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chapter 6 Financial Sector Development: Equity and Private Debt Markets1

Author(s):
Dominique Desruelle, and Alfred Schipke
Published Date:
November 2008
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Hemant Shah,, Ana Carvajal,, Geoffrey Bannister,, Jorɠe Chan Lau, and Ivan Guerra 

Introduction

Banks and their affiliates dominate the financial system. While growing rapidly, financial intermediation in Central America continues to take place mainly through the banking sector. Assets in the banking system are significantly larger (80 percent of regional GDP) than those of the pension funds, insurers, and mutual funds (9 percent). Bank lending to the private sector (ranging from 19 to 82 percent of GDP across countries, and 42 percent of the region) significantly outstrips equity and bond financing provided by capital markets (12 and 6 percent of GDP, respectively (Table 6.1)). Until recently, the banking system has been dominated by regional financial conglomerates. With the recent acquisitions of several major regional banks,2 global financial institutions have acquired an important market share and regional presence.

Table 6.1.Financial System(At end of 2006)
Costa RicaDominican

Republic
El SalvadorGuatemalaHondurasNicaraguaPanamaTotal
Number of
Commercial banks1713122316787175
Insurance companies132171814518105
Mutual funds12848n.a.n.a.n.a.23163
Pension funds2472n.a.6n.a.241
Stock exchanges1112n.a.n.a.16
Stock brokers201013218634112
Size (in percent of GDP)
Commercial banks:
Total assets57.233.264.138.690.857.4221.180.4
Claims on private sector39.319.043.526.847.633.281.741.6
Total deposits13.220.641.728.756.74 1.1155.05 1.0
Assets under management:
Insurance companies2.01.33.31.84.91.9
Mutual funds17.32.92.91.5
Pension funds7.02.118.519.20.45.4
Equity market capitalization8.641.439.811.8
Corporate debt outstanding23.30.64.40.40.00.412.16.0
Memorandum:
Annual CPI inflation (percent)11.57.64.66.65.69.42.5
Deposit interest rate (percent)9.89.84.44.59.34.93.8
Gross domestic product (US$ million)21,38431,60018,65435,3048,9815,36917,113138,405
Total public debt (US$ million)10,01112,8926,6378,7373,5118,04610,45260,285
of which: central government7,4058,3796,1876,6133,3695,76010,45248,166
of which: central bank2,6064,5134502,1231422,28612,120
of which: eurobonds/external issuance2,4057,2663,2903,9573,0214,5277,78832,254
Sources: Country authorities; IMFstaff; IMF, International Financial Statistics; central banks; ministries of finance; country regulators; and local stock exchanges.

For El Salvador, the figure refers to administradoras de cartera which are not technically mutual funds.

Sources: Country authorities; IMFstaff; IMF, International Financial Statistics; central banks; ministries of finance; country regulators; and local stock exchanges.

For El Salvador, the figure refers to administradoras de cartera which are not technically mutual funds.

The underdevelopment of capital markets reflects a common pattern among developing countries and certain business characteristics in Central America that suppress securities issuance. It is commonplace in small and developing countries for banks to dominate financial intermediation, and for capital markets to develop later and more slowly. But the current state of underdevelopment of the Central American securities markets also reflects the small size of most regional businesses, the dominance of family-owned businesses and conglomerates, and gaps in corporate governance and disclosure within the region. These conditions generate informational asymmetries that may justify the observable preferences in corporate financing. Bank financing is preferred by a wide margin, as banks may have advantages in monitoring the use of funds by borrowers.3 The regional conglomerates also prefer financing through the “house” bank rather than from the market for reasons of corporate control. Corporate debt issuance ranks a distant second and equity financing ranks last, in concordance with standard corporate finance theory (Myers, 1984). Moreover, a good part of the current very limited equity issuance is also driven by regulation and overstates the true preference for equity funding. For example, in case of banks in El Salvador, equity listings are mandatory. Equity shares, however, are usually placed with conglomerate shareholders and seldom change hands.

In addition to limited corporate financing through the capital markets, there is little use of asset-backed securitization in the region. Except for Panama and Costa Rica, there has been no meaningful onshore securitization of assets in the region. This reflects the relatively liquid state of many of the region’s banking systems, gaps in the facilitating regulatory and tax framework, and insufficient standardization of underlying assets, particularly mortgages.

The underdevelopment of institutional investors inhibits long-term demand for securities and capital market development. In developed—and increasingly in emerging—markets, insurers, mutual funds, and pension funds are the major and natural investors in tradable securities. In Central America, for a variety of reasons, these investors are as yet poorly developed. With an aggregate resource envelope of barely 9 percent of regional GDP, they lack the resources to contribute meaningfully to demand for capital market securities and thus to capital market development.

Lack of confidence in the enforcement and real value of financial contracts are major constraints on retail demand. There have been several episodes of financial distress in the region, including bank failures (e.g., in the Dominican Republic, Honduras, Guatemala, and Nicaragua); the mutual fund crisis in Costa Rica; and sovereign debt problems in Nicaragua and the Dominican Republic. The region has also experienced significant political strife. These factors have generally weakened confidence in regional currencies and regional financial securities. Most countries face problems with the execution of collateral and lack effective out-of-court settlements. Judicial proceedings are often lengthy, unpredictable, and biased, with overburdened courts that lack specialized judges. In addition, bankruptcy laws are outdated and need to be modernized.

The low number and volume of issuances also reduce possibilities of meaningful diversification for regional retail investors. At the same time, even small investors are generally aware of and able to access investment opportunities abroad. The resulting weaknesses in the retail demand for regional private securities can be overcome only gradually through improved confidence in the financial system, better supervision and disclosure, and an increased supply of investable securities. This chapter takes stock of the development of both the equity and private debt markets, identifies obstacles, and makes recommendations of how to improve the functioning of these markets.

Regulation and Supervision of Securities Markets

Basic Legal and Regulatory Framework for Securities Markets

Securities regulation needs to be developed in several key areas and in most countries. The laws relating to securities markets are still being promulgated, completed, or modernized in several countries. There are significant shortcomings in several areas, including corporate governance for listed companies, powers of the regulator, division of oversight between the regulator and the exchanges, and the regulators’ ability to cooperate with other jurisdictions. In addition, many countries need to introduce or develop the legal framework for newer topics or products. The more important gaps include asset-backed securities (ABS) (in El Salvador, Guatemala, and, to some, extent the Dominican Republic and Honduras) and mutual funds (El Salvador and Guatemala) (Table 6.2). Enabling regulations in many areas remain to be introduced. Guatemala and Nicaragua have the farthest to go to complete the basic legal framework for securities. The former has yet to pass a modern basic securities market law, and the latter just approved a new securities law in 2006, but has yet to enact all the regulations necessary for its implementation.

Table 6.2.Securities Markets: Basic Legal and Regulatory Framework
Costa RicaDominican RepublicEl SalvadorGuatemalaHondurasNicaraguaPanama
Regulator
Legal frameworkYesYesYesNo, it is only a registryYesYesYes
Corporate governance
Legal frameworkVery basicVery basicVery basicVery basicVery basicVery basicVery basic
Code of corporate governance for listed companiesYesNoNoNoYesNoYes
Mutual funds
Legal frameworkYesYesNo1No2YesYesYes
Complimentary regulationsYesYesNoNoYesNoYes
Private pension funds
Legal frameworkYesYesYesnaYes, but only for public pensionsYes, but not implementedYes
Complimentary regulationsYesYesYesnaYesNoYes
Asset-backed securities
Legal frameworkYesYes, but limitedNoNoYes, but limitedYesYes
Complimentary regulationsYesNoNoNoYesNoNo3
Trust
Legal frameworkYesNoYesYesYesNoYes
Sources: Country authorities and IMF staff.

Brokerage houses administer carteras de inversión; which are poorly re gulated quasi-mutual funds.

The legal framework includes sociedades de inversion; which are poorly regulated quasi-mutual funds.

Participants do not consider it an impediment.

Sources: Country authorities and IMF staff.

Brokerage houses administer carteras de inversión; which are poorly re gulated quasi-mutual funds.

The legal framework includes sociedades de inversion; which are poorly regulated quasi-mutual funds.

Participants do not consider it an impediment.

The process for authorization of securities issuance needs to be improved and streamlined throughout the region. Approval by regulators for issuance tends to concentrate on the more formal requirements and less on material issues that can affect transparency and the value of the securities. In terms of timeliness of approval, regulators frequently do not provide comments all at once. Market participants also complain of inconsistent responses across time and over similar issues. The gaps in coordination between the regulator and the exchange in the process of authorization and listing also lead to unnecessary delays. Thus, the authorization process ends up being protracted (often six months or more), costly, and uncertain, creating an incentive in favor of bank loans rather than securities issuance.

Some regulators have taken measures to alleviate these problems. Useful approaches include establishing deadlines for all comments (Costa Rica) and for the authorization of an issue (Costa Rica, El Salvador, and Panama) and establishing fast track approval (basically a “shelf” registration regime) for certain types of bond issues (Costa Rica, and Panama for commercial paper).

Structure of Securities Regulators

The nature and structure of securities regulators vary across the region. Costa Rica, the Dominican Republic, El Salvador, and Panama have specialized regulators for securities markets.4 In Honduras and Nicaragua, securities regulators are housed within a regulatory unit that oversees the whole financial sector. Guatemala does not have a securities regulator, only a securities registry. Five of the regulators have a governing board and a superintendent in charge of day-to-day operations, while Panama has only a board, with no separate managerial figure (Table 6.A1).

Regional securities regulators enjoy only limited independence and self-funding. In most countries (with the exception of Honduras and Panama), the minister of finance and/or the governor/president of the central bank are represented in the governing board of the regulatory agencies; moreover, in the cases of Costa Rica and Nicaragua, they themselves are members of the board.5 Although not un-common internationally, such representation could reduce the independence of the regulator. Most regulators are also largely dependent on public funding either through the ministry of finance (Guatemala, El Salvador, Honduras, and Panama) or the central bank (Costa Rica, the Dominican Republic, and Nicaragua). Levies on market participants provide only a fraction of the regulator’s budget, with the public sources accounting for 75–100 percent of the funding in Guatemala, El Salvador, Costa Rica, and Nicaragua. In the Dominican Republic, the regulator is almost entirely financed by a special fund established by the central bank. Such dependence on public funding tends to restrict independence of securities regulators, especially relative to bank regulators that tend to be better funded from market levies.

Securities regulators are also restricted by the application of civil service rules. In Guatemala, Honduras, and Panama, securities regulators are constrained to varying extents by regulations governing staffing and salaries, which limit their ability to hire qualified personnel, because private sector salaries tend to be significantly higher. In El Salvador, the budget of the securities regulator and personnel contracts are subject to approval of the ministry of finance. Regulators in Costa Rica and the Dominican Republic enjoy the highest level of autonomy within the region.

Authority, Staffing, Budget, and Quality of Enforcement

The regulator’s authority varies considerably across the region. Several regulators face limitations on their legal authority to regulate and supervise securities markets. The most critical case is that of Guatemala, where the registrar has no material powers to regulate, supervise, or enforce. In Honduras and Nicaragua, regulators believe the law provides them with sufficient powers, but these are so far untested. In other countries, there are important limitations on the powers of regulation and supervision. Common areas of weaknesses include (1) the disciplinary framework for regulators (e.g., in Costa Rica, the Dominican Republic, El Salvador, and Panama), where there is a need to better define civil and criminal misconduct, manipulation of markets, and insider trading and widen the range of sanctions; and (2) the power to share confidential information and cooperate with foreign regulators (Panama, the Dominican Republic, and Costa Rica), which can affect regional integration efforts. Some of the regulators have limited powers over rating agencies and external auditors. In both cases, international best practices have experienced considerable changes in recent years.

The staff size and budgets of securities regulators also vary considerably. In terms of resources, it is possible to identify three tiers: (1) Guatemala, Honduras, and Nicaragua, with a staff of fewer than 10; (2) El Salvador and Panama, with a staff of around 40 and a budget of about US$1.5 million; and (3) Costa Rica and the Dominican Republic, with personnel in the hundreds and budgets of about US$4 million.

The quality of supervision and enforcement varies, given the level of market development, authority, supervisory capacity, and resource constraints. There is little supervision of securities intermediaries, stock exchanges, and issuers in Guatemala, where the registrar fulfills only “registry” functions. In Honduras and Nicaragua, supervision is very limited due to resource and capacity constraints, although the securities markets are also relatively underdeveloped. Panama faces a special challenge due to the limited resources available compared with the development of the market. Costa Rica appears to have been able to set up reasonable supervisory programs using a risk-based approach. Enforcement appears to be weak in the whole region, because of limitations in the legal framework (as explained above) and also because of a culture of weak enforcement.

Securities exchanges have been given some self-regulatory powers in most countries. In the case of Nicaragua, the new securities law approved in 2006 provides this role to the exchange. However, in other cases, the division of responsibilities between the regulator and the exchange is unclear, the laws are too broad, and the regulators have yet to establish more specific memoranda of understanding delineating the role of the securities exchanges. In El Salvador, the self-regulatory powers of the exchange are not well defined in the current legal framework. Exchanges have also been weak in the exercise of their self-regulatory powers, particularly in the areas of supervision and enforcement, with Costa Rica and to a lesser extent Panama ahead of their regional peers.

Market Infrastructure

Securities Exchanges

Securities exchanges exist in all seven countries. Guatemala has two exchanges, and all the others have one (Table 6.A2). In almost all the countries only the securities exchanges are authorized to operate trading systems. The majority of securities exchanges are mutualized corporations, except in El Salvador, Nicaragua and Panama, where they are demutualized. In the cases of El Salvador and Panama, the exchanges are themselves listed. All exchanges have electronic, automated systems, with the exception of Honduras. Only two countries (Costa Rica and Panama) have continuous trading systems for the secondary market. Trading systems for secondary markets are all order driven and there are no market makers. The Costa Rica exchange has a pilot project for market makers in the equity market. Only two listed companies have volunteered for the program so far, and a market maker is appointed for one, making it still early to assess its impact.

Regional securities exchanges have enjoyed some unusual privileges, in an effort to promote the development of the securities market. For example, primary public debt issuance is restricted to the securities exchange in several countries.6 Moreover, in some countries, it is mandatory to conduct all secondary market transactions of publicly offered securities (Costa Rica) and all repo transactions (Costa Rica, Guatemala, and Nicaragua) through the respective exchanges. At the same time, secondary market transactions in listed equity and corporate debt are not always required to be routed through the exchanges (Panama, Honduras).

Clearing, Settlement, and Depository Services

Clearing and settlement processes have several weaknesses and are not uniform across the region. Almost all the countries have deficiencies in the legal frame-work for clearing and settlement, mainly in the recognition of the concepts of netting, novation, irrevocability, and finality. All these legal issues have been addressed in a regional treaty on payments that was developed with the support of the Consejo Monetario Centroamericano. All countries have already signed it and it is currently in the process of legislative ratification. Settlement cycles differ across the region (Table 6.A3).7 Clearance and settlement arrangements vary: Costa Rica does multilateral netting, while El Salvador and Panama do netting for the cash side, and the securities side is settled on a gross basis.

