.,PROASAL or FDPE) that guarantee the prices obtained by domestic producersof alcohol and coffee, respectively. Finally, these funds and programsalso support the public provision of crop insurance (PROAGRO) or even pre-export finance (FINEX).

A3.22 Virtually all of the directed credit programs shown in Table 3were established by decree/laws. However, in contrast to the compulsorysaving schemes, they are all now administered by the National Treasury, andthe collection of resources utilized by these programs is more centralized.

A3.23 The resources for these funds and programs has tended to dependless on earmarked tax revenues, with the notable exceptions of PROASAL andthe Monetary Reserve Fund. The latter fund has been the largest fund andprogram transferred to Treasury control. In the past, IOF tax proceedshave been earmarked to support the Monetary Reserve Fund; however, therevenue obtained from this tax is now collected by the Treasury. Many ofthese funds and programs obtain resources from repayments on existingcredits and foreign borrowing -- primarily from multilateral and bilateralinstitutions. FUNAGRI is the most significant recipient of foreign funds,as more than half of its outstanding liabilities were denominated inforeign currency over the 1986-87 period.44 Finally, a particularly im-portant source of funds over the period reviewed has been outright CentralBank advances. The recent budgetary reform has resulted in the eliminationof this form of funding for these programs.

A3.24 Restrictions on the applications of resources by these programsare numerous, as can be seen in Table 3. This is particularly true forFUNAGRI and its 13 major subfunds that provide credits for agriculture andagroindustry, and the Monetary Reserve Fund which has in recent years been-,.ad to provide liquidity to state commercial banks.

441 A large proportion of these liabilities represents Brazilian borrowingsfrom the World Bank in support of agriculture that are repassed throughFUNAGRI.

IakhJ

Directed Credit Oeeration Assoc.ete with the t_icw Fonda and Proa miniftered b. the Treasry Oa at J_snuarv I8

Restriction.on pricing of

recsurces by Financialinteroedisry Znetitut;in interaediary Rstrietione on anal icationa

administering collecting adminietering Type ofMom of Fund or Program Origin of resources funds reourcee rweurce Swetor I Regionsl borresar lkturity Pricing

1. R#V1: Consate; of (a) Forion borroain, which None in that National tktional Tree- Agriculture/ Amounts *r Car. be Eniet depend- Rtnge froma large number of accounted for more than one half Treaury Treaeury with *ary adminis- mgroinduetry allocated to restrictions ing on type an effectivefunda that aupport of the totel stock of reeurces ad-inisters Central eank vera the priorities are particular depending on of vagr;cul- rote af es"esteiaon- of in 1986/87. Much of this foreign funds. Re- acting as accounts and now being set by reions. An the eubfund turel cr*dit then lii forarieculturIl a *aro- l Indng was Provided by intern.- atrictiens on agnt credit lines a group of ge n- egample ie within line. "net PoP" re-industrial eredit.b tional lending in titutieo pricing of ewpporting ciee including PAPP. a ub- FUNAOil of these orcee ep-Establiehed as pert of (b) D n Reenure. due to (i) F.IMI re- ROPI. The (a) the Trea- fund under estained. In credit lInes plied in therural credit aytet- repaents on exieting credit ouree occur Central Bank eury, (b) the FPW. RI that the case of finance (a) Northeast forunder Law No. 4.* 9 of lines, (ii) Central SBnk when fund. act, s the Ministry of a tergetted agricultural working capi- a_11 frees1968 and Decree Law advonces; and (iii) funds are repased aet for the Agriculture, and to the liorih- credit die- tal or pepr- to 01 * 12886i68 of 1965 tranaforrd to FPtl frm to ceomrcial Treasury in (c) tha Central est. in up- tinction are sting credit *.s. for eow

ce rcial bank. that represnt banke in that r*pnising or Bank. Thee port of amIl "ede in (up to 2 agroindus-amount. that banks cnnot apply a Is pread rediscunting three agenieis rural pro- amount. a* lo- yesrs); (b) trial lend-under (NM 18) that requires is required Ft w*ll submit a ducera cated to short-tam ing. Differ-applications of not eight by the Tren- resourcee with budget fgr wal., medi;u investment entiation indeposits to agricultural lending sury of benks commercial FW84MI to the & large credit (up to pricing b',

that are al- banks mOC that W'sI producers 5 years) for type of Ared-lowed to review it waei-fia d it (cmtio.edeinieter seet.a; and invwetiumnto.funds (c) longer etc.) by siz

*turiti;e, af gr;cul-(up to 12 ture! pro-ye rs) for dueur andfinancing r"ion topurchiss of which creditfi sd aeos is extended.

NMC remolu-

tiee defineeaivitingepricing

po' icy

2. Preoraa to Primari ly funded in the post Restriction. Notional Trea- lktlonal Tram- 5Ss as in above Amount. were Differs N.A. ND chear isupport the sugr- through dometic reeurces that only applied sury with awry *daini;- allocated to across typos *sn_e n >e on

*lcohol industry. incluJMd in order of priority (i) to rates at Central BSnk tet the Northeast by the provielon mi eThi; is a price Central Sank advances, and (;i> which Contral acting as account. and NMC of thee C_eqalization fund. It tex on the eel* of sugar. Under Bank agent credit lines reolutione funds _t

w phased out in 191? the budgetary ref._ impleete d rdi ewnee *upcorting at the end of 1987 the Central resource PR0AL Bankc will no longer be able totaks any direct advances tTreaaury funds end progrminclusive of PROASAL.

_ -r A'4NtFX 1Tah 1e Ilwac,e 2 of w

jsEI 4iis -e.4

l~~~~~ _ 1! :+-l

s 4 , 3i Z 4 , i -I

Rstri ctioneef p,iiflr dit0afc by P)nenJi*interoedjmry Zat.Itutia' Intermediary Rar..xtiamsao *5pS ,,catjpw

adisri;t r; ctollectieg UdialdthPiAt T1pe at

Nm o Fund or Program Orii a' .ee.rcoe fun" rercO e rerc Sectoral Rieg.ni bowroree letur t) Pr ei6n1

6. fDw: Prexport Primal Is funded in the tho N.A. Netinal Team- CACEX Only prided to W.A. .A. EsteIi oh" On avera.e

finauncime fee IlIt thrwqh (;) Central 1nb ewry with exporters; by CAC ETb

_t ;eb_ b Dore, advances, Cii) repayWte an Centipl Ban aunut deter- puC. e *

LI SaS of INS end existing lose* NW (tI;l) -o , as elned cahootly

Decree LAW of eaternel funing in; the etext o lt, as part of th

l0o of previam I= export budget, proee

develeent loans for Braxi I

7. eonrat6li de Funded throup Cental 1e1 N.A. National Treo- Netionat Not tawo;IbIs ett *avaleW l Neto *va,lo,v e Ne*t N vt lab's Not Swefable

RJra in : advances A throug esternal oury *itb Traury

Thieo *a trastory eurcew prirIy provided from Central 9ank

accownt official cradited acting sa

N-.A. *- t aplicabla given mature af the operation of the Pund.

A/ f*ormation proidod nthWe tabl ic Still incoele and need, tobe verifiod *ith staff t Centrat Bankand $T.

IX J|-

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A3.25 FUNAGRI onlends its funds to agriculture or agroindustry throughthe financial system, which in turn must apply varying proportions of thesefunds to specific sectors, regions, and types of borrowers (e.g., small,medium, and large producers). Pricing restrictions associated with the useof FUNAGRI's resources on both the liability and asset sides of the balancesheets of commercial banks are highlighted in Table 4.45

Table 4

Aversag R as on Resourcs mand ApII cation, of iMFResoures Utllied by Com_rcial Banke

(GINM *vraeraote)

Rates at uhici resoures providedR teo mt which resoures man li d from TrasUrY

Nra* of Fund 12/31/85 12/31/86 12/31/87 12/81/65 12/21/8 12/81/87

PROALCOOL (Rur) C + 7 CH * i CHFl * 4 arCH 08 4 . 8 C + 0PR1AN ClM * 9 or llb 0 9 or llb CH * 9 or lb C * S oer 7 CM * S or 7 CH s 0or 7PRUALCOML.-BIMPRIFIR (Rural) CH0 + 0 C * 7 C0 4 7 C08 0 a CM a8 C0 +

PROVARZES (Rural) CH + 7C? CH + 7 04 . 3 * a C0 * aPRiTNV (Rural) Ci * S or S.c CM 4 * or .S CH + S or 3.8* 81 81 81PRODlOtE 1U (Rural) 0 + 7_ed C4 + 7 or 9d CF * 7 or od (0/Jurca) (*/Juros) (sfJuros)PRO0DQE (Rural) i * 7 -0 d 04 + 7 or 9d CH + 7 or 9d tx financlianto ewno 4 pton pare.PAPP (Rural) 04 + 3 CN * 8 CH + 8 (/iJuro) (0/Jures) (s/Juros)FROtE (Rural) C. + 7 CM + 0 C.? 0 4. o. 0 4 . 8 OlRRin CH. + 7 Of + 7 C. + 0 C. 8 0. +8 O. + 3fROIAP (Rural) f - 7 CH 0 7 H + 7 04 + a CH + a CH + 0PRWI4F, 04.9 or 11 f e 0. 11 CH.0 or 1 ta. finwse. _onoe2 ad 4 pto. pore.

(Industrial) efa. rem, do A. Finan.

j,/ Rates shown are the reported by Sanco do lrasi I in i FUA#4t0 operations. Thes rates are alsoapplted to other eorilt - .

k/ The first rate refere to credit extxnded to the Northeat (SLCDA1N/0.QE) the other rate applies tofunds estended elsewhere.

gi/ The first rate applies to Oreflovestasanto and the second to other Inveataento.e The first rate refers to sini/email producers and cooperatives. The higher rate applies to mdium and

large producers *nd cooperatives.

Soureex: Banco do Ora-il and Central Bank eetiataa.

45/ In the case of most of FUNAGRI's subfunds, resources are made availableto commercial banks at rates of about OTN + 3Z, significantly below themarket cost of funds such as 60-day CDBs at OTN + 102 or savingsaccounts at OTN + 62 (tax free). The average rates charged onapplications of these funds to final borrowers also are restricted andoften are differentiated depending upon the size of the borrower, theregion where the credit is being extended, or -- in the case ofPROINVEST -- according to the nature of t}e investment contemplated.In addition, as of 1987, pricing of FUNAGRI .funds was generally aboveOTN with the exception of programs like PAP?, a rural credit programtargeted to agricultural borrowers who earn incomes less than 230 OTN.In this case 50S, of the principal value of the credit extended neednot be repaid, so even though the credit is priced at OTN + 32,effectively the rates charged will be below OTN. This program will bephased out in the early 1990s.

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A3.26 During the period reviewed, the Monetary Reserve Fund (financedwith a tax on loans) has functioned as a liquidity facility for state com-mercial banks outside the regular discount window advances available tothese banks. Effectively, the operations of the Monetary Reserve Fund haveamounted to subsidization of state commercial banks. The average ratecharged on funds lent to state commercial banks was OTN + 42 in 1987; how.ever, this masks the large real increases in the credit extended by theMonetary Reserve Fund. Two recent government actions are likely to affectthe future status of this fund. First, as noted above, the IOF tax waseliminated in June 1988, thereby eliminating the only source of financingfor this fund. Second, the Government plans to create a special depositinsurance program for state commercial banks. Hence it now will ask forappropriations in the budgetary process to provide the funds necessary tosupport the deposit insurance program.46

E. Directed Credit Programs Applied to Commercial Banks

A3.27 Directed credit programs applicable to commercial banks are de-scribed in detail in Table 5 below. Such programs have resulted in eitherthe compulsory application of demand deposits to finance the agriculturesector and small enterprises, or in the use of required reserves by commer-cial banks, used either to extend credit directly to microenterprises or topurchase debentures held by financially distressed enterprises.

A3.28 The imp'licit tax associated with such programs can be viewed as anaddition to the tax imposed by reserve requirements. An implicit tax isimposed to the extent that a higher return could have been obtained byapplying these resources to other uses. 47 In the case of items 3 and 4 inTable 5, required reserves are explicitly used in order to support lendingto small enterprises or the purchase of debentures of financially dis-tressed enterprises. As such, these schemes lower the effective reserverequirement imposed on commercial banks. As Table 5 shows, one of theseprograms (under Resolution 1335) already has been eliminated in 1988.

46/ Finally, PROASAL, FDPE, PROAGRO and FINEX, although not credit programsin the strict sense, represent directed subsidies to particular typesof domestic goods producers or exporters. In almost all of these casesthe funds provided effectively have been grants, so even though thevolume of funds provided under these programs has not been high, therapid acceleration of inflation in 1987 meant that the implicit subsidyflows associated particularly with price equalization schemes havesometimes been large.

47/ This argument does not take up the issue of the incidence of this tax.Interestingly, this tax will tend to fall on the commercial bankingsystem if the system were perfectly monopolistic, in which case thebank theoretically could not shift the tax by charging higher rates onfree loans or in the case where the demand for free loans is perfectlyelastic (i.e., perfect competition in financial markets). However,regardless of who bears the tax, "Government policies' still have beenused in an effort to confer benefits on a particular sector and as suchcan be viewed as an implicit subsidy.

Qlea. Creit ga m j hlte .1* A-oe ioeticn, .1 slal. D.Seot sd R&es.rs mary. of C,l_sC- file,s

Typ of Restiction Tp r Iieti-reoure an prichg tution aminti- Resrltim on mlione

esurked of re*oures t_erei reourcs Secthal Region TV" of borrower oburitby Pricing Forced I;_eettt

1. sight ND interest PRmulatiae regardl- AWetjeJo 3 A War Rmolutione US6 mt le to Depe an the type Depren on the typ Not siht depositsdepoits

8can be paid On ing aPlicaticns Of Rural Credit N_AI I1UD0 a 18t0 two mllt aglculturaI of aSgricultural of agricuitural not applied up toeiget deposis net eight depCoit. uidelm ea aeteb- reional gross are producre creit line (C credit l;ine A the the orescribedby regulation aply to privat. liah guidelines for allocated fun": deecription for egion where fund eunt t be hlId

fedral a cr- percentag of not the totheet a R3WMI in Table 3) ore to be lent, as as non-;ntermetciel be e. Thee eight deoitelt aell- Repi rto Sento S Ind.cated in Rev.- beating requiredr*tuletsoen do ot cated to agricul- Central Sul. The lotion 1W0. 110 reservesaply to other tural lending allocation ecroe a 1*49. Pricinginatitation that 1) SeslI banks: M0 theg region de- rane. fran at * 7nhold eight de_.- most b earrirkhd pend0 o where the for mIl producersIts. Regulations 2) Nodtiu eije c4raxiut btanlk to Of * 12t a.DIn this aee are "'I.e: 40t take the net sigst for agro-industri3lism"e by the NtC *ur_rkid deposits credit l new

3) Large bwk: 6Mmast be Dierverod

2. So" as In S _De in 1 See. as in I Prior to February of N. quantitative Swull & e.diue N.A. M of 1C . US if Sem as 1 above1 196 12eof eight *l location seroea enterprises only lent to ml I

deosit. that wore region fnterpim insi cject to reserve tbrtheet. I * WIC

rqu resent. had to if lent ir otherbe lent to *sdiu & part. of Braz; Iomi entrerpriuner ReolutionM. After Februry

1906. the balelent fare froen sothat this restric-tior is being phasedout and *; I I be*liiminted ea-pletaly during June

3. Special N. A. Repased through To ihdutry only Asounts allocated Only to a_1 For working capital Credit as eatnded N.A.credit commercial banks to Nertheest versau enterprim that lonne to _l I W t * i *.a..line, to other reions at will be enterprim. but a reate we 3 3>*icroentar- discretion of recapit laed Iotuit no noeater iven to a_ I s

Prim Central San than 36 mate enterprise eualIfunded from to 41-r1of the tOLLrequired Volue of so ytteryreserves correctionheld bycoaecfeclal

(R1s.oJf 1"7)

Type of Restriction TI* of i "I-

reirc on pricing tutlcn admlnia- Re"kr. .e. an m;e a i

aerrked or roree ferlng rource Sectorat Regtonl Ty, of borrwer tXturity Priei ng Forced inaven

4. lb to 105 N.A. Comercial bunks Sam as in a ND regionat To enterprises of ietentureu iesued Not known N.A.

Of th- roer;ce; h er - different else by corportion

rauire d easprifcing owt ized over 6

rmrvem of finencial dietre. years

_re;tbanks canbe uwd to*vrchiaedebenturesisw_ed byfinanciellydiatr_emdenterpriee(e. 1406

of 196?)

N.A. * NAt icable.

a/ Directed credit Progrm asopi -a to federal. state and pr'it.t commercial ban".h/ Not eight deposits are defind as gram eigt deposits Ion required rvr, overmwit deposits end deposit. for the purpos of _meting ten taysenta Other itam aer olao netted

out. howeer they are very smal in value.

Source: Central bwnh.

