How collateral reform can support other important reforms and initiatives
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Page 13
Donors have supported many reforms to broaden and deepen the financial sector. Some of these aimed directly at increasing prudent financial intermediation. Some took an indirect path, relying on improved macroeconomic stability to correct financial imbalances or supporting judicial reform to improve contract enforcement and debt collection. Yet many failed to include secured lending initiatives.1 As this chapter shows, reform of the legal framework for secured transactions, or collateral laws, supports and reinforces other important reforms targeting the financial sector. At the same time it expands access to credit in ways that these other reforms cannot duplicate.
Macroeconomic reform-aimed at reducing inflation and stabilizing exchange rates, for example-will improve access to credit. The reason is that extreme macroeconomic instability, accompanied by high rates of inflation and large, sporadic changes in the exchange rate, is almost always associated with higher nominal interest rates and shorter loan maturities, and often with higher real interest rates. Lenders always link the size of a loan to the borrower's capacity to service debt, and link that in turn to the borrower's cash flow or income. So, as a matter of arithmetic, higher interest rates and shorter maturities mean smaller loans relative to cash flow or income.
Macroeconomic reform, by reducing the country risk premium and the cost of the government's external finance, makes it possible to lower the interest rate on domestic debt and thus the rate that banks will demand on local currency loans.2 The reform will therefore lower the general level of nominal and real interest rates and in this way improve access to credit. With a strong macroeconomic reform, interest rates on well-secured loans-loans with col-Page 14lateral that can be repossessed and sold in a way timely enough to cover a substantial fraction of the debt-can fall to levels similar to those in industrial countries. In most developing countries well-secured loans are those secured by new, registered motor vehicles-with new automobiles generally the most prized as collateral-and titled urban real estate.
Reforming the system of secured transactions can broaden this effect by extending the interest rate reductions to loans secured by movable property beyond automobiles, which amount to only about 1 percent of the movable capital stock (see figures 1.5 and 1.6 in chapter 1). With changes in the law that extend the benefits to the remaining 99 percent of movable capital-an amount nearly equal to GDP in most countries-macroeconomic stabilization will have a much broader effect on investment and economic activity. Without such changes, interest rates on loans secured by movable property other than automobiles will remain high because the rates reflect the large collection risk that only secured transactions reform can reduce.
Moreover, secured transactions reform can sometimes lead to interest rate reductions exceeding those from macroeconomic reform. The interest rate spread between loans secured by real estate and those secured by movable property other than automobiles can amount to 10-20 percentage points in countries with unreformed systems of secured transactions. In countries with modern (or reformed) systems that spread is only 2-3 percentage points. So secured transactions reform can reduce interest rates for loans secured by movable property other than automobiles by 8-17 percentage points. By contrast, macroeconomic stabilization could be expected to reduce the general level of interest rates by about 2-5 percentage points-the range for typical country risk premiums for developing countries and thus the amount by which their government borrowing rates would fall with stabilization.
The importance of the legal framework for secured transactions also shows up in private loans denominated in foreign currency. Exporters of internationally traded goods face little risk from domestic macroeconomic instability because the prices of their exports are fixed in foreign currency. For this reason a lender making a dollar loan to a producer of export commodities in a country whose currency is about to depreciate would actually face less risk than if the outlook for the exchange rate were stable. Depreciation would raise the foreign currency profit of the local exporter, making it easier to pay off the foreign loan. Yet lenders will not make such foreign currency loans-not because of macroeconomic risk but because they cannot reasonably expect to recover Page 15
BOX 2.1 Why Nicaraguan coffee is good collateral in New York but not in Managua
A coffee grower in Nicaragua has a nearly perfect hedge against domestic currency risk-for example, a depreciation against the dollar-because the dollar price of coffee would be unaffected by depreciation of the córdoba. Indeed, the coffee grower's profits, in both currencies, would typically rise with devaluation: in córdobas, because the córdoba prices of local inputs would rise less than the córdoba price of coffee; and in dollars, because the dollar price of coffee would stay the same while the dollar prices of inputs would fall.
So rational foreign lenders might offer Nicaraguan coffee growers a lower interest rate on foreign currency loans than they would offer the Nicaraguan government, whose tax base measured in dollars would fall with depreciation of the córdoba. But they rarely do. Problems in the legal framework for secured lending prevent potential lenders from looking beyond the farmer to the coffee. So Nicaraguan coffee growers get little credit advantage from the insulation of their collateral from macroeconomic risk. The advantage goes to importers in New Orleans or New York. There the same coffee serves as collateral for loans priced at the lowest inventory...
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