Risk management practices in clearing and settlement also vary. Guatemala and Honduras have no formal risk management mechanisms. In all the other countries, there are some risk management mechanisms, with Costa Rica and Panama being more advanced. Risks from the securities leg are managed through pre-deposit (El Salvador, the Dominican Republic, and Panama) or blocking of securities after trade and lending facilities (Costa Rica). Risks from the cash leg are managed through preapproved debt limits in a bank account (El Salvador and Panama) or a settlement fund (Costa Rica). Only in Costa Rica and El Salvador does settlement occur in central bank money. Delivery versus payment (DVP) is far from common in the region, with only Costa Rica and Panama achieving DVP. There is a need to strengthen legal and operational aspects of depository and custodial arrangements (see Brenner, 2006, pp. 183–85). In general, the legal framework lacks specific provisions clarifying the role of the depository and custodial institutions, except in Costa Rica, El Salvador, and Panama, and oversight of the depository and custodial arrangements by the regulator has been weak. Dematerialization is required only in El Salvador; however, in Nicaragua it is mandatory for listing, and immobilization of securities (the holding of material securities within a depository institution) is required for trading in Costa Rica and Panama.

In practice, most new issuances of private securities in the region have been dematerialized; however, in some countries (Panama) investors can sub-sequently request the paper securities from the issuer, reversing the benefits of dematerialization.

Custodial infrastructure for corporate securities is underdeveloped and insufficiently centralized. Public debt accounts for the lion’s share of capital markets and is often not issued in dematerialized or standardized form, with depository functions being performed by the central bank or a public sector bank. Coupled with the very small issuance of private securities, this creates a poor environment for the development and economic viability of central depository agencies. Honduras has no centralized securities depository (CSD); in the few private issuances that were dematerialized, the issuers carry their own books. In Costa Rica, the Dominican Republic, El Salvador, and Panama, CSD functions are provided by a separate legal corporation, owned by the securities exchange (except Panama where it is owned separately). In Guatemala and Nicaragua, custodial services are performed by a department of the securities exchange. Despite small domestic capital markets, participants do not always agree on a single CSD. In Costa Rica, the central bank is considering an amendment to the legal framework to allow it to provide CSD services for corporate securities, and in the Dominican Republic, Banco de Reserva and CEVALDOM have been competing in provision of CSD services and are currently involved in protracted negotiations about centralizing them.

Regional CSDs are undercapitalized, in need of technical improvements, and have insufficient links to other CSDs. Many investors, particularly foreign ones, regard regional CSDs as undercapitalized and in need of technological improvements. Currently, CEVALDOM (the Dominican Republic) and Latin Clear (Panama) are pursuing alliances with external partners to improve their technological infrastructure and capital base. The central securities depositories of Costa Rica, El Salvador, and Panama have signed sub-custody arrangements with each other, which facilitates cross-country custody.

Rating Agencies and Price Vendors

Rating agencies have a presence throughout the region, except Nicaragua (see Table 6.A3). None of the nationally recognized rating agencies from the United States has a direct presence, but several local rating agencies are affiliated with Fitch Ratings. Rating agencies are subject to a licensing requirement and thus supervision by the securities regulator in all countries except Guatemala, which has no regulator, and Panama, where the securities regulator can only register a rating agency, with no powers to supervise or sanction. In many countries, the legal framework requires rating by a local company. Given the relatively low demand for rating services in the region, it would be natural for agencies to want to operate regionally, without establishing a physical presence in each country.

The region has a major problem of illiquid securities and insufficiently developed price vendors. As discussed below, the regional capital markets are illiquid, particularly in private securities. Illiquidity creates important problems of valuation of security portfolios, especially for mutual and pension funds and other investors who must mark to market their portfolios. Only Costa Rica and Panama—two countries with regionally more developed mutual and pension funds—have begun to address these issues. In Costa Rica, the regulators have developed common regulations for the valuation of pension funds, mutual funds, and the trading portfolio of banks. Regulations do not prescribe a single methodology for the whole financial sector, merely that all members of a financial group use the same methodology to value their portfolios.8 In Panama, the securities exchange is working with Balmer, a Mexican price vendor, to develop a methodology for price valuation. Accurate pricing of illiquid securities is a major problem and would have to be tackled urgently, as deposit-taking activities of loosely regulated investment managers are converted into mutual funds (e.g., in El Salvador and Guatemala—see note 4) and as defined contribution pension plans grow. In June 2007, Proveedora Integral de Precios de Centroamericana (PIPCA), a price vendor with Mexican/Costa Rican capital, announced that it will start providing prices to investors in Costa Rica, Panama, and El Salvador.

Business Environment and the Framework for Public Issuance

Basic business conditions represent a major long-term challenge to improving securities markets in the region. The regional scores on basic business conditions (Table 6.A4) are generally low.9 For 2006, out of 175 countries, El Salvador received the highest score in Central America (ranked 71), and Guatemala the lowest (ranked 118). The region scores even lower in terms of protecting investors (countries ranking from 83 to 156) and enforcing contracts (49–164). For development of securities markets, the quality of accounting and auditing, the adequacy of commercial and corporate law, ability to create and enforce collateral, efficiency of the bankruptcy framework, and more generally the requirements to set up corporations are particularly relevant. Our analysis below does not look at these issues in any detail, but it is consistent with the generally weak ranking of the region on these aspects by the World Bank and other studies.

Accounting Standards, Auditing, and Transparency

Unlisted companies are not required to use international financial reporting standards (IFRS) in the majority of the countries. Guatemala, Honduras, and Nicaragua use local generally accepted accounting principles (GAAP), although in Honduras, IFRS will become mandatory in January 2008. In El Salvador, aversion of IFRS as of 2003 is applicable. Thus, only in Costa Rica, the Dominican Republic, and Panama are unlisted companies required to use IFRS. However, even in these countries, implementation remains a challenge because of the lack of familiarity with IFRS.

Qualifications for auditors are generally low. Several of the top global auditing firms are present in the region. Although these firms employ high international standards in conduct of their work, the minimum requirements for being licensed to work as an auditor are generally low, and limited to basic (not professional) academic degrees. None of the countries requires professional examinations. Continuous education is not mandatory, and efforts to implement such requirements have been rejected in some countries.10 Oversight of the audit profession is very limited. Regulators in several countries do require higher standards for auditors authorized to audit regulated financial institutions and listed companies. As a general rule, the level of transparency is low for unlisted companies. Companies without a public issuance are not required to make their financial statements available to the public. Thus, even for corporate businesses, public issuance involves a major change in the degree of transparency and disclosure that they are used to. In three countries (El Salvador, the Dominican Republic, and Panama), companies are required to audit and file their financial statements with a public entity; but they are not available to the public.11 In Guatemala, legislation introduced in 2004 sought to impose audits on large taxpayers but the provision was suspended by the supreme court.

Corporate and Commercial Laws, Collateral, and Bankruptcy

Requirements for registration of a corporation are not a major problem. There is room for streamlining, but this does not appear to be a critical constraint vis-à-vis other issues relating to basic business conditions. In particular, in the cases of Costa Rica and the Dominican Republic the average time required for registration is far longer than in the rest of the region. Panama and El Salvador have made significant progress in facilitating business formation, and Panama now has the most efficient process in Latin America. Honduras has also made important progress owing to the outsourcing of the corporate registry to the chamber of commerce.

Many countries face problems with the constitution of collateral. The main problem relates to delay in the registration process and the security of registration, which were cited as important challenges in the Dominican Republic, Nicaragua, and Honduras. Also, in some countries, the lack of registration of pledges on movable assets is a significant factor that limits its reliability and acceptance by creditors.

The majority of the countries also face problems with the execution of collateral. In most countries, execution requires judicial proceedings that are lengthy and somewhat unpredictable owing to overburdened courts and lack of specialization of judges. Nevertheless, some attempts to streamline execution of collateral have been made. Nicaragua and the Dominican Republic have created special parallel judicial procedures for banks, although inadequate independence of the judiciary is perceived to be a major problem in Nicaragua. In Honduras, a recent amendment to the notary law allows execution of collateral directly by a notary through a much abbreviated process. However, these provisions have not yet been adequately tested. In some countries (Costa Rica and Honduras), market participants have bypassed judiciary proceedings through the use of “security trusts” as an alternative means of enforcement of collateral.

Throughout the region, bankruptcy laws are outdated and need to be modernized. The most common problems are excessive protection of debtors, excessive judicial intervention, and a lack of expertise of bankruptcy judges in economic and financial matters, all of which result in lengthy and somewhat unpredictable proceedings. Most of the countries also lack frameworks for effective out-of-court settlements, resulting in considerable delays in enforcing contracts or closing businesses. Some countries (Costa Rica and the Dominican Republic) have made amendments to bankruptcy laws to permit reorganization proceedings that allow illiquid but potentially viable companies to remain operating (similar to the U.S. Chapter 11). However, these reforms have shortcomings that have limited their use in practice.

Taxation

Tax treatment of securities income also generally deters investment in private securities. This is a complex subject and not examined comprehensively in this study. However, the available information suggests that regional tax systems are generally not neutral, by and large favoring investment in public debt over private securities, and bank deposits over debt and equity securities (Table 6.A5). Typically, interest and capital gains from private debt and equity securities are taxed at higher rates than corresponding public debt. Dividends are taxed in addition to corporate income tax, and private securities are subject to certain transfer taxes and value-added taxes that do not apply to public securities. Costa Rica, in particular, has a very complex framework, with different tax treatments depending on the nature of the issuer, the currency, and the investor. El Salvador seems to be the most neutral, with the same tax treatment across the board. The Dominican Republic is a close second.

The Regulatory Framework for Public Issuance

Securities regulators have addressed some of the weaknesses of the business framework by establishing stronger accounting and auditing requirements for public issuance. The most important examples relate to the accounting and auditing framework and the level of financial transparency required. Listed companies in all countries except Guatemala are required to use either IFRS (in Costa Rica, the Dominican Republic, El Salvador, and Honduras) or U.S. GAAP (in Nicaragua and Panama). In addition, listed companies in all countries are required to audit and publish their financial statements. The majority of the regulators have also tried to impose additional professional and independence requirements on external auditors authorized to audit listed firms, as well as a registry of such auditors.12 Securities regulators have imposed nonfinancial disclosure requirements for equity and corporate debt issuers; however, the framework is weak for equity issuers, particularly in the area of corporate governance.

Requirements for Equity Issuance

There is no minimum issuance or minimum float requirement in most of Central America. A minimum issuance amount of C 100 million (about US$2 million) is specified in Costa Rica, the only country to require a minimum issuance amount for equity. None of the seven countries requires a minimum float.

Disclosure requirements for equity issuers are weak in most countries. The most common problems relate to (1) timely disclosure to the public of insider and/or substantial holdings, (2) timely disclosure to the public of material events,13 and (3) the minimum requirements for the prospectus, which generally fall short of international best practices (Tables 6.A6 and 6.A7).

In addition, corporate governance and protection of minority rights are weak throughout the region. All the countries in the region have a basic framework for corporate governance for unlisted companies in their commercial codes, and this framework does not differ significantly from other countries with a Napoleonic tradition. However, for companies with publicly issued securities, this basic framework should be complemented with other provisions that afford an appropriate level of protection to minority shareholders. This additional framework is almost absent in the region. Most countries lack adequate public disclosure of insider and/or substantial holdings. Only in four countries (Costa Rica, the Dominican Republic, Honduras, and Panama) does acquisition of control in a listed company (under certain circumstances) require a mandatory tender offer to all shareholders. Only two countries (Honduras and Panama) have developed codes of corporate governance, but even in those countries the codes require further strengthening in issues such as independent directors, qualifications of directors, and use of supporting committees by the board. In Costa Rica, the Bolsa Nacional de Valores has issued a Corporate Governance Code for voluntary adoption. In addition, the banking, securities, and pension regulators are developing a corporate governance code for supervised entities.

Requirements for Corporate Debt Issuance

Disclosure requirements for corporate debt issuers are more complete than those for equity. In the majority of the countries disclosure requirements are reasonable; the main exception is Guatemala, where private debt issuers are not required to disclose material events, nor to update the information in the prospectus. Perhaps the main area of weakness is the timeliness of disclosure of material events (Tables 6.A8 and 6.A9).

Most countries require a rating for each issue. As in many other developing countries, the legal framework of all countries (except Panama) requires mandatory rating of corporate debt issuances. Given the shortcomings in the availability and reliability of financial information, as well as in other research and analysis services, such a measure is reasonable. However, in two countries (Honduras and the Dominican Republic) two ratings are required in certain circumstances, which could be deemed excessive.

Authorization Process

Authorization of securities issuance needs to be streamlined throughout the region. There are several problems. The regulators frequently do not provide comments all at once, drawing out the approval process. The regulatory reviews tend to be more formal and less focused on material events that affect the value of securities. Market participants complain of inconsistent responses across time and issues. The coordination of authorization and listing between the regulator and the exchanges14 also needs improvement in several countries. There are of course also problems of inadequate filing of documents by potential issuers. As a result of these problems, the authorization process ends up being protracted (of-ten six months or more), costly, and uncertain, creating incentives to favor bank loans rather than securities issuance.

Some regulators have taken some measures to alleviate these problems. Useful approaches include establishing deadlines for all comments to the issuers (in Costa Rica), for the authorization process (in Costa Rica15 and Panama), and establishing a fast-track approval process (basically a “shelf” registration regime) for certain types of bond issuances (e.g., in Costa Rica, and in Panama for commercial paper).

In addition, review of compliance with periodic disclosure has been limited. In most countries, supervision is limited to verifying the timely submission of information, but the actual content is not rigorously examined. Costa Rica has made more advances in this area. In addition, in a number of countries, market supervision and enforcement have been weak owing in part to weaknesses in the legal framework (inadequate description of offenses and/or adequate sanctions). Thus, the public perception in some of these countries is that there is insider trading and market manipulation, with insufficient action taken by the regulator.

Institutional Investors

As with many small and emerging countries, and despite recent rapid growth, the regional institutional investor base remains poorly developed and as yet does not offer a significant source of demand for securities.16

Pension funds are not well developed in most Central American countries and their investment regime is constrained. Guatemala, Honduras, Nicaragua, and Panama still have significant gaps in their legal framework for private pension funds (Table 6.A10). Guatemala and Nicaragua do not report any significant activity by pension funds. While Panama does have public sector pension funds, defined contribution private pension plans exist only in Costa Rica, the Dominican Republic, El Salvador, and Honduras. Moreover, all countries have fairly tight limitations on investment, particularly in private securities, by pension funds. Equity investment is not allowed to exceed 10 percent of the total port-folio in any country, and investment in corporate debt and ABS are also tightly restricted.