J32I -.Q.1.1I1iD 1!.

-I'

- 102 -

F. Directed Credit Proarars A&licable to Savings Banks

A3.29 The restrictions placed on the pricing and allocation of passbooksavings accounts collected by specialized federal or privately owned hous-ing finance intermediaries are particularly complex. Table 3 indicatesthat tVe rates offered on savings passbook cannot be less than MC + 62 bylaw. At the same time, the rates charged on these resources have effecti-vely been capped, given the National Monetary Council's right to controlthe rates that savings banks can offer on these accounts.

A3.30 The application of these funds is subject to complex restrictions(see Table 6. Under Resolution 1446, 65Z of the value of passbook savingsaccounts supports the housing sector. Within this allocation, 1O is ear-marked for the housing finance system (SFH), and must therefore be investedin various funds (FAHBRE, FESTA) administered by CEF, while 352 supportslending for housing, commercial construction, etc., on Government-mandatedterms and conditions. The remaining 202 v.,st be used to finance housing,but is not viewed as part of the "housing finance system" as the funds canbe priced freely. Finally, of the remaining 35Z of passbook savings ac-counts available, 152 must be held in government bonds and 202 can be in-vested relatively freely.

A3.31 Table 6 also indicates that the housing sector funds face re-strictions with regard to regional and sectoral allocations, as well as thetype of borrower. In addition, the policy is designed to lengthen thematurity of loans if the amounts to be financed are smaller and to chargehigher interest rates as the value of the loan increases. This operates inpart as a redistribution scheme designed to transfer income from high- tolow-income borrowers. Finally, pricing restrictions vary by region, city,and type of credit extended, as well as by type of borrower -- therebyfurther distorting borrowers' incentives spatially across different housingcredit markets around the country.

TEA

Di;rcted Credit Oseraties Aesecltd *ith °a book Suv;. Aeeant Meld by Sayitu ImBkso

Type f Resbriction Type of inati-reource on pricing tution *dwiniu- _Restrictio on *esIcet;ion-ermerked at resources bering reorces Sectoa5 Roegisal Type of borrower Mbturity Pricing Forced invvetwtott

Savings iC + St by Law Includoe Caixa Under Renolution Quantitative Yes. particularly Yea, depending on There is a grad- 16t of savirnaacconts (ear- 2290 r-nmica Federal 144 no 1s than restrictioe apply in regord to sie the value of the uated schedule for accounts oust bedestew do (CEF). the state 63 af reourcee Me to the amount of of borrowing *nd in lo"n. Longer the pricing of held as oulooryPoupanea) avinsn" banks to be applied to funds lent to co_ instannes by esturity offered if housing credit reserves in the

(CXEE). Societies housing. W to 20^ re"ie and cities incom of borrw- volue financed is whereby the inter- Central ank endCredito Finmnerow of passbook savings erm. Allocation s wlslor et charge in- earn uN * 7.8Sl_larios (SCI) has to finanes hous- differ according to cresse with the a.. The reseinins

PE ;ing at orket rates th- ue of the value in OTN of the 201 of Passvia Central Sank credIt by barroers i on requested. sy inge accounts,regulativ.s N (. S. eentruc- Pricing also varies can be inveetedlee than 10 should tbln, commarcisl;- according to the relatively freelybe appli d to the at;on, houing. type of credit lin.housing finance sys- cooperatives, or ittended and thetea (SIH) with a mmI house city in which fundsvalue up to 2.S00 purchase) are _sdn avai nbleGTN. Thes am_untare to be applied to(FPAM nd (FESTA)each of which arefunde thet supportthe CEF and the SfI.The reesining enmut(2JS) mast be ap-pli d in the hosingfinance systs Ifthe value Is betwmen2.500-5,000 CTNinclusive of asunteprovded to RlS.

X/ The directed credit program dec ribed here apply to federal . abt and private savings banks.

Source: Centrel BIank and CEF.

IJll

- 104'

G. Directed Credit Programs Funded by the Central Bank

A3.32 Table 7 highlights the various means through which the CentralBank has directed credit to different private and public comuercial banksand to the Bank of Brazil. The most significant program has involved the*conta de movimento' and 'suprimento' accounts under which the Central Bankhas advanced funds to the Bank of Brazil. With the former, the accountfunctioned as a zero-interest overdraft line. The suprimentol accountsuperseded the *movimentoZ account and imposed different rates on the Bankof Brazil, depending on the use of the funds advanced. Under the recentbudget reforms, these accounts were closed by the Central Bank and advancesto the Bank of Brazil will have to be shown in the budget, which impliesthat subsequent advances will be made by the Treasury and will requireadditional government borrowing.

A3.33 In addition to Central Bank advances to the Bank of Brazil, theCentral Bank's discount window facilities have been used (particularly in1985) as a means of directing credit to state commercial banks. However,this practice was substantially reduced in 1986-87 as state commercialbanks were extended credit via IOF tas proceeds that funded the MonetaryReserve. The pricing of overdraft facilities, although based on overnightrates during much of the period, has also been linked to the LBC (i.e., theCentral Bank's cost of borrowing), which did not rise at the current rateof inflation during 1987, resulting in negative real rates on overdrafts incertain months.48

48/ This point is taken up in Annex 3, where the subsidies associated withdirected credit programs are discussed.

Centrl t.k BMWt D;rectd Cr dit Prop

Ty, of Restriction ?y. of ;"t;-reorece on pricing tution adainis- RetrietiON on mel .ctior

asraorked of rouree tor ing reourcee Sotorul RegioneI Ty" of borrower Notur ty Pricing Forced invest_at

Central awok:

. Diacount Nn Control bnlk None None Amnt advanced at Dapde on whether Pric;ng war.e NA.waido discretion of it iso liquidity according to nuerfci litie Contral Bank i;ne. epe Ial o an of tim a Bank

(Reomon- or mretion emce" it. te tbt;on aCe0 A loane; rculara

1006/125)

b. Cento de N.A. ad Cent. do No_into Yea, there are N.A. N.A. N.A. NA.Nviaanto/ advne. were not ro trictionr inSupriwnto earrrsrkd. however, regrd to regiom(ciomd at Conte de Supriantoo in which NOd lendsend 197) Were alloceted to funds fro Conta de

agriculture Supreintoindusrtry

N.A. * Not Applicable.

i The limit aP;icable in deteraining charge on commrcial bane overdrafts is deterined as a mjuino *vrm of the end of period (averae) depgit balances in a given month period.It is ejsl to 53 of the average deposit balanes preeet in * giwen 5-wnth period. given a 2-enth log. For esoepl*, in Janury. the lilt could be bed on 0.05 (Anguat-womveerdeposit 1'Iances). A charge of LKC 183 a.*. to levid If a ban a under the li-it and LIC * *6 ra. is chergd if overdrafts aount to # than too tim the Iiit.

g/ The Contact Novimento use cloeed at the beginning of 196 and a" mwereeded by Cente de Soprimnto Eaecie, which was subsequently cloaed at the nd of December 167.

Source: Central Bank.

l.ta

- 106 -

H. Directed Credit Programs for Non-banking Financial Intermediaries

A3.34 A final form of directed credit shown in Table 8 has involved theearmarking of various pools of private savings (e.g., insurance premiums,private pension contributions, or short-term mutual fundi accounts) thathave been directed by law or regulation to investments in government secu-rities. For example, in the case of closed-end pension funds, requiredpurchases of VFND bonds were supposed to grow to 302 of total closed-endpension fund assets. These bonds wtre issued by the National DevelopmentFund at OTN + 62 with a maturity of 10 years, thus providing a captivemarket for the long-term government debt. In contrast, insurance companiesmust invest between 25Z and 502 of total assets in government securities(see column 4 of Table 5). These restrictions have led to an undersizedclass of institutional investors, and contributed -- in conjunction withexisting macroeconomic policies -- to the absence of a long-term capitalmarket.

- 107 -

Toble 8

Forced Investments Required of Non-banking Financiol Intermediaries'

Restriction Type ofon pricing of institution Restrictlons on apDlications

Type of resource resources administering Pricingoarmarked It repassed resources Forced Investments restrictions

1. Insurance None Insurance A minimum of 26X and a Applicablopremis companies maximum of 6OX of assets rat e on

must be placod In one or a tederalcombination of the following securitiestypes of government securi- or OFNDties: OFND bonds, federal bondsor state public debt, LJC,and/or LFT. There Is also a25% minimum and a 56O maxi-mum limit on investments inshares of open companies(i.e., companies with sharesregistered on the stockexchange or OTC market

2. Private None Closed-end Mandatory purchases of OFND Rates onpension pension bonds requirod. Requirement OFND bondscontributions fundsb was for 36X of the Portfolio of OTN + OX

of Assets to be OFND bondsunder Executive Act 95888 ofNovember 8, 1986

8. Private None Open Same as 1 above Sam as 1pension pension abovecontributions funds*

4. Short-term None Short-term Minimum of 80X of assete Same as 1current mutual Invested directly In govern- aboveaccounts funds ment-issued Treasury bills

(LFT/LBC); 40% of requiredrepurchase operations up to28 days must be undertakenwith underlying collateraltaking the form of govern-ment securities

I Does not Include mutual 167 funds Investment clubs, or consumer finance companieswhere some reostrictions are placed on asset composition to encouragediversification.

y Closed pension funds are sact up for employees of a aiven company.g/ Open pension funds are open to the public at largo for participation.

- 108 -

ANNEX 4

gUANTIFICATION OF IMPLICIT SUBSIDIES THROUGHDIRECTED CREDIT PROGRAMS, AND THEIR

ECONOMIC EFFECTS

A4.1 This annex presents estimates of directed credit programs theimplicit subsidy associated with them, along with some of their most im-portant economic effects.

A. The SIze and Comoosition of Directed Credit Programs

A4.2 As the Government has increased its control over the sources ofbank funding, it also has increasingly directed credit to public and pri-vate borrowers.49 Table 1 indicates that directed credit programs in1986-87 constituted a substantial proportion of total outstanding credit topublic and private borrowers, with the major directed credit programs ac-counting for 802 of the total average stock of credit. If housing creditis excluded, 57Z of the average stock was directed. Horeover, compulsorysavings schemes represented 29Z of the average stock of credit; earmarkingof passbook savings to the housing sector represented 24?; Central Bank-directed credit operations represented about 152; forced investment re-quired of non-banking financial institutions (such as pension funds,insurance companies and short-term mutual funds) represented 7Y; andcommercial banks credit operations 2-4Z.

A4.3 Table 2 shows the evolution of the flow of some of the most im-portant directed credit programs by source of funds, 1985_87.50 Taken as awhole, these programs were estimated to account for 40? of the flow oftotal credit extended in 1987, or roughly 180? of Treasury revenue, and 18?of GDP. The significance of directed credit has increased, as 35? of totalcredit extended to the public and private sectors was directed in 1985 --122 of 1985 GDP. Even if official credit programs targeted to the housingfinance system are excluded, the remaining programs accounted for 26Z ofthe flow of total credit in 1987 -- or 12? of GDP and 124? of Treasury

revenue.

A4.4 In contrast, the share of total directed credit accounted for byTreasury-administered funds and programs fell to 12? of total directedcredit, versus 252 in 1985 and 21? in 1986. Over 1985-7, a substantialportion of the Treasury-administered funds and programs was provided tostate commercial banks through the Monetary Reserve, as this fund aloneaccounted for 50? of these resources. In addition, about 302 was allocatedto agriculture through FUNAGRI, PROAGRO, FDPE, PROASAL, and partly througha special account used to provide subsidies to domestic wheat producers.

49/ Although it would be most relevant to examine directed creditoperations targeted to private sector borrowers, sufficient data wasnot available on the set of official cred.t programs analyzed in thisstudy.

501 The flows shown in Table 2 are gross flows not net flows adjusted foramortization.

ANNE 4

- 109 - Table 1

01ated Cred't P.ga t *a Percetage" of tI* 7 rn1 Agor&ag Steelof crooit 3ugeeAI"ie.a to te Public and Privaes Seeta 11n0 lIhe ;do

btsur* of Ue'mrcgo

1) me a/14c0i."2) PU/1,AW '38.45 9 7333) PI83CUL dl I.A.. I.4.4

_____... ... .......... ................................. _._ .................._

*) 623 1 s?8.77 16.:7

O ~~~ ~ ~ ~~~:322 om7

S) SI4Apz :9 45 2 4036) Pw40o o.G. 0o.-nn) r.* lle."t. a ". 1.24.O) PZO 26.4 0 5519) PUDi@0A 0.7 *.Oh

10) Ca*ntrFrtids do Rotw. f/ 114 a O11) gm 0.08 0.00312) 6IOAhAL 2.02 0.04

TotAl (Treasury Adaia;t;eed 131.3 .83 2.7ponds one Por0 6 g)

13) Not Vish Oeeeite 4A1iedby Comawcial Seebs

Aricultuere(er 1) 102.,j 2.UMg_11 * Nad.. bt.rr;ae o 27.62 o.mAeM *lieeti;e for COl1b*anks 10.02 2.700

14) Cent" I Sabftedieounaeng Og ertioA- 1*. 1 o.03

$Sate C*oacial 809ba 14.9o 0.31Opedorg Coercial eamua 0.0 0.0 *2Private ""abe 2.29 0.053

US)CaRal Sal 707.r3 14.60scot de augi_ie. m76.s8 U.011cet. do, oviaeato 128.O 2.41S

Totl c ntral ab MIR 15.4 M16) Savings Aconta aggt pld 6.00 13.450

by Saving. and Lana* h/17) Seviage Aeanta AeI Iad by 541.67 11.253

Ceia; Econoice FederalT*fAl V4MG;Rf SJiaaa 1160.0 24.703

16)Nnbeabiag Ptiagcil Intitutono j/ 360.11 7.48S

G1A1O TOrAL 5960.345 62.413

014 'r(TAL FCOtffi M%4V4 2779 672 n7 713eCAPOrrBe

etel C-edit to Public a*o P-:.Ot Sector: 4816.54S-- - - --- - -------------

Soldrce:Cantrel Sa.nb5Wl.AIaSlef er to the a*veage of the. end of eriod Stao" ; dece_er 19064.7

tn go" "aen.d afvtwoer 106? d*a eg oe*d due to aesnve Ita I i tg of Gaceager 106 aa doets.b/Cul"Mm I a. a 90"rce"t Of te'"I averag balaa.. eWutetdlatg Of Creit asttended to 04, eubl 0 gad private aector.ePbti_enl Develoeaen Pad(me) baleaca eal fl-o boee this fnd S" oily "eel;~ ia il 1066.dlCate; eg ast evei lab I

Pmbrs eaf preliminary ;atiinea r t bJ CI.f/1rat.;y acOLAu fOr tGe PeSiatrtian ad eantrel of .8&r"ni berraringe./oe nat fasludo credit attended to l I an teriaa (or f innancial digtroaged entarree.)

under lteaglutin 6 or 1406. wleft age nt available.hI**i. to eWleitg of the preiing of thin lin in.es *Stiatt t is old centet ase indicate by Central BSa eatn.tee.Also ti incluwle . 1_muts" credit esrt;aia eiited *sob Reeslutian 16. nat g.e. LnlUutian 6*5 or 14i 0.'I/hig calculatian ndaretiestee. the Itac of credit emlae.ndlng te tme, Itmeesin amate saise it aeclude Pas fund".a auntiot l smitlin of ehi*h are l geed ti h *mimse1in financ" agte.UU*aelm,deO en,ai fond.. inmwerne seneieo Oad alref.tar estin fund.. It W" aequed that on averae 373 of the 19076/1'

ratflii of Pesion_ fund Wg inveotd in "Verna"nt aecuruti_ (avan u0 tiMe 1n"dt level 5 8M. SOl fop iagureao: _niee. we for imovt-tara mutual fund.

- 110 -

The remaining Treasury-administered programs flowed to the export sector(1 of total directed credit flows) via the operetiluns of FINEX, or toindustry and some social sectors primarily through fiscal incentiveprograms (FINAM, FINOR, FISET and PINIPROTERRA).

A4.5 Earmarked taxes were also an important source of directed creditover 1985-7, accounting for an average of 16X of total directed creditflows, about 282 of Treasury revenue, and 32 of GDP. The great majority ofthese resources were applied by second-tier federal financial institutions(e.g., BNDES and CEF) in long-term lending operations. Of the compulsorysavings directed in 1987, roughly 50Z of total credit flows were allocatedto industry, 122 to housing, and the remainder to a variety of governmentsocial programs in the areas of education, low income housing, etc. Theresource flows shown for FINSOCIAL primarily represent outright grants asopposed to credit that is used to support a variety of social programs.11

A4.6 Finally, directed credit based on earmarked demand deposits aver-aged about 62 of total directed credit in the 1985-87 period. Of this, thevast majority was allocated to agriculture, with the remainder allocated tosmall and medium-sized enterprises. Moreover, the amount of demand de-posits that commercial banks have had to earmark in support of agriculturehas varied greatly, according to the size of particular banks as well aswhether the bank is government- or privately-owned. Table 3 reveals this,and indicates that in 1985-7, rural lending (most of which was compulsory)averaged about 31 of the total assets of the commercial banking system(excluding the Bank of Brazil), and about 282 of demand deposits. However,the majority of these outstanding balances were accounted for by privatebanks, particularly the large ones. In contrast, public banks (particu-larly large ones) only accounted for about one-third of the rural lendingundertaken by the commercial banking system.

