14 June 2006

Latin American Economies

A question from the mailbag:

A commentator on NPR yesterday stated that it appears a big part of what is wrong with Latin American economies is not lack of resources or money, but a lack of an adequate legal structure. Essentially, he seemed to be saying that if Mexico, Brazil, etc., had a Uniform Commercial Code, they would progress by leaps and bounds. Does this resonate with you?

The Uniform Commercial Code has a number of articles (ironically based on the European model also used in Latin America). Article 1 covers general matters. Article 2 covers sales of personal property. Article 2A covers leases of personal property. Articles 3 and 4 govern primarily the use of checks as payment systems although it is drafted generally enough to cover some other less well known financial arrangements. Article 4A covers electronic funds transfers. Article 5 governs letters of credit. Article 6 which once covered sales of substantially all of the assets of a business has been largely repealed. Article 7 covers warehouse receipts. Article 8 covers the mechanics of transferring stock certificates. Article 9 covers the use of personal property as collateral for loans.

The case that most of this is economically critical is modest. Articles 3 and 4 were for many years largely superceded by Federal Trade Commission regulations on holder in due course doctrines and by Federal Reserve Regulations, since operationally, almost all checks are processed through the Federal Reserve. Article 5 is generally supeceded in most respects by detailed contacts involving sophisticated parties. Warehouse receipts were not an important economic crisis when the UCC was adopted and aren't now. There is no compelling reason for a uniform law of stock certificate transfers, since states individually incorporate corporations, and for decades the internal rules of transfer agents governed long before Article 8 was revised to reflect this reality.

Articles 2, 2A and 9 provide most of the actively litigated cases under the Uniform Commercial Code, and each of these transactions is governed by civil code provisions in Latin America that are very similar to from country to country, because they largely have a common source. Honestly, most of those rules aren't terribly different from those in the United States, although there are some differences. The biggest difference is Article 9 which provides a very streamlined way to obtain and enforce agreements to use personal property as collateral for loans.

This doesn't mean that a lack of an adequate legal structure isn't a key problem in these countries, but often the real problem isn't primarily a lack of adequate statutes. Indeed, you would find very great similarities between civil codes in recently developed nations, like South Korea and Japan, to less developed nations in Latin America.

Less affluent countries in Latin America differ from more affluent ones in Europe and Asia, despite the similar legal statutes, to a greater extent as a result of commercial and legal institutions and organizations.

Many of these institutions are financial. Here are a few:

* Until the Federal Deposit Insurance Corporation came along, bank failures were far more common, which discouraged people from making their funds available to the financial industry to be invested professionally. There was a natural incentive for investors to take unreasonable risks since they got all the gain if it paid off, and depositors paid almost all the cost if it didn't.

* The Federal Reserve System, through voluntary membership by private banks, has provided a very efficient payment system using checks. This ironically, isn't a big problem in most other countries where the same institutional function of creating a working payment system is normally filled by the Postal Service which offers the equivalent of passbook checking accounts from which money orders can be issued with less conflict and litigation than in the United States.

* The New York Stock Exchange makes corporate stock a much more attractive investment because, by centralizing trading in corporate shares, particular investors aren't locked into a long term investment. This institution, in turn, is supported by local brokerages affiliated with NYSE members, which facilitate the purchase and sales of corporate shares and give people the advice they need to have confidence enough to make the investments, by investment banks that facilitate the process of taking a privately held company public by building a coalition of brokerages to sell shares of a company that needs equity financing, by institutional investors like insurance companies and pension funds, which provide wisdom to the market and a depth of liquidity, and by venture capital companies, which bring small start up companies to the point where a nationally oriented investor will consider seriously a stock market purchase of their stock.

* The bond market, in turn, depends not only on a centralized market and on the network of brokers, but also upon key institutions like Standard and Poors that rate the default risk of bonds in a standardized way, greatly reducing the research costs involved in participating in the market, and indirectly regulating the terms of the bonds issued through requirements to obtain particular bond ratings. The vast majority of big business and governmental financing comes not from banks, but from bond offerings sheparded by investment banks through brokers to institutional and high net worth individual investors.

* The creation, in turn, of large numbers of large, private sector corporations, keeps businesses largely free of political influence on their business policies except through direct, generally applicable legislation. And, the custom of having most stock exchange traded companies have 50% or so of their value in equity as opposed to debt, buffers the corporate sector from economic downturns, since equity holders don't have to be paid in bad times.

* The widespread use of private commercial banks as a payment system, created a marketing tool for the widespread use of consumer and business financing. People can come to their local checking account handler to get a car loan, a credit card, a mortgage, a small business loan, or whatever. Commercial practices without the force of law have largely made this possible. One key institution is the collection agency. Credit reporting is largely a function of major lenders going to the same centralized source to collect their debts and then benefitting from the centralized information that this makes available. And, credit reporting is key to making loans at reasonable interest rates commensurate with the risk involved. Another key institution in the loan making field, particularly morggage lending, is a reasonably accurate appraisal industry. A third key to lending is the widespread availability of governmental guarantees and third party purchasers for commercial loans.

