‘A Brazilian Perspective on Reform of the International FinancialArchitecture’

Report commissioned by DFID

By Ricardo Gottschalk*

Institute of Development StudiesUniversity of SussexBrighton, BN1 9RETel: 44 1273 606261Fax: 44 1273 621202

JULY 2001

* This report was prepared as part of the DFID funded study ‘Reform of theInternational Financial Architecture: Views, priorities and concerns of governmentsand the private sector in the Western Hemisphere and Eastern Europe’. I am thankfulto Sophie Messner, from DFID, and Stephany Griffith-Jones for helpful commentsand suggestions on an earlier draft.

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Table of Contents

List of Acronyms 3

Executive Summary 5

Introduction 11

Part I. Views, priorities and concerns of the government, private sectorand others on reform of the IFA 11

1. Progress So Far 112. The New Agenda 12

a. Codes and Standards 12b. The New Basle Capital Accord 15c. New proposals for improving the CCL 16d. PSI 17

3. Further Issues of Concern 18a. The provision of development finance by MDBs and distribution of capital flows across countries 18b. Illegal money in international transactions 19c. Participation of developing countries in the building-up of a new IFA 19

Part II. Assessment of Codes and Standards in Brazil 21

1. Brief Macroeconomic Context 212. Standards in Macroeconomic Policies and Data Transparency 22

a. Monetary and fiscal policy transparency 22b. Data transparency 25

3. Financial Regulation and Supervision 26a. Banking supervision 26b. The strength of the financial sector 27c. The role of Federal Banks in directed credit provision 31d. Promoting the capital markets in Brazil 33

4. Areas for Technical Assistance 38

Conclusions 40

References 42

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List of Acronyms

ABRASCA Associacao Brasileira de Companhias Abertas (the Brazilian Association of Public Companies)

ADRs American Depository ReceiptsANBID Associacao Nacional dos Bancos de Investimento (the National

Association of Investment Banks)ANDIMA Associacao Nacional das Instituicoes do Mercado Aberto (the National

Association of Open Market Institutions)BACEN Banco Central do BrasilBASA Banco da AmazoniaBB Banco do BrasilBIS Bank for International SettlementsBM&F Bolsa de Mercadorias & FuturosBNB Banco do NordesteBNDES Banco Nacional de Desenvolvimento Economico e SocialBOP Balance of PaymentsBOVESPA Bolsa de Valores de Sao PauloCAC Collective Action ClausesC&S Codes and StandardsCCL Contingent Credit Line (IMF)CEF Caixa Economica FederalCLF Committed Loan Facility (World Bank)COPOM Comite de Politica Monetaria do BACEN (Central Bank’s Monetary

Policy Committee)CPSS Committee on Payment and Settlement SystemsCVM Comissao de Valores Mobiliarios (the Brazilian Securities Comission)ECGD UK’s Export Credit Agency (ECA)ECLAC Economic Commission for Latin America and the Caribbean (UN)FAPESP Fundacao de Amparo a Pesquisa do Estado de Sao Paulo (State

Government Research Funding Agency)FDI Foreign Direct InvestmentFSA Financial Services AuthorityFSAP Financial Sector Assessment ProgrammeFSF Financial Stability ForumFTAA Free Trade Area of the AmericasGDDS General Data Dissemination Standard (IMF)IBGC Instituto Brasileiro de Governanca Corporativa (Brazilian

Institute of Corporate Governance)IAS International Accounting StandardsIASC International Accounting Standards CommitteeIFA International Financial ArchitectureIFIs International Financial InstitutionsIOF Imposto sobre Operacoes Financeiras (Tax of exchange transactions)IOSCO International Organisation of Securities CommissionsIRB Internal Ratings Based Approach (New Basle proposal)MDBs Multilateral Development BanksMERCOSUR Mercado Comun del Sur (Common Market of the South)OFC Offshore Financial Centres

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PPA Plano Plurianual (Multiyear Plan)PROEX Programa de Financiamento as Exportacoes (BB)PSI Private Sector InvolvementROSCs Reports on the Observance of Standards and CodesSAL Structural Adjustment Loans (World Bank)SDDS Special Data Dissemination Standards (IMF)SMEs Small and Medium-sized EnterprisesSPB Sistema de Pagamentos BrasileiroSRF Supplemental Reserve FacilityUS FASB US Financial Accounting Standards BoardUS GAAP US Generally Accepted Accounting Principles

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Executive Summary

1) This report presents the views, priorities and concerns of governmentrepresentatives (at the highest levels), the private sector based in Brazil and otherson the reform of the international financial architecture (IFA). The report alsoassesses the ‘state of art’ of different codes and standards in Brazil, and the areasBrazilians believe external technical assistance is particularly welcome.

2) Senior officials have expressed a clear desire for a new financial architecture.They recognise that important progress has been made so far. In their view, sincethe currency and financial crises of the late 1990s, there has been greater relianceon long-term capital flows as a source of external finance, new instruments havebeen created to prevent and better manage crises, the IMF is seen now as taking amuch more pro-active attitude towards crisis-threatened and crisis-affectedcountries, and a more effective private sector involvement (PSI) in crisismanagement has taken place. For Brazilians, these facts and initiativescharacterise a first phase of important changes in the IFA after the crises of thelate 1990s.

3) Brazilian senior officials see now the beginning of a second phase, which has anagenda that includes important issues and initiatives: implementing and improvingCodes and Standards (C&S) of international best practice in developing countries,the new Basle Capital Accord, new proposals for improving the CCL, anddeveloping a framework for PSI in crisis prevention and management.

4) Brazilian officials see efforts to adopt C&S as very important. They also welcomethe fact that C&S can be seen as a soft law, to which countries can adherevoluntarily rather than by force. Voluntary standards allow governments andcompanies to adopt those that best suit their circumstances and give them a senseof ownership. Private sector representatives equally stress the importance of C&S,and welcome efforts in Brazil to implement them, and note that the country isacting on various fronts simultaneously, with the result that the degree oftransparency has increased dramatically in the recent past.

5) However, Brazilian officials raised a number of issues and concerns. First, theybelieve that there are too many C&S – 66 so far – this being especially true forpoor countries. Moreover, C&S are too uniform, which is inappropriate forcountries with different needs, given their different stages of development andcircumstances. Second, there is a need to distinguish between implementing C&Sand the practice of assessing implementation. Implementing C&S is in itself avery resource-absorbing and time-consuming activity, which involves adoptingnew practices, procedures and processes. For these reasons they see assessmentmechanisms such as ROSCs and FSAP as somewhat premature. Third, Braziliansexpressed concern about not only the timing, but also with how assessment ispursued. Specifically, they find unfair that what is usually measured is how muchthe country still has to improve to meet international benchmarks rather than theamount of progress that has been made in implementing or improving C&S.

6) As regards the new Basle Capital Accord, Brazilians welcome the fact that thecurrent proposal aims to introduce more flexible rules in determining the ratio of

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capital to risk-weighted assets. However, they expressed concern about the idea ofallowing banks to use their own internal risk assessment systems to determine thelevels of capital adequacy. For them, this proposal entails a number of problems.First, it would increase pro-cyclicality in bank lending. Second, overall lending todeveloping countries could be reduced, as a reflection of a tendency towards riskaversion. Third, whilst in normal times the internal ratings based (IRB) modelsmay be effective, in situations of market instability, they become counter-productive.

7) According to a senior Central Bank official, the IRB approach would only fit forthe larger international banks of developed countries. In Brazil, very few banks –four or five – would be able to apply sophisticated models. This could lead tobanking concentration. Therefore, Brazilian authorities are encouraging theirbanks to prepare for the IRB approach. This may require technical assistance. Afurther problem is that the current proposal does not suggest any measure toprotect small borrowers, which might suffer from higher borrowing costs causedby stricter requirements being imposed on banks.

8) As noted earlier, Brazilian authorities very much welcome the creation of newmechanisms, such as the SRF and the CCL, for crisis prevention and management.However, although they welcome the recent changes incorporated into the CCL,they believe further improvements can be made. For example, they proposegreater automaticity, which could mean a dispensation from an evaluation processundertaken for the purpose of granting a CCL, using instead information fromroutine assessments applied to all countries, such as the IMF Article IVConsultation. Brazilians believe that it is very important that such step be taken, aspreventing crises is always better than having to manage them.

9) But should a crisis occur, they stress the need to envisage ways to facilitate a PSIin crisis management, so that private finance can complement official finance.This, they believe, would make a crisis less painful and more manageable, andwould bring to the process an important burden-sharing element. However, theBrazilian position is that no strict rules should be set as how PSI should be, giventhat countries face different financing situations and prospects of market access inthe future.

10) Having expressed their views on what they see as the new agenda of the IFA,Brazilians pointed to a number of issues they are currently focusing on. Theseinclude the development finance role of MDBs and the need of a greater role ofdeveloping countries in the discussions of a new IFA.

11) Brazilian officials observed that since the crises of the late 1990s, private capitalflows to the emerging economies are on the whole rather scarce. The new BasleCapital Accord if implemented will reinforce rather than reverse this decliningtrend. In this context, Brazilians view that the MDBs, and in particular the WorldBank, should create new products for middle-income countries. In addition tosupporting their balance of payments and growth needs, and helping reduce thecosts of external borrowing (by giving more leverage power to negotiate betterloan conditions with private creditors), these new products would help countries

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tackle their urgent development needs, which cannot be met by private financealone due to market failures and externalities.

12) As regards participation of developing countries in the building-up of a new IFA,Brazilians believe that although having improved slightly, participation in thediscussions and decision-making process of a new IFA is still very asymmetrical.Greater participation by developing countries is needed, among other reasonsbecause the larger emerging economies have a bearing on the stability of theinternational financial system, and were the ones that suffered most from therecent crises.

13) The second part of the report, which assesses where Brazil stands in terms ofimplementing C&S, highlights two major areas: 1) macroeconomic policy anddata transparency (covering specifically monetary and fiscal policy transparency,and data dissemination) and 2) financial regulation and supervision (coveringbanking, as well issues concerning the capital markets, including corporategovernance).

14) In the monetary area, the private sector welcomes steps by the central governmenttowards greater transparency in how the monetary policy is being currentlyconducted. They mention as positive aspects of this policy the adoption of theinflation targeting framework, the disclosure (monthly) of the minutes of theCentral Bank’s Monetary Policy Committee (COPOM) meetings, the productionof inflation reports (quarterly), and the working papers and seminars that are beingreleased and promoted. They believe these policies reduce the degree ofuncertainty as regards the behaviour of the Central Bank, and help the marketsknow better what constraints are affecting the decision-making process.

15) In the fiscal area, the following initiatives have been pointed out by governmentofficials, the private sector and others as key to the current fiscal adjustment andto the transparency and predictability of the fiscal accounts: the ‘FiscalResponsibility Law’ and the government recognition of the so-called ‘contingentliabilities’. The ‘Fiscal Responsibility Law’ is a code of conduct for the publicadministration at all levels, aimed at improving fiscal management, accountabilityand transparency, thereby preventing risks that can affect the equilibrium of thepublic accounts. The recognition of contingent liabilities, in turn, gives greaterpredictability to the fiscal accounts. Another welcomed step towards greater fiscaltransparency and predictability has been the government’s initiative to develop amulti-year fiscal framework – the Multiyear Plan (PPA).