B. Measuring Implicit Subsidies

A4.7 Laws or regulations that affect the disbursement rate, maturity,pricing, or timing of repayments of directed credit affect the degree towhich the credit operation is subsidized. Several types of conceptual andpractical issues arise in measuring the implicit subsidies associated withdirected credit programs in Brazil.

A4.8 At the conceptual level, a key question concerns the 'appropriatemarket discount rate' to be used in measuring the present value of thecash-flows associated with directed credit operations. If directed credit,taxes on financial transactions, and reserve requirements all drive a wedgebetween borrowing and lending rates affecting the marginal price of credit,the "market' rate to be used for measuring implicit subsidies becomes lessclear. Moreover, the instability in the macroeconomic environment, com-bined with the Government's official credit policies, has also preventedthe development of a long-term capital market and associated long-term

51/ See, for example, McGreevey study.

TAKE. 2Floe at 0ir.ctAW C,edri by source of Foads a/

s.Of s.O ofS. 3* f SO. of. I of S o .Of S.of s of SofCZ WII rare Total Total Tr.eeory CDP CZ Doi A or Total Total Treecar, 00P CZ 0.1l1r, Tot.&l Total traoer.r CDP

type of Far, (.1) (Bill) Directed Credib moenana (Oi) (Sill) Di ractad Cyait E.e... (Bill) (8.II) wDecacwe credit a...Cf-Wit ~~~~~~~~Credit ICredit

a) FW b/ - -- -- ... --- --- ------- --- 144Ad 00 5.47 6.615 2.546 11.M AIT2)P1PIPA3EP 75 1.1 5.64111 1.315 7.315 0.495 17.82 2.15S 8.335 5.275 96175 1.021 107.24 2.85 4.M I-95n 60 0n 65a

of nhiclha. , ma 1.45 0.31 O.75 0.275 1.411 0 141 14.45 1.09 2.155 2.1SOS 5.4351 0.413 34 40 0465 41111 0.715 a9235 0 06repesecto I760 1.25 2.69 1.05 5665 0 11 22.60 A."8 5.218 5.173 1.9411 0 6151 67 64 164 ll.1in 1.065 664S 0 5bs

3) FWKMCAI 8. t0 1.31 5.0121 1.1559 6 Its 0 WIs 22.01 1."1 Sa15 8.061 5.795 0 so 79600 S .92 .Ma 1.455 6.665 0 us54) FMT 1/ 4.32 2.31 5.815 1.465 10.6051 a 025 A9.1 1.45 2.765 2.7315 S.1AU 0.8311 42 as a 02 5.55 onM *.&as s.3611) FM9 3 32 0.64 1.2315 0.463 2. 05 0 245 6.67 0.66 1.261 %.55 2.353 0.2451 11.66 0.29 0.06 0.21, 0.5165 0 105

Total Coogmewlw sq p 45 23 7.29 so. 773 6.2511 06.1115 3 215 125.60 9.19 1?.65 17.4551 85.06 3.415 34635 6-40 16.00 46-2111 55.97 2611

1) 1681061 9.535 1.64 5.65111 1.525 7.195 0 665 6.96 0.66 1.273 1,260 2.831I 0.245 29 20 0 70 1.945l 0.555 2.455 0.2456) P5040 0 41 0.0? 0.155 0.065 0 515 0.036 6.64 0.45 .0. 0.4559 1.75 0.5us 11.20 0.27 0.615 0.55 6.06 00O457) Manor.. limossra 60 24 4.611 11.2115 4.195 22 615 2.115 66.60 6.40 MM66 512.4431 55.15 2.415 105.45 2.57 4.693 1.655 eS 0a .8756) F116 10.32 I." S43.11 1.455 7 785 0 135 15.65 1.09 11.9751 1.95 8.6l5 0 mS 8-.16 0.91 1-75111 0.06 5.15 0.31%9) RA6458 0O4" 0.09 .6 .7 .6 0505 0 0.0.in 0.62 0.055 0.015 0.57 0.01 0.On 0.015 0.055 0.00510) CooaetsrAyrids do 1eC.Et. 4/ 2 69 0.47 1.0?5 0.4,05 .16 l's 02,15 08 0.7 .509 1.466 2.775 0 246 29.65 0.72 1.575 0.545 2.496 0.24511) 1509 0 32 0.09 0.5to 0.045 0.245 0.025 1.27 0.09 0.555 0.1us 0.55 0.06 0.59 0.01 0.06 0.015 0.06 0.0512) FAsM. 8.73 1.41 3.235 1.215 6.163 0.629 4.40 0.11 0.655 0 62 1.1in 0. In -5.97 -0.01 -0.0931 4O.045 -0 In -0.06I)) lEWi 0.47 0.05 09175 0.065 0.355 00O35 1.14 0.09 D.1IsI 0.161 0.35 0.06 4512 0.22 0.455 0.161 0.76 0.07i4) fIlm 5. 87 0.22 0.5115 0.43n 1.06 0105n 4.10 0.20 0.-65 0.55 1.0111 0.115 15682 0551 0.611 0.265 1. in 011ts18) FIlET 0 14 0.12 0.26 0.109 0.565 0 066 3.12 0.55 0.445 0.445 0.623 0.0115 3.65 0.09 0.573 0-.073 1011 0 0316) PIN/F1WA 2.19 0.48 1.0611 0.83 2.1019 0 209 7.46 0.16 1.0631 1.09 1.46 0. ME 26.9? 066o 1.0 0.416 8.46 0.20

Total (Fromeaay £d.eqri.t.rodFoada mNW Fmrosra) a/ 66I.20 11.01 25.315 9.4856 154915 48WS 150.55 11.01 21.8511 21.1SU 806.94 4.09 256.63 6.39 12.5US 4.M6 22.0151 2.1555

17) Rel Sigh,t Ocpoaila AOil.Iby Coemergiel ScsI.

A.rivoltere(scr I6) II 60 1.46 4 45% t.6911 6475 0815 046.12 4.55 0.205 6.16 36.2016 I.M 146. 55 83 5 .725 2.06 12.175 119Fword bedim, to eaeterprr., 0 00 0.00 0.001 0 a0n 0.005 0 005 57.67 2.77 5.11111 1.20 9.963 91.1; 42.31 1.02 1545 0.766 A.555 0.34cramolmtloa 69 & 13S) f/

Total Applications for coml.boals. 11.90 1 .2 4.415 1.6as 6 915 0 68 es.9 St 7.09 13.6511 219.4111 25.203 2.6115 1666 .066 16.06 .9.86 s56.s Isis1o) Coatest ova

fladiecommatlog 0ormtior.. 0 005 13.30 0.97 5651.6 75O 5.503 0.365 -1.7 T 1.25 4.265 -0.45 -6.06 -0.425State Comayeil brIes 0 005 0 005 10.79 0.75o 11.52 1.51s 2.663 0.293 -45.41 -1.23 -. 0111 -0.*m -4.405 0.2Federal Camweria bvAb 0.00n 0 006 1.76o 0.19s 0.255 0.2516 0.4651 0.0511 -I.-1 -0.04 -0.0 -0.095 -0.16 0.1Pri.ate b0ab 0.0015 0 005 0.75 0.09 0.1115 0.115 0.556 0.060 2.66 0.0? 6.145 0.09 0.36 0.06

59) Control Scab 6/ 0.00 0.009 0.06 596.20 11.85 22.473 U22.0 41.061 4.101 961 1611 66I940 IIII.0n 52.06 65.SU 5.06goaw, do arieamLo 006n 121.29 9.219 17.505 17.543 6.665 3.405 765 02 56.44, U6.1UN 15.79 fS.655 6.2goat. do ampriaeas , 0006 12.91 2.41 4.673 : 4.06 6.0 0.69 -611 21 -1.60 -5.045 -1.196 -5.65 -0.545

Total Control Scab 0.00 0.06 0.093 0 00 00 0 .06 209.87 , 1.64 25.743 do40 5503 .61,13 0611.40 1t.6 51.06 15.64 1.541 6A.0

20) Gov Ia"a Llama h/ 65-91 56 SI11 3 665 11.0 64.6OS 6 105 66.00) 4.84 9.3711 9.275 17.305 5.79 516. 12.44 66.69 9.2711 42.551S 4.5I'M21) C.l.. Scomoelee Fadaral */ 56.36 9.42 25 64 6.0651 44.035 4 515I 66.90 4.1 It 6.063 7.0011 56.9711 1.5161 170643 4.11 1.545 5.073 54.193 5.39Total Ioalce systes 164 33 23.215 68.611 19.9 106.855 50 211 155.40 9.09 17.466 8Y.255 52.335 3.341 M.49 56.66 83.06 sass0 or.e pO GMWill61 MOAL 269 75 43.II 100 06 37.355 203 4259 19 165 704.09 81.16 100.063 41.675 5665.221 19.1U5 2177.611 24 5 50.5l65cm 66.545 an1.1132 17.7cs0346 TOrTAL *aws3 ""DCl 125 40 20.29 46.495 11.365 194.13 6915 861.19s 42.37 62.35 61.613 152.59 157M 1491.09 31.54 63.415 gg.06 156.0l 12.12B

om.ramde Items:Treasury Asi.in 132.50 36.1 1202 -40Arerage Eckba 6 fat. 4.20 13.65 41.49FAd of Period lacednog note 10.49 16.65 72.25

Total Credit h/ M2.46 712. 12 5463.00or 5406 00 no1. 16 12255.00

SOURCES: COaRmlI b1eb.6101SEF.5,1M and L.ATTF eat. esawa.*jsaerefer to eyraroaof raeoreas or Grande lab.a.t one, year. for car .. fnd emoet eoS "lied*,l o ""eIne to %h. a.m.e .. olleted.

b/Cal, became,a coeratoal rO J.1, of 1486C/Kt.6baro atom refar to aoe.l.to collected -brl. ere nt,ae not ofl on-lent r.r a gron ee41Refare to Uh. sJaeertory accoot for the regatration med centrol .1of etemal ramoor-eeoAppglic.tice, of the fr.ndm aned rorar er inclrrei. of Orent Ineludea, th* argatteed end "to" emas adm4isit.cd by the Traeasury.f/laol.den, both leading ma a Vroportron of O'GIrt depoalte to er-o eoartsprrae (,ca 141) and mbobidlsad leogo to finmmeeialsdietroaeed csetaprame, cWedr reowl.t,m 5365 cer

alecet St Wrll.. n re., e amr of t.o Macking Syat.. ea aced ,m -ed.r to acCt. aoed operetione ia 1467. ""lO thet in the ces" of Rcc. 691. mrrbera~ aet.. are LATI eatrcted../AtA. for 1961 .c not mdoe cl by. t,(.e C-tral Baab, amc to addt..I (II--- kirro *cre obWeid byr letiPoSt dh iffereca ;am o.tateadse bolcece.

Alao, fir.. for 1961 era b ... d -r oot.tandr.. 4 balc.-ca *m ceb.r 1981K/#.cL.r frrr 5467 as er ata,/f l.c r..... Lad 4. not Ir Col .r. of #Cj-l. j. that are drrlaa bp UP o.ccr., of the." fnda appl red sra rported

reea-telr etc.. a.onrf tIh .. c..r. n fondto A N*.r .,..rletble

14-.3* aee.alto ,emi* *1e bk

10 #*f _ * -- t S *6X10 01 *

, . . .... .. 3

..e~ *..~. t ... . .. . .. ...... .........

8 Cm..c.oS 6..b. 81,4 ......... ........ 2...3.... ... 0..hSal iu f ................ ......... ..0.........t;I 40 00 o1 060 6 of 0065$ * 003 a1 0of 0041 ; of 0Se 01 0 of 0;- 013

& t.ts~. b.t. 136* to to 32ome t1 0 o 1Iles1 letS to too" to 213e6 Je at lo 21 I SIto_ ltotl "to gtet* a" t SOO% 0| teia out*4 Aeasto gut1 * I t" Si st at tww l* t t Aboate letbi O*w I !..oh i

............. ... .. _.... . ... ........... ............. . t _ . ...... . .... .............. .... .. ... .. ... .. .. .... ... . . .........

tosolls^ e.t.pi- e *.. 6913 s.. to f,,o.3 d,...O. 'e.e t&.e..u II. ,.o .X45 '.o. ... s 4.. 133/IOS n. . .. e

et "k.cbprrt same* _-to 2 11,$ 44% t***X 2 3" It 031 6440 ml I u In I~ts

&01* * 0 0 Got O eS a on too a oil O e1e 0 a IU o aus o VA ones

i0.die._a 019 e 6n a" t 9 0 *|7g 0 In S atit I n4244 0 In f e S" t I no

Larg 111116 222 7f 26 to l0111 4315 3 OIS I tol Ut rA *f" 9 4n 4 sn 10 an

b Fbis Mai U44 I 401 3 2* 4 * 1^ 167 1 *%S 0 O"6u |1" me 0 % 3 e son S uSSmall 11111 0 07S 0 on Olf 2 07 0 n3 0 028 a it 31n o Olt o 0% I sefti_ 3 0 In 0 S" an n U 0 in 0 I" as 2010 0 lot a m 1 14S

........... .......................... ___--.... .... .. ............ .................. ........ I....... ..... .. ............ ...... I......... . ... ..... ..... .. .. . .. ..

G tco. co",*l _WA VW LATf

materp *| io" 4,0 496) to ""0100 {nf-l #- w - *t -v- t leal-0 (res 1336 lJ ) ess -nX .***0ob

IJIC

- 113 -

interest rates which could be compared with government-mandated rates as-sociated with directed credit programs.52

A4.9 Their intemporal nature of subsidies presents further difficul-ties. Specifically, the subsidy inherent in directed credit operations canbe viewed as a contingent obligation taken on by the Government (or by afinancial intermediary) the size of which is not known with certainty.Hence, when inflation accelerates, the implicit subsidy estimated can varydramatically depending on the terms, including the maturity at which credithas been extended.53

A4.10 In light of the above considerations, the following procedure forestimating implicit subsidies was used.54 The average balance in 1987was computed using end-December 1986 and 1987 balances. Given thisinformation, the implicit subsidy was calculated by multiplying theaverage balance by the difference between the market interest rate and theaverage interest rate on directed credits. Because of the sensitivity ofthe results of this approach to the market interest rate chosen, theimplicit

52/ In effect, market-determined long-term rates (i.e., or a term structureof interest rates) are not available so as to discount cash flowsexpected in periods after the first year of a loan. To some degreethis situation is due to macroeconomic policies, but it is also duesomewhat to the existence of directed and subsidized credit programsthat support long-term investment.

531 This point also has been made in past World Bank reports. See, forexample, paras. 5.53-5.57 on pages 62-63 of "Brazil Financial SystemsReview,' or Wattleworth, M., iCredit Subsidies in Budgetary Lending,'IMF Staff Paper DM183140.

54/ At a more practical level, both the coverage of programs and dataavailability present problems. First, with regard to coverage, thelarge number of directed credit programs the many lines of creditextended, and the large degree of intra-official transactions acrossdifferent funds and federal financial intermediaries make itimpractical to calculate precisely the implicit subsidies for alldirected credit programs. Also, the data available for estimating theextent of implicit subsidies is also limited. Although data on theoutstanding balances for various directed credit programs can beobtained, reasonable data on the maturity composition of loansoutstanding or the marginal or average rates at which lines have beencontracted at different historical dates are often not readilyavailable due in part to the frequent changes over the period reviewed.

- 114 -

subsidy was calculated under a range of plausible market rates.55 Themarket rates chosen weres (i) the marginal cost of foreign borrowing equalto "correcao cambial" plus average six-month LIBOR plus a spread of 21;(ii) the rate on loans to prime borrowers at OTN + 152 p.a.; and (iii) therate of inflation or yield on the broadest basket of goods available asmeasured by the IGP-DI which rose 415.82 in 1987. Interestingly, theannual rate of increase in the IGP-DI was greater than that implied byeither of the other alternatives.56

C. Quantifying Implicit Subsidies

A4.11 In spite of measures taken at the end of 1987 aimed at pricing allcredit programs in line with inflation (i.e., OTN), loans contracted atpast non-indexed interest rates under the Cruzado Plan were not alwaysrepriced, resulting in large subsidies on such loans as inflation ac-celerated.57 In addition, in some months in 1987, the "correcao cambial"rose at rates that exceeded the growth in OTN, thus eroding the principalvalue of loans outstanding if the loan was funded using foreign borrowings.