A very large share of all loans to small businesses, first time home buyers with limited abilities to make down payments, and college students for their educations, are made with guarantees from government agencies that set lending standards, leaving the commercial bank to be basically a risk free marketing institution. A great deal of automobile loans and conventional mortgages are promptly sold by commercial banks to third party investment companies which sell bond and shares on the stock exchange backed by purchased loans which are rated and grouped on a standardized basis so the risk can be controlled.

Credit cards are also often resold, rely heavily on good credit reporting, and have also served the economically useful role of minimizing transaction costs for consumer lending and serving as a payment system even better than checks because they involve less paper and less credit risk for the merchant. This is worth a significant (often 3%) share of sales to merchants who no longer have to offer store credit as was common place before credit cards. Yet, the institution of the credit card invented in the 1960s, did not involve any major new law and indeed, is still governed almost entirely by contract rather than by statute.

There does need to be some means of promptly and efficiently foreclosing upon mortgages (normally a special expedited procedure or a non-judical process), repossessing cars when loans code bad (normally without court supervision at all, subject to liability for improper acts), and evicting people who don't pay rent (normally a special expedited court process) to make the financial markets work. But, good underwriting keeps these cases to a minimum and greatly limits losses when they do happen and sets interest rates sufficient to pay for inevitable losses from time to time. Also, transactions are typically mass produced to make any legal case, if one arises, very straightforward. If you borrow money from a bank and use the money to buy a car, you can't complain to the bank if the car doesn't work. They have you sign a note and you either pay or you don't pay, and that is all that matters to the judge and can be proven with business records exclusively because the transaction is intentionally kept very simple.

What most of the developing world lacks that developed nations have are the institutions, and honesty in the institutions that do exist. You can't have a large private sector without stock exchanges, brokerages, institutional investors to mediate investments, a largely money based economy, truthworthy public accounting firms and bond rating agencies, venture capitalists and a pool of people who trust these institutions enough to put their money into them. You can't have a functional business and consumer debt system without a branch banking system to market loans, centralized collection services that rate people's credit, and institutions that feed this kind of lending with outside money or guarantees.

It it hard to have economic growth without the liquidity provided by sound debt and equity financial markets.

If the government doesn't regulate product safety well, you need institutions like Underwriter's Laboratories, that do.

It doesn't take a lot of contract law to provide a foundation for very complex institutions. But, it does take an educational establishment to churn out people like accountants and lawyers and brokers and bankers, and it does take institutions to hire them, and it does take a culture of integrity to guard against corruption.

The legal structure does matter, but only a small portion of it comes from the laws. And, the structure doesn't have to be the American norm. But, if you don't have American institutions, you need substitutes that get the same thing done in the end. Singapore, for example, has almost no mortgage market and almost no private ownership of real estate, but a very good system of government leases of property to private individuals, and a strongly anti-corruption culture.

Building respect for the law often has to start very basic. Malaysia is setting up national commissions to encourage people to respect public toilets (also a major dilema in Singapore), rather than leaving them grotty. But, it is hard to get people to respect things like paying car loans and mortgages, until you have community consensus on using public toilets appropriately.

Basic problems of attitude are common. In most of Africa, traffic laws are pretty much ignored. In Mali, one of the big problems with setting up solar panels to power a community well and provide fresh water is keeping the solar panels from being stolen or damaged. It is one thing to have property rights on the books, and it is another to get people to take them seriously, with common theft being a major impediment to economic development in Tanzania. Tax collectors who take bribes are a major problem in many transitional economies that greatly impair economic development. One of the keys to the success of the Grameen Bank in India was its focus on creating social pressures to repay small business loans. In Nigeria people trying to poach oil from pipelines is a major problem. In much of Latin American, electrical, phone and other utility services are often poached. In the United States, some of these attitudes can be traced to very active courts in the Colonial era which quickly processing vast numbers of relatively petty complains in summary proceedings, with case loads immensely higher than any court in the United States today.

Much of the misery of the developing world also comes from the lack of what in the United States would be local government services or utilities, and the tax collection capacity that makes them possible. Simple things like a water and sewer systems, trash collection, building code enforcement and elementary education are life and death issues in much of the world. Most basic policing and resolution of minor disputes is also provided by local governments in the United States. But, these local government institutions prove very hard to keep in place for a variety of reasons.

Create institutions and the right attitudes, and you can create prosperity. But, legislation, per se, is rarely the major culprit.


Anonymous said...
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Andrew Oh-Willeke said...

How do civil law countries handled loans with personal property collateral? As explained here they basically used the "deed of trust" model which was that basis of real estate lending in Colorado before the courts made them de facto mortgages.