Most countries in Latin America have adopted significant economic reforms over the past 15 years—opening their markets to trade and foreign investment, reducing government budget deficits, embracing more flexible currency regimes, and lowering inflation. Despite these reforms, the region’s financial systems remain small: altogether, its financial assets amount to just $3 trillion, compared, for example, with more than $5 trillion in China. What’s more, their value is only 133 percent of GDP, compared with 228 percent for emerging Asia¹ and 230 percent for China (Exhibit 1). Moreover, Latin America is largely cut off from the growing volume of capital now flowing around the world.

Latin America is diverse, and there are bright spots on the financial landscape. Chile has one of the region’s most developed financial systems, boasting a modern pension scheme and a sound equity market. Brazil has a dynamic equity market, and Mexico is quickly developing a market for long-term bonds and securities denominated in local currency.

Still, Latin America’s overall lack of financial depth has significant consequences for the economy. Although large companies can and do raise money in Europe and the United States, small and midsize ones have more restricted access to capital and pay more for it. In a recent McKinsey Quarterly survey, just 40 percent of business executives from Latin America said that their companies have good access to external financing, compared with 60 percent of executives from other emerging markets. Twice as many Latin American executives—31 percent—as executives from other countries report that insufficient funding for new investments will constrain the growth of their companies in the next three years.²

The situation may brighten. Since 2002 the region’s stock of financial assets has grown by 20 percent annually, up from just 5 percent from 1995 to 2002. Many countries have reduced inflation significantly and adopted more flexible exchange rate regimes—moves essential to maintaining macroeconomic stability. Foreign investors are starting to take notice, with foreign-capital inflows to Latin America’s stock markets and private-equity investments both up in 2005 and 2006. Is the region on the verge of a breakthrough? That depends on whether policy makers can continue to reduce public debt and to reform financial and legal systems.

Missing money

One way to assess the development of a financial system is its financial depth—the value of financial assets as a percentage of GDP. (For more on the global capital market, see Mapping the Global Capital Markets, Third Annual Report, published by the McKinsey Global Institute in January 2007, or the more comprehensive report $118 Trillion and Counting: Taking Stock of the World’s Capital Markets, February 2005. Both are available free of charge online.) For the most part, deeper financial markets are beneficial because they are more liquid, ease access to capital for borrowers, price assets more efficiently, and increase opportunities to share risk.

Latin America’s lack of financial depth is apparent across countries and asset classes alike. The comparison with emerging Asia is particularly striking, since the two regions have similar levels of GDP per capita and education. Chile’s financial sector (the deepest in Latin America) is equal to China’s—a country with a per capita income half that of Chile, and far below the better-developed Asian markets of Malaysia and South Korea. Brazil’s financial depth is on par with that of the Philippines, despite having twice the level of income per capita. Given the size of Mexico’s economy, that country’s financial depth is startlingly low, at 100 percent of GDP (and just 85 percent if international equity and debt issued by Mexican companies are excluded). Venezuela’s financial depth is less than 50 percent of GDP—the lowest of any country whose GDP exceeds $50 billion, and on par with the figures for most African countries.

Of course, Latin America’s financial depth has grown over time, from 40 percent in 1990 to 133 percent in 2005. Still, its depth has not grown faster than that of countries in emerging Asia, so the region is not catching up.

This low level of financial depth is an issue across the banking sector, the corporate-bond market, and equity markets. The assets of the banking system equal 32 percent of GDP in Latin America, compared with 75 percent in emerging Asia and 166 percent in China (Exhibit 2). Chile’s equity market, at 118 percent of GDP, is quite deep—more so than the equity markets of Japan or the eurozone. But the depth of Brazil’s equity market is just half that: 60 percent. Mexico’s equity market, at 31 percent of GDP, has only half the depth of Brazil’s.