Aggregate assets of the regional pension funds amounted to only about US$7.4 billion at end-2006, or about 5.4 percent of regional GDP. Total assets of public and private pension funds (Table 6.3) are significant only in El Salvador and Honduras (about 19 percent of GDP) and in Costa Rica (7 percent). Information available on asset composition is sketchy, but it appears that only about 5 percent of the total assets were invested in stocks, and another 8 percent or so were invested in local corporate debt, with public securities and foreign securities accounting for the lion’s share.

Table 6.3.Pension Funds
Number of Authorized Pension Funds
200120022003200420052006
Costa Rica322726242424
Dominican Republic009877
El Salvador322222
Honduras555566
Panama222222
Total423644414141
Assets Under Management (US$ million)
200120022003200420052006
Costa Rica559772103483011121502
Dominican Republic0034184368643
El Salvador79010991599222429493495
Honduras000001727
Panama222835527273
Total137118992702329045017440
Assets Under Management (percent of GDP)
200120022003200420052006
Costa Rica3.44.65.94.55.67.0
Dominican Republic0.00.00.21.01.32.0
El Salvador5.77.710.614.117.418.7
Honduras0.00.00.00.00.019.2
Panama0.20.20.30.40.50.4
Total1.41.92.83.13.65.4
Sources: Country authorities and IMF staff.
Sources: Country authorities and IMF staff.

Mutual funds have an even smaller presence in the region. They exist in only two countries, Costa Rica and Panama.17 El Salvador and Guatemala have yet to develop an adequate legal framework, while Nicaragua has yet to issue detailed regulation for mutual funds (see Table 6.A10). The mutual funds industry in the region needs to overcome a bad image problem, given its origination in informal and poorly regulated investment pools, involving considerable maturity transformation, whose risks are not always adequately controlled, regulated, or understood by the depositors. Finally, there are problems in authorization requirements and regulations that are deemed burdensome by market participants, for example, in Costa Rica. The mutual fund industry appears to face several efficiency challenges. There are 163 mutual funds with aggregate assets of only about US$2.1 billion (Table 6.4). On average, a mutual fund manages only about US$12 million, which is very low, even allowing for multiple funds managed by the same house. Second, the industry suffers from a lack of sufficient diversity of regional private sector assets that would enable local mutual funds to add value in a special niche. The Panamanian funds appear to invest the bulk of their assets in local corporate bonds, while in Costa Rica the funds appear not to invest in equity, with 27 percent in corporate bonds, and the rest in sovereign and foreign securities. This makes the Costa Rican funds susceptible to foreign competition.

Table 6.4.Mutual Funds
Total Number of Mutual Funds Authorized for PO
200120022003200420052006
Costa Rica129131144135131128
Panama131414162123
Total142145158151152163
Number of Funds Authorized for Equity Investment
200120022003200420052006
Costa Rica333322
Panaman.a.n.a.n.a.n.a.810
Total33331012
Number of Funds Authorized for Corporate Debt Investment
200120022003200420052006
Costa Rica505973476257
Panaman.a.n.a.n.a.n.a.1313
Total505973477570
Total Assets Under Management (US$ million)
200120022003200420052006
Costa Rica1,6181,7872,8131,3461,2541,569
Panama270304282494524488
Total1,8882,0913,0951,8401,7782,057
Percent of Net Assets Invested in Local Equities
200120022003200420052006
Costa Rica100000
Panama000023
Total000011
Percent of Net Assets Invested in Local Corporate Debt
200120022003200420052006
Costa Rica445325
Panama00009897
Total34423127
Total Assets Under Management (percent of GDP)
200120022003200420052006
Costa Rica9.910.616.17.26.37.3
Panama2.32.52.23.53.42.9
Total2.02.13.21.71.41.5
Sources: Country authorities and IMF staff.
Sources: Country authorities and IMF staff.

The penetration rates for the insurance industry are very low, especially in life and annuity segments. An enabling legal framework exists in most countries, and insurance companies face little or no restrictions on their investment plans. However, the insurance industry is currently inconsequential for the development of markets given the low level of assets under management (0–5 percent of GDP), which reflects the low income levels as well as a significant transfer of their exposure to foreign reinsurers. The business also appears to be rather fragmented, with 105 companies operating at the end of 2006.

Equity Markets

Current Status

Several Central American equity markets are severely underdeveloped. There are no equity markets in four out of the seven countries (Guatemala, Honduras, Nicaragua, and the Dominican Republic), and markets are small and shrinking in the other three (El Salvador, Costa Rica, and Panama (Tables 6.5 and 6.6)). Market capitalization in El Salvador and Panama, at about 40 percent of GDP, compares reasonably well with other small developing countries, but it is quite low at 8 percent of GDP in Costa Rica. Market concentration is very high, with the top five companies making up more than half of capitalization in El Salvador and more than two-thirds in Costa Rica and Panama. Trading in secondary markets is almost nonexistent, with only 1 and 3 percent of market capitalization changing hands per year.

Table 6.5.Equity Market Capitalization and Turnover
Equity Market Capitalization (US$ million)
200120022003200420052006
Costa Rica2,4662,1411,6961,4061,4171,841
El Salvador01,9371,9723,5004,8497,716
Panama2,6022,9503,0754,0475,7326,819
Total5,0687,0286,7438,95311,99816,376
Equity Market Capitalization of the 5 Top Companies
200120022003200420052006
Costa Rica2,0211,8101,4361,1891,2281,527
El Salvador01,3771,3862,2202,8914,460
Panama1,6641,9752,2983,1394,3145,424
Total3,6855,1625,1206,5488,43311,411
Equity Market Capitalization (percent of GDP)
200120022003200420052006
Costa Rica15.012.79.77.67.18.6
El Salvador0.013.513.122.128.641.4
Panama22.024.023.828.537.039.8
Total5.37.16.98.49.511.8
Market Capitalization of the 5 Top Companies (percent of GDP)
200120022003200420052006
Costa Rica12.310.78.26.46.27.1
El Salvador0.09.69.214.017.023.9
Panama14.116.117.822.127.931.7
Total3.95.25.26.26.78.2
Trading Volume (US$ million)
200120022003200420052006
Costa Rica868133452825
El Salvador23241050380197
Panama4559455475149
Total15416488602183370
Turnover Ratio (percent)1
200120022003200420052006
Costa Rica7.03.51.72.92.01.5
El Salvadorn.a.2.50.518.41.93.1
Panama1.72.11.51.51.52.4
Total3.12.71.37.71.72.6
Sources: Country authorities and IMF staff.

Trading volume divided by market capitalization.

Sources: Country authorities and IMF staff.

Trading volume divided by market capitalization.

Table 6.6.Equity Issuance and Delisting
Number of Listed Companies
200120022003200420052006
Costa Rica252220222018
El Salvador04039394543
Guatemala033333
Panama282625262624
Total539187909488
Number of IPOs
200120022003200420052006
Costa Rica513200
El Salvador000000
Panama330314
Total843514
Value of IPOs
200120022003200420052006
Costa Rica61200461300
El Salvador000000
Panama757001902595
Total136270462032595
Number of Companies that Requested Delisting During Year
200120022003200420052006
Costa Rica345022
El Salvador300621
Panama142202
Total787845
Sources: Country authorities and IMF staff.
Sources: Country authorities and IMF staff.

The universe of listed stocks is extremely small and shrinking. At the end of 2006, there were 88 equity issues listed in the Central America region. There are 18 companies listed in Costa Rica (compared with 25 in 2001), 24 in Panama (28 in 2001), and 43 in El Salvador (40 in 2002). The relatively larger number of listed firms in El Salvador is the result of public sector privatizations implemented through the stock market and the fact that banks, insurance companies, pension funds, and other financial institutions are required by law to list on the stock exchange. Although these measures have boosted listings and market capitalization, very few of these stocks are traded in the secondary market. More worrisome is the fact that, over time, equity listings have been shrinking because of companies delisting following foreign purchases of local companies and to avoid information disclosure, with fewer initial public offerings (IPOs) than delistings. Finally, although the volume of new equity issuance is variable, it seems to have fallen considerably from the highs (US$270 million in 2002) to US$95 million in 2006.

The relatively low development of equity markets in Central America is a trait shared with many smaller economies. The analysis above suggests that the equity markets in the region are neither a particularly good source of price discovery nor of raising new capital. Table 6.A11 compares the size of capital markets in Central American countries with other countries with comparable GDP. Equity market capitalization is perhaps somewhat inflated owing to the public listing requirement imposed on financial intermediaries. Table 6.A11 also allows a comparison of the region as a whole with countries with comparable GDP. In GDP terms, the region is comparable in size to Chile, Colombia, Israel, Malaysia, and Pakistan, whose equity market capitalization ranged from 36 to 156 percent of GDP. By contrast, the region’s aggregate equity market capitalization amounted to less than 12 percent of GDP. Although this comparison between an incompletely integrated region and a country has many obvious limitations, it may be suggestive of both the difficulties of achieving equity markets of a viable size for smaller economies, and some of the potential gain from regional integration, a subject to which we revert later.

Incentives and Obstacles to Equity Issuance

The limited number of equity issues is the result of a number of causes that are common to the region as a whole. Problems are perceived to be more on the supply side than the demand side.

Supply Side

  • Size of firms and family ownership: The small size of regional economies and of most firms naturally limits the need or ability to raise equity financing through public issuance. Most of the firms that reach a critical size where equity issuance would be a possibility18 belong to family groups and are tightly held. While a company can be relatively easily controlled with a majority, and certainly with a super-majority, of shares, in Central America there is a strong aversion to minority shareholders of any size. Therefore, there is very limited float in the market, including in some of the largest listed companies.
  • International acquisitions: Market participants suggest that for many of the larger firms, and especially for the banks, the apparent goal of the major owner/managers is to build up the company for eventual sale to foreign investors. Such whole business sale is an additional incentive to maintain nearly total control in the hands of the founder and family members, and thus avoid public issuance.
  • Information: As discussed earlier, there is a culture of secrecy regarding business practices and a firm’s financial statements, for both competitive and tax-related reasons, and owners are reluctant to reveal information necessary for public offering.
  • Process of issuance: As mentioned before, for a variety of reasons, the time required to obtain regulatory approval of an IPO can be very lengthy (up to six months or more) and uncertain despite rapid approval envisaged in the law,19 leading some companies to seek listings abroad (e.g., in El Salvador) rather than in their respective countries, or to obtain bank finance.
  • Cheap cost and ease of bank financing: The current high level of liquidity in the regional banking systems implies relatively attractive loan financing. Together with the ease of bank loans (in terms of fewer disclosure requirements) and speed, this creates a weak environment for supply of equity securities. Many large firms that might issue equities also have tight relationships with banks and can extract favorable terms for loan financing. Many of these companies of critical size are usually part of financial conglomerates that set up their own bank and get cheap financing at least up to the prudential limit of related borrowing. For other smaller firms, the fixed costs of issuance make debt financing more attractive.
  • Tax treatment: As in most countries in the world, funding through debt results in a tax-deductible expense. Although lower tax rates apply to listed companies (e.g., in Costa Rica and Panama) for most issuers, the after-tax cost of servicing the debt seems lower than after-tax returns required for additional equity issuance because equity income is subject to multiple taxation (corporate income tax, dividends, and capital gains tax). In addition, as discussed earlier, private securities are subject to taxes that public securities are often exempt from.
  • Lack of liquidity in the secondary market: Secondary market trading in equity is extremely limited. For most equity issuers, this obviously reflects problems related to issuance, such as the lack of a genuine free float, size, or lack of dematerialization. However, some potential issuers also suggest that this reduces their interest in equity issuance, because equity markets do not provide meaningful price discovery or exit options for large shareholders.

Demand Side

  • Underdevelopment of regional institutional investors: As discussed earlier, the regional institutional investor base is very weak. There are few mutual funds, fewer still with a mandate to invest in equity, resulting in paltry investment in equities. The same is true of pension funds, which face even stronger restrictions on equity investment. Thus, institutional investors in equity markets neither provide a sufficiently strong demand nor act as a mechanism of market discipline.
  • Lack of meaningful diversification: The small and shrinking universe of corporate listings offers very poor diversification opportunities through investment in national securities. While a regional equity portfolio would improve the size and scale of diversification, constructing a regional position is currently not easy in the absence of a seamless market. Furthermore, for investors capable of doing so, it would be more interesting and perhaps less operationally difficult to access well-developed foreign markets than several fragmented regional markets. Similarly, foreign investors are likely to be uninterested in the regional markets in the absence of adequate size, depth, and liquidity; absence of most regional markets from emerging market indices that serve as portfolio benchmarks; and absence of any regional equity index.
  • Corporate governance and investor protection: All of the real and perceived problems of poor corporate governance and investor protection act as a powerful constraint on investor demand. Although the supply constraints are more binding currently, these factors are likely to inhibit demand and the growth of equity markets over the long term.

Corporate Debt Markets

Current Status

The regional corporate debt markets are small overall and vary dramatically in size and importance across the region. Corporate bond markets have grown (Table 6.7) from US$6.3 billion in 2001 (6.6 percent of GDP) to US$8.3 billion in 2006 (6 percent of GDP). Costa Rica accounts for 60 percent of corporate debt securities outstanding in the region, with Panama being the distant second at 25 percent, and El Salvador the only other regional country with a measurable debt market. In Costa Rica, the debt market (in terms of outstanding book value) has grown steadily from US$3.0 billion in 2001 to US$5 billion in 2006. While Costa Rican market size (at 23 percent of GDP) compares well with other emerging markets, the markets in the Dominican Republic, Guatemala, and Honduras remain at an incipient stage, but there appears to be good growth momentum in the Dominican Republic (Table 6.8).

