Capital markets and human capital

Agenda

• Latin America’s attempt to become financially “anglo-saxon”

• The difference between banks and capital markets

• Bonds vs. loans• Equity vs. debt• Privatizing social security

Going anglo-saxon

• Banks have difficulty dealing with risk– They fund themselves with deposits which should have a

fixed price and be liquid– Assets however have variable values– This creates the risk of bankruptcy in the intermediaries

• Latin America wanted safe banks but also risk finance• Solution: the anglo-saxon approach

– Relatively “narrow” banks and deep capital markets

How to get there?

• Privatize state enterprises to create a supply of securities

• Privatize social security in order to create a demand for securities

• Modernize capital market legislation to make markets more efficient

What happened?

• Public firms were privatized• Social security was privatized• Capital market legislation was modernized• But for the most part, the market did not develop• Pension funds invest mainly in government bonds• Many companies have been “de-listed”• Corporate bonds are very limited

Latin America: Stock market capitalization and trade volumes(as percent of GDP)

0

5

10

15

20

25

30

35

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

(as percent of GDP)

Market cap Trade volume (% of GDP)

The difference between banks and capital markets

• Depositors take the risk of the bank; the bank takes the risk of the lender

• Bondholders take the risk of bond-issuers• Banks gather information about their

borrowers that they keep “private”• Capital markets need to “broadcast”

information so that the public can assess the risk of the issuer

Implications• Broadcasting information is costly and the cost is

relatively fixed– This means that it is too expensive for small issues

• This cost has to be compared to the cost of bank intermediation– Unless you are very big, banks are cheaper

• You must reveal information that may be used by– Tax authorities– Competitors– Criminals

Loans vs. bonds• Loans can be tailor-made while bonds need to be

standardized• Loans need not be liquid; bonds must be

– Liquidity depends on how many identical bonds are in the market and how much they trade

– This creates another reason for bond issues to be large• Loans are easy to renegotiate if things change; bonds are very

difficult– The emerging market pendulum– Advantage (1970s)? Disadvantage (1980s)? Advantage (2000s)?

• Bonds need to be rated – Typically by two separate rating agencies– Again: fixed costs

Equity vs. debt• Debt involves a commitment to repay a given amount• It may involve collateral, i.e. assets that can be seized in case

of non-payment• Equity is a claim on the residual income after all other

claimants have been paid• Management can more easily erode the value of residual

claims– Executive pay, perks– Procurement– Spinning off new business ideas

• Majority shareholders can expropriate minority shareholders • If investors cannot trust that they will be treated fairly, they

will only buy the shares at a highly discounted price• …making everybody worse off

How to prevent all this from happening?

• Not easy• Requires rules on corporate governance• Rights of creditors and bankruptcy procedures• Rights of shareholders

– Appointment and removal of management and board of directors

– External audits– Authorization requirements– Protections of minority shareholders

• Information and disclosure requirements

And once you have done this…

• Companies may dislike the restrictions it imposes on them– Disclosing sensitive information– Limiting flexibility– Creating take-over threats– Generating greater administrative costs

• So they may prefer not to go public and those that have, to delist

Capital markets, venture capital and entrepreneurship

• In the US, angel capital firms invest in new business ideas and help set up or “incubate” new firms

• They make their money by selling to venture capital firms

• Venture capital firms invest in these small private companies in order to make them grow and sell them in the stock market through an Initial Public Offering (IPO)

Another Latin American tragedy

• Since going to the market is not an option…• …venture capital firms cannot recover their

investment and hence have not developed• …and angel capital firms don’t have whom to

sell to• This severely limits entrepreneurship and

makes it dependent on existing firms and families

Privatized pension funds

• Latin America converted government pay-as-you-go pension schemes (a la US and Europe) – Active workers pay a tax and retired workers get a pension– When today’s workers become tomorrow’s retiree’s

tomorrow’s workers will pay for them– This is vulnerable to demographic changes– …and to populism

• …into private individual capitalization pension funds

The original idea

• Each generation saves for its own retirement• Pension funds will be able to invest in the

capital market helping its development• Firms will open their capital and issue bonds

to tap into those savings• But it is not happening….