Not surprisingly, Latin America’s companies use equity funding less than companies elsewhere do. In the McKinsey Global Institute (MGI) survey of business executives, just 14 percent of those from Latin America reported that their companies use equity to finance new investments, compared with 30 percent in India, 25 percent in China, and 22 percent in other emerging markets.

Latin America’s corporate-bond markets, averaging just 13 percent of GDP, are very small and shallow in every country. Chile’s is the deepest, but at 21 percent of GDP it has less than half the depth of South Korea’s or Malaysia’s. Latin America’s government bond markets, on the other hand, are quite deep, apart from those in Chile and Peru. Brazil’s and Argentina’s government bonds amount to 60 percent of GDP, deeper than the US market, at 47 percent. The Latin American average is 41 percent of GDP, putting the depth of government debt roughly on par with that of the eurozone and the United States and a third higher than that of emerging Asia.³

Ignored by global investors

Latin America is not participating as much as it should in the rapidly growing volume of capital whizzing across the world. In 2005 it received only $71 billion of foreign-capital inflows—about one-third of the amount that went to Eastern Europe or emerging Asia (Exhibit 3). As recently as 2001 foreign-capital flows to Latin America were more than twice the size of flows to Eastern Europe. In that year, however, Argentina defaulted on its government debt and devalued its currency, causing foreign investors to shun the region.

Over the past 15 years foreign direct investment has been the only consistently positive type of capital inflow to Latin America. Apart from a dip in the years after the Argentina default, it has held steady at around $60 billion annually since 1999. Net cross-border bank lending, in contrast, has been negative every year since 1999, reflecting the foreign banks’ lower loan exposure to the region and the efforts of its governments and companies to pay down their foreign debt. More worrisome, inflows of foreign capital to Latin America’s equity markets, though positive in most years, have amounted to just a few billion dollars annually for the majority of the past ten years. This has hindered the development of Latin America’s equity markets, at a high cost to the region.

Given the dearth of money from foreign portfolio investors, remittances from Latin America’s emigrants make up a large portion of capital inflows in many countries. Mexico has received the most: an average of $11 billion annually (38 percent of foreign investment) from 2000 to 2004. Across Central America, and even in larger countries such as Colombia, remittances can equal 30 percent or more of capital inflows. But remittances, a slow-growing source of foreign money, have increased at only half the rate of all cross-border capital flows since 1990 (4.8 percent and 10.7 percent, respectively), in line with rising GDP growth and immigration. Countries that rely heavily on remittances are missing out on a large and growing source of funding for their economies. Although remittances are a positive factor in Latin America’s balance of payments, they are no substitute for significant inflows of foreign equity investment to finance the growth of corporations and spur the development of the financial sector.

Low savings and high government debt

Why does the depth of the region’s financial systems remain so low? Findings from MGI’s research on Latin America and other parts of the world show that one important factor is a historically low rate of savings over the past 25 years. Since 1990, for example, emerging Asia’s gross savings rate has been 10 to 20 percentage points higher than Latin America’s (where household savings are also lower). The latter region’s average was 8.8 percent of disposable income over the past decade, compared with 10.4 percent in the Philippines, 25.6 percent in India, and 32.1 percent in China. As a result, a lower level of savings—the main source of the growth of financial systems anywhere—flows into the financial system. Even in China, one of the world’s largest recipients of foreign capital, the volume of domestic savings is many times greater in any year. Latin America’s persistently low savings rate has thus deprived financial markets of the capital to grow.

Compounding the problem is the fact that many Latin American investors and corporations lack confidence in domestic financial systems because of the region’s financial crises, high inflation, and macroeconomic volatility over the past several decades. These investors and corporations send part of their savings abroad or put the money in tangible assets like land, buildings, and commodities. While these assets are a rational choice, such investments divert savings from local banks and equity and bond markets, thus stunting their development. Indeed, the financial depth of Brazil grew rapidly after it ended hyperinflation through the 1994 Real Plan.