Table 6.7.Corporate Debt Outstanding and Turnover
Total Amount of Outstanding Debt (US$ million)
200120022003200420052006
Costa Rica2,9513,3023,4074,2644,6664,985
Dominican Republic0001120187
El Salvador340363439865698823
Guatemala0628076118143
Honduras000003
Nicaragua515038352721
Panama1,3071,3271,5381,5541,6312,079
Total4,6495,1045,5026,7957,2608,241
Total Amount of Outstanding Debt (percent of GDP)
200120022003200420052006
Costa Rica18.019.619.523.023.423.3
Dominican Republic0.00.00.00.00.40.6
El Salvador2.52.52.95.54.14.4
Guatemala0.00.30.30.30.40.4
Honduras0.00.00.00.00.00.0
Nicaragua1.21.20.90.80.60.4
Panama11.110.811.911.010.512.1
Total4.95.25.66.45.76.0
Total Traded Volume During Year (US$ million)
200120022003200420052006
Costa Rica1,0209549591,188938985
Dominican Republic00003850
El Salvador1,9971,056494939665913
Guatemala0567478128135
Honduras000000
Nicaragua211318766
Panama1,0441,4141,4341,3431,6812,254
Total4,0823,4942,9793,5553,4564,343
Corporate Debt (Turnover Ratios)
200120022003200420052006
Costa Rica34.230.528.631.021.020.4
Dominican Republicn.a.n.a.n.a.n.a.63.532.7
El Salvadorn.a.300.5123.2144.085.1120.1
Guatemalan.a.181.9104.699.6132.0103.2
Hondurasn.a.n.a.n.a.n.a.n.a.0.0
Nicaragua43.825.740.920.220.323.9
Panama80.9107.4100.186.9105.6121.5
Total90.971.656.257.849.256.0
Sources: Country authorities and IMF staff.
Sources: Country authorities and IMF staff.
Table 6.8.Corporate Debt Issuance and Delisting
Number of Companies with Outstanding Debt Issues
200120022003200420052006
Costa Rica595453514743
Dominican Republic000149
El Salvador444547525456
Guatemala04748474935
Honduras000002
Nicaragua997666
Panama323539414552
Total144190194198205203
Number of New Corporate Debt Issues
200120022003200420052006
Costa Rica564536675743
Dominican Republic000000
El Salvador12520131418
Guatemala031342
Honduras000002
Nicaragua121021
Panama8128141822
Total776766979588
Value of New Corporate Debt Issues (US$ million)
200120022003200420052006
Costa Rica141121134307719261
Dominican Republic000112077
El Salvador2,24786511,1631,6085,85070,258
Guatemala02627415713
Honduras000003
Nicaragua1350210
Panama138356166329634835
Total2,5271,37111,4702,3197,48271,458
Number of New Companies That Requested Authorization for Debt Issuance During Year
200120022003200420052006
Costa Rica332303
El Salvador0001510
Dominican Republic300252
Guatemala031342
Honduras000002
Nicaragua121021
Panama211647
Total995152027
Number of Companies That Requested Delisting During Year
200120022003200420052006
Costa Rica000000
Dominican Republic000000
El Salvador230621
Guatemala001002
Honduras000000
Nicaragua000002
Panama202221478
Total2225320913
Sources: Country authorities and IMF staff.
Sources: Country authorities and IMF staff.

Regional corporate bond markets share several common features. First, there appears to be more liquidity in secondary bond markets than in equity markets. Costa Rica leads in volume and Panama leads in terms of turnover ratio. Second, most issuers are financial institutions, mainly banks. Third, most corporate debt securities have short maturities, typically between 3 and 12 months. In some countries, though, it is possible to find maturities of up to three to five years. Issuance of asset-backed securities is minimal in the region. The exception is Panama, where there have been 12 securitizations, of which 11 are collateralized by mortgages. Most of the securitizations, however, correspond to just one issuer, a specialized lending company focused on housing for lower-income families.

The institutional investor base varies from one country to the other, but is generally thin. Banks account for most of the demand for corporate debt securities. In some instances, bank demand is partly driven by tax incentives. Pension funds are important institutional investors in Costa Rica and El Salvador, and they could play a potentially important role in the Dominican Republic and Honduras. In most regional countries, except the Dominican Republic, regulations bias the asset allocation toward government securities and impair the growth of the corporate debt market. As discussed before, mutual funds (except in Panama) and insurers play a limited role in investing in corporate bonds.

Foreign investors and high net worth individuals are important in select markets. Bond market data are scarce, but market conversations suggest significant foreign investor interest in El Salvador and Panama. Some of the mortgage and remittances securitizations structured locally were placed with foreign investors. Finally, high net worth individuals also invest in corporate debt securities. Generally, bond issues that target high net worth individuals are “pre-placed” ahead of the formal listing in the securities exchanges.

Incentives for Corporate Bond Issuance and Investment

Market Environment

The degree of dollarization and level of domestic interest rates, and broadly the confidence in the domestic currency and monetary arrangements, are important hurdles to the growth of domestic corporate bond markets. Panama and El Salvador are fully dollarized, and other countries have high levels of de facto dollarization. Thus, corporate debt issuance is divided between domestic and foreign currencies, making each market smaller, and external borrowings for the latter an important alternative. The growth of corporate bond markets is also hampered by several problems in the public debt management. These include high levels of debt in some counsuance between governments and central banks, lack of a coherent public debt management strategy, issuance of nontradable and nonstandard securities, and poor liquidity. These problems make it difficult to establish a

  • As discussed, financial disclosure in the region is generally poor. This prevents credit rating agencies from issuing investment-grade ratings, even by local rating standards, to many issuers.
  • All countries except Panama require a rating for public issues of corporate debt. In El Salvador, every debt issue requires a rating, and two ratings if the security is purchased by pension funds. Competition among rating agencies to secure a rating mandate is reported to lead to a “race to the bottom” at times. Given the low thresholds for capital and experience required by authorities to establish and to operate a rating agency, there are some concerns about the reliability and comparability of ratings issued by different agencies. Moreover, market participants are not always sophisticated enough to price different ratings or those issued by different agencies discriminatingly.
  • Mark-to-market valuation of portfolios is seldom used in the region, and in some countries (e.g., Guatemala), loss recognition based on mark-to-market is not recognized by tax authorities. This creates incentives against regular trading and contributes to the low liquidity in the secondary market.

Supply Side

  • Many potential corporate issuers are partly family-controlled or a part of a conglomerate. Corporate control motives and the unwillingness to disclose information to outsiders favors “house” banking financing over market financing. In addition, the financing needs of large “blue-chip” corporations are met in more developed external markets, which offer better rates and deeper pools of capital. Indeed, several important conglomerate members have raised market financing in the United States.
  • Excess liquidity in the banking sector poses strong competition to all alternative funding, including equity and bond markets. Currently, liquidity in the regional banking sector has been high owing to favorable cyclical factors and a strong flow of remittances (exceeding 10 percent of GDP in El Salvador, Honduras, Nicaragua, and Panama).
  • The small size of most regional businesses, the small size of their funding needs, and the fixed costs of listing requirements reduce the number of enterprises in each country for whom bond issuance is an economic alternative to bank financing. Moreover, although an issuance of, say, above US$5 million may be made cost-effective, it is insufficient to create adequate liquidity in secondary markets and thus interest institutional investors.
  • In some countries, certain legal and regulatory factors impede faster development of corporate bond markets. For instance, in Guatemala, only financial institutions are authorized to raise funds in public markets, and only if they have an investment-grade rating. Disclosure requirements are generally moderate,20 but issuers complain of fatigue owing to an issuance authorization process that is excessively bureaucratic and to treatment that is at times arbitrary and inconsistent.21 In addition, in Honduras, two credit ratings are required for investment by pension funds, whereas in the Dominican Republic, two separate approvals by securities and pension regulators are required, which is onerous for most issuers.

Demand Side

As mentioned earlier, the generally weak confidence in private securities, disclosure, and enforcement of contracts depress demand from domestic and regional investors.

  • Corporate debt suffers also from some “crowding out” by government securities in most markets. Government securities enjoy several advantages over corporate debt securities. Foremost among them is the favorable tax treatment, that is, lower tax rates or exemptions, on interest and capital gains from investments in government securities. Banks do not need to hold reserve requirements against government bond holdings, which is not usually the case for corporate debt securities. Public securities are also often much larger issues, more liquid, and more continuously offered. The crowding out trend would likely be reinforced as bank supervision practices in the region converge to Basel II.
  • The average corporate debt issue is about US$50 million. This is not too small, but many issues are often well below this size and too small to satisfy the maximum concentration limits to be observed by pension funds, and often too illiquid for mutual and pension funds that must mark to market or need to trade.

Asset-Backed Securities

Current Status

ABS markets in the region remain incipient. There have been a few transactions of domestic mortgage-backed securities: 12 in Panama, 1 in Guatemala, and a few in Costa Rica. In addition, there have been a few ad hoc securitizations backed by cash flows, for example, of auto loan and credit card receivables, factoring (IOUs), remittances from abroad, and public infrastructure (Costa Rica). Many of these transactions have been structured abroad, use a foreign law, and are denominated in foreign currency. The large number of factors affecting debt markets adversely also discourages asset-backed securitization. But securitization also suffers from a few more specific problems within the region.

Problems in Issuance of Asset-Backed Securities

  • Except for Costa Rica and Panama, the law poses material problems for the issuance of ABS. In El Salvador and Guatemala, there is no specific legal framework governing the issuance of ABS, though one is under consideration in El Salvador. In the Dominican Republic and Honduras, the laws contain very few provisions on securitization; therefore, important issues such as bankruptcy remoteness are not explicitly contemplated. Trusts are the preferred vehicle for securitization in many countries, but trust laws do not exist in the Dominican Republic and Nicaragua and have important limitations on the type of intermediaries that can act as trustees (Honduras).
  • In the face of the current large liquidity, regional banks lack strong economic incentives to securitize their assets. Many banks are eager to book and hold assets and value the size of their balance sheets and regional market share rankings more than profitability, because size is often an important indicator of safety to the lay depositors.
  • For several reasons, regional banks have had a wait-and-watch attitude toward ABS. Many regional banks lack experience and expertise in the issuance of asset-backed securities. Because securitization transactions are also relatively new for the regulators, banks worry about the potentially longer delays and difficulties of receiving issuance authorization and rating for ABS, and prefer the relatively easier process for issuance of bonds. Many banks also prefer, for strategic reasons, to establish their bond issuance programs successfully prior to venturing into the ABS arena. Others, aware of the imperfections in their underlying documentation and asset origination standards, prefer not to be exposed to the scrutiny of rating agencies and investors until they have taken internal measures to clean up.
  • As with many countries in the world, creation of a mortgage and transfer of assets attract taxation based on the asset value or loan amount, and in some cases, financial transaction taxes on payments, resulting in multiple levels of taxation for the same underlying financing transaction. In some countries (e.g., the Dominican Republic), transfer of mortgages to the special purpose vehicle entails a significant additional stamp tax. In El Salvador, a special purpose vehicle collateralized by mortgages is also required to pay municipal taxes. In the Dominican Republic, ABS-related payment flows would attract financial transaction taxes. In Guatemala, net income from mortgages guaranteed by the Instituto de Fomento Habitacional (IFHA) is tax-exempt and the underlying mortgages are not subject to capital provisioning. Because these provisions may not apply to a special purpose vehicle, banks, therefore, have strong incentives to hold the mortgages in their loan books.
  • Mortgages are not originated to common standards, even within individual banks, as is the case for mortgages in the Dominican Republic and Guatemala. In several countries, mortgages are linked to individual bank’s deposit interest rates rather than an external interest rate benchmark. The low reliance on marking to market also can cause problems because sale of securitizable assets to the special purpose vehicle may create gains and losses, with tax implications.
  • Finally, the quality of the infrastructure supporting the ABS market differs between countries. In Guatemala, for instance, the registration of mortgages is easy. In contrast, the obsolescence of the real estate property registrar in Nicaragua works against the introduction of real estate investment trusts and mortgage-backed securities.

Despite the very low level of ABS activity so far and the problems cited above, securitization represents one of the most important opportunities for developing domestic fixed income markets. The need for public debt sustainability limits the amount of sovereign debt. Corporate debt markets tend to be substantially smaller in emerging rather than mature capital markets and the growth rate of highly rated corporate securities issuance is likely to remain low in Central America for many reasons discussed earlier. In this context, ABS represent the most interesting opportunities for expansion of potentially highly rated securities that can offer pension and mutual funds, insurance companies, and retail investors a high-quality and diversified investment opportunity.

Although many hurdles remain in development of this market segment, its potential is also becoming evident. Panama is a good example of the growth potential of ABS markets. In Panama, the legal and regulatory framework does not impede the issuance of ABS, relatively clear tax policies avoid double taxation of ABS instruments, there has been a good pipeline of relatively standardized mortgages, and full dollarization has helped secure the interest of foreign investors. Under these favorable conditions, Panama has led the region in the number of securitizations backed by domestic assets, which were placed successfully with both domestic and foreign investors.

Several factors suggest potentially good growth rates in ABS starting from a low base. The takeover of several regional financial groups by foreign institutions bodes well for securitization. The global financial institutions are more likely to be more interested in maximizing return on equity than regional market shares, are more familiar with securitization techniques, and, even in the current highly liquid environment, may be interested in securitization and fee-based income. Successful placement of initial transactions by leading institutions could encourage many others, who would not like to incur the costs of being the first movers, to follow suit.

Scope for Developing Capital Markets in the Region

The seven Central American private capital markets are at a very low stage of development compared with those in advanced economies, but also with those in economies of comparable size, in terms of market capitalization, type and number of private financial securities available, and liquidity. The major structural and historical factors explaining the current state—political and economic uncertainties; banking, debt, and currency crises; small size of the economy; small size of businesses; family-owned businesses; and aversion to disclosure—are changing, but slowly. There are important gaps in the development of securities laws, regulatory agencies, and market infrastructure as well as in many of the basic preconditions for development of securities markets and a more broad financial system.

The Case for Policy Action

There are important costs from the failure to develop more vigorous private capital markets for local businesses. The underdevelopment of private capital markets is a major hindrance to external equity financing. However, it may not be a major hindrance to financing per se, and excessive reliance on the banking system represents a deliberate and often rational choice, for the vast majority of the relatively small regional businesses with, say, less than US$25 million in financing. In the globalized world of today, the larger businesses (say, those needing financing of more than US$50 million) do not find it too difficult to access the financial centers of Miami, New York, or Latin America. Thus, apart from the financing difficulties of the medium-sized businesses, the principal costs of poorly developed regional capital markets for local businesses may lie in generally lower valuations of their businesses, higher costs of financing, discontinuous growth prospects, and relatively greater difficulties of exit for principal shareholders.

The consequences may be worse for institutional and retail investors. For investors—particularly pension and mutual funds, insurers, and retail investors—the lack of a well-developed capital market implies failure to attain a well-diversified portfolio of regional financial assets. This is a particularly important problem for institutions such as insurers or pension funds that must invest in regional assets because of regulation or currency preferences. To the extent that local investors may be presumed to be among the more willing and informed investors in regional private financial securities, they bear disproportionate costs of this underdevelopment.

Banks may also suffer in the long run from a strategic weakness as a result of poorly developed capital markets. Banks may gain in the short run from under-developed capital markets, through a higher market share of financing. In the long run, such underdevelopment may constrain the growth prospects of local banks, which must maintain an adequate access to external equity capital and long-term borrowings. It also impedes the banks’ ability to securitize their assets, which may be needed in an environment of tighter liquidity or capital adequacy.

A thin capital market may make several public policy choices more difficult. Small and illiquid Central American capital markets would undoubtedly reduce the degree of foreign portfolio investment in the region. Such markets would also raise the cost of policy-based restrictions in favor of domestic investments typically imposed on banks, pension funds, and insurers, resulting in larger costs for affiliates and greater possibilities of cherry-picking and front-running from investment of approved investable securities. Other implications may include poorer financing possibilities for housing or large infrastructure projects, reduced possibility of divestment or value realization in privatization, and greater concentration of risks in the banking system.

Limited Scope for Developing Individual Country Capital Markets

The preceding discussion underscores that the development of the seven individual private securities markets is a difficult and complex challenge with no quick or simple solution. The fundamental issues of small size of individual economies and businesses, a culture of family ownership and aversion to minority shareholders, a lack of equity culture among investors, and the like cannot be resolved quickly.