16) As regards data transparency, it is a widely shared opinion that the country hasundergone big changes in the recent past. Today the composition of externalreserves is published very month, and their levels, every day. The most recent steptowards greater data transparency has been the country’s adherence to the SpecialData Dissemination Standard (SDDS). Brazil, together with 40 other countries, isdeemed by the IMF as having met the SDDS specifications for the coverage,periodicity and timeliness of data.

17) Moving on to the area of banking supervision, areas judged as particularly strongare the legal structure and power enforcement. In addition to these, other areas in

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which the country is also strong include assessing operational risks of banks, andonsite supervision. Areas in which supervision is less strong include supervisors’capacity to evaluate credit policy of banks and supervise risks, the offsitemonitoring system and accountancy procedures, for which technical assistancemight be helpful.

18) To tackle some of the problems mentioned above, a number of initiatives havebeen taken. These include the implementation of a new loan classification systemand the central risk information system, both aimed at improving assessment ofbank credit policies and risk. Moreover, the government has proposed regulationsfor ensuring that bank accounting procedures conform to international standards,and also regulations for liquidity risks; furthermore, it has required a consolidatingreporting by banks. Another major initiative, which relates specifically to thefunctioning and stability of the financial system, has been the development of anew payments system.

19) More generally, it is broadly agreed that overall Brazil’s financial system is strong– on the whole well capitalised, with ‘relatively low ratios of non-performingloans and high provision levels’. The average level of capital adequacy met bybanks in Brazil was 14.5% by November 2000, a level much higher than what isrecommended by the current Basle Accord. However, this level is not uniformacross different categories of banks.

20) In the view of a Brazilian academic, the current strength of the banking systemreflects a defensive strategy by banks of holding a portfolio of assets composedmainly of government bonds with little of consumer or other credit. His concern isthat the current trend of strong consumer credit expansion may create turbulencein the system. Among a group of nine private foreign and domestic banks, totalcredit expanded over 34% in the year 2000. Although government officialsrecognise that growth of credit has been high, they seem relatively unconcerned,given that it starts from a low basis.

21) Interestingly, the recent credit expansion has not been translated into more creditto the SMEs or to the poor, and there is no evidence that the pattern of freelyallocated credit will change in the future. Until now, federal public banks havetended to fulfil more the role of providing development finance, and targeted morevulnerable sectors and customers.

22) However, to the extent that the public banks start meeting the Basle and othernew loan loss provisioning requirements, they may stop lending to the poor. Thisis seen as a cause of serious concern in view of the huge developmental needs andlevels of poverty incidence the country still exhibits, despite its status of anemerging economy. This could be a field for technical assistance to help establishclearly possible impact of different measures.

23) More generally, long-term financing provided by domestic banks has beenhistorically limited, and the public banks have been able to meet this financinggap only modestly. In face of that and given that the current trend of the country’sfinancial system is to aggravate this problem, much of the focus today in Brazil ison the development of the country’s capital markets.

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24) Brazilians agree that national companies need the support of strong and deepcapital markets in order to be able to grow and compete internationally. However,in order to promote the capital markets in Brazil, a number of obstacles need to beremoved, such as the burden of financial transaction taxes on companies, aninefficient bankruptcy law, the malfunctioning of the judicial system, andinadequate corporate law and corporate governance practices.

25) Various agents are coming forward with initiatives aimed at either fixing orgetting around these problems. The government is seeking to act on various fronts.It has started by informing and encouraging a public debate on corporategovernance. Private sector representatives and academics acknowledge thatenormous progress has been made in the past year putting the corporategovernance issue in the spotlight. A concrete government initiative has been tosubmit to congress a new corporate law.

26) Another important initiative taken by the country’s main stock exchange(BOVESPA) has been the launch of the New Market, which means a parallelequity market to the existing one, but governed by stricter corporate governancerules. In parallel to Bovespa’s initiative to create the New Market, the country’ssecurity commission (CVM) is making efforts to improve its legislation in the areaof securities and move it towards international standards. However, Bovespa andCVM officials face acute lack of human and financial resources to carry out theirtasks, particularly in negotiations with other countries, at FTAA and at IOSCO.Thus they see a great need for technical assistance in that area.

27) Still on capital markets, it is important to mention that Brazil has a well-developedfuture markets, whose activities are conducted under the Bolsa de Mercadorias eFuturos (BM&F). BM&F offer a wide range of financial instruments, such asfutures, options and swaps. Brazil’s financial institutions and non-financialcorporate sector have relied on these instruments to hedge against risks. Hedgingwas quite widespread in Brazil in the wake of the 1999 currency crisis, aphenomenon that greatly helped avoid major devaluation effects across thefinancial and corporate sectors, thus ensuring the stability of the whole financialsystem.

28) In summary, this report shows that Brazil is making huge efforts to implementC&S of international best practice. As part of these efforts, the country iscurrently pursuing reforms in its domestic financial system, in order to conform itto international rules, like the Basle ones, which are aimed at ensuring domesticfinancial stability. However, a new institutional format of the financial system thatmay result from this process may lack some basic instruments and mechanisms topromote growth and especially credit to poorer people and to SMEs. Therefore,there seems to be a conflict between the stability objectives associated with theadoption of C&S and the need to have mechanisms in place to supportdevelopment finance.

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Introduction

Brazil is the largest economy in Latin America, and one of the largest developingeconomies in the world. For this, it is expected in the next few years to take anincreasingly leading role among developing countries in the international negotiationsfor a better international financial architecture (IFA). Moreover, Brazil is potentially asystemic risk country (due to the size of its economy). It experienced a currency crisisin early 1999, caused by the sudden reversal of short-term capital flows, with negativeeconomic effects on the Latin American region, especially on neighbouring countries.It is therefore crucial to know better what reforms of the IFA the country see asnecessary to reduce the likelihood of crises in the future and the spread of contagion,and what it thinks can be done to support growth and development.

A further reason for analysing Brazil is that this is one of the few countries among theemerging economies that still have institutional and financial mechanisms in place tosupport development finance and those sectors associated with higher incidence ofpoverty, and to deal with regional inequalities. It would be interesting to see the extentto which efforts towards meeting codes and standards of best practice (geared mainlytowards improving financial stability) could put these mechanisms in jeopardy, andreduce the scope of the government to promote policies aimed at combating povertyand supporting growth and development. Furthermore, it is important to note thatBrazil is the only developing country that has experienced a currency crisis without amajor impact on growth (though growth in Latin America was adversely affected bythe Brazilian crisis, with some countries like Argentina experiencing negativegrowth). This may be related to particular features of the country’s financial system,which this study aims to highlight.

The current assessment of the Brazilian economy and its prospects is fairly optimistic.Government officials, the private sector and the international financial institutions(IFIs) are all sharing this optimism, to a large extent explained by the country’s recentachievements, which include a rapid economic recovery after the 1999 currencycrisis, and a strong macroeconomic adjustment, especially in the fiscal area. Thesefacts together with further reforms being undertaken at present are seen as factors thatmay help the country regain a sustainable growth path, after years marked byrelatively slow growth. There are concerns of course, that a sharp slowdown of the USeconomy, the lack of recovery in Japan and a worsening of the Argentinean situationmay become important elements that could undermine the current path of recovery.

It is against this background that this study will assess the main views, priorities andconcerns of the government, the private sector based in Brazil and others on the IFA.The focus will be on the implementation of codes and standards (C&S), as well as thecriteria that have been used to assess them. The study will firstly report the country’sviews on the international financial architecture more generally, and secondly assessthe ‘state of art’ of different codes and standards in Brazil, and the areas in whichBrazilians believe external technical assistance is particularly welcome.

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Part I. Views, priorities and concerns of the government, private sector and others on reform of the IFA.

1. Progress so far

Senior officials in Brazil have expressed a clear desire for a new financialarchitecture. They recognise that important progress has been made so far, but theybelieve more needs to be done in order to reduce the instability of the internationalfinancial system, and to support growth and development.

As senior government officials see it, before the currency and financial crises of thelate 1990s, short-term private capital flows to the emerging economies predominated,the capacity of international bodies to regulate the international financial system wasvery limited, and the instruments and mechanisms to deal with the crises were veryfew. Since then, it is believed, the situation has considerably changed, and for thebetter.

Today, there is much less reliance on short-term capital flows, with foreign directinvestment (FDI) replacing them as a main source of external financing. This is seenas a very positive development, albeit Brazilians call attention to the fact that, whilstemerging markets had too much of private bank lending and portfolio flows for mostof the 1990s, now perhaps there is too little of these flows. FDI is very welcome byBrazilians, but largely relying on such a single source of external financing is seen asrisky. A potential problem with FDI is whether it will be sustained, at current levels,once privatisation finishes. Also, Brazilian policy-makers point out that FDI also hasvolatility elements, including hedging to cover exchange rate risk, that may exertpressure on exchange rates in similar ways to short-term capital flows.

Brazilians also identified as other recent positive developments the creation of newinstruments to prevent and better manage crises, such as the IMF SupplementalReserve Facility (SRF) and the IMF Contingent Credit Line (CCL), and the creationof the Financial Stability Forum (FSF), to identify systemic risk situations andregulatory gaps in the international financial system. Also, the IMF is seen now asmuch more pro-active in crisis situations, an example of this being the way it has dealtwith the crises in Mexico, Brazil, and Turkey and Argentina more recently (thoughthey point worryingly to the risk of a hands-off approach in the future, dueparticularly to the possible position of the Bush administration). Another majorchange noted by Brazilians has been a more positive private sector involvement (PSI)in crisis management, particularly in countries seen in a period of crisis to haveconditions to regain access to markets in a post-crisis period.

All these aspects – greater reliance on long-term capital flows as a source of externalfinance, the creation of new mechanisms to deal with crises, the more pro-activeattitude of the IMF towards crisis-threatened and crisis-affected countries, and a moreeffective PSI for the category of countries seen as capable of regaining access to theinternational capital markets – characterise a first phase of important changes in theIFA after the crises of the late 1990s.

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2. The New Agenda

Brazilian senior officials see now the beginning of a second phase, which has anagenda that includes important issues and initiatives: implementing and improvingCodes and Standards of best practice in developing countries, the new Basle CapitalAccord, new proposals for improving the CCL, and developing a framework forprivate sector involvement (PSI) in crisis prevention and management. In whatfollows we report Brazilian officials’ views on each of these areas. This will becomplemented by the views of private sector representatives and others.

a. Codes and Standards (C&S)

Brazilian officials see efforts to adopt Codes and Standards of best practice as veryimportant; in this regard they reported that a lot has recently been done in Brazil in awide range of areas, from macroeconomic policy transparency to financial regulationand corporate governance (as will be seen below). They also welcome the fact thatC&S can be seen as a soft law, to which countries can adhere voluntarily rather thanby force. Voluntary standards allow governments and companies to adopt those thatbest suit their circumstances and give them a sense of ownership.

Private sector representatives equally stress the importance of C&S, and welcomeefforts in Brazil to implement them. They note that the country is acting on variousfronts simultaneously, and as a consequence the degree of transparency has increaseddramatically in the recent past, particularly in monetary and fiscal policies. Althoughawareness of C&S is still not widespread within the private sector, this will begradually achieved, though at different speeds. For example, it will be seen below thatwhilst public awareness of C&S in corporate governance has increased very rapidly,other C&S remain unknown.

However, government officials raised a number of issues and concerns. First, theybelieve there are too many C&S – 66 so far -, this being especially true for poorcountries, which just lack the institutional capacity to implement them. Moreover,countries have different needs, given their different stages of development andcircumstances, while C&S are too uniform. This means that the ‘one size fits all’approach is not appropriate, and that a more flexible approach should be pursuedinstead.