A4.12 Table 4 presents estimates of tne subsidies of the major directedcredit programs identified, given three different 'market* rates. Undercase 1 (using IGP-DI as a market proxy) the implicit subsidy per year

55/ This methodology is quite similar to that adopted in previous WorldBank reports; see Knight et. al., 'Brazil: Financial System Review,"except that a single "Base" rate is not determined in the presentcontext, but rather a range of 'market" rates are employed. The pastmethodology of determining a base rate was somewhat arbitrary (as isthe notion of a range) since the 'base rate" was hypothesized to be thereal rate necessary to drive the subsidy to zero. Since the marketrate itself is not known the subsidy or zero base rate is not welldefined. Thus, it is unclear that the definition in Knight et al.should be preferred to the use of a range of rates as adopted here.

561 The IGP-DI is not the official general price index. This index takesinto account a broader set of goods in its basket than the presentofficial price index, the IPC. Also, if the discount on Brazil'sexternal debt were taken into account in calculating the marginal costof foreign borrowing, this cost would substantially increase. Thethree rates chosen are indicative and represent both lending andborrowing rates as well as the rate of inflation. The Government'sdomestic borrowing rate was not used because in various moLths thereturn yielded on the LBC actually grew at a rate below inflation. Thereal cost o0 capital implied by the historical incrementalcapital/output ratio also was not used in order to determine a realcost of capital. In part this is because such a measure does not allowfor the impact of technology on the productivity of capital, nor doessuch a computation account for depreciation or taxes, which can affectthe real cost of capital.

57/ An interesting legal issue arises here in regard to whether loancontracts could be retroactively changed if language was not includedto allow fot automatic re-indexing in the original loan agreement.

- 115 -

amounted to t..$1.17 trillion in 1987 -- more than 802 of Treasury revenues,and between 72 and 8t of GDP. By contrast, if the marginal cost of foreignborrowing is taken as a "market* rate, the implicit subsidy would amount toCz$550 billion, or 372 of Treasury revenue and 42 of GDP. Finally, usingthe prime rate offered to corporate borrowers, the implicit subsidy wasCz$955 billion per year. The estimation of the subsidy for this year is apeak due to the high credit outstanding as a consequence of the CruzadoPlan. We estimate that such a subsidy has probably diminishedsubstantially by 1989.

A4.13 Regardless of which "market rate' is viewed as appropriate,Central Bank operations (particularly in advancing funds to the Bank ofBrazil) accounted for the predominant share of these subsidies. CentralBank operations alone resulted in an implicit subsidy of 4-62 GDP. Thiswas largely due to the balances still remaining in the *conta de movimento"account between the Central Bank and the Bank of Brazil over the periodreviewed. Although this account has been closed, balances still remain andno interest was charged by the Central Bank on these advances. To theextent that the Bank of Brazil had used these funds in its lendingoperations in past periods, extensions of funds by the Central Bank to theBank of Brazil for this purpose have resulted in a non-interest bearingloan that has in turn been onlent by the Bank of Brazil. Given the 400Zrate of inflation in 1987, the existence of previous Central Bank advancesthrough this account resulted in lsrge subsidies by the Government ofBrazil. 5 8

A4.14 The "conta de suprimento' account, extended to the Bank of Brazilby the Central Bank at a positive interest rate, has also resulted in sub-sidies that depend on the market rate assumed. For example, Table 1 in-dicates that these subsidies amounted to more than Cz$100 billion undercase 1 and case 3, or about 12 of GDP. Finally, besides Central Bank oper-ations, the compulsory savings funds earmarked for long-term investmentsand the subsidies associated with the earmarking of passbook savings ac-counts each amounted to between Cz$100 billion to Cz$200 billion (see case1 and case 3 of Table 4), in excess, combined, of 32 of GDP.

A4.15 In summary, the extent of implicit subsidies associated with someof the major directed credit programs has been very large, as is the pro-portion of total credit extended to the public and private sectors by theGovernment.

D. Economic Effects ef Directed Credit

A4.16 This section briefly examines some of the economic effects ofdirected credit programs on the financial intermediation process and on thebudgeting p.ocess.59

58/ This assertion rests on the assumption that the Banco do Brasil'slending operations do not constitute 'government' operatiors. Inaddition, the degree of subsidy depends on the exact terms upon whichthe Central Bank advanced funds to the Bank of Brazil, which apparentlywas at zero interest with no specific repayment schedule.

59/ With particular reference made to the credit budget and to theimplications for the transparency of the budgeting process of thebudgetary reform implemented at the end of 1987.

Table 4Estiasted Subid;** i asociated *th Directed Credit Programs (in bill;on Scruk ) */

---_ - -_-_ - -_--- -- --_-- -- --- -- ----_----- -- -- -- -_- -- -- _-- -- --- -- --- -- - -- __- _ _ _--_--- --- -- -_-_-___- -- --

1986/167 b/ Average A-or* Rate c/ lI picit Sobsidy Flow d/Bel nce. cost of fund. on spotctiont --------------------------------(amlZ) (SAA) (C A.A.) Case C** 2 Cse 3 Cme I Cs" 2 Coe 3

415.635 369.405 406.533 5 CDP S DP S CDP--.- _ --_ ---_-_ ----_ --_ -- ----_ ---- ----- ----- -_--- ---- ---------- ---- ----- ----- ---- ----- -_-_------ ---- ----- ----- ---- ----- ----- ----

Nature of IReeurceEarorted me adminstered

1) FlD *e 144.00 0T1..13 11 07.3 399.535 -23.47 14.59 -10.O8 -0.19 0.123 -0.OllSt2) PISIPAE 466.85 Gt6161 OTI1at 399.S5I -73.41 47.80 -32.82 -062 0.391 -0.2733) FD15C3L f/ N.A.4) fU1' a/ 778.77 0tN*3.75 07625 3ne.53rt -150.23 55.54 -77.80 -. 225 e 15 -o.t3s6) Ftt U.22 07W#6. 397.536 -2.42 1.0 -1.19 -0.021 0.011 -0.015

Total Copulmory Sevia 14046.4 -252.5t 118.71 -121.97 -2.051 0.975 -0.991

8) F 19.4t OTlb4 3 / 3I m21.641 -18.31 -13.16 -16.49 -O.1I -0.111 -0.135

6) PR0ACt t.90 0 0 -36.99 -34.64 -36.17 -0.3D1 -0.261 -0.297) ber"a Pbnt>rlm 59.49 0T74S 1. S9395.833 -12.07 3.65 -6.54 -0.10 0.0# -0.05r6) FWtE 26.44 0lTlt 391.5s -6.42 0.56 -3.97 -0.055 0.005 -0.0359) RFCEH1 0.73 0 0 -3.04 -2.65 -2.98 -0.075 -0.02S -0.025

10) Contrveert;d e 4 Nemc.fEt. h/ 14.08 0 0 -50.56 -44.84 -57.25 -0.4Stt -0.445 -0.47511) FD 0.05 0 0 -0.22 -0.20 -0.21 O.OO S 0.005 0.0052) PROASAL 2.02 0 0 -4.40 -7.33 -0.21 -0.073 -. 065 -0.07o

Total (Tr"eury Adminiatered 131.183 -144.01 -109.34 -131.82 -1.176 -0.m89 -1.0715

Fund and Prer_am)

13) Nat S.g..t Ooei' Appl,idby Comrcial Denbah

Agrmcultuee(ar 16) 102.20 0T7.75 396.s3s -17.53 9.31 -8.16 -0.145 0.061 -0.07o

Small A NMdu e Ent.rpreo / 27.62 -6.0S5 -t.05 -8.05 -0.07n -0.075 -0.07%T*tAl Apt icatione for comal.beak 10.02 -25.76 1.25 -16.23 -0.21t 0.015 -0.133

14) C'ntral SankPadiecountine Oporetiona 16.17 LOC LOC1811 371M.00 -6. 15 -3.34 -6.46 -0.07o -O.tl5 -005S

State Commrcial bnks 14.98 371.005 -6. 71 -2.76 -5.32 -0. OS -0.021 -0.04S

Federal Commercial Banks o.90 271.00 -0.41 -0. 17 -0.32 0.00C 0.00 0.001Private eanbs 2.29 371.005 -1.02 -0.42 -0.81 -0.019 0.005 -0.01

IS)COntral beab 707.63 -736. 16 -549.17 -670.38 -5.99 -4.461 -5.45Sconto 4. auprimnto 576.55 e 361.291 -199.83 -46.92 -146.04 -. 6e8 -0.368 -1.195conte . mvato 12S.96 O.O0S 0. O5 -531.33 -502.24 -54.34 -4.36n -4.081 -4.265

Total Central ek 753. 52 -782.39 -560.59 -664.92 -6.12t -4 564 -s.sn716) Savings Account. applied 646.00 011.5.35 397.033 -121.81 49.46 -61.5s -0.9" 0.40 -0.O5x

by Saving. and Loans j/17) .livlage Accounts APP led by 541.67 0tSS 396.531 -104.53 3e.63 -54.17 -4.5 0.315 -0444S

Caina Econcics FderalTotal Itraing Systes 1189.67 -226.34 33.09 -115.73 -1.845 0.721 -0.94

a01 TOTAL 3609.2365 -1401.09 -4e1.69 -1070.69 -11.391 -3.765 -0.705

UJM TOTAL tCUW.I4H410.1146 2419.542 -1174.75 -549.976 -954.963 -9.5S -4.475 -7.765

SourceoaCentrel Bank.Me f.S1IM.CIF.LATIae/Calcvlated ao tho meighted average of the rate charged on Lo to We8 in euport of Wirel 9 or other opHeMeiona.

eec/Calculated baaed on th Weighted av*erge Of different rate. made available to th norHthoet or ctro aul for both agricultural nd indwutr;al credit.a/Swe rate. and bhlances shon in table are preliminary.b/Refeor to He average of the end of period stock in taeoaer 19S6-7.cRf ao to th average rate that o legally to be paid not to the affectivw rat.. ln mae cm... roflect. only tHe anerage in theyear indicated rather than reflecting the average rate on the aweage stock d lo em outatanding if the reporting institution didnot ha.* this inforaation.4/Casa l0PIDaI(for 19S7);Cae 2.Cocr.Cnb;ialsLibor.2S;Cm*e 3-0125S The Percentage under each heeding reler. to the ain;iml srobet rat. tor 1966 >

o/Mational Devalopeent Fund(FND) balance ewals floa becave* this fund was only eetablihed in Jl1y 196. _

f/Finaccial fund. are almat *al outerght grant. and are th. not *enmined her..g~bare are preliminary etiaste- roport.ed by CEF.h/Transitory account for the registration nd control of *etornal borroringe.i/Due to comlesity of the pricing of these linea estimate ahown ie held constant n indicated by Central bnab *-t.-ates. Also this

include coapuleory Credit oprationo aseoc;at*d with R eolutior 1. not. -ith Resolution 695 or 1406.j/Osta on Salancem for 1987 are estimatad by Central sank.I lhis aveorag cot to the coaaercial banks of FUK4=1 r6eeou0rc dome not ncloda the 14 foe charged on them I ine by the Not.onal Tre**.ry.

I/Thia representa an effective rat* on ho I ines entendad to the state, commrcial banlis via Amearva hMeteria.

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Effects on the Financial Intermediation Process

A4.17 Directed credit programs in Brazil, as in many other developed anddeveloping countries, have been justified on a number of groundss (a) theneed to correct market failures because credit cannot be acquired at'reasonable" cost; (b) as a means for the provision of public goods; andtc) as a response to monopolistic elements in the iitermediation process(e.g., in the context of agricultural lending in Brazil). In many casesthese original rationales may not have been valid in the Brazilian context.However, existing macroeconomic policies and high and variable inflationrates have made such "cheap credit,' allocated by the Government, a cri-tical source of 'unds for various sectors or particular classes of bor-rowers within the economy.

A4.18 The degree to which the different types of directed credit pro-grams described in Annex 2 distort resource allocation decisions depends inlarge part on whether the particular programs described actually affect the'marginal' price of credit. Thas is, to the extent that some of the pro-grams amount to 'income transfers,n the marginal price of credit providedto borrowers may not be altered. This will largely depend on the size ofthe credit market (i.e., number of participants, the size of the subEidy,and other structural characteristics of the credit markets.)

A4.19 Directed credit misallocates resources because the operations, asconducted in Brazil, affect the relative prices of real and financial as-sets. For example, under some of the subsidized credit operations providedto agricultural producers, incentives are created tor 'excessive' landhold-ing and associated land price increases. This can reduce real capitalformation and economic growth.

A4.20 Investment decisions are affected to the extent that t becomesvery difficult to use standard techniques (e.g., present value analysis) tocompare the attractiveness of competing investments, because a yield curvedoes not exist to provide a guide as to how cash flows in periods out fur-ther than one year should be discounted. Although the non-existence of a*market-determined' cost for long-term funds largely results from "macro-economic' instability, the directed credit programs operating in Brazilhave also contributed to this problem. These programs have not permittedthe growth of long-term capital markets because of restrictions on theability of institutional investors to allocate portfolios freely (astypified by restrictions on pension fund and insurance company operations);some programs that have provided subsidized credit in support of long-terminvestments (e.g., BNDES), thereby not forcing economic agents to activelybid for the use of long-term funds; and frequent changes in the government-mandated formulas for pricing long-term credit and changes in governmentregulations regarding these programs have increased uncertainty and com-plicated the process of entering into long-term contracts.

A4.21 In sum, the degree of government intervention in the savings-in-vestment intermediation process has distorted the market to the degree thata term structure of interest rates does not exist to provide 'information"to market participants. Also, these programs have increased the searching,

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screening, and transaction costs to savers and investors. That is, bor-rowers and lenders have to spend greater amounts of time and real resourcesto select appropriate investments. Thus, it is the interest rate net ofinformation and transaction costs that matters to lenders and borrowersthen the effect of directed and subsidized credit programs coupled withhigh inflation has been to increase the interest rate spreads on freeloans. As a consequence, capital formation has probably been reduced, witha negative effect on economic growth.60

A4.22 Directed credit programs and rrequent changes in regulationscreate incentives for intermediaries and other economic agents to expandresources to take advantage of inconsistencies in regulations. Thoseresources are not devoted to supporting domestic investment, and perhapsmore important, highly skilled labor is allocated to pursuits that are lesslikely to increase capital formation.

A4.23 Official credit programs administered by federal financial insti-tutions have adversely affected the efficiency with which these institu-tions operate and has distorted their financial structures. For example,in the cases of BNDES and CEF, Government constraints on operations haveprevented them from carrying out the normal functions associated with in-termediating credit, as a substantial proportion of the resources inter-mediated by these institutions are provided by the Government and fundsmust be applied on terms and conditions specified by the Government.Hence, such federal financial institutions act as administration and col-lection agents for the Government.

A4.24 Finally, directed and subsidized credit operations have also in-creased the segmentation of deposit and credit markets. This has occurredbecause the regulations associated with directed credit operations oftenrestrict both the quantity and pricing of credit allocated to particularsectors, as well as the pricing of particular liabilities. Forced invest-ments have accentuated the difference between controlled and free-marketlending rates.

Effects of Directed Credit Programs on the Measurement and Control ofGovernment Expenditures and the Implications of Recent Budgetary ReformMeasures

A4.25 Directed credit programs as currently administered in Brazil havecontributed to the Government's inability to acct-ately measure and controlexpenditures, and have increased the size of the structural deficit. Thesix different types of official directed credit programs identified inAnnex 2 are likely to have different effects on the structural deficit,depending on the extent of subsidies inherent in a given program, and thespecific characteristics of the program ~hat affect present or futureGovernment expenditures or tax revenues. For example, in the case of theforced-saving programs supporting long-term investment, some programs suchas FINSOCIAL operate as outright grant programs that are reflected in the

601 For a fuller treatment of this point, see Boyd and Kwast, "BankRegulation and the Efficiency of Financial Intermediation" in PublicPolicy and Capital Formation, Board of Governors, April 1981.

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budget. By contrast, FGTS or PIS/PASEP funds have been provided atGovernment-mandated rates that have been quite highly subsidized (see Annex3), completely outside even the recent unified budget process that includesa "credit" budget. In addition, to the extent that "past loans extendedunder these programs" remain outstanding, these programs are likely to havea large effect on nondiscretionary government expenditures under rapidinflation.

A4.26 By contrast, other types of official directed credit programs --such as those associated with forced investments by non-bank financialintermediaries in Government securities or the compulsory applications ofcommercial bank demand deposits -- will tend to have different fiscal im-pacts than the forced savings prtgrams. In the case of forced investments,the Government creates a captive market for its domestic debt, so this typeof directed credit program is used as a means of financing the fiscal defi-cit, but does not necessarily increase non-discretionary Government ex-penditures in present or future periods. In fact, elimination of theserestrictions will (ceteris pa 'us) require additional Government borrow-ing. In the case of compulsory dpplications of required reserves or demanddeposits, the fiscal effect can be difficult to measure. For example, whenrequired reserves are earmarked to support the financing of financiallydistressed enterprises, the Government trades off the inflation tax revenueit would accrue frcm having these reserves held at the Central Bank earningzero interest, against the future revenue that it will receive from taxingthese enterprises.