In many Latin American countries heavy government debt also dampens the financial system’s development. Although government debt has fallen throughout the region, it is still significantly larger, at 42 percent of GDP, than that of emerging Asia (30 percent) or Eastern Europe (27 percent). On the one hand, government debt contributes directly to financial depth by adding to the financial stock. On the other, it slows the growth of other components of that stock and exacerbates the savings problem by absorbing already low domestic savings that could otherwise go to companies through the financial system.

To finance government debt, banks often hold a large percentage of their assets in government bonds, reducing the amount of lending they can do. In Colombia and Venezuela, for instance, banks hold 26 percent and 23 percent,⁴ respectively, of their assets in government bonds, compared with less than 10 percent in Malaysia and none in the United States. The banks of other Latin American countries lend directly to governments. In Argentina, Brazil, and Mexico, for instance, more than half of all bank loans went to the public sector from 2001 to 2003, compared with less than 10 percent in China, Malaysia, or Thailand. In Chile just 1.5 percent of bank loans go the public sector.

Financing government spending, either through bond purchases or loans, offers banks low risk but, often, attractive returns. Although this course raises their profitability, it reduces their incentive to improve lending operations and adopt new credit-assessment and risk-management skills. Diverting assets to government bonds also reduces the volume of loans to the corporate sector, the driver of economic growth. Academic research has found that banks with higher levels of public-sector lending are more profitable but significantly less efficient than banks that lend to private borrowers.⁵

In addition, excessive government debt raises interest rates for all borrowers. Since 1997 Brazil has paid an average of 11.9 percent on its government debt, more than 7 percentage points higher than the average in the United States over the same period. Over the past ten years Latin America’s governments have paid, on average, 2 percent more for government debt than governments in East Asia did. Corporations, which carry greater risk, must then issue debt at an even higher rate. This problem limits the amount of debt they issue, thus making the financial system less deep. Although higher interest rates may be attracting more savers to the financial sector, they are still wary because of the macroeconomic volatility in the region over the past several decades.

Small companies get hurt

Because the financial markets of Latin America are shallow, its governments and largest companies raise a substantial part of their funding in the United States and other international markets. Over the past ten years these borrowers have relied on international debt issues at nearly twice the rate of their Asian counterparts. Latin America’s companies are also more likely than Asian ones to list equity shares on foreign stock markets. As a result the number of companies listed on Latin America’s domestic stock markets has actually declined by 8 percent, from 1,403 in 1995 to 1,291 in 2005, while in emerging Asia it increased by 33 percent, to 2,802, from 2,105.

Overall, the funding available to Latin America’s private sector is very low. The value of outstanding corporate loans and bonds amounts to just 34 percent of GDP, compared with 95 percent in emerging Asia (Exhibit 4). Excluding Chile, which has Latin America’s deepest financial market, credit to the private sector amounts to just 24 percent of GDP. This lack of funding particularly hurts small and midsize companies, which are not large enough to raise capital abroad.

Companies in Latin America thus rely heavily on credit from suppliers and on retained earnings—both limited sources of financing—to provide working capital and investment funds. In MGI’s survey of business executives, 43 percent of the Latin American respondents report that their companies rely on credit from suppliers, compared with 27 percent of the respondents overall. Some 83 percent of the respondents from the region also say that more than half of the funds for their companies’ new investments come from retained earnings, compared with 66 percent of the respondents overall. This dearth of external funding constrains the growth of many companies in Latin America.

On the verge of a breakthrough?

Over the past few years Latin America’s financial markets have been looking up. The stock of financial assets has nearly doubled, increasing from $1.7 trillion in 2002 to more than $3 trillion in 2005 (Exhibit 5). The capitalization of equity markets has increased even more, and the region’s financial markets have outperformed those of the emerging world as a whole by 40 percent. Nearly all of this increase has resulted from the earnings growth of companies. Both Brazil and Mexico are seeing more initial public offerings. Corporate-bond markets, though small, have increased by 50 percent since 2002. The banking sector’s assets grew by 60 percent over that period.