Second, Brazilian officials emphasise the need to distinguish between implementingC&S and the practice of assessing implementation. Implementing C&S is in itself avery resource-absorbing and time-consuming activity. As a policy maker noted, thework being done on C&S (and more broadly on improving financial regulation,corporate governance, etc) at the Central Bank and elsewhere is absorbing so much interms of time and human resources, that they are even considering creating adepartment just for that. Moreover, implementing standards involves adopting newpractices, procedures and processes. For these reasons they see assessmentmechanisms such as the Reports on the Observance of Standards and Codes (ROSCs)

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and even the Financial Sector Assessment Programme (FSAP)1 as somewhatpremature. This helps to explain why Brazil is moving more slowly than othercountries in preparing ROSCs and FSAPs, despite the fact that work has beenintensively done on different fronts simultaneously towards meeting C&S.

Third, Brazilians are uncomfortable not only with the timing, but also with howassessment is pursued. For example, they find unfair that what is usually measured ishow much the country still has to improve to meet the standards of international bestpractice, rather than the amount of progress a country has achieved in implementingand/or improving them. The latter seems a useful methodological point, for how toassess C&S.

A further issue refers to pressures from the markets for reports like ROSCs to becomemore quantitative based. Brazilians see these demands as very worrying. They believethat it will be very harmful and unwelcome, if the markets start to judge and comparesovereign and corporate risks using scores.2 In their view, this would mean making aprocess simplistic that is complex by nature and aimed at achieving greatertransparency. Qualitative reports are believed to lead to a higher degree oftransparency, so they welcome ROSCs’ current format.

But even outside the assessment framework, comparability remains a problem. Forexample, how to compare banking supervision between Argentina and Brazil? Or howto compare the fiscal accounts of different countries, given the large differences in theway they are presented today? Efforts towards harmonising the different statisticsmust be made, but this may create many problems for the countries. Moreover, thecomparability problem has to do not only with how information is displayed (and thisreflects institutional and political factors that are not easy to overcome), but withfundamental underlying differences in what is being compared.

A private sector consultant illustrated well this problem. She pointed out that withinthe Mercosur area, financial and capital markets’ regulations are marked by enormousdifferences, that efforts have been made in the past towards mapping these differencesand proposing recommendations for reducing them, but that very little has beenachieved since then.

It follows that for Brazilian authorities adherence to C & S should be seen as a long-term process, rather than a short-term effort towards meeting assessment criteria andobtaining immediate benefits. They noted that countries like Argentina that have been‘champions’ in the process of implementing C&S are, however, currently facingcredibility problems.3 Indeed, Brazilians do not think that better transparency wouldplay a large role in improving these countries’ credibility. A senior official with largeexperience with international crises noted that ‘he does not know of a crisis wherelack of information was a serious issue’. Another senior official shared this view, towhom ‘even if all C&S were in place, still crises would continue’. A further aspectpointed out was that too much emphasis on more information on C&S would be very

1 Although the FSAP focuses mainly on the health of the country’s financial sector, it has an element ofC&S as well.2 Worryingly, markets are already doing this.3 However, such credibility problems may – as in the case of Argentina – be largely caused by otherproblems.

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worrying, as it would put even more pressure on countries to adopt standards forwhich they are still not prepared.

Some Central Bank officials have a more positive view towards C&S. They believethat the culture of C&S has been increasingly disseminated, and society is starting toperceive as positive standards that are established on a voluntary basis, as ‘soft laws’.According to them, financial authorities from all over the world have becomeincreasingly interested in knowing whether governments and corporations areadopting C&S of international best practice.

Private sector representatives believe that C&S can influence markets’ perceptions,but recognise that to date the private sector has not heard much about them. Thus,they welcome initiatives aimed at informing the sector about C&S and the fact thatimplementation of C&S will enable the private sector to have greater access tovarious sorts of information. They concede, however, that too much information maybecome counterproductive, leading to higher volatility (e.g. ‘daily publication ofreserve levels could make markets nervous’), but they also think that Brazil has notyet reached that phase of excessive information being made available.

Interestingly, Brazilians expressed concern that whilst developing countries are beingrequired to disclose information, the same has not been required from theinternational financial community. More information on how international playersoperate would be highly welcome. In addition, they observed that rating agencies,supposedly vehicles of information to the international markets, have themselves beenvery obscure as regards the methodologies they use to generate their ratings.Brazilians also note that the methodologies used by export credit agencies are verysecretive. This is equally, if not even more worrying, in face of the new Basle Accord,which proposes reliance on the ratings of export credit agencies and private ratingagencies for establishing adequate capital levels in the banking system. 4 Therefore,they think it is crucial that rating agencies, both public and private, become moretransparent.

Finally, the authorities believe C&S should not be part of the IMF conditionalities,which would be in conflict with the Fund’s announced intention of streamliningconditionalities, a move they very much welcome. Indeed, they emphasise theimportance of less conditionalities and more country ownership in the design andconduct of IMF-supported programs, a point they noted has been made even by theFund’s current managing director.

4 There was also concern about the very low rating unrelated to current conditions that the UK’s exportcredit agency (ECGD) has given to Brazil.

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b. The New Basle Capital Accord

Brazilians welcome the fact that the new Basle Accord being currently discussed aimsto introduce more flexible rules in determining the ratio of capital to risk-weightedassets. However, they expressed concern about the idea of allowing banks to use theirown internal risk assessment systems to determine the levels of capital adequacy. Forthem, this proposal entails a number of problems.

First, it would increase pro-cyclicality in bank lending.5 This is very serious, and it isnot clear what mechanisms could be used to reduce that tendency. A possibility wouldbe to create forward-looking provisions, to be invoked in times of booms. A seniorpolicy maker remarked, however, that this mechanism could also discourage apparentbooms that were actually just a normal phase of economic sustainable expansion.

Second, in addition to the risk of increased pro-cyclicality, it was pointed out thatoverall lending to developing countries could be reduced, as a reflection of a tendencytowards risk aversion. As a senior academic put it, ‘the current reduction of exposureof banks to the emerging markets would be validated by the regulatory framework’. Afurther problem is that, whilst in normal times the internal assessment models may beeffective, in situations of market instability, they become counter-productive(Griffith-Jones and Spratt 2001). The answer the Basel Committee on BankingSupervision gives is that stress testing could be performed at the individual and at theCentral Bank levels, but again it is feared that this may not work sufficiently welleither (e.g. due to lack of historical data).

In the view of a senior Central Bank official with large experience in bankingsupervision, the new proposal of internal risk assessment would only fit for the largerinternational banks of developed countries. In Brazil, very few banks – four or five –would be able to apply sophisticated models. Moreover, it would be very difficult tosupervise this new scheme. The fact that only a few major banks would be able to relyon their own assessment models could lead to banking concentration. To avoid asituation that puts Brazilian banks at a disadvantage the Brazilian authorities areencouraging their banks to prepare for the Internal Ratings Based (IRB) approach. 6

This may require technical assistance.

Finally, the proposed Basle Accord does not propose any measure to protect smallborrowers, which might suffer from higher borrowing costs caused by stricterrequirements being imposed on banks. This is a problem that the EuropeanCommission aims to address in the European context,7 but no such concern has beenexpressed for developing countries, where higher borrowing costs would particularly

5 One interviewee noted that regulation should be neutral instead.6 The new Basle proposal suggests three possible approaches for measuring credit risk: 1. TheStandardised approach, the Foundation Internal Ratings Based approach, and the Advanced InternalRatings Based approach.7 As reported in The Economist April 21st 2001, page 97, it is highlighted in the EuropeanCommission’s consultative document, which is adapted from the new Basle proposal (Basle 2) ‘thespecial need for banks to finance small and medium-size enterprises (SMEs), most of which have nopublic credit rating’.

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affect the ability of their small- and medium-size enterprises (SMEs) to survive andexpand.

The option envisaged for those banks still not ready to adopt internal risk assessmentsystems, of relying on the external assessment provided by export credit agencies, isalso seen with worry. They believe that the quality of the agencies’ assessment ofsovereign risk is very poor. They suspect that the scores they generate are based onrudimentary methodology, and probably affected by political and commercialinterests.

c. New proposals for improving the CCL

As noted earlier, Brazilian authorities see as very positive the Fund’s initiative tocreate new mechanisms to better manage and particularly prevent crises, such as theSRF and the CCL. The SRF was successfully used by Brazil during the 1999 currencycrisis, thus proving to be a very important mechanism of official liquidity provision.As regards the CCL, Brazilians welcome its recent changes, but believe that furtherimprovements can be made.

Today a country has to pre-qualify in order to be entitled to a CCL. As stated recentlyby the IMF first deputy managing director, pre-qualification may include compliancewith codes and standards of good practice, in addition to the more commonmacroeconomic conditions a country is normally expected to fulfil.

As mentioned earlier, Brazilians are against the inclusion of codes and standards aspart of IMF conditionalities, and they particularly object such inclusion in the CCLmechanism. They propose instead greater automaticity, so that the right to a CCL canbecome a reality (as of today, no country has applied for a CCL yet, though somehave demonstrated interest in doing so). Greater automaticity could for example meana dispensation from an evaluation process undertaken especially for the purpose ofgranting a CCL, using instead information from routine assessments applied to allcountries, such as the IMF Article IV Consultation. 8 Moreover, the idea of greaterautomaticity could also be used when a country that has already been pre-qualified fora CCL, needs to be evaluated again in order to have access to the money, neededwhen a crisis hits.9

It is very important that such steps be taken, as preventing crises is always better thanhaving to manage them. (A senior official would however take a different position;for him there is already an implicit CCL, in the sense that countries that are justunlucky but otherwise deemed as good can have access to the Fund’s resources veryquickly when facing a crisis situation. In this sense fighting for a better CCL would beunnecessary).

8 However, given that the CCL has been recently modified, further changes may not be attainable in theshort run.9 That is, CCL mechanism has two phases. The first consists of a country’s pre-qualification, and thesecond, of activating it when an already pre-qualified country becomes in need of immediate officialassistance to countervail a crisis.

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d. PSI

Although Brazilian policy-makers emphasise the importance of having internationalmechanisms for crisis prevention, they note that mechanisms for crisis managementshould be readily in place, should a crisis occur. In this regard, they see as crucial theprovision of official liquidity, which can come in the form of a SRF, but they alsostress the need to envisage ways to facilitate a private sector involvement (PSI) incrisis management, so that private finance can complement official finance. This, theybelieve, would make a crisis less painful and more manageable, and would bring tothe process an important burden-sharing element.

However, the Brazilian position is that no strict rules should be set as how PSI shouldbe, given that countries face different financing situations and prospects of marketaccess in the future. As a senior official put it, ‘ our experience with voluntary PSI isthat there are shades, a continuum of possibilities’.

In the specific case of Brazil, PSI (in the form of a standstill) happened on a voluntarybasis in the 1999 crisis10, mainly for rolling over short-term bank credit lines. In orderto make the process more manageable, the government created committees for eachcreditor country. Although each credit country had its own committee, thegovernment did its best to make it sure that general rules were adopted across thecommittees. Moreover, it was important that creditors were informed that allcommittees were guided by the same rules, so they could feel secure about thenegotiation process (they were also told that all the information would be shared withthem). In order to reduce communication problems, it also created a generalcommittee. According to Brazilian officials, markets like general rules, a major reasonbeing that they are easy to explain to their boards.