In the four countries with no stock markets currently, investors and issuers alike may not have a realistic option to create a sustainable domestic stock market any time soon, and may be better off adopting a market in the region as their own. The Dominican Republic, Guatemala, Honduras, and Nicaragua are unlikely to see more than a handful of equity issuance and listings per year in the near future. Given the uncertainties of the equity approval process and market reception and the limited investor base, issuers in these markets may well prefer to list in one of the more established exchanges of Costa Rica, El Salvador, or Panama. For investors in these four countries, stock markets that offer only a handful of stocks, with little float and liquidity, cannot provide a meaningful diversification possibility to retail or institutional investors who must explore investment opportunities abroad. For investors whose scale of investment, regulatory freedom, and sophistication permit investment in equity markets abroad, the latter are likely to be so superior in terms of diversification possibilities, trading environment, and liquidity that their interest in domestic equity markets will become marginal.

Technical measures such as dual listing standards, aggressive promotion of public issuance to “targeted” companies, or tax incentives may all help, but are unlikely to result in a stock market that would reach a “take-off” stage. The regional listing standards are already very accommodating, and development of a “lower tier” equity market with even more liberal disclosure and approval standards is not a realistic option. Promotion by the relevant exchanges to coax new listings certainly has merit, but it is issuers’ unwillingness rather than a failure of marketing that is the primary problem. Although equity listings can be motivated through favorable tax treatment, it is preferable to remove unequal treatment rather than offer new incentives. Thus, for the four countries with no stock market at the moment, it may be worth making a hard and realistic assessment of the merit of developing a domestic stock market versus essentially adopting one of the existing regional markets.

Proximity to the United States may also be an issue. The region’s proximity to the more developed financial markets in the United States, the sizable diaspora present in the United States, dollarization, and the history of periodic economic turbulence have all created incentives to transfer or maintain savings abroad. The relative familiarity with the more developed U.S. markets and financial products raises the bar for investing in domestic securities.

Even the three better-developed markets may struggle for viability in an increasingly globalized world. Collectively, these three countries have 90 stocks, most of which are not at all liquid, and none of which carries a minimum free float. The total market capitalization (end-2006) was only about US$16.4 billion, with the top five stocks in each market (15 in all) accounting for about US$11.4 billion. Individually these exchanges are able to absorb issuances up to, say, US$50–$100 million, but they would be of limited interest to both large issuers and global investors. Thus, even if they survive individually, these stock markets are likely to struggle for viability without some form of integration. Under these circumstances, it may be worth examining if financing of corporations and investment in securities could be facilitated by bolstering the integration of the several small exchanges scattered across the region.

Scope for Regional Integration of Private Capital Markets

Given the limited number and size of issuers, it is worth considering the creation of a regional capital market, balancing the benefits from economies of scale with the cost of implementation and coordination. Such analysis merits a complete assessment that is beyond the scope of this section. However, the section addresses many elements that need to be discussed, including past experience with capital market integration and some possible steps forward to addressing the most important concerns.

International Experiences with Integrating Capital Markets

Past experience in mature and emerging market countries suggests powerful forces urging vertical and horizontal integration of securities exchanges and related services. In the United States, there were more than 100 regional exchanges in the late 1800s; the number fell to 18 by 1940 and 7 by 1980. Similarly, in India, although there are 22 regional stock exchanges, the two major ones attract about 90 percent of the trading volume, and many of the remaining regional exchanges have united under a common platform. There have been important cross-border mergers and/or acquisitions, including Euronext (which has brought together the exchanges of Portugal, France, Belgium, and the Netherlands) and OMX (which has brought together the markets of the Nordic and Baltic countries) (Box 6.1), and more recently the case of NYSE and Euronext. There have been similar instances of mergers and integration of several centralized securities depositories.

At the same time, few of these examples can serve as a complete or easy model for the region. Each of them has very special features and contexts, and although regional authorities can draw some useful lessons from them, none of them would serve as a reasonably complete or relevant model for the region.

Box 6.1.Steps Toward Integration of Regional Capital Markets

While relevant to the entire region, so far the most significant steps toward integration have been taken by the three countries with the most developed securities markets: Costa Rica, El Salvador, and Panama. So far their initiatives have had limited success, and concerned regulators and exchanges are now trying to advance the integration through a somewhat more systematic “regional” approach.

Regulators. The three regulators have tried a “fast track” approval of primary issuance of securities and mutual funds on a bilateral basis, so far with limited success. In 2003, El Salvador and Panama signed a memorandum of understanding (MoU) committing to a fast track registration. In addition, Panama granted El Salvador the status of recognized jurisdiction. In practice, this mutual recognition has not worked well, as Panamanian firms wishing to list in El Salvador have faced additional regulatory requirements. In 2003 El Salvador and Costa Rica signed another MoU, only to engage in best efforts to streamline the registration process. Thus, there was limited progress except in clarifying the main differences between the two regulatory frameworks. In 2004 Panama and Costa Rica initiated the same process, but Costa Rica chose not to sign an MoU, preferring instead a move toward more uniform regional standards of issuance, supervision, and enforcement, before entering into such agreements. However, in 2005, Panama unilaterally recognized Costa Rican jurisdiction allowing fast track registration of Costa Rican issuers in Panama. As of now, Panama has given a fast track registration to eight corporations and mutual funds originally registered in El Salvador and Costa Rica.

More recently, regulators have started exploring the implications of regional integration, following the 2006 regional seminar by the Toronto Center. The Dominican Republic has proposed the creation of a Central American Institute of Securities Markets, along the lines of the Instituto Iberoamericano de Mercados de Capitales, a Spanish learning center. In the absence of a full consensus, the regulators have agreed to create a council of Central American superintendents and requested a second seminar, facilitated by the Toronto Center, on global experience in capital market integration and the next steps for the region.

Security exchanges. Regional integration has been considered since the creation of Bolcen, the Association of Central American and Caribbean stock exchanges, in 1994. Its main objective is to promote capital market development with the overarching goal of achieving one single market with interconnected exchanges. However, so far there has been limited progress.

Separately, the stock exchanges of Costa Rica, El Salvador, and Panama signed an MoU in September 2006 for the development of a common trading platform permitting member brokers to trade in real time in all three markets through correspondent local brokers. The goal was to have these arrangements developed by March of 2007, and thus serve as a catalyst for regulatory action. However, technical problems, such as different settlement conventions and the disagreement on common trading, have stalled the project. The exchanges agreed to seek technical support from OMX—the operator of the Nordic exchanges. In parallel, the Panama Stock Exchange is also exploring an order-routing system with South American countries. Local intermediaries would place orders from their clients to buy and sell foreign exchange listed securities to those exchanges for a fee.

Challenges to Developing a Regional Market in Central America

Central America would face particularly important challenges if it chose to integrate regional markets. The region is not fully integrated in terms of economies and monetary or fiscal policies. Unlike the European Union or Eastern Caribbean Currency Union, Central American capital markets remain divided in important respects, including currencies, restrictions on domestic institutional investors, the presence of as many as eight exchanges and custodians, the mutual structure of most exchanges, and the presence of competing exchanges and custodians. To advance toward a regionally integrated market, substantially greater progress would need to be made toward harmonizing securities laws and regulation, approval and listing processes, supervision standards, disclosure, and corporate governance norms. While a full study of these issues is beyond the scope of this effort, the following section touches on key issues and approaches to developing a regional strategy on capital market integration, if any.

Central American regulators and exchanges have been considering some approaches to integration in recent years, but with limited success. The progress so far has been slow and these efforts reveal many important regulatory and operational differences; a lack of consensus (Box 6.2) on the need for, urgency of, or approach toward regional integration; and some important differences in confidence in the capacity of regulators across countries. Securities regulators would have many legitimate concerns in dealing with cross-border integration of markets. Regulators have a mandate to protect investors, which they implement through a system of disclosure for issuers, prudential regulations for intermediaries, observance of market conduct, and supervision. Allowing foreign issuers and/or intermediaries direct access to the local market under a different framework than that applicable to local players poses important concerns to regulators (see Tafaris and Peterson, 2007):

  • Permitting foreign access to local investors without direct oversight would result in unknown risks to investors and capital markets, with the regulator possessing few or no powers to investigate or discipline foreign issuers or intermediaries.
  • Such regional integration could be abused to seek regulatory arbitrage, with issuers and intermediaries registering in jurisdictions with weaker investor protection while still enjoying access to the local market.
  • Local access to foreign players subject to very different frameworks might also make it difficult for local investors to understand the differences between the different investment options.
  • There are important legal, political, and reputation risks for the regulator if a scandal or fraud arises involving foreign issuers or intermediaries that access the market in different conditions than those afforded to locals.

The regional integration process must address these regulatory concerns to be successful. The key elements would include (1) comfort in the requirements established by the home country regulator, (2) comfort with the capacity of the home country regulator for reviewing the information provided by issuers, (3) a robust framework that permits exchange of information and cooperation, and (4) regional legal frameworks that meet minimum standards of investor protection and regulatory authority. In this context, it is worth mentioning that the regional (MoU) in order to share information and set up a framework for mutual cooperation and technical assistance. They also agreed to meet periodically and discuss integration efforts.

Box 6.2.Integration in Nordic/Baltic Securities Markets

The Nordic/Baltic region offers a good example of both the benefits and difficulties involved in consolidation of securities exchanges and related centralized security depository (CSD) services. OMX began as a derivative exchange in 1985. Recognizing that the well-developed but small Nordic markets could not compete effectively in the long run against major European bourses, OMX merged with the Stockholm Stock Exchange in 1998, when a joint trading platform initiative started on all the Nordic exchanges.

OMX’s bid for London Stock Exchange (LSE) in 2000 was unsuccessful, but efforts to create a unified Nordic market advanced, with common member and trading rules instituted in the Nordic region in 2001, the merger of OMX and the Helsinki Stock Exchange (HEX, including the Tallinn and Riga exchanges already owned by HEX) in 2003, the acquisition of Vilnius Stock Exchange in 2004, and mergers with Copenhagen (2005) and Icelandic (2006) Stock Exchanges. Today, OMX is the fifth largest equity exchange and third largest equity derivatives exchange and a global leader in exchange technology. OMX directly or indirectly also owns the central securities depositories in most of these countries, and accounts for more than 80 percent of the exchange trading in the Nordic and Baltic countries. There has been some talk of including the Warsaw stock exchange. In 2007, OMX and NASDAQ announced their intention to combine the two companies.

The Nordic/Baltic exchange benefits companies, members, and investors alike. Listed companies gain exposure to a much broader investor base, exchange members enjoy more efficient access to trading in a large number of securities, and investors can easily choose among more investment alternatives than the pre-merger national exchanges did. All of this boosts trading, liquidity, and market discipline and enhances corporate transparency.

Several aspects of the OMX experience may be relevant to Central America. The initiative was led largely by the private sector. The process was certainly difficult and entailed acquisition/merger of one exchange at a time, with CSD integration usually following. Some of the individual stock exchanges retained their separate legal identity, remain a subsidiary, and operate under different local securities laws and regulators. As with Central America, countries in the OMX umbrella do not have a common currency. OMX has dealt with these regulatory and brand distinctions, while reducing the operating differences between national markets, by sharing the same trading system, providing common listing and index structures, enabling efficient cross-border trading and settlement, offering cross-membership, and providing one market source of information.

In some ways, the Nordic/Baltic mergers were more difficult than future mergers in Central America could be. The countries and companies in the OMX group are much more diverse in size, did not have the same degree of political and regulatory cooperation that currently exists in Central America, and do not speak the same language. OMX has found practical solutions to these, for example, by creating two lists, Nordic and Baltic, with varying listing standards, and adopting English as its corporate language.

At the same time, OMX history suggests that merging exchanges is a complex process that is likely to take years, and may require strong leadership. It also suggests that there may be several paths toward an eventual creation of a single Central American market. For example, exchanges may continue to maintain their separate identity and ownership structures, while sharing a common technology platform, or two exchange groups (say, one combining Panama, Costa Rica, and El Salvador and another the other four) may emerge first, followed by an eventual merger between them.

In addition, the region would face major operational challenges in integrating the current variety of trading platforms and settlement systems. As discussed under market infrastructure, the regional exchanges do not share compatible platforms, and there are substantial variations in settlement cycles, degree and requirement of dematerialization, and degree of delivery versus payment. Because countries in the region do not share currencies, integration may require development of a platform that can trade and settle multiple currencies. While the technical solutions to these problems are feasible, the challenge lies in several regional exchanges, CSDs, settlement banks, and related institutions agreeing to collaborate toward a unified system, to share costs, and to appoint a common management structure that would manage such a transition without any interruption of existing trading arrangements.

The transition toward a more harmonized and perhaps eventually integrated regulation may involve the following approach. Building on ongoing regional efforts, it may be reasonable to postulate a three-pronged strategy involving (1) incremental harmonization of regulation and supervision; (2) mutual recognition of foreign securities and regulatory actions; and (3) raising/converging regulatory capacity to regionally appropriate standards. In terms of harmonization, it would be most useful if the countries that need to develop new laws or regulation sought out regional counterparts with a similar need or prior experience in developing them, aim to introduce new laws and regulation that aspire to a good regional/international standard, and minimize national deviations from the regional standard to the greatest extent possible. Similarly, supervisory practices could be harmonized to the maximum extent possible in areas of common interest. As harmonization of regulation and supervisory practices meet certain norms, regulators could increasingly rely on regulatory actions (e.g., registration, licensing, and submission of periodic information and off-site and on-site supervision) by their counterparts. In parallel, regulators can also recognize certain ju-risdictions—whose practices may differ in important respects—as providing adequate investor protection, and admit securities issued in such jurisdictions as tradable within their own markets.22 Third, there would be a need to raise the capacity of all regulators (e.g., staff strength, quality, training, implementation of common manuals), and develop institutional mechanisms to consult among regulators and resolve issues that arise during transition. Third-party consultants may be judiciously used to facilitate this process and maintain regional commitment and confidence.

There may be some merit in phasing such regulatory convergence. Countries where the underlying law and regulation are better developed and whose markets are more active could take the lead in thinking through a harmonized legal and regulatory framework. Others may prefer to adopt the regulatory framework that results from such consultations. Similarly, there may be merits in phasing the application of harmonized regulatory standards to some brokers, issuers, and markets before being extended to all issuers and markets.

A common regional securities market linking the seven Central American countries may make more sense than other possible configurations. While securities markets are integrating across countries for a variety of reasons, it may be legitimate to inquire if a common market for these seven countries is necessarily the dominant choice. The principal arguments against this may be reservations among the more developed markets about the magnitude of efforts required to bring up others to a regional standard, the greater economic incentives of the private sector in integrating with, say, a more developed market such as Mexico or Colombia versus those in the region, and the ease of bilaterally adopting a more developed market standard of a senior partner versus negotiating regional standards among seven more equal partners. These are compelling considerations. Arguments in favor include the relatively small size of all seven regional economies compared with neighbors such as Colombia, Peru, Mexico, or Venezuela; common language; physical proximity; political appeal and acceptance; other initiatives such as a common customs union and supervision of financial conglomerates; and the existence of regional political bodies and a regional association of exchanges. This is ultimately a choice for the regional policymakers and private sector. But it may be fair to say that while some top companies may be able to “graduate” eventually from Central American exchanges to a more developed foreign market, for the large majority of issuers, a regional securities market may be a more friendly marketplace than alternatives. Thus, if neither elimination of all exchanges in Central America nor continuance of seven national markets is a desirable outcome, it would make sense to strive toward a Central American marketplace.