A4.27 Finally, the official credit programs carried out under the aus-pices of the Treasury, those associated with the housing finance system andCentral Bank rediscounting facilities (inclusive of lines of credit avail-able to the Bank of Brazil) have resulted in substantial implicit subsi-dies. Hence, many of these programs have increased the structural deficitof the Government. In addition, over the period reviewed the Government'sability to forecast its cash requirements and future Government expendi-tures has been compromised given the non-transparency of these programs --which results from their non-inclusion in the budget and because of diffi-culties in revenue collection.

A4.28 During the period under review, the Government began to take ac-tion to reduce these subsidies and to enhance transparency. Reforms havefocused on three areas: directed credit programs affecting commercialbanks that result in mandatory applications of demand deposits or outrightearmarking of required reserves; directed credit programs administered bythe Central Bank (inclusive of Central Bank advaices to the Bank ofBrazil); and measures to alter budgeting procedures and to enhance theinformation available on the characteristics of all directed credit pro-grams, so as to ensure that the effects of all such programs are reflectedin the budgeting process.

A4.29 The Government has taken the following actions: (a) Resolution695, which that required commercial banks to lend 12? of demand deposits(net of reserve requirements etc.), began to be phased out after February1986 with complete elimination expected in 1989; (b) a directed creditprogram introduced in 1987 under Resolution 1335, which targeted a certain

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portion of required reserves held by commercial banks to small and medium-sized enterprises at subsidized rates has been discontinued; (c) in July1987, all directed credit programs to the industrial and agriculturalsector were indexed to the OTN.61 One of the only exceptions was the PAPPprogram, providing a small amount of credit to farmers in the Northeast atsubsidized rates; and (d) in June 1988, the Minister of Finance formed aworking group that will explore alterrative means for directing resourcesfor the agricultural sector, so as to gradually reduce mandatory applica-tions of net demand deposits to finance agriculture under MCR 18.

A4.30 Several reforms have been undertaken by the Government in order toreduce the implicit subsidies associated with Central Bank administereddirected credit programs. The most important actions have included closingof the "conta movimento/suprimento" accounts between the Central Bank andthe Bank of Brazil, thereby reducing an important source of directed andsubsidized credit; under new budgeting procedures, funds will have to beappropriated by Congress to support the development banking functions ofthe Bank of Brazil that had previously been supported by the Central Bank,and all funds and programs administered by the Central Bank were trans-ferred to the control of the Treasury.

A4.31 The actions taken to promote transparency (item iii) have includedtransferral of all funds and programs administered by the Central Bank tothe Treasury, to be incorporated in an explicit credit budget, and explicitrecognition that the Central Bank will be responsible for the monetarycontrol function and not domestic debt management. In addition, theGovernment will operate under a debt-ceiling that can only be raised withCongressional approval.

A4.32 Despite these reforms, the directed and subsidized credit programslying outside the control of the Treasury and not accounted for in thecredit budget remain large. Of particular importance are the directedcredit programs administered by Federal Banks. 6 2 Systematic information onthe directed credit programs administered by these institutions is cur-rently not available for putting together the credit budget. In addition,the credit budget provides little information on the directed credit pro-grams administered by State Governments, state and regional developmentbanks, and state-owned savings banks.

A4.33 Finally, enhancing the transparency of directed and subsidizedcredit programs will also require changes in the way in which the creditbudget is formed and presented. Discussions with National Treasury staffindicate that the following specific actions should be considereds (a)information disclosure by federal financial institutions administeringdirected credit programs and the quality of information provided needs tobe improved; (b) coverage has to be expanded to include all direct loan

611 Until July 1987, many directed credits lines were extended givenallowance for only partial monetary correction, of the principal valueof the loan.

62/ These include the Bank of Brazil, Caixa Economica Federal, BNDES, Bankof Amazonia, Bank of Northeastern Brasil, Bank of Roraima andMeridional Bank.

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obligations and "loan guarantees" offered under official credit programs.and no distinction should be made between on- and off-budget institutions;(c) intragovernmental transactions -- such as inter-official agency fundingor government agency repurchases of government loans -- need to be ac-counted for properly in the credit budget; and (d) the format of the in-formation presented in the credit budget should be altered so as to eluci-date the average terms (interest rate and maturity) for each program, andestimates of the present value of the subsidy stream implied by theprogram.

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APPENDIX I: MARKET STRUCTURE AND CONCENTRATION

1. Table 1 shows the value of the Herfindahl index for total assets,deposits and number of branches of each commercial bank. The Herfindahlindex is defined as the sum of squares of the relative size of firms in anindustry, where size is the percentage of total industry assets, depositsor branches. Consequently, if all firms are of equal size the index isequal to 1/n, where n is the number of firms in the industry, and it be-comes equal to 1 if there is a single supplier. The inverse of theHerfindahl index shows the equivalent number of "equal" firms supplying themarket, the lower this number of "equal" firms, the higher the level ofconcentration in the industry.

| ~~~~~~~~~~~Table 1

Estimates of the Herfindahl Index as of 1987for Assets. Deposits and Branches of Commercial Banks

Excluding Bank of Brazil

- Total assets 0.041- No. of branches 0.054- Total deposits 0.042

Including Bank of Brazil

- Total assets 0.210- No. of branches 0.067- Total deposits 0.177

Note: The number of banks included in the calculation of assets,branches and deposits is 96, 104 and 85 respectively.

Sources: Central Bank of Brazil, Sistema Financiero Nacional. DatosEstatisticos e Gerais. December 30, 1987 and Revista BancariaBrasilera.

2. Table 1 confirms that the Brazilian commercial banking system isconcentrated when the Bank of Brazil is included in the calculation. Inthis case, the number of "equal' firms supplying the market is around five(measured in terms of equity and total deposits), although the score de-creases to 15 when the variable "number of branches" is used. This resultis not surprising since the Bank of Brazil holds 442 of total assets and182 of the total number of branches of the commercial banking system.

3. When the Bank of Brazil is excluded from the calculation, thevalue of the Herfindahl index decreases. The number of "equal" firms sup-plying the market increases to 24 for assets and total deposits and 18 fornumber of branches respectively. In any case, the market is still con-centrated, with results consistent with those shown in the main text ofChapter 1 (to see this, compare the share of the 20 largest banks with thenumber of 'equal* firms supplying the market).

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4. Table 2 shows the evolution of the Herfindahl index for totaldeposits of private commercial banks during the past four decades. Thetable clearly shows systematic concentration in the banking industry (atleast for private commercial banks)60 after 1965, wi.ich stopped after 1975.The number of equal firms supplying the market decreases from 50 in 1955 to32 in 1970 and to 15 in 1975, rising to 18 in 1987. This shows that thedeliberate government policy of favoring concentration in the banking in-dustry has been successful.

Table 2

Estimates of the Herfindahl Indexof Total Deposits for Private

Commercial Banks(Annual Data, 1946, 1955, 1965, 1970, 1975, & 1987)

Year Herfindahl No. of EqualIndex firms

1946 0.022 451955 0.020 S01965 0.020 501970 0.031 321975 0.066 151987 0.055 18

Sources: 1946 to 1975, Portocarrerode Castro. 1987 calculatedfrom data in Revista BancariaBrasileira.

5. Another measure which give an idea of recent changes in relativeconcentration is the estimate of the variance of the logarithm of deposits(sZ). The higher the value of sZ, the more uneven the composition of thebanking industry, in other words the higher the variance, the higher thedifference in size between large and small banks.61 This measure is shownin Table 3.

60/ The comparison is made only for private commercial banks because theindex from 1946 to 1975 was only available for these banks.

61/ This assumes that the distribution of deposits is lognormal. SeeCarvalheiro (1982).

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Table 3

Variance of the Logarithm of Total Deposits of CommercialBanks (Excluding the Bank of Brazil)(Annual Data, 1964, 1976, & 1987)

Year Number of Banks in Variancethe Sample

1964 303 4.7851976 102 4.0231987 80 4.057

Sourcess Data for 1964 and 1976 from Carvalheiro (1982).Data for '.987 from Revista Bancaria Brasileira.

6. Table 3 shows how sz has changed in recent years. Although thebanking industry became more concentrated from 1964 to 1976, relative con-centration has decreased (i.e., there is less disparity between large andsmall banks).62 In 1987 the value of sZ is )tactically the same than thatof 1976, showing that relative concentration was more or less the same inboth years.

62/ Calvalheiro (1982) concludes that in the period 1964-1976 the Braziliancommercial banking industry became more concentrated in absolute terms,but there was great mobility between large, medium and small banks. Onaverage, large banks were more able to survive, but small banks thatcould survive had the highest rates of growth.

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APPENDIX II: THE INFLATION TAX

Methodologv and Data

1. We draw a distinction between the two largest deposits (inputs)of the banking systems demand deposits, which do not bear interest, andsavings and time deposits, which do. There are also private and Goverumentsector demand deposits,63 a distinction needed because the average levelof reserves required on government demand deposits is different from thatrequired on private demand deposits. This is important in determining theexact inflation tax transferred to the banking sector. 6 4

Inflation Tax Model

2. A simple measurement of the total gross inflation tax, Tt, can beobtained by multiplying the rate of inflation Pt (equivalent to the taxrate), by the sum of the real stock of demand deposits, DDIP, and the realstock of currency, C/P, (the sum being equivalent to the gross tax base); Pis the price level and pt the rate of inflation. Other than this rate,lower case denotes real values throughout the appendix.

Tt - Pt (DDt + Ct) I Pt- Pt (ddt + ct) (1)

631 Private sector demand deposits also include demand deposits offinancial institutions.

64/ The Brazilian banking sector is composed of private and Government(official) banks. Formally, these banks are grouped as privatecommercial banks, official comnercial banks, Bank of Brazil, BNCC(National Bank of Cooperative Credit), and federal and state savingsbanks. This grouping has consequences for data collection, and hencein this presentation; i.e., statistics for the Bank of Brazil and BNCCare grouped together. Savings banks are excluded from our study,except where noted, due to the relatively small size of their demanddeposits and the quality of the data available. This omission producesa small underestimation in private demand deposits and anoverestimation in government demand deposits. However, it does notalter the significance of the results.

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Although many other more complex forms of the equation have been estimated,this simple definition will serve as a good starting point.65 Equation ;6)is separated into equations (2) and (3) in order to estimate the inflationtax paid by private demand deposit holders, TPt, and the Government'stransference as a holder of demand deposits, TGt.

PPt - Pt (DDPt / Pt) + Pt (Ct / Pt) (2)= Pt ddpt * Pt Ct

TGt - Pt (DDGt / Pt) (3)- pt ddgt,

where DDP are the demand deposits of the private sector, DDG are demanddeposits of the government sector and C is currency in the hands of thenon-banking public.66

3. The inflation tax on demand deposits was first "collected" by thebanking sector and then applied to reserve requirements (tranfering part ofthe tax to the Central Bank), loans, banking services (implicit iLtW.restrate on demand deposits) and banking expansion.

4. Consider the following set of equations:

BPt =Pt ddpt (1 - rtl) (4)BGt - Pt ddgt (1 - rt1g) (5)Bt Pt ddpt (1 - rtl) + Pt ddgt(l-rtl8) (6)

In equation (4), BPt represents the initial inflation subsidy to thebanking sector received from private demand deposits. BGt estimates thietransfer from government demand deposits to the banking sector. Inequation (6), Bt denotes the subsidy to the banking sector from totaldemand deposits, rl the average legal reserve ratio on private demanddeposits and rlg the same ratio on government demand deposits. This groupof equations has been estimated for each type of banking institution andfor the banking sector as a whole. When estimating the subsidy to officialcommercial banks for instance, it would mat-a sense to drop the last part ofthe equation since the Government is making transfers on its demand

65/ The specification of equation (1) warrants further discussion.According to Drazen (1985), Friedman (1953) and Bailey (1956) haveestimated the inflation tax as the product of the inflation rate timesreal money balances; Cagan (1956), Marty (1967) and Friedman (1971),'.ave used the rate of monetary growth times real money balances; andPhelps (1971, 1972) and Marty (1978), have used the nominal interestrate times real money balances. Drazen himself, distinguishing betweenthe Government's dual role as taxing authority and as monopolisticproducer of money, estimates the inflation tax as the rate of monetaryexpansion times real balances to which he adds the real return onGovernment's assets.

66/ For ease of exposition, all currency in the hands of the non-bankingpublic is assumed to be held by the private sector.

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deposits to official (government) banks. However, we will retain thisvariable, since it is instructive to know the Government's subsidy to itsown official credit institutions.

5. Government sector revenue from the inflation tax has been esti-mated with the following equations:67

GRt - ptdd rtD + pt ct (7)- Pt (ddtrDt + Ct)- Pt ht. (8)

GRt is the revenue of the Government sector and ht is the real value of themonetary base; in fact, instead of estimating GRt indirectly through equa-tion (7), we estimate it through equation (8).68

Incidence

6. We will consider only two kinds of moneys currency and demanddeposits. The reserve requirement on the latter, z, is assumed to bebinding. The central bank pays no interest on reserves, although theanalysis would not change significartly if it did. There is an unspecifiedthird asset in the system whose real rate of return, r, is assumed to beunaffected by inflation. All variables referring to money and credit areassumed to be in real terms.

671 rD is the overall legal reserve ratio on demand deposits (dd). Ifsaving deposits paid no interest on its reserves, its legal ratioshould have been included; in Brazil bank hold government bond asreserves against savings deposits.

681 All monetary data were obtained from publications of the Central Bankin Cruzados. The series for total demand deposits, the monetary baseand currency were obtained from the Central Bank's monthly bulletin.The private sector demand deposits in all banking institutions, as wellas their respective legal reserve ratios, were obtained directly fromCentral Bank sources. The price level (IGP-DI) and annual GDP for 1985and 1986 were obtained from the monthly, Conjuctura Economica,published by Fundacao Getulio Vargas. The GDP estimate for 1987 wasobtained from the Country Operations Division of the Brazil Departmentof the World Bank.

All data used are end of period quarterly series. Figures required inreal terms, as indicated by the inflation tax model discussed above,are converted from nominal terms using the IGP-DI index (IGP-DI inDecember 1987 equals one hundred) and then multiplying by one hundred.Real Cruzados were then converted to U.S. Dollars using the parallelmarket exchange rate of December 1987 (Cz$l - US$93.5), obtained fromthe International Financial Statistics of the International MonetaryFund. All data from the Central Bank are end-of-period quarterly orannual; all annual inflation taxes and subsidies are aggregations ofaverage quarterly estimates. For a complete listing of the series usedin this chapter (see Appendix V).

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7. The demand for currency and deposits depends upon the real ratesof return on the three assets:

C = C(rc, rd, r), (1)

D - D(rd, rc, r), (2)

where rc and rd are tje real rates of return to currency and deposits,respectively. The real rate of return on currency is the negative of theinflation rate, rs

ic ' (3)

The supply of bank loans is given bys

SL - (l-z)D, (4)

and the demand for those loans is a diminishing function the rl, the reallending ratet

DL - DL(rl). (5)

As the economy is closed, the loan market must clears

DL SL. (6)

8. We have nine variables of which seven (C, D, SL, DL, rd, rc, rl)are endogenous, but only six equations.69 The missing equation comes fromthe specification of the nature of the banking system. Any specificationwill do. but we shall assume that it is competitive, so that expectedmarginal profits are zero. Letting il by the nominal interest rate onloans and id be the cost to the bank of attracting a deposit of one unit of

69/ We could introduce another variable, the real monetary base, B, whichwould provide the seven equations B - C + zD. This does not close thesystem, however; although the nominal monetary base can be exogenous,the real monetary base is always endogenous (as is the real exchangerate). This approach would i4directly introduce an endogenous pricelevel, vhich we will treat as exogenous as we are interested only incomparative statics results.

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currency (including all gifts, services, etc., in the case where payment ofinterest on deposits is prohibited) we have the following zero marginalprofit conditiont

il (AS) = id (AD) +S(ASL),

where a is the constant marginal cost of doing business, per unit of loan.70

We will define the real "interest" rates ass

rl - il - r, and

rd - f(id - . f' > 0.

The specification for rd is necessary because it is the real rate of returnas perceived by the holder of a deposit, whereas id is the cost to the bankof attracting that deposit. It is the difference between rd and f(id - i)that leads to the inefficiencies associated with rent seeking. As thismodel will not be used to analyze rent seeking, we simplify as follows:

f(id - r) - id - t

9. using the above defined real 'interest' rates and the relation inequation (4), the zero marginal profit condition can be reduced to:

rl- (1+a)rd + a 1 +, (7)

where a is the reserve requirement defined on loans rather than deposits:

a - z/(l-z)

- A(zD)/(AL).

and1

(l+a) = ---1-z

In principle, the system can now be solved for any endogenous variable.

