McKinsey Quarterly

Fulfilling the potential of Latin America's financial systems

Although the region's financial depth is low, Latin America could be on the verge of a breakthrough if policy makers continue reducing public debt and reforming the financial and legal systems.

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

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

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

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

Missing money

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

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

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

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