The current situation

• Except for Mexico and Chile, there has been very little capital market development

• Pension funds are full of government bonds and increasingly foreign assets

• At best, only the very large firms (telecoms, electricity) can use this source of savings

• No impact on entrepreneurship and new firms

New idea

• Recognize the advantage of loans over securities

• Recognize the problem with banks– They issue deposits which are part of the payment

system, have fixed price and have to be liquid making them potentially to go bankrupt

• Create a hybrid that has loans but is not a bank

The new idea

Banks Non-banks

Loans Current situation New idea

Securities Anglo-saxon model

Why a non-bank

• It issues shares, not deposits– These have a variable price and can be negotiated

• But it gives loans instead of buying bonds, making financing available to firms which should not issue bonds

• Pension funds could be allowed to invest in them• Managers should have an equity claim to make sure

they have the right incentives to collect on loans

A broader lesson

• Avner Greif’s view of institutions• Private institutions• A role for government• Coercion-constraining institutions• The specifics of government rules is jus the tip of the

iceberg• We are copying just the tip• No wonder it sinks

A. Growth diagnosticsProblem: Low levels of private investment and entrepreneurship

High cost of financeLow return to economic activity

Low social returns Low appropriability

government failures

market failures

poor geography

low human capital

bad infra-structure

micro risks: property rights,

corruption, taxes

macro risks: financial,

monetary, fiscal instability

information externalities:

“self-discovery”

coordination externalities

bad international finance

bad local finance

low domestic

saving

poor inter-

mediation

Assessing human capital market

Is it lack of human capital?Problem: Low levels of private investment and entrepreneurship

High cost of financeLow return to economic activity

Low social returns Low appropriability

government failures

market failures

poor geography

low human capital

bad infra-structure

micro risks: property rights,

corruption, taxes

macro risks: financial,

monetary, fiscal instability

information externalities:

“self-discovery”

coordination externalities

bad international finance

bad local finance

low domestic

saving

poor inter-

mediation

Is it lack of education?

• Low attainment levels of education• …but there have been large recent

improvements– If you relax the binding constraint you should

observe big effects• Very low returns to education• Skill premia low by regional standards

School attainment is low School attainment of in 1998

2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 GUA BRA SLV NIC

HON COL PRY CRI CHL VEN PAN ECU ARG URY

…but recent progress has been large

Years of schooling by age

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

1992

1998

2002

Ret

urn

s to

ed

uca

tio

n

Education at age 254.95732 13.0638

.084308

.136268

ARG

BRA

CHL

COL

CRI

ECUGUA

HON

NIC

PANPRY

SLV

URY

USA

VEN

…and education returns have been low

…and have been falling(men who were 25-30 years of age in 1992)

0

50

100

150

200

250

300

350

400

450

500

1992 2002

No education

Incomplete primaryComplete

primary

Incomplete HS

Completed HS

Higher education

Given endowments, social returns should be higher much higher in El Salvador

Figure 9: Cross Country ComparisonHuman Capital Markets: ( (hs/hu) / (h*s/h*u) )

-1

El Salvador

Bolivia

Uruguay

Panama

Peru

Chile

Mexico

Argentina

Venezuela

OECD

Ecuador

Colombia

Brazil

0.00 0.50 1.00 1.50 2.00 2.50 3.00

…but they are not

Measure of Distortions in Human Capital Markets:(wm

s/wmu) / (wns/wn

u)

Chile

Mexico

Panama

Peru

Colombia

Bolivia

Uruguay

Brazil

El Salvador

Ecuador

Venezuela

Argentina

0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60

Returns to Schooling

• The path-breaking studies of investments in human capital were pioneered by Jacob Mincer (1958,1962,1979) and Gary Becker (1964, 1975)

• This led to one of the most famous empirical applications, “The Mincer Equation” or the “Mincerian Earnings Function”

Mincer Earnings Equation

2

210)ln( EErSw

termerroranisandpotentialtypicallyeriencemarketlaboryearsisE

schoolingofyearscompletedisSwagehourlytypicallyearningsiswwhere

)(exp

)(

Why famous?The Mincer equation captures the empirical regularities:

1) earnings increase with schooling (note: this is a semi-log specification. Since the LHS is logged, the derivative with respect to S d ln(y)dS=(dYdS)*(1/Y)=r which is a percentage change, so r is a percentage change for a 1 unit change in S)

2) earnings are concave wrt experience (first increase then flatten)

This equation has been shown to fit the data remarkably

well across diverse countries -- even in countries with very different educational and economic systems. (I.e., it explains much of the variation in ln wages – good R-squares)

• Concerns about ability bias (I.e., return was not due to schooling but to unobserved factors correlated with schooling) has proven to be relatively minor according to Nobel Prizewinner Heckman

• Brazil, Lam and Schoeni (JPE)

Some advances

1) the original Mincer equation assumes that the return to experience does not vary by education (parallel log earnings experience profiles for different education groups). Can have interactions with education and experience.

2) the original Mincer equation assumes that the return to schooling is linear:

can substitute less parametric specifications, including:

piecewise linear spline single year dummies (must annualize returns)