10. We will solve the system only for the behavior of rd and rl. Welet d be the differential operator and assume a local linear approximationof the various functions (all parameters being positive)s

dD - a drd - P drc,= a drd + Pu, (2')

dDL -9 drl. (5')

701 If the 'interest' rate in this expression are taken to be ex ante, ther.s includes default risks.

- 130 -

Combining equations (2'), (4), (5'), (6) and (7), and for simplicitysetting s equal to zero, we obtains

drd/d r - - 1ZO + (l-z)2p]/[0 + (1_z)2 I < 0, (8)

drdld X - (l-z) [Zn - PI/[G + (l-z) 2 0J. (9)

11. Unless currency and deposits are perfect substitutes, it followsthat a > P, and as z is a positive fraction, is it clear that drd/dr is anegative fraction. That is, the real rate of return on depositsnecessarily declines as inflation increases, but at smaller rate; clearlythe nominal yield on deposits increases with inflation.

12. With respect to drl/du, we see that it will be positive ifZ > PIa, equal to zero if z - p/a, and negative if z < PaI. Thus ifreserve requirements are *low" and/or currency and deposits are 'good"substitutes (meaning that p is close to a in magnitude), the real rate ofinterest on loans will decline as inflation increases. As the banks paynone of the inflation tax on their reserves (by assumption), and ifborrowers from the system are net beneficiaries of the inflation, then thecost of inflation to depositors is clearly more than the inflation tax onbank reserves.71 Alternatively, if reserve requirements are high and/ordeposits are a poor substitute for currency, the real lending rate will bepushed up by inflation, forcing borrowers to pay a part of the inflationtax.

71/ The explanation is simple. If the reserve ratio is low, the rate oftaxation of deposits is also low and hence drd/d is small, givingcurrency holders great incentive to move into deposits and hence realbank credit will actually increase with inflation; it can be shown,however, that both the real money supply and the real monetary basewill decline.

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APPENDIX II.s RESERVE EQOUIREMENTS

1. Empirical Evidence of Instability of Reserve Reauirements

1. To examine the effect of multiple reserve requirements on the rateof change of the money multipliers, we measure the latter's mean andstandard deviation. An *ideal' system for monetary control would be thatin which a very large share of money growth is explained by changes in themonetary base, thus implying very little variability in the moneymultiplier. The following table illustrates Brazil's experience.

Table 1

Rate of Change (X) of the Money Multiplier(Monthly Data, Jan. 1980 - Jun. 1989)

Multiplier Concept* Mean Standard Deviation

ml -0.19 9.70m2 0.24 8.52Ms 0.80 9.30m' 1.16 9.93

* The multiplier concept' refers to the different money supplydefinitions. The monetary base aggregate is similar to that used by theCentral Bank.

Source: Central Bank Bulletins and Information.

2. Table 1 portrays the extreme variability experienced by the moneymultiplier in Brazil -- a source of important financial instability. Thesechanges in the multiplier were caused by exogenous and endogenous forces.Portfolio allocation switches were very important -- as shown later inTable 3 -- but exogenous shoces -- Central Bank determined -- should not bedisregarded. For example, during the period 1983-87, legal reserve ratioson time deposits were changed by the Central Bank 14 times. These were notminor changes; legal ratios on time deposits varied from a maximum of 302to a minimum of zero. At least these were policy changes desired by themonetary authorities, whereas portfolio switches whi-h forced changes inthe money multiplier surely were not.

3. The time period covered in Table 1 includes that of the CruzadoPlan when there were large changes in the endogenous determinant of themoney multiplier.69 The inclusion of those months in the sample perioddramatizes the deleterious effect cf multiple reserve ratios; these effects

691 These endogenous determinants are, in the most simple multiplier model,the cash to deposits ratio and the portfolio choice of the publicregardirg different bank's deposits.

- 132 -

could have been better hidden under more *normal conditions, but the highvariability of both the multiplier and its rate of change are not duesolely to the Cruzado Plan stabilization period.

4. By the end of 1988 Brazil had 42 different compulsory reserves ondemand deposits, depending on a bank's size and location. Thus, wheneverthe relative importance of demand deposits in each category of bankchanged, the multiplier also changed. Mhost importantly, required reserveson other deposits, like savings and time deposits, were different fromthose on demand deposits and different from each other. This means thatany shift from demand to time or savings deposits changed the money supplythrough its impact on the base multiplier. This will become clearer if wedevelop a very simple model. Assume that the country has three types ofdeposits with different reserve ratios; in the case of Brazil these wouldbe approximately the followings

Legal reserve ratio ons

Demand Deposits - .43 where DD - demand deposits

Reserve ratio onSaving Deposits - .03 where SD - savings deposits

Reserve ratio onTime DepositS70 - .03 TD - time deposits

In addition, let TOD - DD + SD + TD.

5. Define Total Reserves (TR) of the banking system as:

(1) TR -UDD + RSD + RTD

where RDD, RSD and RTD are reserve ratios on demand, savings and timedeposits.

Divide (1) by total deposits (TOD)

(2) TR/TOD - RDDITOD + RSD/TOD + RTDITODDivide and multiply each term in the right-hand side of (2) as

follows:

70/ Savings banks are required to hold 152 of their deposit liabilities ingovernment bonds. This is forced portfolio allocation which issometimes mistakenly treated as the imposition of required reserves.The legal ratio for time deposits in Brazil is currently zero. Atechnical ratio of 32 in both savings and time deposits is assumed inthis example. Excess reserves are neglected in other ratios for thesake of simplicity.

- 133 -

(3) TR/TOD - RDD/DD (DD/TOD) + RSD/SD (SD/TOD) + RTD/TDtTD/TOD)substituting lower case letters for the reserve ratioss

(4) rtOt - rdd Wd + red Ws + rtd Wt

The weights are given by W and sum to usity. The Central Bank mayhave great power over the reserve ratios but has little direct power overthe weights. The greater the gap between rdd and the other legal ratios.the Ereater the instability of the total reserve ratio. In Brazil theformula would bet

(5) rt°t - .43 Wd + .03 Ws + 0.03 Wt

6. In Brazil, the public has reshuffled its portfolio in large swingsaccording to significant changes in the relative profitabilities of dif-ferent financial assets. If legal -- and voluntary -- reserve ratios arethe same for all types of deposits, a shift in the desired portfolio com-position -- i.e., any relative increase of demand deposits -- will notchange the average reserve ratio. Therefore, on this account, the moneymultiplier will not be affected either.

7. Table 2 shows the change in those relative weights including thepercentage of government bonds held against total deposits (GBITOD).

Table 2

Average Ratios (X) relevant to the Money Multipliers(Monthly Data, Jan. 1980 - Jun. 1989)

Mean Std. Dev. Min. Max.

DDITOD 24.8 10.0 11.2 43.6SD/TOD 48.7 9.4 32.4 72.8TDITOD 26.6 4.5 14.5 36.1GBITOD 44.9 17.2 22.2 91.3

Sources Central Bank of Brazil.

8. Table 1 showed that money multipliers were very unstable inBrazil, and Table 2 shows that the weights of the different legal reserveratios have had wide swings.

- 134 -

9. The next steps ares (a) to see if movements in the money multi-pliers are related to movements in the aggregate reserve ratio; and then(b) to correlate this aggregate reserve ratio with its determinants. Thefirst test will give us an idea of how well the total reserve ratioexplains changes in the multiplier. The second test will tell us if thevariables exogenous to Central Bank policy -- relative weights -- are re-levant to explJ;.. ing changes in that aggregate legal reserve ratio.

10. Tabi 3 illustrates the simple correlation between the aggregatereserve ratio -- rtot -_ and: (a) different multiplier concepts (m3, m4),and (b) the weights (W as defined in equation (4). The same table alsoshows the simple correlation between those multipliers and those weights,including the cash deposit ratio and the bonds-deposit ratio.

Table 3

Correlations Coefficients(Monthly Data Jan. 1980 - Jun. 1989)

m3 m4 DD/TOD SDITOD C'TOD GB/TOD

rtot -0.92 -0.93 1.0 -0.89

m3 -0.92 0.77 -0.93 0.62

m4 -0.93 0.84 -0.89 0.80

Notes The variable rtot has been calculated be equation (5).Source: Central Bank of Brazil. The definitior. of the monetary

base is the same as that used by the Central Bank.

11. Table 3 displays several important featurest

(1) The aggregate reserve ratio (rt0t) is a very important vari-able in explaining fluctuations in the money multipliers;

(2) The portfolio composition chosen by the public is a verysignificant factor in accounting for the variability of thelegal reserve ratio; and

- 135 -

(3) The direct impact of those endogenously determined weights onthe money multiplier is so important that it sheds seriousdoubts on the overall exogeneity of money supply flows inBrazil. For example, the correlation coefficient between themultiplier (m4) and the demand deposits to total depositsratio is -0.93. This becomes more relevant when we recallthat, contrary to the case in other stable countries, themoney multiplier explains a large proportion of the moneystock's variability over the last years.

Is the Money SuPPlV EndoRenous in Brazil? 71

12. The endogenous component of the money multiplier is very importantin Brazil which means that the Central Bank has an extremely difficult taskin monetary programming. Not only must it respond passively to theTreasury's demand for cash and credit, but also it has to keep the balancewith respect to the private cum public sector rediscount mix, whileresponding to a highly variable multiplier. In addition, it should havesome sort of control over the money stock during the fiscal cycle.13. Simple examples will illustrate the scenarios within which thepresent compulsory ratios would make monetary policy play a more difficultrole. Suppose that there is an excess flow demand for money, driving realinterest rates upward and causing a switch from demand and savings depositsto time deposits (and bonds). This portfolio change would increase themultiplier and the money stock, thus tending to equilibrate the excessdemand for money. If the Central Bank attempts to compensate for this withsales of bonds to the public, it would further increase interest rates andthus reinforce the portfolio switch.

14. Other examples illustrate ways in which differential reserve re-quirements may at least partially have sterilized monetary policy. Supposethat interest rates are 'too high' and the Central Bank enters the openmarket, buying bonds to drive them down. As interest rates are drivendown, the portfolio composition changes, decreasing the multiplier and therate of change of the money stock. That would push interest rates upward,thus counterbalancing the Central Bank efforts.

15. Empirical estimates tend to support to the idea that the CentralBank may have carried out some open-market operations "as if" it had beenmainly concerned by the price (interest rate) or quantity (money stock or'liquidity') effect of the endogenous components of the multiplier. Thefollowing table shows the relationship between the rate of change of bondsin the hands of the non-banking public and those endogenous components.

71/ We will not be discussing here endogeneity that may be the result ofexchange rate policies or indexation schemes.

- 136 -

Table 4

Correlations CoefficientsMonthly Data Jan. 1980 - Dec. 1987

m3 m4 DD/TOD T+SITOD BITOD

DGB* 0.54 0.61 -0.63 0.63 0.35

wj DGB is the rate of change in federal bonds federalbonds in the hands of the non-banking the non-bankingpublic.

Sources Central Bank of Brazil.

16. Table 4 shows the signs that would be expected under the hypo-thesis that the Central Bank has used open-market operations to counter-balance endogenous multiplier changes. Take, for example, the ratio oftime and savings deposits to total deposits. It shows a positive andhighly significant correlation of 0.63 with the rate of change of federalbonds in the hands of the public. This is consistent with the hypothesisthat when that ratio increased, thereby increasing both the multiplier andthe money stock, the Central Bank carried out open-market operations sel-ling bonds to the public, producing a positive correlation between thosevariables as expected.

17. The hypothesis that switches in portfolio composition regardingdemand, savings, and time deposits have tended to endogenize the moneysupply in Brazil is further strengthened when the direct impact of thesefactors on the rate of change of the money stock is examined in the follow-ing table:

Table 5

Correlation CoefficientsQuarterly Data Mar. 1980 - Jun. 1989

Rate of Change in Money SupolyRatios Ml M2 M3 M4

GB/TOD 0.60 0.67 0.77 0.77

TDITOD 0.05 0.13 0.03 0.03

SDITOD 0.43 0.60 0.82 0.82

T+SITOD 0.42 0.62 0.78 0.79

DDITOD -0.42 -0.62 -0.78 -0.79

Source: Central Bank of Brazil.

- 137 -

18. Table 5 shows the strong impact of endogenous, market-determinedratios on the rate of change of the M3 and M4 definitions of money. Thesavings deposit ratio and the rate of growth of M4 has a correlation coef-ficient of 0.82. Thus, according to our theory, such a ratio explains 67Zof the variability of the rate of change of the stock of money. The ratioof term deposit to total deposits and the rate of change of M4 has acorrelation coefficient of 0.79. Thus, such a ratio explains 62Z of thevariability of money supply growth.

2. Comparina the Cases of Brazil and Chile

19. The following graphs depict the sharp contrast between Brafil andChile regarding their reserve requirement policies. Here, only the graphsrelated to the M4 definition of money, which includes federal bonds held bythe non-banking public, are shown. However, two definitions of base moneyare utilizeds (a) the usual Central Bank definition -- currency plus bank-ing reserves; and (b) a broad concept that includes the federal bonds out-side the Central Bank.

20. Whatever the definition of the monetary base, and whatever thedefinition of the monetary aggregates, the graphs clearly show that themoney multipliers in Brazil have behaved in a manner exactly the oppositeof those in Chile. As a result, the Brazilian pattern has been disruptive.Hence, the evidence from the comparison supports our argument that there isan urgent need to change the present structure of compulsory reserves.

- 138 -

Graph 1

MONETARY AR'E a MULTIPLIER (M4'1)

A

I

R 6E

0U 2-

- -

JMIIJsNJt¶PJsNJnnIsJSnJMJSNJMMJsNJMMJ5NJM9I1983 1988 1958 1986 1987 Ioe8 1M98

MONTHLY DATA JAN 1983 - JUN 1989

IGRHILt. -T.

Graph 2 -

MONETARY BASE & MULTIPLIER (MH)Brazil

R1 6 A

E I

0 , -F

16~~~~~~~~~~~~~~~~~~~~~~~~~~~.

A~~~~~~

U 2 a I I I a I'

J n n J 5 N J n J 5 N J n J 5 J rM n J s N J M 11 J S N J M J 5 Ni J n n1983 198a 1985 1986 1987 Igoe ,is9

MONTHLY DAt. JAN 1983 - JUN 1989

A~~~~~~89I --E

a,~~~~R uL a1~~~~ ~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ CRH _ _

- 119 -

Graph 3MONETARY BASE2 & MULTIPLIER (M'4)

rhileR

E

0F

GFA 2-

-~~~~v 2- IV'., .. , V I .I..

- I~ ~ ~

J M M J S N J n J 5 N J M J S N J M J 5 N J nMi J S iN J M n J 5 N J M 1983 194 1985 1986 1587 1988 1585

MiONTHLr DATAQ JAN 1983 - JUN 1989

NI-LIE - IE(

t;A14lr2 -- -

Graph 4MONETARY BAzE2 g MULTlPIPIER (MH

9rat i iA 4

E

F

II I

A~~~~~~~~~~~~~~~Ior~~~~~~~~~~~~

A 1- "\A . - i -r A I 1 I

s9e3 1304 IS85 1986 1987 1988 i198MNoTHLY DAtA. JAN 1983 - JUN 1989

8RQZIL - IYIGRMuLT9ZI

- 140 -

C. Monetary Implication of Changes in Legal Reserves.

21. The rate of change of the multiplier (for any monetary aggregate)caused by a one percentage point change in the legal reserve ratio of atype of deposit may be measured as the ratio of the corresponding depositto the monetary base. The following derivation illustrates this. Lets

M s Money Stockm s Multiplier of Money Stock (M)B s Monetary BaseC : CurrencyDD : Demand DepositsTD : Time DepositsSD : Savings Depositsrdd t Legal Reserve Ratio on DDrtd : Legal Reserve Ratio on TDred : Legal reserve Ratio on SD

m M (1)B

D M _ . (2)C + rdd DD + rtd TD + r8d SD

s = -DD M (3)dr ~BZ

X -DD M B 6rddm BZ M

& - -DD 6rdd. (4)m BZ

As 6m/m is a growth rate, it ought to be multiplied by 100 to yield thepercentage change in the multiplier. At the same time, a change in onepercentage point in the legal reserve ratio of rdd is 0.01 (6rdd - 0.01).Hence by substitution we see that the percentage change in the multiplierof a monetary stock is rendered by the ratio of demand deposits to themonetary base. This calculation assumes that there is no change in excessreserves.

22. By the same token, 6m/m - (-TD/B) 6rtd if the legal reserve ratioon time deposits changes, and 6m/m - (-SD/B) 6rsd if the legal reserveratio on savings deposits changes.

23. A numerical example with end-January 1989 data follows.

la (100) = -D 6rdd (100)m B

- (-6.093.170) (0.01) (100)(4,117,381)

- (-1.48).

-141 -

Hence. SAy monetary aggregate [(6m/m) (100)1, be it Ml# M2. M3. or Me4falls 1.46 percent following a one point increase in the legal reserveratio on demand deposits.

* 24. Graph 5 illustrates the responsiveness of any multiplier to achange in the legal reserve ratio on demand, time, and savings deposits.