The integrated market need not imply a single, physical location. This study is not sufficiently in depth to offer detailed operational recommendations. However, a convergence of the regional markets need not only imply a single marketplace. Indeed, as the Nordic/Baltic experience suggests, it may entail maintenance of several exchanges linked to a common electronic platform, coupled with ownership and shareholding arrangements that may eventually replace multiple existing institutions. Such incremental convergence can take many paths that nonetheless offer substantial benefits of an essentially regional rather national market.

If a regional market is desirable, regional authorities may need to take the lead in establishing the vision. The discussion above clearly underscores the need for strategic leadership and consensus by the regional authorities. National regulators and interested private sector representatives are likely to be too handicapped by a parochial vision, limited authority, and perhaps conflicting interests, to successfully steer the process without a strong and clear political commitment. Such commitment is needed to ensure the necessary changes in the securities laws and even possibly a treaty to ensure a sound framework for regional integration, while empowering and tasking regulators and exchanges with the requisite regulatory and operational tasks. Operationally, this may mean adoption of a resolution by the political authorities and creation of a regional tripartite working group to spearhead the work. The analyses and groundwork underlying the existing initiatives and proposals could be harnessed, together with the necessary external support (e.g., of the Toronto Center and/or interested international financial institutions) to jump-start the process.

Articulating a vision for promoting regional integration of capital markets is a major and radical step. The problems in the process cannot be underestimated, and the success is unlikely to be achieved without years of hard work. Yet, it does appear that without such an effort, the region may fail to achieve many of the benefits of an efficient and liquid capital market, and these opportunity costs warrant such an effort. This may require the authorities to resolve at the highest level their goal and vision for facilitating such an interlinked market; lead in developing a consensus among the many regulators, private sector interests, and institutions involved (no small task); and harmonize national securities laws in line with such a regional vision.

While the private sector must have a lead role in arrangements relating to integrating the marketplace, the public sector can provide powerful incentives for integration. The market participants, particularly in the smaller exchanges, already realize the somewhat dim prospects for growth and profitability within individual markets, and many are already positioning themselves through partnerships with regional counterparts. Second, a decisive signal by the authorities to harmonize varying regulation could provide just the powerful signal about the eventually successful emergence of a regional market to align issuers, investors, and intermediaries toward such a goal. Finally, it is worth recalling that about 90 percent of market capitalization and trading in securities is in government securities. Efforts by regional governments facilitating listing and trading in a shared or linked marketplace could be the most powerful driver of a regional integration process.

Conclusions

A number of remedial measures could be considered to promote national and regional capital markets. However, such efforts should focus on the removal of obstacles and expansion of potential opportunities, rather than direct promotion, tax concessions, or subsidies aimed at capital market transactions. The following summarizes the main insights and recommendations of this chapter (Table 6.A12).

Securities Laws and Regulation

The regional legal framework needs strengthening in several areas. Securities laws need to be updated in most countries, and overhauled in El Salvador. Securities laws need to be amended to provide to regulators better and clearer powers over the market and its participants, widen the range of sanctions, and facilitate MoUs and the exchange of information between regulators, as well as with the stock exchanges. Regulatory framework for mutual funds, asset-backed securitization, and derivatives need to be completed or thoroughly modernized in several countries, and particularly in Guatemala, Nicaragua, and El Salvador.

Securities Regulators

There is a need to strengthen the budget and staff of securities regulators in El Salvador, Guatemala, Honduras, and Nicaragua. However, as discussed under regional integration, these regulators may wish to make maximum use of regulation, laws, and good supervision practices already available within the region and elsewhere, and develop required regulation jointly. We do not have specific recommendations on the regulatory structure (e.g., within or outside the central bank, or a combined or single regulatory agency), save to say these arrangements should ensure a degree of independence to the regulators, and the ability to attract and retain the right staff. The latter may require independence from civil service pay scales.

There is a need to substantially simplify and speed up the issuance approval process in most of the region. The process is generally considered bureaucratic, lengthy, uncertain, and involving multiple levels of scrutiny (between regulators and stock exchanges in all countries, and between two regulators in some). There is a need to make this process more efficient, time-bound, and certain, without sacrificing thoroughness or lowering standards. Key measures would include setting business standards for responses and clearances, responding to all aspects of an application at one go, focusing on materiality rather than formality, eliminating scrutiny by multiple regulators in all cases, and better coordinating with the stock exchange. This should be supplemented with a proactive, regular, and business-like dialogue with representative of issuers and investors to identify and address problems, and develop applications, criteria, and supervision approaches for new products jointly with market participants.

Developing Institutional and Retail Investor Bases

Further development of institutional investors, particularly mutual and pension funds, is needed to facilitate sound intermediation in securities markets. Several countries still have important gaps in the basic enabling laws (El Salvador, Nicaragua, and Guatemala) for mutual funds, and some need to force and facilitate the transition of poorly structured and regulated quasi-mutual funds into properly regulated mutual funds. Regulatory reforms in some countries (e.g., Guatemala) allowing private pension funds would facilitate the establishment of an institutional investor base. Also, there is potential scope to relax investment restrictions on pension funds, particularly for foreign and private sector securities. Restrictions on pension fund products need to be reviewed comprehensively to permit the offer of diverse portfolios suitable to different investors.

Further efforts are also needed to develop a retail investor base. The low income, past crises, and lack of investable securities have created a weak investor base. Although the underlying structural problems of income, education, and lack of securities can be addressed only in the long term, there is also a need to educate investors regarding financial products such as equity, bonds, asset-backed securities, and mutual funds, and inform investors of regulatory efforts to improve corporate governance, disclosure, and safety of market conduct. Again, regional cooperation and development of standards and educational tools may be particularly efficient.

Corporate bond rating standards could be made more uniform across the region. Countries with no rating or multiple rating requirements (e.g., El Salvador, where pension funds are required to invest only in bonds with two ratings) should converge to requiring one rating. A mandatory rating is needed in the region to improve transparency and pricing at this stage of the market, but requirements for two ratings are excessive for most of the regional issuers, and unnecessary for investment by institutional investors. The regional rating agencies are not of uniform quality, and there may be a need to gradually improve the capital and experience thresholds required from rating agencies, but such a move needs to be tempered given the low issuance activity within the region, and the low income of agencies. Standardization of criteria for rating agency accreditation and facilitating the regional operation of agencies (e.g., through mutual recognition) could both improve rating standards and homogenize ratings across the region.

Several steps are needed to develop a regulatory framework and market for ABS. Securitization represents the most promising step toward developing fixed income private markets in the region, given the presence now of several regional and foreign financial conglomerates with skill and interest in ABS, strong demand from even the limited base of institutional investors, and successful completion of several transactions in Panama. In some countries of the region (the Dominican Republic, El Salvador, Honduras, and Nicaragua), authorities still need to address important gaps in the current law or regulation. Most of the countries also need to resolve more subtle and specific gray areas or problems in tax treatment (particularly double taxation), inefficiency of registration or execution of collateral, bankruptcy remoteness, and borrower consent requirements.

Banks, institutional investors, and financial regulators need to collaborate in improving standardization of mortgages and other securitizable assets, and related pricing norms. Such standardization is critical to facilitating future securitization, and there may be a role for moral suasion, fine-tuning of prudential parameters, and developing criteria for any government-supported mortgages or insurance to encourage such standardization. Finally, development of adequate pricing standards and methodology for more complex and structured products such as securitization is an important need. Development of regulation, standards, and pricing methodologies are all useful areas for further regional collaboration.

Development of Equity Markets

There is a need to promote development of a regional corporate governance code. Such a code should ideally be developed jointly by investors, issuers, regulators, and government, but the latter needs to take a substantial lead in making it happen. There is a need to encourage greater participation of minority share-holders in family-owned companies, and the discussions surrounding development of a corporate governance code could be used by the authorities and private business leaders to foster this change.

Market Infrastructure

Regulators, exchanges, and CSDs could take several steps to improve the efficiency and security of exchanges. These measures could include requirement of dematerialization for new security issuance, a phased program to dematerialize existing securities (with the authorities taking the prominent lead with respect to government and central bank debt), favoring a private sector–led (but widely held) CSD, and eliminating requirements on specific investors (such as Asps in the Dominican Republic) for holding securities outside CSDs. In some countries, CSDs need resources to be adequately capitalized and to implement needed technological upgrades, a process that is severely hampered by the current low volume of trading and resulting revenue. The authorities could facilitate these measures by reining in public sector banks or central banks from attempting to develop CSDs.

Improvements in DVP and settlement are needed in most countries. Several countries do not have DVP or settlement in central bank funds. More important, the settlement practices vary across exchanges, and these differences are an important operational hurdle to be overcome in successfully linking or integrating the regional exchanges. With the emergence of regional financial groups, a region-wide settlement bank is easier to find.

Broader Policy Measures

There is a need to eliminate uneven taxation of securities income. In particular, relative tax concessions aimed at public securities and bank deposits should be reviewed and either extended to income from private securities or all such income should be taxed uniformly. Second, there is a need to improve general tax collection to a point that successful tax avoidance and maintenance of two books of accounts are not serious impediments to public issuance of private securities.

Governments should consider eliminating unnecessary incentives to “promote” capital markets. In particular, concessions and regulations aimed at conducting repo transactions through the stock exchanges for institutional investors, issuance of public debt through the stock exchange (which generates fees for the exchange and brokers), and requiring pension funds to deal through brokers in primary markets may be phased out. While these measures might have been useful to jump-start exchanges and brokers in the past, they are not necessarily rational or value-additive for markets today. Such changes should be phased in without reducing price transparency, and prices of both on- and off-exchange transactions should be captured, consolidated, and disseminated in a timely way.

Instead, the governments could consider supporting private capital markets through several measures in public debt management, infrastructure financing, or privatization. Key measures include increasing the share of the standardized, tradable portion of the public debt; consolidating public debt both across issues and between the central bank and the government; developing a domestic yield curve; dematerializing government securities, and facilitating retail investment in public debt. Another important policy tool could be the use of securitization techniques for infrastructure financing. In addition, governments could support equity market development through full or partial privatization of large state-owned companies (especially utilities) through the exchanges, without necessarily eliminating a strategic buyer, and setting high standards of disclosure and corporate governance.

More generally, governments should continue to work on improving the business environment. As noted in this report, improvements are needed in all areas. However, for the development of securities markets, the most critical issues are improving the accounting and auditing framework applicable to all corporations, the legal framework for the constitution, and execution of collateral, as well as insolvency proceedings. Some of these issues would require changes in the judiciary.