Brazilian officials believe that they could adopt this light-touch approach (i.e. no pre-defined rules, with PSI being voluntary), because the country was seen as capable ofregaining access to capital markets, making it easier for the private sector to step in toprovide complementary finance. There are instances, however, in which a moreheavy-handed approach that implies debt restructuring is made necessary, as was thecase of Ecuador, for which the FMI should be more active and PSI should take placewithin a different framework.

Although their recent experience with PSI has involved on banks, Brazilian officialsalso expressed their opinion about the use of collective action clauses (CACs) in bondcontracts, a key instrument to facilitate debt re-negotiation with bond holders.11

Brazilian officials know that, like in London where CACs have been included in bondcontracts for some time, in New York bonds that include CACs are becoming 10 It should be noted that as IMF (2001) points out initially the private sector resisted to co-operate,doing so only after the IMF encouraged it to do so.11 There are basically four types of collective action clauses: majority action clauses, collectiverepresentation clauses, sharing clauses and non-acceleration clauses. Under English law, bondsnormally include majority action clauses, which allow bondholders to convene and change the terms ofpayments of a bond contract by a qualified majority (normally 75%) of bondholders. Collectiverepresentation clauses permit bondholders to be represented collectively, for example by a trustee,thereby reducing co-ordination problems in the negotiation process. Sharing clauses require anypayments received to be distributed on a pro-rata basis among all creditors (Dixon, 2000).

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increasingly accepted. Whilst not knowing for certain the cost effects that thisinclusion may have, they reckon there would be very small costs, if any at all.

For a senior official, whether and how countries use the above instruments andmechanisms in crisis prevention and management, very much depends on theconditions the country exhibits. According to him, broadly three categories ofcountries can be found. The first category is that of very good countries, which willhardly have a crisis or be affected by contagion (though he acknowledges that thevery fact that the country is perceived as such may lead people to take very highrisks). The second category is an intermediate case, in which a country facing a crisisshould respond to it with strong policies, hopefully obtain prompt IMF lending andbenefit from voluntary PSI. And the third case, seen as more complicated, is that ofcountries facing a crisis in which the official sector has to intervene and involve theprivate sector in the negotiations on debt restructuring.

3. Further Issues of Concern

Having expressed their views on what they see as the new agenda of the IFA, theypointed to a number of issues they are currently focusing on. These are: a) thedevelopment finance role of the multilateral development banks (MDBs) anddistribution of capital flows across countries, b) illegal money in internationaltransactions, and c) the need of a greater role of developing countries in thediscussions of a new IFA.

a. The provision of development finance by MDBs and distribution of capital flowsacross countries

As pointed out earlier, Brazilian officials observed that since the crises of the late1990s, private capital flows to the emerging economies are on the whole rather scarce.This is partly due to a greater caution by banks and markets to lend to and invest inthe emerging markets, and partly due to recent economic developments in theindustrial countries, particularly the US. However, middle-income countries still needsubstantial amounts of external capital to finance their balance of payments (BOP)and growth needs. As seen above, the new Basle Capital Accord if implemented willreinforce rather than reverse the declining trend of private capital flows, particularlybank lending, to middle-income countries. Thus, official lending in normal timesremains crucial to this category of countries.

In this context, Brazilians view that the MDBs, and in particular the World Bank,should create new products for middle-income countries. To date, Brazil has primarilyhad access to structural adjustment loans (SAL), a source of long-term finance whichhas been used for balance of payment financing. This kind of loan is seen as veryimportant, as least for two reasons: first, it helps fill in financing gaps and, second, ithelps reduce the costs of external borrowing. This is because if a country can count onofficial lending to meet part of its rollover needs, it will have more leverage power tonegotiate better loan conditions with private creditors.

World Bank lending to Brazil has been considerable when compared to the country’slevel of reserves, but very limited when compared to the country’s overall investment

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levels. Thus, new products should be created to support middle-income countries,which in addition to the benefits mentioned above, would help countries tackle theirurgent development needs (e.g. infrastructure, education, health), which cannot bemet by private finance alone due to market failures and externalities.

Brazilians emphasise, however, that such lending should be seen in the context ofmacro policies. That is, lending to micro projects of governments at differentadministrative levels may create budgetary problems, which according to seniorgovernment officials, should be avoided if the country wants to meet its fiscal targets.Indeed, a senior official proposes a ‘wholesale financing of the budget, with generalconditionalities and not related to specific projects. If you are borrowing from abroad,the money has to be part of your budget, and produce a counterpart result. If this doesnot happen, nobody will borrow anymore, since the planning of the budget will loseforce’.

Still in the context of development finance, Brazilians welcome the proposal made bythe World Bank Middle Income Task Force to create a new lending instrument, calledCommitted Loan Facility (CLF), which a country could draw on when needed. Theadvantage of this instrument is that it could be used at a most convenient point of thecountry’s business cycle (and most interestingly, that it could have a counter-cyclicalrole) and in line with the country’s budgetary planning.

In the same way that Brazilians see that MDB lending should go not just to the poorcountries, but also to middle-income countries, they believe that measures should betaken in the industrial countries to encourage more private capital flows to the poorercountries, thereby reducing the current concentration of these flows in the middle-income countries.

b. Illegal Money in International Transactions

As regards illegal money in international transactions, this is seen as an issue thataffects middle-income countries as well, in the form of its impact on tax evasion.Thus, Brazilians suggest that the FSF and IMF should enforce regulatory measures onoffshore financial centres (OFC).

c. Participation of developing countries in the building-up of a new IFA

Brazilians believe that though having improved slightly, participation in thediscussions and in the decision-making process of a new IFA is still veryasymmetrical. Greater participation by developing countries is needed, first becausethe larger emerging countries have a bearing on the stability of the internationalfinancial system, and were the ones that suffered most from the recent crises.

Second, from their own experience they see a clear difference between being involvedin the discussion and decision-making and being just informed only after decisionshave been taken. Third, participation helps them better understand the issues, andtherefore adopt the most appropriate strategy to deal with them. Their participation inthe G-22 and G-20 has been an example of this. It helped them have a greater

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awareness and understanding of C&S. As further noted by a very senior official, evenmore interesting would be to be involved in the primary production of C&S, whichimplies greater participation in the international fora, such as the Financial StabilityForum and the Basle Committees.

Fourth, senior officials from the Central Bank noted that they have been invited by theBIS to participate in some of the Basle committee sessions, or some of their workingparties. This experience has proved very positive, among other reasons because theycould transmit their experiences and knowledge, giving the opportunity for developedcountries to learn a lot about the problems and issues that affect developing countries.Unfortunately, their participation has been mainly limited as observers.

Although participation in G-22 or the newly created G-20 is welcome, they see this asinsufficient. It has been particularly frustrating when a proposal that is presented bythe G-20, had been already agreed by the FSF or the Basle Committees. Therefore,they strongly suggest that the latter forum should include developing countries notonly in its working groups but also in the Forum itself.12

This insufficient participation is seen as reflecting lack of interest by the industrialcountries to share control of the decision-making process regarding major issues ofthe IFA. Brazilians recognise, however, that developing countries should be more pro-active regarding the general issues of the IFA, and less focused on their own reality.This is already happening, though. A few developing countries such as the LatinAmerican ones, South Africa and China, are moving towards taking up issues of moregeneral interest in the international fora, rather than just those that affect them moredirectly.

12 The attainability of some of these proposals, however, is not very high, due to political resistance onthe part of the G-7.

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Part II. Assessment of Codes and Standards in Brazil

The assessment of where Brazil stands concerning implementing codes and standards,and of the progress that the country has made in implementing and improving them,will focus on two major areas: 1) macroeconomic policy and data transparency, and 2)financial regulation and supervision. The latter will cover banking regulation, as wellas issues concerning the capital markets, including corporate governance.

1. Brief Macroeconomic Context

Until the end of the first quarter of 2001, Brazil’s economic recovery from thecurrency crisis in early 1999 was quick and strong. Growth was 0.8% in 1999, whichthough low is positive – a unique achievement among crisis-affected countries in thelate 1990s –, reached 4.2% in 2000 and was maintained at that level until the time ofwriting this report. However, current growth projections are being revised downwardsdue to an electricity energy rationing, and to domestic interest rate increasesundertaken by the Central Bank, in response to the contagion effects from Argentina.

Other macroeconomic indicators have also been very positive. These include animpressive fiscal performance, relatively low inflation despite the sharp currencydevaluation of early 1999, improved external accounts, and employment creation.A number of factors can explain this overall positive performance.

First, the country’s access to official lending, which together with a private sectorinvolvement in the rollover of private credit lines, helped reduce the first-roundeffects of the crisis (see IMF, 2000).

Second, the financial sector was relatively strong, with adequate levels ofcapitalisation and with a healthy loan portfolio. The latter was in part explained by aprivate sector that had low levels of indebtedness and hedged against exchange-raterisk. The strength of the banking sector combined with a well-hedged private sectorhelped reduce the crisis’s knock-on effects.

And third, the sharp currency devaluation that occurred in early 1999 gave thecountry’s exports and import-substituting industries a boost. Moreover, the fact thatthe passthrough to inflation was very low permitted the government to graduallyreduce domestic interest rates from the high levels observed in the wake of the crisis.The declining trend in interest rates helped to stimulate production and investment.

The rapid and sustained recovery observed until March 2001 helped to create a senseof optimism and confidence in the country. Government officials, the private sectorand representatives of IFIs believe that confidence has been reinforced by theeconomic reforms that the country is implementing (like privatisation), by the strongfiscal adjustment and by the monetary and exchange rate regimes being pursued sinceearly 1999.

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2. Standards in Macroeconomic Policies and Data Transparency

It is important that the implementation of standards in macroeconomic policies anddata transparency be assessed having Brazil’s macro context in mind. This is becausemuch of the recent progress that the country has achieved in implementing C&S hasto some extent been made possible by a better macroeconomic environment.

Of the 12 standards compiled by the FSF as key (and which are the focus of thisstudy), the following ones fall under the headings of macroeconomic policies and datatransparency: monetary and financial policy transparency, fiscal policy transparencyand data dissemination.

In assessing progress in implementing these standards, it is useful to see what policytransparency means. In a detailed FSF description of the code of good practices ontransparency in monetary and financial policies, we find that

‘For the purposes of the Code, transparency refers to an environment in which theobjectives of policy, its legal, institutional, and economic framework, policy decisionsand their rationale, data and information related to monetary and financial policies,and the terms of agencies’ accountability, are provided to the public on anunderstandable, accessible and timely basis.’ (FSF, 1999, our underlining).

In addition, the FSF describes the code of good practices on fiscal transparency as‘being open to the public about the structure and functions of the government, fiscalpolicy intentions, public sector accounts, and fiscal projections’ (FSF, 1999).13 Withthese descriptions in mind, we will examine now various recent governmentinitiatives for the purpose of assessing progress made in meeting standards.

a. Monetary and fiscal policy transparency

In the monetary area, the private sector welcomes steps by the central governmenttowards greater transparency in how the monetary policy is being currentlyconducted. They mention as positive aspects of this policy the adoption of theinflation targeting framework, the disclosure (monthly) of the minutes of the CentralBank’s Monetary Policy Committee (COPOM) meetings, the production of inflationreports (quarterly) that they regard as of high quality, and the working papers andseminars that are being released and promoted. These policies are believed to reducethe degree of uncertainty as regards the behaviour of the Central Bank, and help themarkets know better what constraints are affecting the decision-making process.