International investors have taken notice, putting an additional $12 billion of new money into Latin America’s equity markets in 2005 and even more in 2006, according to projections.⁶ Private-equity and venture capital firms have also returned to the region, investing more than $1.5 billion there during the first half of 2006, compared with $600 million in all of 2004. Although this level is still far below the 1998 peak of $5 billion, the upward trend is encouraging.

Not surprisingly, Latin America’s real GDP growth has also reached new highs recently, averaging 5.1 percent from 2003 to 2005, compared with just 1.8 percent from 1995 to 2002. Gross domestic savings rose as well, to 21.7 percent over the past three years, from 19.8 percent in 1995 to 2002. These developments fueled a financial deepening as more savings went into financial assets.

The positive trend, though clear, must be sustained for several more years to restore confidence. After all, the region’s financial markets have endured a steady stream of setbacks, from the debt crisis of the 1980s to Mexico’s financial crisis in 1994 to Brazil’s financial turmoil in 1998 to, most recently, Argentina’s 2001 default and devaluation. Not surprisingly, 17 percent of business executives from Latin America in the Quarterly survey believe that a domestic financial crisis will constrain the growth of their companies during the next three years, compared with 7 percent of all respondents.

Nevertheless, there are several reasons to believe that current growth trends will persist. The first is the rapid increase of private-pension assets in many countries, including Argentina, Colombia, and Mexico. In Chile as in other emerging markets, pension reform was critical to the development of financial markets because it generates a class of domestic institutional investors with a long-term perspective and creates a larger pool of assets for investment than a “pay-as-you-go” system does. The assets of mutual funds and insurance companies are growing as well. Given the relatively young populations of Latin American countries, assets will continue to accumulate for years to come. This trend bodes well for the deepening of the financial system.

In addition, most countries in the region have reduced inflation significantly and adopted more flexible exchange rates—both essential to maintaining macroeconomic stability.

Sustaining the momentum

To ensure that the current trend continues, policy makers must build on the macroeconomic reforms of the past few years. The first imperative is to go on reducing the size of government debt. Most Latin American countries have already made progress in replacing foreign-currency debt with domestic issues, thereby reducing the currency mismatch that increases the risk of financial crises, but more must be done to reduce public spending and the drain on savings. The second imperative is to increase the independence of central banks. While Chile and Mexico have made notable progress in this area, other countries lag behind. An independent central bank is necessary to restore investor confidence and to signal a commitment to controlling inflation.

Additional financial reforms are needed as well, according to the Quarterly survey of business executives. Among the measures executives in Latin America wish to see, stock market reform is the highest priority, followed by further improvements in pension systems and better corporate-bond markets. Reducing the cost of issuing equities and bonds on domestic markets is critical.

Finally, most of Latin America’s economies would benefit from the strengthening of legal protections for creditors and from expediting bankruptcy proceedings. Although the region has liberalized its financial systems over the past 15 years, protections for investors and the enforcement of contracts are less effective than those in the United States and high-performing emerging markets. According to the World Bank’s Doing Business survey, for example, enforcing a debt contract takes an average of 587 days in Latin America and costs more than 20 percent of the debt’s value, compared with 230 days and 5.5 percent in South Korea. Results from the Quarterly survey show that 39 percent of business leaders view ineffective bankruptcy laws or inefficient courts as a barrier to the development of financial systems.

Financial and legal reforms not only improve the operations of a financial system but also attract more savings to it. As Latin America’s growth picks up, mobilizing savings will be essential. Mexico’s current experiments with banking outlets in retail stores may be one way of achieving this goal. Cutting back the size of the economy’s informal sector will also be important to increase savings: as more workers join the formal economy, they will have greater access to banks and increase their contributions to pension funds. And reining in inflation and maintaining macroeconomic stability will help reduce capital flight.