Appendix Tables
Table 6.A1.Structure and Resources of Securities Regulators
Costa RicaDominican RepublicEl SalvadorGuatemalaHondurasNicaraguaPanama
NameSuperintendencia General de ValoresSuperintendencia de Valores de la Republica DominicanaSuperintendencia de ValoresRegistrador del Mercado de ValoresComision Nacional de Bancos y SegurosSuperintendencia de Bancos y de Otras Instituciones FinancierasComision Nacional de Valores
NatureDependency of the central bankSeparate legal entitySeparate legal entityDependency of the central government RegistrarDependency of the presidencySeparate legal entitySeparate legal entity
Governance structureBoard and superintendentBoard and superintendentBoard and superintendentBoard and superintendentBoard and superintendentBoard only
Composition of the board7 members, including 5 from private sector, the ministry of finance, and the president of the central bank.7 members, including the superintendent, 1 representative of the central bank, 1 from the ministry of finance and 4 from the private sector.5 members, including the superintendent, 1 from the ministry of finance; 1 from the central bank; 1 from shortlist from the unions, 1 from shortlist from professional associations.There is no board.3 members, one acts as President of the Comision Nacional de Bancos y Seguros.6 members, including 4 from private sector, the bank Superintendent, and the president of the central bank.3 members from private sector.
FundingCentral bank: 80%; fees on participants: 20%Central bankCentral government: 90%; fees on participants: 10%Central governmentCentral government: 50%; fees on participants: 50%Central bank: 25%; fees on participants: 75%Central government: 40%; fees on participants: 60%
BudgetCentral Bank BudgetSeparate budgetCentral government budgetCentral government budgetCentral government budgetSeparate budgetCentral government budget
2006 funding (US$ million)4.013.861.57n.a.n.a.n.a.1.23
2006 staff1091154553742
Sources: Country authorities; and IMF staff.
Sources: Country authorities; and IMF staff.
Table 6.A2.Securities Exchanges
Costa RicaDominican RepublicEl SalvadorGuatemalaHondurasNicaraguaPanama
Stock exchange
Number1112111
NameBolsa Nacional de ValoresBolsa de Valores de la Republica DomincanaBolsa de Valores de El Salvador, S.A. de C.V.Bolsa de Valores Nacional and Bolsa de Productos y MercanciasBolsa de Valores de CentroaméricaBolsa de Valores de NicaraguaBolsa de Valores de Panamá
NatureMutualizedMutualizedMutualized and listed itselfn.a.MutualizedDemutualizedDemutualized and listed itself
Trading systems for secondary market transactions
Is it automated?YesYesYesYesNoYesYes
Continuous/discontinuousHybrid: continuous with market callsDiscontinuousDiscontinuousn.a.n.a.DiscontinuousContinuous
Order driven/quote drivenOrder-driven (Limit order book)Order drivenOrder drivenOrder drivenOrder drivenOrder drivenOrder driven
Sources: Country authorities; and IMF staff.
Sources: Country authorities; and IMF staff.
Table 6.A3.Clearing and Settlement Systems
Costa RicaDominican RepublicEl SalvadorGuatemalaHondurasNicaraguaPanama
Clearing and Settlement
Entity in chargeBolsa Nacional de Valores (BNV) with participation of Central de Valores (CEVAL)CEVALDOM, Central de Valores DominicanaBVN, using accounts at the central bank. Securities are liquidated at the CSDCan be done on or off exchange. If on the exchange, the BVN is in chargeCarried out off exchange by parties in the traden.a.Latin Clear with participation of Banco Nacional de Panama
Settlement periodt + 3 for equity; t + 1 for debt; t + 0 for repost + 1t + 3 for secondary market; t + 0 for repost + 1 if done in the BVNAgreed bilaterally by partiesNot defined by regulationt + 3
SystemMultilateral netting (MN)Gross for securities; MN for cashGross for securities; MN for cashn.a.Agreed bilaterally by partiesn.a.Gross for securities; MN for cash
Risk managementBlocking of securities after trade; settlement fundn.a.Predeposit of securities; overdraft limits in bank accountsNoneNonen.a.Predeposit of securities; individual bank guarantees
Is it DVP?Yes, model 2 (1.5 hours difference between cash settlement and securities settlement)NoNoNoNoNoYes, model 2
Is it central bank money?NoNoYesNoNoNoNo
Central Security Depository (CSD)
Is dematerialization mandatory?No, but immobilization is required for tradingNoOnly for corporate debtNoNoDematerialization required for listing and tradingNo, but immobilization required for trading
Is there a CSD?CEVALCEVALDOMCEDEVALThe exchange itselfThere is no CSDCENIVALLatin Clear
Rating Agencies
Are there rating agencies?YesYesYesYesYesNoYes
Number of registered rating agencies22n.a.31n.a.5
Sources: Country authorities and IMF staff.
Sources: Country authorities and IMF staff.
Table 6.A4.Indicators of Ease of Doing Business, 2006
Costa RicaDominican RepublicEl SalvadorGuatemalaHondurasNicaraguaPanamaCentral America AverageLatin America RegionOECD
Ease of doing businessRank10511771118111678195.7
Starting a bussiness
Rank99119123130138622699.6
Procedures (number)1110101313671010.26.2
Time (days)777326304439194473.316.6
Cost (% of income per capita)23.530.275.652.160.6131.623.956.848.15.3
Min. capital (% of income per capita)01.1119.726.428.60025.118.136.1
Getting credit
Rank3333334821481332.7
Legal rights index44446464.64.56.3
Credit Information index66655565.63.45
Public registry coverage (% adults)2.511.930.516.18.312.5011.778.4
Private bureau coverage (% adults)39.257.179.69.218.73.459.838.127.960.8
Protecting investors
Rank156135991351518399122.6
Disclosure index25631433.44.36.3
Director liability index50235543.45.15
Shareholder suits index27664675.45.86.6
Investor protection index344.743.354.74.15.16
Paying taxes
Rank16014685122152153164140.3
Payments (number)4187665048645959.341.315.3
Time (hours)402178224294424240560331.7430.5202.9
Total tax rate (% profit)8367.927.440.951.466.452.455.649.147.8
Enforcing contracts
Rank11410811614912449164117.7
Procedures (number)3429413636204534.439.322.2
Time (months)51385212240415757.353.529.3
Cost (% of debt)18.7351526.530.421.85028.223.411.2
Closing a business
Rank1181427983102667194.4
Time (years)3.53.5433.82.22.53.22.61.4
Cost (% of estate)14.538914.5814.51816.613.67.1
Recovery rate (cents on the dollar)17.67.429.228.32334.332.324.625.774
Economy characteristics
GNI per capita (US$)4590237024502400119091046302648.6
Population4,327,2288,894,9076,880,95112,599,0597,204,7235,486,6853,231,502
Source: World Bank, Doingbusiness.org.Note: Indices range from 0 to 10, with higher scores indicating more favorable business conditions. Rankings compare 175 economies during 2006.
Source: World Bank, Doingbusiness.org.Note: Indices range from 0 to 10, with higher scores indicating more favorable business conditions. Rankings compare 175 economies during 2006.
Table 6.A5.Taxation of Income from Securities
Costa RicaDominican RepublicEl SalvadorGuatemalaHondurasNicaraguaPanama
Corporations
Income tax30%Special regime for SME29%S25%5%General regime (gross)25%Temporary SS tax30%30%
31%Optional regime (net)5%
Government Debt
Capital gainsE29%S10%10%General regime10%WH/NDEE
EIndividuals trading at Stock Exchange31%Optional regime
InterestNSdollarsE25%S10%WH/D except for FisEE
8%colones10%WH for corporations31%Net income for supervised Fis
WH/DEIndividuals trading at Stock Exchange
Private Debt Securities
Interest
Listed8%WH/DE25%S10%WH/D10%WH/ND10%WH/NDE
10%WH for corporations
EIndividuals trading at Stock Exchange
Not listed15%WH/D10%10%WH/D10%WH/ND10%WH/ND5%if CNV registered
SWH/ND
Special cases8%colones WH/NEAll supervised Fis have no WH but pay25%Corporate income tax for banks and Fis
NSdollars31% net income tax
NSat state owned banks
NSBHV colones or dollars
NSBPDC colones
Capital gains
ListedS29%S10%Individuals trading at Stock Exchange10%General regimeSEE
31%Optional regime
Not listedS29%S10%General regimeSNS5%of transaction amt
31%Optional regime10%of capital gains
Other taxes
ListedN3.00%Transfer taxesVAT exemptN
0.15%Check taxes
1.00%Fixed asset tax
Not listedN3.00%Transfer taxes12%VATN0.01%Stamp duty
0.15%Check taxes1.00%Special Fund
1.00%Fixed asset tax
Equity Securities
Dividends
Listed5.00%29.00%in cash25%S for corporationsESNE
Ein stockEif share’s issuer declared them and paid tax
Not listedXXX29.00%in cash25%S for corporationsESE10%
Ein stockEif share’s issuer declared them and paid taxEWH/ND fpr dividends from non-taxable sources
Capital gains
ListedS29.00%S10%10%General regimeSNE
EIndividuals trading at Stock Exchange31%Optional regime
Not listedSS10%10%General regimeSNS5%of transaction amt
31%Optional regime10%of capital gains
Other taxes
ListedN3.00%Transfer taxes3%Stamp dutyNNE
0.15%Check taxes
1.00%Fixed asset tax0.01%Stamp duty
Not listedN3%Stamp dutyNN1.00%Special Fund
Bank Deposits
InterestNS29%S25%S10%WH/D except for FisISRfor deposits over L50K10%WH/ND, if over $5KE
Other taxesNE10%WH for corporationsNNN
Efor individuals
Mutual Funds
0%Interest on securities that already paid or were exempted from taxEInterest25%SN10%WH/DNEif listed
5%Other interest for securities that did not pay tax29%Dividends10%WH for corporationsEfor dividends if portfolio is listed
5%Capital gains WH/NDEIndividuals
Pension Funds
Tax treatment of the PFENDfor contributionsNMandatory public pension funds contributions are not deductible as expenses but pensions are tax free
ECapital gains29%Capital gainsNSfor capital gains
Other incentivesDfor voluntary contributionsContributions are not considered from income taxBanks can manage funds and contributions are deductible from income taxContributions to private deductible from income tax
Sources: Country authorities; and IMF staff.Notes: S = Subject to income taxE = ExemptD = Deductible from income taxWH = Withholding taxNS = Not subject to taxN = NonexistentND = Nondeductible from income tax
Sources: Country authorities; and IMF staff.Notes: S = Subject to income taxE = ExemptD = Deductible from income taxWH = Withholding taxNS = Not subject to taxN = NonexistentND = Nondeductible from income tax
Table 6.A6.Equity Issuers: Registration Requirements
Costa RicaDominican RepublicEl SalvadorGuatemalaHondurasNicaraguaPanama
1. System
Do issuers have to carry out separate registration and listing processes?YesYesYesYesYesYesYes
2. Registration Requirements
a) Is there a minimum issuance amount?C 100 millionNoNoNoNoNoNo
b) Minimum free float requirement?NoNoNoNoNoNoNo
c) Is dematerialization mandatory?No, but immobilization required for tradingNoNoNoNoNoNo, but immobilization required for trading
3. Financial Statements
a) Mandatory filing?YesYesYesYesYesYesYes
b) Mandatory auditing?YesYesYesYesYesYesYes
c) Accounting principles?IFRSIFRSIFRS as of Oct-03Local GAAPLocal GAAP IFRS in 2008US GAAPIFRS or US GAAP
d) Number of audited periods that have to be presentedn.a.3 fiscal yearsn.a.n.a.3 fiscal years (or less if company is new)3 fiscal yearsLast fiscal year
4. Prospectus
a) Mandatory filing?YesYesYesYes1YesYesYes
b) Minimum content IssuanceYesYesYesYesYesYesYes
Issuing companyYesYesYesYesYesYesYes
Risk factorsYesYesNoYesYesYesYes
Financial results (Management report)YesYesYesYesYesYesYes
Directors, managerial staff, employeesYesYesYesYesYesYesYes
Insider/substantial holdings, related-party operations.YesYesYesYesYesYesYes
5. Legal and Administrative Information
a) Company by-lawsMain info in prospectus; rest available at SUGEVALYesYesNoYesYesYes If company provides
b) Issuance agreementYesYesYesNoYesYesYes
Sources: Country authorities; and IMF staff.Note: IFRS = International Financial Reporting Standards; GAAP = Generally Accepted Accounting Principles.

If the offering is carried out off the exchange.

Sources: Country authorities; and IMF staff.Note: IFRS = International Financial Reporting Standards; GAAP = Generally Accepted Accounting Principles.

If the offering is carried out off the exchange.

Table 6.A7.Equity Issuers: Ongoing Disclosure Requirements
Costa RicaDominican RepublicEl SalvadorGuatemalaHondurasNicaraguaPanama
1. Quarterly Financial Statements
a) Is filing required?YesYesYesYesYesYesYes
b) Deadline20 days if issuer does not consolidate; 30 business days if issue consolidates with local companies 40 business days if issuer consolidates with foreign companiesNot defined30 days after end of quarter quarter3 days after close of of quarter20 calendar days after end1 month2 months after end of quarter
2. Annual Financial Statements
a) Is filing required?YesYesYesYesYesYesYes
b) Deadline40 days if issuer does not consolidate or consolidates with local companies; 45 days if issuer consolidates with foreign companiesNot defined35 days after close of fiscal yearn.a.30-Apr3 months3 months after end of fiscal year
c) Do they have to be audited?YesYesYesYesYesYesYes
3. Material Events
a) Mandatory disclosureYesYesYesNoYesYesYes
b) DeadlineNo later than 1 business dayNot defined8 daysn.a.15:00 hours of following dayImmediate1 business day after it happened
4. Insider Holdings
a) Must insider participation be disclosed?YesNoYesNoNoNoYes
b) Is there a threshold?Non.a.10%n.a.n.a.n.a.No
c) Filing deadline5 business daysn.a.8 daysn.a.n.a.n.a.In the prospectus
d) Is this information public?Yes, at the SUGEVALn.a.Yes, in the registryn.a.n.a.n.a.In the prospectus
5. Substantial Holdings
a) Must substantial holdings be disclosed?YesYesYesNoYesYesYes
b) Percentage share that must be disclosed?10%Not defined10%n.a.10%5%25%
c) Filing deadline5 business daysNot defined8 daysn.a.n.a.1 monthNo, must be included in prospectus
d) Is this information public?Yes, at the SUGEVALn.a.Yes in the registryn.a.YesYesYes, in prospectus
6. Prospectus
a) Must prospectus be updated frequently?YesYesNoNoYesYesYes
FrequencyAnnuallyAnnuallyn.a.n.a.Any time the conditions of the offering have changedAnnuallyAnnually; 30 days after general report is submitted
Sources: Country authorities and IMF staff.
Sources: Country authorities and IMF staff.
Table 6.A8.Debt Issuers: Registration Requirements
Costa RicaDominican RepublicEl SalvadorGuatemalaHondurasNicaraguaPanama
1. System
a) Do issuers have to carry out separate registration and listing processes?YesYesYesYesYesYesYes
b) Is there an obligation to list debt issuances?No1NoYesYesYesYesNo
c) Is there an obligation to carry out secondary market transactions in the stock exchange?YesNoYesYesYesYesNo
d) If no, is there an obligation to report all OTC transactions?N.ANo. Mandatory as of 2008n.a.n.a.n.a.n.a.No
2. Registration requirements
a) Is there a minimum issuance amount?C 100 millionNoNoNoNoNoNo
b) Is standardization mandatory?YesYesNoNoYesYesYes
c) Is dematerialization mandatory?NoNoYesNoNoNoNo
d) Is a legal representative of debt holders required?NoYesNoYesYesNoNo
3. Risk rating
a) Is rating mandatory?YesYesYesNoYesYesNo
b) If yes, number of required ratings121 (2 for pension funds)n.a.11
4. Financial statements
a) Mandatory filing?YesYesYesYesYesYesYes
b) Mandatory auditing?YesYesYesYesYesYesYes
c) What are the accounting principles?IFRSIFRSIFRSLocal GAAPIFRSUS GAAPIFRS or US GAAP
d) Number of audited periods that have to be presentedN.A.3 fiscal yearsLast fiscal yearN.A.3 fiscal years3 fiscal yearsn.a.
5. Prospectus
a) Mandatory filing?YesYesYesYesYesYesYes
b) Minimum content:
IssuanceYesYesYesYesYesYesYes
Issuance guaranteesYesYesYesYesYesYesYes
Issuing companyYesYesYesYesYesYesYes
Risk factorsYesYesNoYesYesYesYes
Financial results (Management report).YesYesYesYesYesYesYes
6. Legal and administrative Information
Is there mandatory filing of the following documents:
a) Company by-lawsYesYesYesYesYesYesNo
b) Issuance agreementsYesYesYesYesYesYesYes
c) GuaranteesYesYesYesYesYesYesYes
Sources: Country authorities; and IMF staff.Notes: OTC = Over the counter; IFRS = International Financial Reporting Standards; GAAP = Generally Accepted Accounting Principles.

But all secondary market transactions have to be carried out in the stock exchange.

Sources: Country authorities; and IMF staff.Notes: OTC = Over the counter; IFRS = International Financial Reporting Standards; GAAP = Generally Accepted Accounting Principles.

But all secondary market transactions have to be carried out in the stock exchange.

Table 6.A9.Debt Issuers: Onaoina Disclosure Requirements
Costa RicaDominican RepublicEl SalvadorGuatemalaHondurasNicaraguaPanama
1. Rating
a) Mandatory update?YesYesYesn.a.YesYesn.a.
b) FrequencyBiannuallyNot definedEvery 3 monthsn.a.Every 3 monthsEvery 3 monthsn.a.
2. Quarterly Financial Statements
a) Is filing required?YesYesYesYesYesYesYes
b) Deadline20 days if issuer does not consolidate; 30 business days if issuer consolidates with local companies;Not defined30 days after end of quarterNot defined20 calendar days after end of quarter1 month2 months after end of quarter
40 business days if issuer consolidates with foreign companies
3. Annual Financial Statements
a) Is filing required?YesYesYesYesYesYesYes
b) Deadline40 days if issuer does not consolidate or consolidates with local companies;Not defined45 days after end of fiscal yearNot defined30-Apr3 months3 months after end of fiscal year
50 days if issuer consolidates with foreign companies
c) Mandatory auditing?YesYesYesYesYesYesYes
4. Material Events
a) Mandatory disclosure?YesYesYesNoYesYesYes
b) DeadlineImmediate but not later than 1 business dayNot defined8 daysn.a.15:00 hours of following dayImmediate1 business day after it happened
5. Prospectus
a) Mandatory update?YesYesOnly if subscription period was extendedNoYesYesYes
b) FrequencyAnnuallyAnnuallyn.a.n.a.Any time offer conditions have changedAnnuallyAnnually; 30 days after general report is is submitted
Sources: Country authorities; and IMF staff.
Sources: Country authorities; and IMF staff.
Table 6.A10.Regulations of Mutual and Pension Funds
Costa RicaDominican RepublicEl SalvadorGuatemalaHondurasNicaraguaPanama
Mutual Funds
Is there a legal framework?YesYesNo1No2YesYesYes
Has the regulator issued complementary regulations?YesYesn.a.n.a.YesNoYes
Are the funds allowed to invest in:
a) Public debtYesYesn.a.n.a.Yesn.a.Yes
b) StocksYesYesn.a.n.a.Yesn.a.Yes
c) Corporate debtYesYesn.a.n.a.Yesn.a.Yes
d) Securitization issuancesYesYesn.a.n.a.Yesn.a.Yes
e) Foreign securitiesYesYesn.a.n.a.Yesn.a.Yes
Pension Funds
Is there a legal framework?YesYesYesNoOnly for public pension fundsYes, but not implementedYes
Has regulator issued complimentary regulations?YesYesYesn.a.Yesn.a.n.a.
Are the funds allowed to invest in:
a) Local public debtMax 50%NoMax 50%n.a.Max 50%n.a.n.a.
b) StocksMax 10%YesMax 5%n.a.Max 10%n.a.n.a.
c) Corporate debtYesYes15–40%n.a.Max 10%n.a.n.a.
d) Securitization issuancesYesYesMax 20%n.a.Max 30% with ratingn.a.n.a.
e) Foreign securitiesMax 25%NoMax 20% but must be done through the local stock exchangen.a.Non.a.n.a.
Sources: Country authorities; and IMF staff.