Graph 5

DEPOSITS TO MONETARY BASER 10AT

A A I~~~~5~ ~ ~ ~ ~ ~~~~~~~~~~~I I

6. ' VA . .~ /

I 2 3 4 1 2 3 4 1 2 3 4 2 3 4 1 2 3 1 2 3 4 1 2 3 4 l 2 3 4 1 2 3 1 21980 1981 1982 1983 1984 1965 1986 1987 1988

OURRTERLY ORTR . 1380 1 - 1989 11

RRT1 000.8TO_8 ---SO 8

- 142 -

From the last attarter of 1987 to the last quarter of 1988 the percentagechange in the multiplier caused by a one percentage point change in thelegal reserve rate on savings deposits almost doubled, from almost 4.3percent to almost 9.0 percent; this is shown by the change in the size ofsavings deposits relative. to the monetary base. The hypothetical responseof the multiplier to a one percentage point change in the legal ratio ondemand deposits is not very variable, nor very important, nor very largethroughout the. period of study but it does increase during the CruzadoPlan.

25. A decrease in the legal ratio on demand deposits by one percentagepoint would ceterus paribus have increased M1 by 1.48 percent. The fiscalimplication of this reduction in reserve requirements is that another taxis needed to reduce advances to the Treasury in such a way as to exactlycompensate the 1.48 percent increment of M1.

- 143 -

APPENDIX IV, INDEXATION OF FINANCIAL INSTRMENTS

A4.1 The ORTN, the readjustable Treasury Bond, was the most widely usedmeasure for monetary correction until its replacement by the OTN, when theCruzado Plan was introduced to freeze its value until February 1987. Atpresent the OTN is revalued on a monthly basis. ORTN adjustments had notkept up with other measures of inflation because of delays related tobroader stabilization efforts. For this reason the "real" value of theORTN declined by 1502 between 1975 and 1985 to the benefit of borrowers butat the expense of lenders. Real interest rates thus were reduced for of-ficial financial transactions each time the ORTN adjustment lagged. Themethod used by the Federal Goverrnment to adjust the ORTN (or OTN) haschanged many times since the first methodology was established under Law4357 dated July 16, 1964. In fact, since mid-1975, the methodology toadjust the OTN changed 12 times; eight times since March 1985. Since mostof the Federal Government borrowing instruments are based on OTNs, to con-fiscate assets from the public the Government only needed to change thebasis of its debt adjustment. Moreover, on at least three occasions (1979,1983 and 1986) in the last eight years, the Federal Government did not evenadhere to the OTN adjustment methodologies and adjusted the OTN by asmaller percentage than that established by the existing regulations/-resolutions at the time. Table 1 illustrates the decline of the ORTN(OTH)value in the last 17 years, compared to some measures of inflation.

A4.2 The percentages shown in Table 1 indicate that for the periodbetween December 1970 and December 1987 the ORTN(OTN) adjustment lagged by169Z compared to the IBGE-IPC index. No comparison can be made between theOTN and the IBGE-IPCA index for this period, since this index only startedto be collected from January 1980. For the period December 1970 through1987 the OTN adjustment lagged by 244Z, compared to the IPADI index, whichis the one most generally used by industrial corporations. In the lastthree years, i.e., December 1984 through December 1987, the OTN lagged by42 compared to the official price index used by the Government (IPC), andby 17Z compared to the IPCA. Between December 1985 and December 1986, theOTN lagged by 222 compared to the IPC and by 51Z compared to the IPCA,although the Government stated, under Resolution No. 1062 datedNovember 27, 1985, of the Central Bank, that the OTN would be adjusted, inthat year, by the same percentual variation of the IPCA index.

A4.3 The extreme differences between official and market rates providea striking example of the general problem. The nominal 30-day, CD rates inmid-1987 paid an equivalent of OTN plus 20Z to 30Z per annum. Most admin-istered credit lines still are available at average yields of OTN plus 3Zto 102 annually. These rates could become increasingly negative in realterms if inflation accelerates and the OTN adjustments do not fully reflectthis inflation.

- 144 -

Table 1

Price Indices and OTN adiustmentVariation

(in percent)

FGVIGVF IBGE OTN(ORTN)IGP-D IPA-DI IPC IPCA INPC

Dec. 70-Dec. 75 178 135 178 - - 165Dec. 75-Dec. 80 964 1,020 964 - - 439Dec. 80-Dec. 85 13,055 13,076 12,635 20,584 10,171 9,892

Dec. 70-Dec. 80 2,862 3,089 2,857 - - 1,328Dec. SO-Dec. 87 111,918 113,745 96,112 88,076 80,642 73,905Dec. 70-Dec. 87 3,317,512 3,630,029 2,844,789 - - 1,056,445

Dec. 75-Dec. 85 139,920 154,519 135,360 - - 53,804Dec. 84-Dec. 85 235 226 224 234 228 219Dec. 85-Dec. 86 65 63 62 77 58 51

Dec. 86-Dec. 87 416 407 365 367 398 392Dec. 84-Dec. 87 2,754 2,586 2,351 2,653 2,479 2,265

Sourcess FGV/GVF - Getulio Vargas FoundationIBGE - Instituto Brasileirc de Geografia Economica/Brazilian

Institute of Economic Geography.OTNIORTN - Obligagoes do Tesouro Nacional/Treasury BondsIGPDI - Indice Geral de Pregos--Disponibilidade Interna/-

General Price Index collected from the let day ofthe month through the 30th day of the same month.

IPADI - Indice de Pregos por atacado--DisponibilidadeInterna/Iholesale Price Index collected from the 1stday of the month through the 30th day of the samemonth.

IPC - Indice de Pregos ao Consumidor (Consumer PriceIndex). This index is the latest official(Government's) price index, which is used to adjustthe OTN value (Resolution 1338 of June 15, 1987).This index is based on a basket of goodsiservicespurchased by an earner of up to five minimum salariesand is collected from the 15th day of the monththrough the 15th day of the next month.

IPCA - Indice de Pregos ao Consumidor--Amplo/Consumer PriceIndex-Wide Range. It is based on a wide range ofgoods, not limited to the purchase power of any givengroup. It is collected from the 1st day of the monththrough the 30th day of the same month.

INPC - Indice Nacional de Pregos ao Consumidor/NationalConsumer Price Index. It is based on the same basketof goods/services as the IPC, however it is collectedfrom the 1st day of the month through the 30th day ofthe same month.

- 145 -

A4.4 Getting interest rates right, or broadly right, is clearly the keyto overall efficiency in any financial system. Brazil is unusual in thatdistortions built in over a long period, apparently, have not preventedgeneral economic growth over long periods, especially when assisted byexternal capital flows. This, however, has been achieved by macro-economicimbalances and has increased income distribution inequalities. Stateenterpriaes typically account for around 802 of public sector investment orabout 251 of all fixed investments in Brazil. With ready access to fundsallocated on the basis of priorities determined by the administrationrather than by markets, public enterprises have been able to concentrate onexpanding their production of goods and services without the usual marketconstraints on investment decisions.

A4.5 There is, at present, no long-term market interest rate inBrazil's financial system. This is mainly due to high inflation and thepresence of federal subsidized credit at the long end of the market.Official long-term lending rates have not been related to market rates,even in periods of greater stability. On the funding side, demand depositsabove required minimums are now bearing some interest rates, even thoughtraditionally, they have not yielded anything. Indexation on CDs aregenerally related to the OTN index. However, there are many other short-term interest rates that are pegged to other indices (referential rates)and that are also used for short-term financial transactions. The best-known rates ares the ANBID, the SELIC and the CETIP.

(i) The daily rate for ANBID (National Association of InvestmentBanks) is the average rate of CDs sold by a group of 34 parti-cipant investment banks. Since these CDs are sold for dif-ferent terms -- 60, 90 and 180 days -- a separate rate for eachtype of CD is calculated and published daily. Likewise, sincesome CDs are sold at a pre-fixed or post-fixed rate, a separaterate for each of them is published. The pre-fixed rate in-cludes the forecast inflation, the post-rate is based on theOTN index plus a real interest rate. The ANBID rate also isbased on CD transactions amounting to more than US$50,000 each.Moreover, ANBID excludes from the calculation of its daily rateany CD rate quoted that is 102 higher or lower the arithmeticalaverage of all CDs sold on that day, and a new average rate iscalculated excluding those extreme rates. The ANBID rate re-flects the CD transactions of a small number of financialintermediaries and basically is a quotation of a rate for one-day money only," because even 60-day CDs (the shortest termallowed by the Central Bank) are repurchased on a daily basis.

- 146 -

(ii) The SELIC daily rate is the averageO rate of all overnightrepurchase agreements of Treasury Bills/Notes/Bonds (LFT's,LBC's and LTN's)72 traded daily in the financial system. Hereagain, like for the ANBID rate, only 952 of the traded instru-ments (t 2.5? of the extremes is eliminated) is taken intoaccount in determining this rate. The Central Bank, whichcalculates this rate, takes the mode (instead of the average)to derive this rate.

(iii) The CETIP daily rate is the average rate of all types of secu-rity transactions (including repurchases) undertaken by privatefinancial institutions. Naturally these securities refer tothose issued by private financial institutions, and the methodto calculate this average rate is similar to the ANBID rate.The name CETIP comes from the organization that controls theissuance of securities by private financial institutions, the'Central de Custodia e de Liquidagao Financeira de Titulos,'which is a clearing, custody and safekeeping house for theNrtional Association of Open Market Institutions (ANDIMA).

A4.6 The CETIP rate is restricted to privately owned financial institu-tions. This rate reflects the average cost of security transactionsbetween financial institutions that is reported to CETIP. Not alllending/borrowing transactions between these institutions are (or need tobe) reported. Only those transactions involving issuance of securitiesthat are traded are registered. The CETIP system assures the reliabilityof the security issued, i.e., that these securities are bona-fideinstruments.

72/ These are all the same type of instruments. In the past they werecalled LTNs and were issued by the Central Bank on behalf of theGovernment under the name LBC. Now they are called LFTs.

- 147 -

APPENDIX Vs DATA SERIES AND BIBLIOGRAPHY

I

- 148 -

Data to Annex 1

Table 1

Apar soat Monetary Data. Price Level. Credit(Cxl Ulilons)

(End of Period Quarterly Data, 1981 IV - 19s IV) 1/

1 2

Total Credit toYear/quarter Base ml VS M4 loP-el Prtv.Sect aov.Sect

1881 IV 1,188 2,6e4 6,549 8,828 1.0382 9,814 2,594

1982 I 1,284 2,475 7,518 10,448 1.2643 19,765 2,9701982 II 1,458 8,026 9,279 18,144 1.6265 12,928 8,8811982 III 1,668 8,851 10,991 15,447 1.7760 15,402 5,1091982 IV 2,226 4,416 18,537 18,402 2.0740 10,887 7,694

1988 I 2,412 4,a84 18,288 28,781 2.6510 28,182 19,7761983 Ir 2,8s 5,485 19,644 26,275 8.489s 28,684 14,6591988 III 8,411 6,484 26,759 84,659 4.8820 8,086 19,7471988 IV 4,867 8,665 a8,480 45,988 6.4490 58,126 8o,795

1984 I 4,852 9,444 48,728 61,647 8.7419 68,148 41,1091984 II 6,887 12,102 68,970 83,116 11.8240 89,091 52,8721984 III 9,112 16,280 88,949 121,875 15.2720 117,681 67,9121984 IV 15,01 26,0980 128,576 181,867 20.8810 166,597 s8,427

1985 I 14,427 8w,998 176,872 256,469 29.2006 221,282 116,1921985 II 17,829 44,567 246,868 875,812 86.8900 297,676 159,8191985 III 25,768 66,014 821,048 597,208 49.8160 401,187 217,7191985 IV 45,468 111,976 478,777 787,266 69.970o 561,744 292,067

1988 I 70,e29 216,012 718,607 1,988,838 100.9060 718,659 488,6591986 II 120,565 834,09s 808,297 1,168,186 199.2800 889,474 525,3071986 III 149,852 875,996 988,941 1,296,210 18.8600 9590,275 724,196198l IV 178,896 456,476 1,976,886 1,485,884 156.5990 1,888,170 926,151

1987 1 169,218 424,991 1,491,099 1,985,892 189.7700 1,875,974 1,965,4811987 II 170,957 475,116 2,100,188 8,246,121 827.s8se 2,644,661 2,078,8101987 III 324,931 622,894 2,740,725 4,294,881 494.2600 8,827,956 2,694,1611987 IV 508,581 1,985,929 4,297,269 6,474,718 596.6086 5,160,960 8,741,568

1988 I 675,2s 1,170,122 6,626,641 10,957,84 986.1599 7,886,799 8,614,0671988 II 916,995 1,887,095 11,999,948 18,697,564 1712.6800 18,241,485 18,975,7161988 III 1,428,477 2,898,s86 19,547,848 84,062,075 2847.7800 22,651,822 44,799,0181988 IV 2,598,185 6,989,896 * 88,812,11S * 68,982,286 * 6622.0e09 * 84,518,197 188,947,564

/ Astersks denote projections at time calculations were made.J Figures for some variables may not correspond directly between this and other statistical

appendicos a work on this report has begun since September 1987; tho latest available datahas always ben used as the work progressed.

Source: Central Bank ot Brazil

- 149 -

Date to Annex 1 (continued)

Table 2

Aggregate Monetary Data and Gross Domestic Product(CZl Millions)

(Annual Average, 1081 - 1988)1/2/

YEA Mml mg M4 CDP ease

1981 1,98 4,861 6,245 24,561 9441902 8,480 10,048 18,618 48,777 1,707s9a 6,541 26,001 82,195 119,166 8,297

1984 17,878 62,621 118,822 890,678 9,690199S 69,620 8068,77 469,462 1,418,699 86,2411986 288,T67 777,721 1,s66,657 8,820,268 112,1821987 758,966 2,558,674 8,880,406 12,788,679 841,2181988 8,571,482 * 21,170,799 * 87,089,669 *161,601,218 e 1,649,858

Asteritko denote projections at time calculations were made.J Figures for some variables may not correspond directly btseen

thie and other statistical appendices as work on this report hasbegun since Septembr 1967; the latest available data has alwaysben ued as the work progresed.

Sourcet Central Bank ot Brazil

- 150 -

Data to Appendix II

Table 1

A9araopt. Monetary data. Price Indox, and Inflation Rate(Caz Millions and Rate of Change)

(End Of Period Quarterly Dat-e 1984 III - 1987 IV)1/

Currency Total Price Index* quarterlyMonetary In Hands Demand (106.80 = (1.00011 Inflation

Year/Quarter Base of PuLlic Deposits 1988 I) 1987 IV) Rate

194 III 7,748 8,658 18,684 15.27 0.0262 0.29981984 IV 12,725 6,180 21,568 20.08 0.0360 0.812°

19s6 I 14,427 6,448 24,651 29.20 0.0490 0.83641986 II 17,829 9,648 35,219 88.89 6.O111 0.22611985 III 25,768 11,901 58,113 49.81 0.0828 6.W8as1985 IV 45,408 28,611 88,465 69.97 0.1174 0.8499

1986 I 70,029 29,638 180,194 180.16 0.1678 0.86711986 II 120,655 48,174 287,917 100.26 0.1683 0.10261988 III 149,852 65,918 820,001 109.86 0.1785 0.0m61986 IV 178,896 84,046 871,826 115.48 0.1938 6.1109

1987 I 189,218 64,819 851,971 189.77 0.2849 6.88651987 II 170,657 88,218 888,071 327.88 0.6494 O.65671987 III 824,981 126,764 498,277 404.02 0.8760 0.21031987 IV 456,127 207,W66 787,816 696.88 1.6006 6.8886

!/ Price Index Is IOP-DI.9. See note 2, Data to Annex I, Appendix II.Sources: Monetary date: Monthly Bulletin, Central Bank of Brazi!;

Price index: Conjuctura Economic&, several issues.

- 151 -

Data to Appendix II (continued)

Table 2

Deposits Sublect to Reserves and Lesal Reserve Ratios By TYpe of Institution(Czs Millions and Ratios)

(End Of Period Quarterly Data, 1984 IlI - 1987 IV)

Deposits Subject to Reserves Legal Required Rerve Ratios

Private Official Bank of Private Offietal Bank ofCommercial Commercial Brazil A Commercial Commercial Brnzil &

Year/quarter Banko Banks BNCC Banks Banks BNCC

1984 III 7,061 1,782 1,785 0.484 0.4065 0.4121984 IV 10,123 2,898 2,417 0.435 0.4e6 0.403

1985 I 12,870 8,888 8,038 0.484 0.410 0.4261985 II 16,8e 4,278 4,081 0.482 0.410 0.40a198 III 23,758 6,404 6,674 o.u8s 0.843 o.8691985 IV 86,464 9,757 9,822 6.868 0.836 6.865

1986 I 65,844 18,2U4 13,286 0.877 0.866 0.87811986 128,154 86,92 89,0890 0.879 0.882 0.8701986 III 18,540 46,224 48,064 0.388 6.864 6.8681986 IV 192,170 58,s64 53,S55 0.856 e.866 o.s6

1987 I 143,481 40,752 89,666 0.884 6.368 0.8721987 II 141,787 89,167 47,462 6.887 o.868 o.869

1987 III 214,115 64,261 67,288 0.448 0.427 0.4281987 IV 862,715 99,811 122,798 6.462 0.486 0.428

Deposits Subject to Rmrvea.Source: Central Bank of Brazil.