The inflation targeting framework (adopted in mid-1999) is deemed as verysuccessful, with the target remaining within the stipulated band; moreover, as noted in

13 More generally, the Code of Good Practices on Fiscal Transparency is based on the followingprinciples: clarity of roles and principles as regards the boundaries within different governmentactivities and between the public and private sectors; public availability of information, which shouldbe published comprehensively and at clearly specified times; open budget preparation, execution andreporting, with emphasis on the need to develop and harmonise international statistical and accountingstandards; and independent assurances of integrity, to be provided through external audit and statisticalindependence (FSF, 1999).

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an IMF report, the government is making continuous efforts to refine the tools used topredict inflation, such as use of vector-autoregression (VAR) models. The privatesector particularly praises the fact that this framework is transparent about what theultimate objectives of the monetary policy is and what instruments should be used toachieve these objectives. A key instrument is, of course, the interest rate; for itsdetermination, the Monetary Policy Committee uses as a guide the Central Bankreports that rely on model-based inflation predictions, as well as qualitativeinformation provided by the markets.

In the fiscal area, the following initiatives have been pointed out by governmentofficials, the private sector and others as key to the current fiscal adjustment and tothe transparency and predictability of the fiscal accounts: the ‘Fiscal ResponsibilityLaw’ and the government recognition of the so-called ‘contingent liabilities’14.

The Fiscal Responsibility Law15 is a code of conduct for the public administration atall levels, aimed at improving fiscal management, accountability and transparency,thereby preventing risks that can affect the equilibrium of the public accounts. It setstargets for revenue and expenditures, as well as limits on personnel expenditures andon public debt. It also sets rules for increased transparency, such as ample disclosureof budgetary information, including the methodology used to set the fiscal targets, anddegree of compliance with the targets set for previous years. It also requests that theannual budgetary law contain a contingency reserve, aimed at meeting unforeseenevents, including the recognition of contingent liabilities. It rules out the possibility ofthe central government bailing out sub-national governments.

According to a senior official, one should expect government administrators at alllevels to abide by it, as it carries tough punishment to those who fail to comply withits norms and rules. Private sector representatives highly welcome this new law,noting that it gives a further impulse to a tendency observed in the past five yearstowards higher degree of disclosure in all fiscal areas, at all government levels. Itparticularly praises the recognition of contingent liabilities by the government (andthe request that budget proposals should contain an Annex only on that) which givesgreater predictability to the fiscal accounts.

The importance of contingent liabilities lies with the fact that they can have a verylarge impact on the government’s net public debt. To illustrate this point, thoseliabilities that the government has recognised between the years 1996 and 2000 haveled to an upward adjustment to the public debt stock of 7% of the country’s GDP.Fortunately, this increase has been largely offset by debt stock reduction broughtabout by the proceeds of privatisation (of 5.8% over the same period; see IMF, 2000).

14 Contingent liabilities refer to what is known in Brazil as ‘fiscal skeletons’. They are past governmentliabilities that originate in unclear past fiscal practices, as well as economic measures taken in the past(such as temporary suspension of indexation mechanisms) that implied losses to individuals and sectors(e.g. under-correction of savings and earnings). The government is keen on recognising some of theseliabilities, which would imply an upward adjustment to its public debt stock, while others are beinglegally contested. Contingent liabilities are also those implicit losses that the government aims torecognise at some point, such as the recapitalisation of the workers severance payment fund (FGTS)and of federal banks.15 The Fiscal Responsibility Law was enacted on May 4, 2000. For more details, see ‘The BrazilianFiscal Responsibility Law’, Ministry of Planning, Budget and Management of Brazil, athttp://www.planejamento.gov.br/legislacao/mp/lei_complementar/lei_101_ingles.PDF

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In addition, the private sector in Brazil, as well as the representatives of IFIs, havewelcomed the government’s initiative to develop a multi-year fiscal framework – theMultiyear Plan (PPA) -, which unlike in the past has become a feasible exercise intoday’s macro environment marked by relatively low inflation. This framework isseen as another step towards greater fiscal transparency and predictability.

It is important to note that Brazil is also seeking to promote greater transparency ofmonetary and fiscal indicators within the Mercosur 16 negotiations. During 2000,initiatives were taken at the Mercosur common market towards promoting commonmacroeconomic targets among the Mercosur member countries, and to a lesser extent,the harmonisation of statistics, the latter being deemed as a more difficult task, for thereasons discussed earlier.

For all Mercosur countries, in the monetary area an inflation target of 5% over theperiod 2002-2005 was agreed upon. In the fiscal area, targets for a number of keyindicators were specified. These include a ceiling of 3% for the budget deficit, and atrajectory of declining public debt, with a ceiling of 40% to be met by 2010.

The idea behind these targets is to work on macro policies that can reduce thelikelihood of monetary and fiscal shocks that ultimately affect the exchange rates.That is, the long-term objective of this regional initiative is to create the pre-conditions for exchange rate convergence within the region. This strategy is based onthe recognition that having exchange rate convergence as a short-term objective issimply not feasible today, given the opposite exchange rate regimes being currentlyadopted by the region’s two largest members – Brazil and Argentina.

The driving force behind these negotiations seems to be political more than economic.This is because Brazilians seem quite happy with the floating exchange rate regimebeing currently adopted in the country. A top policy maker believes that for a largeand relatively closed economy like Brazil, a floating exchange rate regime is the mostappropriate one. If devaluation occurs, the passthrough to inflation is believed to berelatively small (recent experience confirms that). In a very open economy, a fixedexchange rate regime might be better. An intermediate option – the managedexchange rate – is seen as problematic, as, he believes, it leads to confusion, ‘associety does not know how to structure their balance sheets’, problems of governanceand time consistency (‘the government tends to work with a short horizon, whichshould be avoided’). He recognises, however, that the floating regime can lead toexcessive exchange rate volatility and misalignment, and that in exceptionalcircumstances, the government should intervene, as indeed has recently happened.

Private sector representatives have also expressed satisfaction with the floatingregime. It is seen as more transparent and consistent with the inflation-targetingregime, and embedded with a self-correcting mechanism by inflicting costs to thosewho rush out of the country in times of crisis. They believe it is the best way to absorbexternal shocks, and makes the level of foreign reserves a less important vulnerabilityindicator. These arguments have been challenged, however, by the recent turbulence

16 Mercosur is a regional trade agreement that includes Argentina, Brazil, Paraguay and Uruguay asmember countries, and Bolivia and Chile as member associates.

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in Argentina and its effects on Brazil. This has led Brazilian authorities to unwillinglyintervene in the exchange rate market almost continuously for several weeks, in orderto avoid excessive currency devaluation and its negative impact on inflation and thefiscal accounts.

b. Data Transparency

It is a widely shared opinion that the country has undergone big changes in the recentpast as regards greater data transparency. As a senior official noted, today thecomposition of external reserves is published every month, and their levels, everyday. The most recent step concerning data transparency has been the country’sadherence to the Special Data Dissemination Standard (SDDS). The SDDS is aboutdisseminating economic and financial data to the markets, and is tailored to thosecountries willing to have or secure access to the international capital markets.17

As of today, 49 countries have subscribed to the SDDS. Of this group Brazil, togetherwith 40 other countries, is deemed by the IMF as having met the SDDS specificationsfor the coverage, periodicity and timeliness of the data. This indicates that Brazil hasimproved its data production and dissemination practices considerably in the pastseveral months, since, according to an IMF assessment made in March-April 2000,the country still had not met the requirements specified by the SDDS, with importantgaps to fill at the time.

According to a senior government official, the work for the preparation of SDDS atthe Central Bank has absorbed an enormous amount of resources. Yet, he believesthat the marginal gains of adhering to the SDDS are far greater than not adhering to it.His view is that it sends a positive signal to the markets. A less formal, but veryvaluable initiative, the Brazilian Central Bank has undertaken in regard to informationdissemination was to establish a direct communication channel with the markets,through an email system that delivers information almost on a daily basis to more than13.000 subscribers. The email service covers a wide spectrum of information, such asthe latest data available on key macroeconomic indicators (inflation, fiscal results),the minutes of the Monetary Policy Committee, markets’ forecasts for keymacroeconomic indicators, government decisions concerning its contingent liabilities,the government economic agenda for the week, and more in-depth studies on keymacroeconomic topics (i.e. working papers, discussion papers, etc.).

This is an interesting initiative, and perhaps other developing countries (especiallyemerging market ones) could consider taking similar steps.

17 The SDDS is posted on the IMF’s Dissemination Standards Bulletin Board (DSBB), and entails thefollowing practices: data dissemination should have broad coverage, clear periodicity and be timely;the public should have easy and timely access to the data; broad disclosure of information, includingmethodology, sources, comments and notices on future methodological changes; dissemination of otherdata that allows for statistical cross-checks (FSF, 1999). Countries that subscribe to the SDDS areexpected to cover 20 different categories of data, on the real, fiscal, financial and external sectors, andon population, and to have a website where the disseminated data is displayed, with the purpose offurther facilitating the public’s access to it. Given its broad coverage and degree of sophisticationrequired, poorer countries are not expected at all to subscribe to it; for the latter category of countries,there is the General Data Dissemination System (GDDS), whose aim is to encourage countries toimprove data quality through the continuous practice of data dissemination.

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3. Financial Regulation and Supervision

This section will focus firstly on banking supervision, and then on issues concerningthe capital markets. The latter will also discuss compliance with codes on corporategovernance.

a. Banking supervision

Standards in banking supervision are set by the Basle Committee on BankingSupervision18, e.g. the Core Principles for Effective Banking Supervision. They weredeveloped as a guide to support supervisory authorities from developed anddeveloping countries in their task of strengthening their supervisory regimes and forultimately contributing to the strengthening of national financial systems all over theworld (Basle, 1997). There are 25 Core Principles, which can be grouped under thefollowing headings: preconditions for effective banking supervision; licensing andstructure; prudential regulations and requirements; methods of ongoing bankingsupervision; information requirements; formal powers of supervisors; and cross-border banking.

As reported by a Central Bank official, in a joint quantitative evaluation (based on aranking system) by the IMF and the World Bank conducted in early 2000, the countryscored highly in all but two principles: independence of supervision and budget (i.e.the Central Bank does not have its own budget).

In an accompanying qualitative assessment, areas judged as particularly strong werelegal structure and power enforcement. In addition to these, in the view of this CentralBank official areas of banking supervision in which the country is particularly strongare assessing operational risks of banks, and on onsite supervision. As regards thelatter, everything is scrutinised. This enabled them to readily identify problems thatoccurred during the 1995-1996 mini-banking crisis19 in Brazil. Among theweaknesses, he identified problems with the rules set for new banks entering themarket, which in his view lack sufficient requirements. Another weakness refers tothe supervisor’s capacity to evaluate credit policy of banks and supervise risks.Moreover, in his judgement the offsite monitoring system is in some respectsoutdated, thus in need of improvements, for example in the area of accountancyprocedures, for which external technical assistance might be helpful.