Brokerage houses administer ‘carteras de inversión,’ which are poorly regulated quasi-mutual funds.

The legal framework includes’ sociedades de inversion,’ which are poorly regulated quasi-mutual funds.

Sources: Country authorities; and IMF staff.

Brokerage houses administer ‘carteras de inversión,’ which are poorly regulated quasi-mutual funds.

The legal framework includes’ sociedades de inversion,’ which are poorly regulated quasi-mutual funds.

Table 6.A11.Size of Emerging Capital Markets(As of end-2006)
GDP (US$ billion)Equity Market CapitalizationBonds Outstanding (US$ billion)Private Bonds Outstanding (US$ billion)Equity + Private Bond Markets (% of GDP)
(US$ billion)(% of GDP)
China2,630.11,144.443.51,212.9421.659.5
Brazil1,067.7708.466.3795.2228.887.8
Russia979.01,030.0105.2124.561.4111.5
Korea888.3815.191.81,110.8643.2164.2
India886.9816.592.1345.740.896.7
Mexico840.0368.943.9401.9188.666.4
Turkey392.4154.039.2226.48.741.5
Indonesia364.2137.337.7105.820.543.3
Taiwan, Prov. of China355.7649.6182.6223.3118.9216.1
Saudi Arabia348.6322.892.63.4n.a.92.6
Poland338.7148.543.8160.76.445.8
South Africa255.2383.6150.4135.557.4172.9
Argentina212.7399.7187.9137.522.6198.5
Thailand206.3137.866.8121.846.089.1
Hong Kong SAR189.51,715.4905.0115.495.3955.3
United Arab Emirates168.3138.682.431.931.1100.8
Malaysia150.9235.1155.8178.5115.6232.4
Chile145.2168.6116.149.931.6137.9
Czech Republic141.850.835.888.515.746.9
Israel140.2130.493.019.611.1100.9
Central America138.116.411.968.58.217.8
Colombia135.152.138.660.91.940.0
Singapore132.2363.8275.3124.267.9326.7
Pakistan129.046.936.434.30.636.8
Romania121.926.621.94.41.122.8
Philippines116.967.958.177.011.668.0
Nigeria115.427.824.1n.a.n.a.24.1
Hungary114.342.337.087.114.749.9
Egypt107.479.473.94.62.376.1
Ukraine106.136.134.18.73.036.9
Kuwait96.1127.1132.23.1n.a.132.2
Peru93.348.051.417.75.557.3
Morocco57.448.284.00.5n.a.84.0
Qatar52.761.8117.211.08.6133.5
Croatia42.529.068.214.30.970.4
Slovenia37.315.441.22.00.241.8
Oman36.012.935.91.2n.a.35.9
Guatemala35.3n.a.n.a.8.90.10.4
Dominican Republic31.6n.a.n.a.13.10.20.6
Tunisia30.64.414.53.5n.a.14.5
Bulgaria30.68.929.03.01.032.2
Lithuania29.810.133.94.2n.a.33.9
Kenya23.29.741.9n.a.n.a.n.a.
Lebanon22.67.131.543.90.935.3
Costa Rica21.41.88.615.05.031.9
Latvia19.63.015.21.20.417.2
El Salvador18.37.742.07.50.846.5
Cyprus18.216.590.34.93.1107.2
Estonia16.45.734.91.81.644.8
Panama17.16.839.812.52.152.0
Jordan14.327.8194.20.20.0194.3
Ghana12.91.29.7n.a.n.a.n.a.
Zambia10.91.08.9n.a.n.a.n.a.
Jamaica10.65.955.64.01.166.3
Honduras9.0n.a.n.a.3.50.00.0
Mauritius6.43.453.70.2n.a.53.7
Malta6.11.829.90.3n.a.29.9
Nicaragua5.4n.a.n.a.8.10.00.4
Barbados3.40.37.50.80.417.8
Sources: Local exchanges; Bloomberg.
Sources: Local exchanges; Bloomberg.
Table 6.A12.Summary of Recommendations
Costa RicaDominican RepublicEl SalvadorGuatemalaHondurasNicaraguaPanama
Regulator’s capacity to effectively regulate and supervise the market
Independence
Create a securities regulatorX
Review role and composition of the boardXXXXX
Strengthen administrative independence by removing limitations on number and salaries of staffXX
Appoint commissionerX
Delink periods of commissioners from presidential periodsX
Powers
Securities market lawAmendAmendRevampRevampAmend
Provide explicit powers over brokeragesX
Provide explicit powers over auditorsXX
Provide explicit powers over rating agenciesX
Exchange of informationXX
Disciplinary frameworkXX
Legal protection of staffX
Resolve gaps in regulation and supervision of issuances by financial institutionsXX
Establish informal mechanisms to discuss issues with industryX
Carry out diligences with supreme court to explain powersX
Supervision and enforcement
Implement risk-based supervision of securities intermediariesXToo limited activity to assessEnhanceEstablish a securities regulatorToo limited activity to assessToo limited activity to assessEnhance
Implement a more active enforcement policyXToo limited activity to assessEstablish a securities regulatorToo limited activity to assessToo limited activity to assess
Clarify responsibilities of the exchange via MoU or other documentXXXXXXX
Market infrastructure
Trading
Eliminate obligation to conduct repos through brokerage houses
Work toward DVPXXXXX
Ratify treaty on paymentsXXXXXXX
Central securities deposit
Impose dematerialization and work on conversion of current physical securitiesX?XXXProhibit reversion of dematerialization
Eliminate central bank custodyX
Capitalize CSDXX
Price formation
Develop mechanisms for appropriate price disclosureX
Develop a strategy for mark to market valuation of carteras de inversiónX
Legal and regulatory framework for issuance
Equity issuers
Strengthen disclosure requirements for equity issuersEnhance public disclosureXXXXX
Include disclosure of insider holdingsStricter rulesXXXX
Include disclosure of substantial holdingsX
Include disclosure of material eventsX
Deadlines for disclosureEstablishShorten
Enact code of corporate governanceXXXImproveXImprove
Debt issuers
Stop non-standard issuesCentral bankGovernment, corps.
Strengthen disclosure requirements by ensuring timely disclosure of material eventsX
Registration process
Streamline registration processX
Improve coordination with Stock ExchangeXXX
Expand shelf registration of bondsX
ABS
ABS regulationClarify authority of public institutions to constitute trusts for ABS purposesStrengthen ABS frameworkEnact ABS lawEnact ABS lawStrengthen ABS frameworkDevelop regulations for ABS
Develop standardized mortgage contractsX
Develop reference rateX
Issue regulations for marketing of foreign securitiesX
Legal and regulatory framework for investment in securities
Mutual funds
Issue mutual fund regulationsXXXReview
Enact mutual fund lawXX
Reduce rating requirement for pension fund investmentX
Phase out carteras de inversiónX
Pension funds
Allow investment in government debtX
Allow investment in foreign securitiesX
Eliminate a second, individual security approval for AFPs’ investments and replace it by general criteria for approved investmentsX
Preconditions
Commercial and corporate law
Streamline process to constitute companiesX
Streamline registration of mortgagesXX
Develop mechanisms for expedited execution of collateralXXX
Modernize bankruptcy frameworkXXXXX
Accounting, Auditing, and Transparency
Implement IFRSXXCompleteX
Consider the inclusion of thresholds for filing and auditing of financial statementsXReview thresholdsXXXXX
Enhance auditors requirements and oversightXXXXXXX
Taxation
Review taxation framework of different financial productsEliminate/clarify imposition of 4.3% tax at origination and transfer to the SPVReview taxation issues on mutual funds draft law
Remove tax on financial transactionsX
References

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    DiamondDouglas W.1984“Financial Intermediation and Delegated Monitoring,”Review of Economic StudiesVol. 51 (July) pp. 393414.

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    International Monetary Fund2007“Guatemala Financial Sector Stability Assessment” p. 21.

    International Monetary Fund2005“Nicaragua Financial Sector Assessment Program Technical Note: Creditors Rights.”

    MyersSteward C.1984“The Capital Structure Puzzle,”Journal of FinanceVol. 39 (July) pp. 57592

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    ShahHemantAnaCarvajalGeoffrey J. BannisterJorge A. Chan-Lau and IvanGuerra2007“Equity and Private Debt Markets in Central America, Panama, and the Dominican Republic,”Working Paper No. 07/288 (Washington: International Monetary Fund). Available via the Internet: http://www.imf.org/external/pubs/cat/longres.cfm?sk=21496.0.

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    TafaraEthiopis and Robert J. Peterson2007“A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework,”Harvard International Law JournalVol. 48 (Winter) pp. 3168.

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    World Bank2006“Guatemala Report on the Observance of Standards and Codes (ROSC): Accounting and Auditing.”

This is an excellent and timely publication. In fact, at a time when simultaneous external shocks are striking the global economy, this publication constitutes a significant and valuable guide for policymakers in the region. It not only fills a void in applied research on Central America, but also provides specific policy recommendations on how to pave the way for sustainable economic growth and poverty reduction.

The authors, while recognizing the progress the region has made over the past years in terms of macroeconomic stability and growth performance, highlight the main challenges ahead to further reduce vulnerabilities and improve policy effectiveness aimed at bringing down income inequality and poverty. In this context, the book calls for more policy coordination among the Central American countries to keep up with increased regional and global integration. It makes recommendations on how to attract more foreign investment and reap the benefits of a customs union, without sacrificing needed tax revenue. On financial markets, the publication constitutes an important source of information on the main obstacles the region faces for the development of private debt and equity markets and the steps to follow.

The insights of this publication will be useful for policymakers, academics, students, and the informed public alike.

Maria Antonieta Del Cid Navas de Bonilla

President, Central American Monetary Council and Central Bank of Guatemala

1For more detailed studies on individual countries, see Shah and others (2007).
2Citibank of Grupo Cuscatlan (2006), Banco Uno (2006), HSBC of Banistmo (2006), and GE Consumer Finance of Banco de América Central—BAC (2005).
3See Diamond (1984). Indeed, anecdotal evidence suggests that borrowers may provide banks with accounting data different from those reported for tax purposes.
4Costa Rica is a hybrid case in that three superintendencies (for banking, pensions, and securities) share the same governing board. This paper does not discuss it fully, but the presence of several financial conglomerates makes effective consolidated supervision of the financial sector an important issue.
5In Nicaragua only the governor of the central bank is a board member since a recent legal amendment eliminated the participation of the minister of finance.
6In Panama, all public debt auctions must be conducted through exchange brokers. In Costa Rica, banks can participate directly in an auction, whereas other investors must submit their bids through brokers and pay-related commissions. In El Salvador, the Ministry of Finance auctions are open not only to brokers but to other approved investors, including domestic and foreign banks, whereas central bank auctions are only open to brokers. See Shah and others (2007).
7El Salvador, Costa Rica, and Panama settle at t + 3 (t + l in Costa Rica for debt), Dominican Republic and Guatemala at t + 1. Nicaragua and Honduras do not have a standardized cycle; moreover, in Honduras the Bolas does not provide clearing and settlement services, and brokerage houses settle their trades directly between themselves.
8Operationally, the Costa Rican exchange (BNV) is the de facto pricing vendor. BNV has two committees, one with industry participation to deal with methodological issues, and the other with external advisors to deal with price disputes.
9The composite scores for the World Bank’s “Doing Business” indicator include such factors as procedures for starting a business, ease in hiring and firing, property registration, investor protection, tax collection, contract enforcement, cross-border trading, and business closure.
10For example, in Panama the attempt by the Junta Técnica de Contabilidad to implement continuous education requirements was ruled unconstitutional by the supreme court.
11All companies in El Salvador, and companies above a threshold in the Dominican Republic and Panama.
12However, in some countries (Panama and Costa Rica) the use of regulatory powers over external auditors has been challenged before the courts.
13No disclosure of material events is required in Guatemala, and the deadlines for disclosure are loose or not defined in the Dominican Republic and El Salvador.
14In El Salvador, the law requires presentation of the issuance documents first to the exchange by a broker, and then by the exchange to the securities regulator.
15Securities regulators in Costa Rica are planning to increase the staff dealing with the authorization process substantially in 2008 and also set up an advisory committee to revise current processes.
16Although, as discussed later in this chapter, the supply of securities is probably a more binding problem.
17El Salvador and Guatemala have loosely regulated quasi-mutual-fund-like products (carteras de inversion in El Salvador and sociedades de inversion in Guatemala) under which brokerage houses, some associated with banks, accept deposits into special accounts that seek to obtain a higher return by investing mostly in public securities. Several institutions in Costa Rica suffered significant problems in 2002, after which the regulation of these products was substantially improved to conform to international norms.
18Fifteen companies account for a market capitalization of $11.4 billion, or more than $750 million on average. By contrast, the bottom 64 listed issues account for a market capitalization of $4.0 billion, with an average size only one-tenth of the top 15.
19For example, in El Salvador, where the law requires an approval within 15 days. However, the law also requires sequential presentation of the issuance documents first by the broker to the exchange and then by the exchange to the regulator.
20Or weak, as in Guatemala, where private debt issuers are not required to disclose material events, nor to update the information in the prospectus.
21As discussed above, some but not all regulators have tried to streamline the registration process, including deadlines for comments, for the authorization process, and for shelf registration systems.
22Ideally, this could involve a “blanket” acceptance of securities admitted to public issuance and trading in another jurisdiction, or it may involve a fast track approval process, focusing more on disclosure to foreign jurisdictions but minimizing or eliminating a substantive approval process in another.

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