- 152 -

Date to Appendix III

Tabl- 1

Date tor Chile: Monetary Asaresntes(Chi Millions)

(End ot Period Monthly Data, Dec. 1?982 - Jun. 1989)

Drawable Central Indexed AMonoy BSnk Dlsecountable

(Government Instruments TreasuryMonetary DOmand (Treasury ProeessorvBase Mal Deposits) Bills) Notes

Year Month (B) (Ms8) MOg) (DBC) (PT)

1982 12 61,760 884,180 89,452 10,760 11,648

1988 1 68,580 878,500 89,298 19,750 12,6702 72,080 882,240 88,8a5 U,490 14,2808 70,260 86s,170 85,882 46,800 15,9074 78,180 850,840 41,950 48,200 21,0005 74,700 848,420 52,789 61,470 27,866 86,020 866,180 86,167 62,100 81,0407 66,10 856,260 40,481 54,860 85,88 62,180 869,250 88,420 69,640 89,7109 84,870 871,750 88,758 54,100 42,84010 62,640 878,e60 88,658 62,680 48,20011 64,260 882,140 40,651 67,460 44,87012 70,140 885,270 48,507 60,190 48,569

1984 1 69,750 401,710 44,748 65,460 42,1502 72,620 418,690 42,616 62,480 41,1808 76,560 428,820 48,949 66,610 42,4004 77,470 480,580 41,711 e1,898 89,29W5 78,279 484,210 50,867 65,210 89,6706 76,642 441,080 45,002 66,990 42,7207 76,854 447,120 42,918 67,010 44,450* 74,758 454,610 44,062 67,480 61,0409 78,680 460,960 42,409 69,400 47,66010 76#46 470,160 45,S56 75,790 62,29011 78,a87 475,8O 45,001 80,280 61,89012 62,465 502,290 46,181 88,040 W,880

1985 1 86,469 658,600 55,618 88,980 68,6802 89,578 648,270 61,509 92,490 62,810a 92,910 564,909 51,69 104,780 46,4704 92,729 677,880 47,676 118,650 41,776 94,071 598,770 59,952 182,598 48,800

Note: Continued on next page.

- 153 -

Date to Appendix III (continued)

Table 1 (continued)Dote for Chilo: Monetary Agrepate.

(Chi Millions)(End of Period Monthly Data, Dec. 1982 - Jun. 1989)

Drawable Central Indexed AMoney Sank Discountable

(Government Instrumnts TreasuryMonetary Demand (Treasury PromissoryBase Mal Doposits) Bille) Noter

Year Month (B) (1U') (og) (DBC) (PT)

19s6 6 95,396 615,616 68,685 125,660 48,6107 94,495 689,996 54,220 182,990 48,1266 94,713 662,196 62,621 145,690 46,56e9 162,611 675,896 657,56 150,240 45,49616 99,709 676,920 86,188 158,060 47,69911 166,471 694,860 73,966 152,676 49,18012 116,658 76,916 68,268 177,n76 67,810

1966 1 118,793 782,166 67,169 179,940 54,860

2 117,786 752,496 68,279 186,886 55,6198 121,763 768,820 66,866 187,210 67,4364 122,669 790,240 64,061 191,9960 61,816 128,728 768,786 96,852 196,866 81,4S66 126,784 866,996 89,441 264,216 64,7207 127,989 95,5160 61,884 208,060 76,7808 127,964 605,160 69,165 216,7760 78,669 188,876 868,470 78,628 281,780 68,6861O 188,672 876,2560 61,672 241,286 67,456011 187,174 908,186 66,724 249,470 70,0812 161,816 988,280 118,064 263,196 68,826

1987 1 161,771 959,760 120,298 278,966 76,0702 162,9s6 997,290 106,844 294,786 68,6808 156,U40 1,067,990 66,647 812,990 61,1604 160,818 1,60S,989 98,367 828,700 59,980

5 159,662 1,067,650 127,868 844,969 6W,2808 164,781 1,118,880 186,189 846,796 62,6707 187,847 1,148,196 184,442 852,986 61,7108 159,018 1,132,894 117,281 896,820 61,180

9 167,082 1,184,410 114,071 468,470 47,42016 164,655 1,196,660 126,151 407,296 47,48011 170,549 1,254,160 127,672 419,980 47,22012 187,869 1,814,581 188,560 429,060 45,740

Note: Continued on noxt page.

- 154 -

Date to ADDendix II! (continued)

Table 1 (continued)

Date for Chile: Monotary Assrgates(Chi Millions)

(End of Period Monthly Data, Dec. 1982 - Jun. 1989)

Drawable Central Index d AMoney Bank Discountable

(Government Instruments TreasuryMonetary Doemand (Treasury PromissoryBass oS' Deposite) Bills) Not"s

Year Month (B) (US') (DO) (DBC) (PT)

1980 1 198,510 1,372,657 171,891 488,170 46,7502 196,476 1,806,467 179,646 424,220 42,2408 196,164 1,418,466 166,965 460,929 86,5904 209,476 1,427,790 101,867 476,280 86,760a 209,615 1,449,681 121,749 602,210 86,6206 208,987 1,469,607 128,169 515,920 865,987 206.560 1,489,670 115,669 588,480 87,,096 209,657 1,620,887 108,618 542,510 28,2209 221,404 1,660,415 99,280 527,990 22,46010 227,657 1,640,809 197,691 628,610 22,98011 228,86B 1,646,886 106,788 587,820 22,67012 247,964 1,696,922 140,477 566,16 28,090

1989 1 258,841 1,776,644 165,701 618,110 28,7592 251,749 1,601,016 160,177 688,689 22,4808 259,696 1,828,788 140,617 676,200 21,7704 272,276 1,887,600 169,646 687,959 21,1W05 269,586 1,866,410 227,507 7B8,040 22,4606 281,608 1,889,870 280,827 808,480 22,710

1 Detinition of Monetary AggreateetBare2 a Baoo * PT + DOBCU8 a C * D1 * Dv + Dp * AhMW * M5, + DgM4 a MI + DBC * PTwhere C is curreney In the hands of the publlc, DI Is demanddeposite of private sector, Dv to demand deposit. not IncludedIn Dl, Dp Is time deposit of private s*etor, Ah Is savingsaccounte, and Dg Is government sector demand depositt.

S The above definition of MIO corresponds to Mg In the MonthlyBulletin of the Central Bank of Chile; above definition of MScorresponds to MIA of the meao Contra I Bank Bull tin.

Souret: Central Bank of Chile.

- 155 -

Data to Aeppndix III (continued)

Table 2

Date for Brazi!: Monetary Aagreastes(CAz Millions)

(End of Perlod Monthly Data, Dec. 1979 - Jun. 1989)

FederalBonds

Currency OutsideMonetery In Hands of Sight Savings Time Centrol

Year Month Base Public Deposits Deposits Deposits Banks

(a) (CP) (DOD) (SD) (TD) (08)

1978 12 2a8 98 406 289 227 814

1979 1 248 84 892 818 285 824

2 256 88 419 *; 247 al8a 251 89 418 82s 284 8444 267 90 481 848 280 8496 265 91 449 8s5 284 8w8o 276 101 490 889 292 8797 298 101 503 414 801 4088 808 11 508 428 811 4219 821 118 649 448 817 429

10 841 117 578 489 8a8 42811 880 182 812 498 865 42812 448 165 708 628 879 897

1980 1 428 188 878 5so 408 4102 419 149 69? 808 484 4478 427 142 787 eas 456 4454 468 154 808 709 489 4585 468 165 845 727 478 5056 609 168 988 780 486 4857 658 178 899 827 490 5158 587 196 984 838 S00 s509 669 187 983 868 518 5981o 688 214 1,008 932 688 80811 882 287 1,089 945 549 82112 699 286 1,200 986 569 821

1981 1 688 280 1,106 1,111 598 6712 689 278 1,149 1,168 6s0 746a 698 2as 1,157 1,219 657 8804 698 278 1,284 1,429 706 1,0356 782 288 1,294 1,471 759 1,1178 793 272 1,44e 1,664 842 1,218

Note: Cont:nued on nert page.

- 156 -

Date to Appendix III (continued)

Table 2 (continuod)

Data for Brazil: Monetary Apprepates(Millons of CzS)

(End of Period Monthly Data, Dec. 1979 - Jun. 1989)

FederalBonds

Currency OutsideMonetary In Hands of Sight Savings Time Central

Year Month Bass Public Deposits Deposits Deposits Banks

(B) (Cp) (DD) (SD) (TD) (tO)

1981 7 887 321 1,406 1,888 926 1,892a 864 312 1,491 1,897 995 1,4919 912 821 1,60O 1,990 1,077 1,60610 959 U82 1,722 2,800 1,168 1,79811 1,081 390 1,898 2,884 1,268 1,98812 970 518 2,278 2,485 1,882 2,170

1982 1 1,070 499 2,116 2,880 1,476 2,2782 1,085 481 2,192 2,948 1,685 2,879a 1,089 462 2,160 8,128 1,686 2,6014 1,060 511 2,806 8,445 1,827 2,8475 1,121 479 2,61S 8,538 2,003 8,0156 1,220 562 2,648 8,756 2,216 8,4697 1,298 624 2,738 4,288 2,862 8,5278 1,884 609 2,768 4,872 2,648 8,8769 1,856 686 2,907 4,698 2,694 8,97710 1,481 683 8,148 5,809 2,920 4,25611 1,706 781 8,868 5,427 8,085 4,47612 1,944 986 8,683 s,720 8,828 4,865

1983 1 2,059 927 8,756 6,604 8,524 5,1782 2,163 909 8,843 6,598 8,888 5,2818 2,072 988 3,717 6,984 4,182 5,4484 2,174 1,056 8,987 8,038 4,671 5,7875 2,292 1,000 4,211 8,191 5,071 6,2086 2,861 1,088 4,758 8,792 5,382 6,6817 2,862 1,078 4,862 10,085 5,722 7,4628 2,850 1,080 5,091 11,903 6,199 8,4279 2,689 1,801 6,640 18,888 6,948 7,90010 2,821 1,826 6,058 16,137 7,645 9,04911 8,189 1,450 6,482 16,942 8,528 9,88812 3,495 1,842 7,884 18,164 9,629 9,522

Note: Continued on next page.

- 157 -

Data to ADpendix Ilt (continued)

Table 2 (contInue)

Date tor Brazil: Monetary Approactes(Millions of CzB)

(End of Period Monthly Data, Dec. 1979 - Doe. 1989)

FederalBonds

Currency OutaldeMonotary In Hands of Sight Savings Time Central

Year Month Base Public Deposits Deposits Deposits Banks

(B) (Cp) (DD) (SD) (TD) (as)

1984 1 8,794 1,683 7,443 19,800 10,859 10,5162 3,744 1,714 7,547 21,837 12,637 11,0773 3,639 1,781 8,271 24,589 14,541 12,9214 4,179 2,011 9,503 27,183 15,920 13,8545 4,435 2,188 9,938 29,240 17,748 6le,9o6 5,782 2,366 10,579 31,504 19,858 19,1467 6,391 2,634 11,534 35,670 22,287 22,7808 7,016 8,189 12,183 40,038 24,635 27,1699 7,748 s,538 13,864 46,067 26,787 33,32610 8,229 8,343 14,845 50,898 30,636 40,385it 9,427 4,316 16,913 67,731 34,372 48,75112 12,726 6,180 21,588 62,160 39,256 53,079

1985 1 13,269 5,173 19,767 70,PO7 48,024 62,1412 ls,689 5,618 22,610 81,268 50,827 68,202a 14,427 6,443 24,560 88,809 57,070 78,6984 14,602 6,408 27,916 100,865 61,856 93,7635 16,532 7,800 29,405 109,970 69,728 112,2286 17,829 9,048 35,219 121,118 80,684 128,9437 19,626 9,579 39,522 126,753 88,034 161,8828 22,877 11,733 44,296 134,538 98,165 171,0479 26,768 11,901 68,118 161,818 104,221 186,16710 26,817 13,006 54,499 168,528 118,841 216,31811 32,108 17,746 66,172 186,679 124,512 285,12012 45,468 23,511 88,465 217,837 149,184 258,487

1986 1 45,941 21,869 80,265 265,139 168,956 293,2942 51,653 21,018 95,518 311,840 206,658 831,7733 70,029 29,633 180,194 800,566 203,115 870,1264 94,782 38,502 212,108 288,587 194,660 366,3995 109,024 48,911 244,688 283,022 186,166 388,0426 120,563 46,282 287,990 288,684 185,484 364,888

Note: Continued on next page.

- 158 -

Data to Appendix II (continued)

Table 2 (continued)

Data for Brazil: Monetary Aggregates(Millions of Cs8)

(End of Poriod Monthly Data, Dec. 1979 - Dec. 1989)

FederalBonds

Currency Outel doMonetary In Hands of Sight Savings Ttm. Central

Year Month Base Public Deposits Deposits Deposits Banks

(8) (Cp) (OD) (SD) (TD) (08)

1988 7 187,565 4. 95 284,443 294,688 194,384 844,6898 146,798 66,289 800,939 299,980 228,288 848,9609 149,852 68,156 820,278 812,285 249,087 858,169

10 167,605 62,849 889,868 81s,630 288,614 887,70811 172,456 89,928 852,465 817,284 808,124 819,89512 178,896 84,211 887,984 329,841 291,669 859,219

1987 1 172,444 69,285 286,770 869,050 869,s88 417,7062 164,809 77,005 300,479 461e,00 410,610 519,6588 169,218 84,789 860,202 577,000 899,907 584,7094 167,203 78,787 278,982 686,00 486,968 710,0255 184,568 83,162 277,992 84,00 516,759 987,88a8 170,057 88,281 a886,s6 1,081,000 548,655 1,145,9857 219,014 111,840 411,289 1,282,000 641,164 1,267,9828 271,299 110,911 462,628 1,865,000 642,128 1,321,4569 824,931 125,730 497,164 1,496,000 822,620 1,468,606

10 378,188 162,859 642,924 1,629,000 686,000 1,692,47911 389,286 159,149 682,910 1,811,000 75s,876 1,992,50212 508,581 248,831 787,589 2,210,000 981,084 2,267,449

1988 1 505,879 228,288 706,179 2,586,000 1,103,519 2,776,4892 4e9.609 218,881 807,451 8,171,000 1,280,267 8,088,827a 675,378 287,299 882,828 8,922,000 1,626,548 8,481,2184 726,125 812,804 1,019,347 4,688,005 1,724,829 4,107,6595 837,455 824,179 1,255,878 6,448,000 2,076,918 6,492,8976 911,081 892,685 1,494,610 6,496,000 2,684,056 7,598,5067 1,003,891 481,159 1,534,289 7,987,000 2,991,178 9,256,8a68 1,088,191 508,012 1,782,650 9,949,000 8,746,462 12,178,6209 1,426,890 715,000 2,179,000 12,268,000 4,648,000 14,514,000

10 1,860,104 980,000 2,781,000 14,980,000 5,768,000 17,698,00011 2,197,172 1,045,000 8,509,000 19,877,000 7,082,000 22,740,00012 8,687,152 2,040,000 4,918,000 24,976,000 9,486,000 81,527,000

Note: Continued on next page.

- 159 -

Dota to Appendix III (continued)

Table 2 (continued)

Date for Brazil: Monetary Apareagtes(Millions of Czs)

(End of Period Monthly Data, Dec. 1979 - Dec. 1909)

FederalBonds

Currency OutsideMonetary In Hands of Sight Savings Time Central

Year Month Base Public Deposits Deposits Deposits Banks

(8) (Cp) (OD) (SD) (TD) (08)

1989 1 4,117,881 2,051,9W 8,998,90 80,288,999 10,471,999 88,046,OMO2 4,925,270 2,259,999 6,897,9NO 33,893,699 10,140,09 47,409,8998 5,772,98 2,701,009 7,950,096 46,568,009 10,310,0W 568,8U94,64 6,649,020 8,821,090 10,898,069 66,841,099 11,098,000 65,192,0006 8,748,187 8,788,000 10,3S,990 66,444,990 16,104,999 87,666,0096 1, 014,829 4,885,999 11,108,999 63,138,999 21,866,900 64,68,000

/ See Note 2, Data to Annex X, Appendix V.J Definition of monetary aggregates:

Ml = Cp + DDM2 = Ml + TDMS a M2 + SDM4 = MU + aB.

Source: Central Bank of Brazil.

- 160 -

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CHAPTERS 1 AND S

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APPENDIX II

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