To tackle some of the problems identified above, a number of initiatives have beentaken. These include the implementation of a new loan classification system and thecentral risk information system, both aimed at improving assessment of bank creditpolicies and risk. Moreover, the government has proposed regulations for ensuringthat bank accounting procedures conform to international standards, and also

18 The Basle Committee on Banking Supervision was established in 1975 and is composed ofsupervisory authorities of 10 industrial countries - Belgium, Canada, France, Germany, Italy, Japan,Luxembourg, Netherlands, Sweden, Switzerland, United Kingdom and the United States.19 The mini-banking crisis of 1995-96 refers to the intervention of the Central Bank in some majorBrazilian banks facing financial problems caused by high levels of default. The latter resulted from anumber of factors (fall in agricultural prices, undermining farmers’ ability to pay back their debts, thegovernment induced credit crunch in response to the Mexican crisis, which undermined bank debtor’sability to rollover their debts, etc.).

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regulations for liquidity risks; furthermore, it has required a consolidating reportingby banks20. These measures are expected to further improve the banking regulatoryframework and the operations of the financial system.

Another major initiative taken by the Brazilian authorities in relation to thefunctioning and stability of the financial system has been the development of a newpayments system.21 Whilst in the previous system clearing procedures used to takeplace overnight, with the Central Bank bearing the risk, now clearing will happenduring the day on a continuous basis, way by which risks will be transferred to themarkets.22 This system is viewed as beneficial, because ‘it will force the markets topolice themselves’. This is an important area, as poorly designed payment systemscan be a conduit for financial shocks, implying systemic risks. Implementing this newpayments system is seen as an important move towards meeting the core principlesfor systemically important payment systems, which sets the standards of best practicefor payment and settlement.23

A further area that has been strengthened relates to money laundering. Acomprehensive legislation has been approved on that. This new legislation requestsbanks to bring all information to the Central Bank, with more than 200 peopleworking in that area. The reason for tackling that issue has been moral rather than forstability purposes.

b. The strength of the financial sector

It is broadly agreed that overall Brazil’s financial system is fairly strong. This is anopinion expressed by IMF officials in their assessment reports, governmentauthorities, the private sector and academics. As noted in an IMF report, ‘the bankingsector as whole appears fundamentally sound, with relatively low ratios of non-performing loans and high provision levels’. An academic expert on the Brazilianfinancial system commented that ‘the banking system is solid, operationallycompetitive and flexible’. A Brazilian government official went as far as to claim thatBrazil has the strongest banking system among the emerging economies; this claimcould be exaggerated.

20 See IMF (2000).21 The new payments system will be fully in place on August 1st , 2001. A payment system constitutes aset of norms, rules and instruments for the transfer of funds between participants of the system. Apayment system can be owned and operated by the central bank or by private sector institutions (seeBIS, 2001).22 Banks will have to keep a strict control on their daily cash flows in order to meet their payments. TheCentral Bank will not longer be a ‘first lender’. These operations will be on-line, and banks withoutsufficient cash to meet their payment needs will have their operation invalidated (see Gazeta Mercantil,2001, ‘Bancos estao prontos para SPB, diz Andima’, March 16-18, p. B-2).23 The Core Principles for Systemically Important Payment Systems were set by the Committee onPayment and Settlement Systems (CPSS) of the central banks of the Group of 10 countries. They wereestablished to ensure a safe and efficient payment system, seen as crucial for the stability of a financialsystem. The risks normally associated with a payment system that are expected to be reduced by meansof compliance with the Core Principles are: credit risk, liquidity risk, legal risk, operational risk andsystemic risk. A payment system is considered systemically important when the failure of a participantto pay can trigger a disruption or transmit shocks to the whole domestic (or even international)financial system (BIS, 2001, p. 16).

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An indication of the current solidity of the banking system is the level of capitaladequacy met by banks in Brazil. The average level met by these banks was 14.5% byNovember 2000, while the Central Bank currently sets a minimum level of capitaladequacy at 11%, a level still higher than what is recommended by the BasleAccord.24

Table 1. Total Capital Adequacy Levels of Banks in Brazil %Type of Bank LevelTotal Private Banks 17 Private Foreign Banks 17 Private Domestic Banks 17 Private Domestic Banks with Foreign Participation

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Public Federal Banks 10.7Public Banks (at state-government level) 23Total 14.5Source: Interview material.

The capital adequacy level met by Brazilian banks is not uniform, however. While thelevel observed by private banks is 17%, that observed by public federal banks is10.7% (see Table 1). Within the category of public banks, the banks owned by stategovernments exhibit a much higher level of capital adequacy than the category’saverage, due to the process of restructuring (which included re-capitalisation) theyhave been subjected to.

A reason given by government officials for setting a higher capital adequacy levelthan what is recommended by the Basle Accord is that volatility in the Brazilianmarkets is higher than in developed countries. To a private sector representative, thisoption reflects government concerns with the quality of credit in Brazil, and hebelieves that to the extent that the quality improves in the next year or two, the levelof minimum capital required will decrease.

A Brazilian academic contested these arguments. In his view, such a measure was partof a government agenda to promote greater concentration in the banking system, aprocess that has indeed taken place since the 1995 mini-banking crisis. Still accordingto this academic, the current strength of the banking system is a legacy of defensivestrategies banks adopted during the macro instability that characterised the Brazilianeconomy in the 1980s and early 1990s. This strategy was in part based on a portfolioof assets composed mainly of government bonds and in which there was very littleroom for consumer or other credit.25 His concern is that changing this strategytowards strong expansion of consumer credit may create some turbulence in thesystem.

24 The Basle Accord recommends a minimum capital requirement of 8% for internationally activebanks.25 Even with stabilisation after 1994 banks maintained such strategy, due to high interest rates andslow growth as a consequence of the Mexican, Asian and Russian crises; see interview with Carvalho,in Gazeta Mercantil, ‘Bancos estrangeiros ja emprestam mais’, March 16-18, 2001, p. B-1.

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The system is already moving towards that direction. Among a group of nine privateforeign and domestic banks, including the two largest private domestic Brazilianbanks, total credit expanded over 34% in the year 2000 (see Table 2).

Table 2. Credit Operations R$ millionBanks 1999 2000 Change %Bradesco 27.576 38.872 41.0Itau 19.596 27.253 39.1Unibanco 15.811 21.250 34.4BankBoston 5.051 5.739 13.6Sudameris 5.755 6.078 5.6BBV 1.624 2.960 82.2ABN Amro 13.060 15.420 18.1HSBC 3.503 5.808 65.8Lloyds 805 1.292 60.5Total 92.781 124.672 34.4Source: Balancos. Extracted from Gazeta Mercantil, March 16-18, 2001, p. B1.

Consumer credit expansion has been especially high. ABN Amro Bank increasedindividual credit by 60%; HSBC, by 85%; Itau by 75%; and Unibanco, by 59%.

Government officials recognise that growth of credit has been high, but they seemrelatively unconcerned, given that it starts from a low basis. As they noted, total creditcorresponds to 30% of the country’s GDP, whereas in other countries (developed andeven developing ones) this share is normally around 50%. Moreover, while it is truethat freely allocated credit is growing very fast, directed credit is actually falling,resulting in a much more modest increase in total credit. They observe that thecountry inevitably has somehow to make the transition from a lower to a higher levelof credit supply, even if this may be difficult and have a pro-cyclical aspect, thusrequiring monitoring.

From Table 2, it can also be noted that credit expansion by foreign banks wasparticularly large, this being primarily the case for BBV Bank, HSBC and Lloyds, allexhibiting growth rates of 60% or above. This tendency could be indicating thatforeign banks are gaining market shares, and that this was due to their higher levels ofefficiency. This has been an argument for promoting the internationalisation of thebanking system in Brazil. With a greater presence of foreign banks in the Brazilianmarket, it was expected that the banking industry would become more competitive,with more sophisticated methods of credit risk being adopted and the cost of credit,which is extremely high in Brazil, significantly falling.

The evidence so far shows that, in fact, foreign banks are relying on new mechanismsof credit risk assessment in their lending decisions, such as credit scoring andbehaviour scoring, 26and that these new mechanisms have indeed guided them in theirrecent move towards credit expansion.

26 See Gazeta Mercantil, 2001 ‘Bancos estrangeiros ja emprestam mais’, March 16-18, p. B-1, andinterview material.

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However, credit expansion by foreign banks has not been a reflection of morecompetitive credit loan rates. Data from the Central Bank, which has a website thatmonitors this information, shows that such rates are similarly high across banks –foreign and domestic -, for all types of credit (individual, corporate, etc). Moreover,research conducted by Brazilian academics show that foreign banks are adoptingsimilar operational practices to those of domestic banks and are relying mostly onpublic bonds to generate their financial revenues and profits.27Therefore, their higherrates of credit expansion are explained by their starting levels of credit supply, whichwere extremely low, rather than by the adoption of more modern and competitivestrategies to gain market shares (according to a view expressed from inside thegovernment Brazilian banks actually have better expertise in terms of market strategy,being better positioned to gain small customers, which offer enormous potential ofgrowth; foreign banks tend to adopt a ‘cherry picking’ strategy, i.e. lending to the bestcustomers). Further research seems urgently needed in this area.

In an implicit recognition that increasing competition in the banking system alone willnot be sufficient to reduce high credit costs in Brazil, the Central Bank is seeking toreduce bank spreads and therefore the costs of their credit supply through increasingtransparency in the system (e.g. it established a website to make information on banklending rates and fees available to the public), reducing minimum reserve depositrequirements and reducing the financial operation tax (IOF)28 for credits toindividuals (IMF, 2000).

27 See, for example, Carvalho (2001).28 IOF is a tax of exchange transactions that falls only on financial operations.

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c. The role of Federal Banks in directed credit provision

The recent expansion of credit in Brazil has not been translated into more credit to theSMES or to the poor, and there is no evidence that the pattern of freely allocatedcredit will change in the future. This is a historical pattern, in which commercialbanks have provided mostly short-term loans to large commercial activities (asopposed to long-term financing to the production sectors). Until now, federal publicbanks have tended to fulfil more the role of providing development finance, andtargeted more vulnerable sectors and customers.

The group of federal banks includes29: Banco do Brasil (BB), Caixa EconomicaFederal (CEF), Banco Nacional de Desenvolvimento Economico e Social (BNDES),Banco do Nordeste (BNB) and Banco da Amazonia (BASA). BB and CEF are thetwo largest banks in Brazil, with assets equivalent to 29% of the country’s totalbanking system assets. When BNDES is included, the share increases to 38%.

BB is a major lender to the agricultural sector, providing credit to small and largeproducers. The bank also provides financing to the export sector, through a specialmechanism called PROEX30. In addition, it allocates funds to support development inMid-Western Brazil.

CEF is a major mortgage provider, and also lends to sanitation projects. BNDES is adevelopment bank that lends to the production sectors. In addition, it supports exportactivities (through the provision of credit lines), as well as social programs.

BNB and BASA, though much smaller, with assets equivalent to only 2% of thecountry’s total banking system assets, still are regarded as key providers of regionallending, with BNB allocating funds for North-Eastern Brazil, and BASA for North-Western Brazil (these two regions comprise the poorest states in Brazil). They provideloans to small farmers, with the help of a network of agencies that stretches to theremotest areas of the country.

The government aims to reform the federal banks, and has opened a public debate todiscuss their future format. For that purpose, it has commissioned a study to serve as abasis for the debate. This study, which was carried out by a consortium formed by theconsultancies Booz-Allen & Hamilton and FIPE, 31 points to a number ofvulnerabilities in the system of federal banks. For example, according to it CEF doesnot comply with the Basle Accord capital adequacy rules, nor with the new loanprovisioning rules set by the Central Bank 32. More generally, the study questions thefinancial prospects of the 5 federal banks, by projecting low operational profits overthe period 2000-02, and negative operational profits thereafter.

29 The information that follows are taken from Booz-Allen & Hamilton-FIPE (2000) and IMF report.30 PROEX stands for Programa de Financiamento as Exportacoes.31 The study they conducted is ‘Instituicoes Financeiras Publicas Federais – Alternativas Para aReorientacao Estrategica; Audiencia Publica’, Booz-Allen & Hamilton-FIPE, 2000, and can be foundon the government website http://www.fazenda.gov.br/portugues/audienciapublica/apresenta.html.32 The loan loss provisioning rules were implemented last year by the Central Bank as a soft law; itmade loan provisioning required to public banks higher by changing the credit classification (interviewmaterial).

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The study proposes a range of alternatives for the future of these banks, fromretaining their commercial and developmental roles but improving their financialperformance, to privatising them with the state retreating entirely from itsdevelopmental role and thus being limited to regulating and supervising the financialsystem.

The study seems to represent the view of country’s policy-makers in the economicarea. It is clear from the conversations with them that they see the federal system offinancial institutions in need of ample restructuring. Their current structure andfunctioning are seen as complex, non-transparent and inefficient. Lack oftransparency and inefficiencies are seen to a large extent associated with their quasi-fiscal operations. Also, a Brazilian policy-maker expressed particular dissatisfactionwith the country’s directed credit system (most of which are managed by thesebanks), which he believes should be replaced by a more market-based approach.

More generally, the federal banking system is seen as a major area of vulnerabilitywithin the overall financial system, this allegedly being the reason why Brazilianauthorities have not yet agreed to undertake a FSAP33.

Some Brazilian academics question the quality of the Booz-Allen & Hamilton – FIPEstudy, which in their opinion has serious methodological weaknesses, in addition tolacking transparency in how results were generated, and they see with great concernthe government plans for the federal banks, though it is still not clear to them whatsuch plans exactly are.

They believe that there is at least two positions being defended by differentgovernment groups. The first position is to transform the public banks into agencies,in which form they would continue to have a developmental role, and the funding fortheir activities would come from the fiscal budget (the fiscal approach). The beliefunderscoring this option is that the private banks would not be able to enter the area ofdevelopment finance and social infrastructure due to market failures. The secondposition defends maintaining these institutions as banks, but taking away from themtheir commercial activities, thus turning them into specialised banks, devoted to thepoor.

These academics see problems with both positions. To them, the fiscal approachwould ‘spotlight the amount of subsidies being given, thus making it vulnerable tocuts’ (it was suggested external technical assistance to assess how much the poorwould be affected if this approach were adopted), while the proposal of taking awaythe commercial portfolio from these banks would dispossess the government of animportant instrument of economic and counter-cyclical policies.

At the same time, these academics recognise that the current system of federalfinancial institutions is not compatible with the Basle and the new loan lossprovisioning requirements. To the extent that the public banks start meeting theserequirements, they may stop lending to the poor. BB lending to small farmers wouldbe at risk, as would micro-credit lines of the development bank BNDES and the

33 This reason is also mentioned in an IMF report.

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regional bank BNB. This is seen as a cause of serious concern in view of the hugedevelopmental needs and levels of poverty incidence the country still exhibits, despiteits status of an emerging economy. This could be an area of concern for DFID, andcould be a field for technical assistance to help establish clearly the possible impact ofdifferent measures.

The problems just discussed make it evident that in the pursuit of meeting the Basleand other requirements, Brazil’s financial system will move towards an institutionalformat that supports financial stability and supposedly reduces the country’svulnerability to international financial instability, but that at the same time may lacksome basic instruments and mechanisms to promote growth and especially credit topoorer people and to SMEs.

The system, as it currently stands, is of course far from perfect. There are huge gapsin credit lending, a notable example being limited credit to small firms (specifically inthe area of micro-finance Brazil is far behind other countries, according to a WorldBank official). There have been a number of ‘ad-hoc’ initiatives to address thisproblem, with some degree of government involvement. One of these is the attempt toform a pool of institutions (involving the public banks BB and BNDES, plusSEBRAE34) to provide guarantee for credits to small enterprises, thus overcoming akey barrier to their access to bank credit. Another initiative, undertaken by FAPESP35,is to create funds to support small business innovation (the money being given in theform of grants rather than loans).

These initiatives are important, and external technical assistance might be welcome tosupport them. However, they are far from sufficient to meet a central problem ofBrazil’s financial system, which is the lack of long-term financing. Long-term foreignloans have been limited, and the public banks have been able to meet this financinggap only modestly, mainly through the BNDES.

In face of that and given that the current trend of the country’s financial system is toaggravate this problem, much of the focus today in Brazil is on the development ofthe country’s capital markets, a topic we discuss in the next section.

d. Promoting the Capital Markets in Brazil

Brazilians agree that national companies need the support of strong and deep capitalmarkets in order to be able to grow and compete internationally, especially in face ofthe inability of the country’s current banking system to provide them with sufficientlong-term financing. According to a study conducted by the BNDES, more than halfof the investments of Brazilian companies are self-financed, mostly from retainedprofits.36

The government’s crowding-out of domestic savings through the issuance of publicbonds is seen as having historically been a major deterrent to the supply of domestic

34 SEBRAE is a private entity aimed at promoting technical assistance and training.35 FAPESP stands for Fundo the Amparo a Pesquisa do Estado de Sao Paulo. It is a state governmentresearch funding agency.36 See Financial Times, 2001, ‘Drive for liquidity continues’, 19th March, Latin American Financesupplement.

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funds to private securities, especially equities. On the demand side, the more recentphenomenon of mergers and acquisitions in the country has implied the disappearanceof Brazilian companies and, as a consequence, the reduction of the trade volume inthe country’s equities markets. Similarly to other Latin American countries, the listingof Brazilian companies on foreign equity markets has further contributed to thisreduction. 37 By promoting fiscal balance the government believes the first problemwill be gradually solved, as more space will be left for private borrowers to raisecapital domestically, through debt and equity securities. In addition, the governmenthas simplified the administrative procedures for external portfolio flows38, so thatexternal capital can complement the domestic one in financing Brazilian companies.The second problem is to be tackled by creating an environment more favourable toequity financing, which can lead to the deepening and higher liquidity of the equitymarket in the country.

Creating this new environment implies removing a number of obstacles, such as theburden of financial transaction taxes on companies, an inefficient bankruptcy law, themalfunctioning of the judicial system, and inadequate corporate law and corporategovernance practices. These areas involve legislative reforms, so overhauling themrequires time and political will.

Various agents are coming forward with initiatives aimed at either fixing or gettingaround these problems. Among these agents are the government, the country’ssecurity commission (CVM)39, the country’s stock exchange (BOVESPA), theBrazilian Institute of Corporate Governance (IBGC) and the National Association ofInvestment Banks (ANBID). The efforts these agents are making include the creationof new codes of conduct for a better corporate governance, legislative reforms thathelp remove obstacles to the development of capital markets, and the creation of newmechanisms to attract new investors and companies to equity investment andfinancing.

The government is seeking to act on various fronts, pushing for changes and thustaking the lead in the process. It has started by informing and encouraging a publicdebate on corporate governance. Private sector representatives and academicsacknowledge that enormous progress has been made in the past year putting thecorporate governance issue in the spotlight. A concrete government initiative has beento submit to congress a new corporate law, which touches on a sensitive issue:minority shareholders’ rights.

Today, listed companies on Brazil’s stock exchange are allowed to issue non-votingpreferred shares equivalent to up to two-thirds of their total capital stock (Lang and

37 Trade volumes were by the first quarter of 2001 equivalent to half the level observed in 1997(Financial Times, 2001, ‘Drive for liquidity continues’, March 19, Latin American Financesupplement).38 This step was undertaken in the wake of the 1999 currency crisis to encourage external investment inthe country. The simplification consisted of the unification of the application form, which is now validfor both fixed and variable income. This form is sent by foreigners to the Brazilian SecuritiesCommission (CVM), which has 24 hours to accept it or not. It gives access to any kind of instrumentavailable to residents, with no exception (interview material).39 CVM is charged with regulating and supervising the securities markets and in particular the stockexchanges (together with the Central Bank), and specifically with monitoring and enforcing bestgovernance practices for public companies.

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Mendes, 2000). This means that shareholders that wish to have total control of acompany only need shares that represent 17% of the company’s capital stock. The billthe government has sent to congress proposes to reduce the two-thirds threshold downto 50%, so that it can attract potential investors that fear their interests will be under-represented by lack of voting rights.

Minority shareholder rights are a contested topic in Brazil, due to the predominance offamily-owned companies in the country (together with the big state-ownedcompanies). In the past, public companies40 listed on Brazil’s stock exchange haveopposed changes in the threshold for non-voting shares proposed by the CVM (Langand Mendes, 2000).

Today Brazil’s stock exchange is facing a particular difficult time. This is because ofloss of trade volume, due, as mentioned earlier, to the flight of companies to foreignstock exchanges, the disappearance of others through mergers and acquisitions, andlack of external flows to emerging equity markets, including Brazil’s. In response tothat, BOVESPA has launched the New Market41, which means a parallel equitymarket to the existing one, but governed by stricter corporate governance rules.42

Companies that join the New Market are required, among other things, to: issue onlyvoting shares; have a minimum free float equivalent to 25% of the company’s totalcapital stock; offer the same conditions obtained by the controlling share holders to allshareholders when selling the company; publish balances following the US GAAP orIAS 43 norms; and comply with an independent arbitration committee, established tosettle disputes among shareholders.44

Bovespa officials involved in the design and launch of the New Market have pointedto the lack of resources they face to carry out their work, and expressed great interestin external technical assistance, being open to suggestions about the modality of suchassistance.

The government has signalled intent to support the New Market. For that purpose, it isplanning to create financial incentives and investment rules that can result in capitalbeing allocated to equities. For example, it wants to allow companies’ specific debtinstruments (e.g. debentures) to be converted into stocks, and create investmentdiversification rules for pension funds, and within such rules to benefit thosecompanies that comply with the best standards of corporate governance.45

40 Public companies are those companies registered with the CVM with the purpose of being listed onthe stock exchanges, thus negotiating its securities there and thereby raising funds.41 The New Market was officially launched on 11th December 2000.42 For an interesting analysis of the prospects of the Brazilian New Market, see Financial Times, 27Februay 2001 ‘Brazil’s pitch for market credibility’.43 US GAAP stands for US Generally Accepted Accounting Principles, set by the US FinancialAccounting Standards Board (FASB), while IAS stands for International Accounting Standards, set bythe International Accounting Standards Committee (IASC), a private body formed by over 140professional accounting bodies from all over the world. A brief analysis of the differences between theUS GAAP and the IAS is provided by IASC, 2000 ‘SEC Concept Release: International AccountingStandards: Comments’, and can be found at http://www.iasc.org.uk/news/44 See Bovespa (2000) ‘Novo Mercado, Bovespa – Brasil’, Sao Paulo, and Merrill Lynch (2000) ‘BrazilLaunches The New Market’, Comment Brazil, 8th December.45 Interview material.

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A private consultant expressed a certain degree of scepticism as regards the chancesof the New Market to thrive. In her view, there are not enough incentives to attractcompanies to it. The alleged price incentive (i.e. investors would be willing to pay apremium to companies listed on the New Market46) does not appear sufficient orconvincing; fiscal incentives would be necessary to give the market a chance todevelop. But a key aspect is the degree of liquidity, seen as crucial to attract investors,especially those characterised by ‘short-cycles’. The timing is not seen as suitableeither. Like the German Neue Market, the idea is to attract technology-basedcompanies and start-ups, but equity markets in technology are bearish globally.

In parallel to Bovespa’s initiative to create the New Market through the establishmentof stricter corporate governance rules, the CVM is making efforts to improve itslegislation in the area of securities and move it towards international standards of bestpractice. According to experts on security markets, to this end it is nowadays workingclosely and exchanging experiences with IOSCO47.

The CVM has promoted important progress in various areas, one of these beingcustody, clearing and settlement. For example, it has required the stock exchange tohave an independent clearing and compensation agents.

Compliance with accounting standards is another key area under the CVMsupervision, in which progress has been noted. In the assessment of an ex-CVM topofficial, the country is moving towards complying with most of internationalaccounting standards (IAS). A private banker noted that an impressive number ofcompanies are trying to adopt the US GAAP, and this trend in improving accountingprocedures includes even those companies with a small presence in internationalcapital markets. This is seen as very good, given that this is a way of moving towardsdisclosure and improving the country’s capital markets. Another private sectorrepresentative was less enthusiastic about the progress being made. In his opinion, thelevel of transparency by companies is still not adequate, and is improving only inthose companies that use American Depository Receipts (ADRs).

However, our interviewees with close contacts with the CVM and its activities alertedto the problem of acute lack of human and financial resources the commission isfacing to carry out its tasks (‘they have 500 companies to supervise with a very smalltechnical staff’). This is seen as particularly true for those tasks carried out at theinternational level, such as negotiations with other countries, at FTAA and at IOSCO.This lack of resources has overloaded its staff and thus undermined their ability tonegotiate in international fora. Thus they see a great need for technical assistance inthat area.

Other bodies that have promoted corporate governance standards in the form of softlaws are the Brazilian Institute of Corporate Governance (IBGC), the National

46 The hypothesis that investors would be willing to pay a premium to companies that have bettergovernance has been tested positively by a study carried out by the World Bank with McKinsey,according to an interviewee.47 IOSCO stands for International Organisation of Securities Commissions, the institution charged withsetting standards of best practice in the area of securities regulation.

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Association of Investment Banks (ANBID), BOVESPA and the National Associationof Open Market Institutions (ANDIMA).48

Finally, it is important to mention that Brazil has a well-developed future markets,whose activities are conducted under the Bolsa de Mercadorias e Futuros (BM&F).BM&F offer a wide range of financial instruments, such as futures, options andswaps. Brazil’s financial institutions and non-financial corporate sector have relied onthese instruments to hedge against risks. Hedging was quite widespread in Brazil inthe wake of the 1999 currency crisis, a phenomenon that greatly helped avoid majordevaluation effects across the financial and corporate sectors, thus ensuring thestability of the whole financial system.

48 The IBGC published a ‘Code of Best Practices of Corporate Governance’ in 1999, with a focus onthe Board of Directors. In March 2001 it then launched a much broader Code, which includesrecommendations in the areas of minority rights, governing body, fiscal body and transparency.ANBID has launched a ‘Code of Self-regulation for Transactions of Public Placement and Distributionof Securities in Brazil’. The aim is to improve the level of disclosure; it requires disclosures on riskfactors, company’s business, analysis of financial statements, description of securities, etc. It is a softlaw applied to the institutions members of ANBID (Lang and Mendes, 1999). BOVESPA hasdeveloped the project ‘Bovespa-Empresas’ with the purpose of ‘improving the relationship betweencompanies and investors’, and ANDIMA has set an operational code for the open market.

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4. Areas for Foreign Technical Assistance (TA)

The provision of international technical assistance in Brazil could fulfil basically threeroles: i) supporting the country’s efforts to improve its regulatory and supervisoryframework for the financial system; ii) supporting mechanisms that can encouragemore financing, especially to the small and the poor; and iii) assessing the impact ofcompliance with C&S.

i) TA to support efforts to improve the country’s framework on regulation andsupervision of the financial system would be very welcome. The system isincreasingly requiring a higher degree of co-ordination between its regulatory bodies,given the gradual dissipation of frontiers between its different segments.

The Brazilian government is currently considering the creation of a unified regulatoryagency for pension funds, insurance and the capital markets.49 This new agency wouldimply merging some of the regulatory and supervisory activities currently carried outby BACEN with those by the CVM. This initiative is aimed, among other things, atbuilding the needed framework for the expansion of the capital markets in Brazil. It isstill not clear how to precisely shape this new agency. Some officials from BACENbelieve that institutional capacity is a problem, and that a critical mass should first becreated within the BACEN, implying that the merging would be only partial. TA fromthe UK would be particularly appropriate, given its recent experience with its newlycreated Financial Services Authority (FSA).

In addition, Central Bank officials indicated that TA would be welcome in such areasas offsite monitoring system for banking, particularly accountancy procedures, andthe capital markets. TA to the latter is needed to support their main regulatory agency,the CVM, in negotiations in international fora, which are carried out as part of theagency’s efforts to improve regulation and supervision and make them compatiblewith international norms. This need exists because CVM’ s international negotiations(with other countries, at FTAA and IOSCO) require specialised human resources,available at present only in small numbers.

ii) The second role for TA - of supporting new ways and mechanisms forencouraging more financing in Brazil, particularly to small businesses and the poor –could be pursued in the form of technical advice to initiatives such as the creation ofguarantees that can ensure the provision of credit lines to SMEs. TA would also bewelcome to support initiatives aimed at creating funds for small business innovation.

As pointed out above, long-term finance through the banking system has been limited,with a tendency to worsen rather than improve. In face of that, supporting efforts tostrengthen the capital markets become key. Bovespa officials have been trying topromote the New Market in Brazil, but are currently facing acute lack of resources tocarry out their work; they thus highly welcome TA and are open to suggestions aboutthe modality of such assistance.

49 See Gazeta Mercantil, 12/03/01, ‘Reestruturacao do setor financeiro em debate’, p. A-8.

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iii) The third role, of providing TA to assess the impact of C&S, could take the formof carefully conducted research, to specifically assess the impact of compliance withcertain C&S on the structure of the financial system, and on the most vulnerablesegments.

For example, the Brazilian authorities are encouraging their banks to prepare for theIRB approach proposed by Basle II, so that they will be better positioned to facecompetition from international banks entering the Brazilian market. This area mayrequire technical assistance, to assess the extent to which implementing IRB isfeasible and what implications it would have, in terms of the consolidation of thebanking system.

Meeting the Basle and the new loan loss provisioning requirements by public banks,which are the ones that provide credit to SMEs and the poor, may result in the end oflending to the poor. Technical assistance in the form of carefully conducted researchcould be provided to help establish clearly possible impact of different measures.

Finally, as discussed earlier there is also a proposal to transform the public banks intoagencies, in which form they would continue to have a developmental role, with thefunding for their activities coming from the fiscal budget (the fiscal approach). TAmight be helpful in assessing how much the poor would be affected if this approachwere adopted.

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Conclusions

This report shows that Brazil is making enormous progress in implementing C&S ofinternational best practice, covering a wide range of areas, from macro and financialpolicies’ transparency to corporate governance. Efforts to comply with C&S areultimately aimed at strengthening the country’s financial system and reduce thecountry’s vulnerability to international financial instability. In addition, they areaimed at helping develop the domestic capital markets that can in turn underpin astrong and dynamic private sector.

The report also reveals that Brazilians are acutely aware that efforts being carried outat the domestic level, though very important, are not sufficient to prevent the countryfrom being affected by an international financial crisis. This means that in order toreduce financial contagion, measures for crisis prevention should be implemented atthe international level as well. Moreover, if still a crisis occurs, crisis managementmeasures should be readily in place.

Brazilians of course would like to contribute to the design of international measuresfor crisis prevention and management, but actions by them to influence theinternational policy process are inhibited by lack of representation in the internationalfora. Brazilians have expressed discontent with that and claim for more developingcountry participation in the decision-making process that takes place in these fora.

Since the financial crises of the late 1990s, private capital flows to the emergingeconomies have become far less abundant. However, these countries still needexternal capital to finance their balance of payments and growth needs. ForBrazilians, this means that a new IFA should be devoted to ensuring internationalfinancial stability, but also to providing mechanisms to support development finance,an issue that remains key to middle-income countries. Paradoxically, whilst Braziliansstress the need of official finance to middle-income countries in normal times to helpthem tackle their urgent development needs, the country is currently pursuing reformsin its domestic financial system that are increasingly narrowing the scope for domesticmechanisms that can support development finance.

These reforms reflect to a large extent the country’s efforts to conform its financialsystem to international rules, like the Basle ones, which are aimed at ensuringfinancial stability. However, this is being done at the cost of reducing finance to thoseborrowers deemed as riskier, which tend to be the small and the poor. Reactions tonew international regulation that largely ignores these issues have been noticed insome quarters, such as the European Commission, and even among European banks,which are concerned with the cost of credit to small borrowers. But as yet there is notsuch concern being expressed by developing countries, on how these new rules mayundermine development finance schemes in their own countries.

Brazil is one of the few developing countries with such schemes still largely in place,but all its efforts so far have been towards meeting C&S whereby stability can besupposedly ensured, with the development dimension being entirely left apart. Thereis thus an important dimension missing in standards, which is the developmental role

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of a new financial system. Legislation should be modified to include developmentfinance as part of the objectives of a new financial system.

Brazilians welcome TA from the UK government, which they believe can be veryhelpful in complementing scarce domestic resources being assigned to this task.Indeed, the UK government is correct in seeking to actively contribute to a new IFAthat can ensure a more stable global financial system. However, it is also importantthat it can make sure these efforts are fully consistent with poverty reduction, a majorobjective of its department for international development. To this end, among otherinitiatives it could help design and implement compensatory actions, thereby ensuringthat meeting C&S can also have a developmental role and protect the poor.

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References

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BIS (2001) ‘Core Principles for Systemically Important Payments Systems’,Committee on Payment and Settlement Systems, January.

Booz-Allen & Hamilton-FIPE (2000) ‘Instituicoes Financeiras Publicas Federais –Alternativas Para a Reorientacao Estrategica; Audiencia Publica’, Booz-Allen &Hamilton-FIPE, at:http://www.fazenda.gov.br/portugues/audienciappublica/apresenta.html

Bovespa (2000) ‘Novo Mercado, Bovespa – Brasil’, Sao Paulo.

Carvalho, F. C. (2001) ‘The Recent Expansion of Foreign Banks in Brazil: FirstResults’, mimeo, Federal University of Rio de Janeiro.

Dixon, L. (2000) ‘Private sector involvement in debt workouts’, mimeo, Bank ofEngland, March.

Financial Times (2001) ‘Drive for liquidity continues’, March, 19th, Latin AmericanFinance Supplement.

_____, (2001) ‘Brazil’s pitch for market credibility’, February, 27th.

Gazeta Mercantil (2001) ‘Bancos estrangeiros ja emprestam mais’, March, 16th –18th,p. B-1.

_____, (2001) ‘Bancos estao prontos para SPB, diz Andima’, March, 16th –18th,p. B-2.

_____, (2001) ‘Restruturacao do setor financeiro em debate’, March, 12th , p. A-8.

Griffith-Jones, S. and Spratt, S. (2001) ‘Will the proposed new Basle Capital Accordhave a net negative effect on developing countries?’, IDS, mimeo.

IASC (2000) ‘SEC Concept Release: International Accounting Standards: Comments’, at:http://www.iasc.org.uk/news/

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