The Political Challenges of Advancing Economic Reforms in Latin America

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CIAO DATE: 2/99

The Political Challenges of Advancing Economic Reforms in Latin America

Daniel Morrow

September 1998

Carnegie Endowment for International Peace

Table of Contents

Preface

Summary

Overview of the Political Status of Market-Oriented Reforms

Strengthening Banking Systems

Advancing Education Reforms

Preface

The Carnegie Economic Reform Network (CERN) convened on February 27-28, 1998, in Miami to discuss "The Political Challenges to Advancing Economic Reforms in Latin America." CERN is a distinguished group of former ministers and other senior policy-makers who have played key roles in advancing market-oriented economic reforms in developing and transitional economies. The meeting discussed the broad political challenges to economic reforms in Latin America and two specific issues—strengthening banking systems and advancing education reform—that are especially important in many countries of the region.

This Report, written by Daniel Morrow, Resident Associate at the Carnegie Endowment, synthesizes and elaborates on the ideas and insights that emerged during the meeting. The diagnosis and recommendations presented here are largely derived from and inspired by the discussion at the meeting but do not necessarily represent the consensus view of participants.

Participants in the meeting (listed in Annex 1) included CERN members, several current policy-makers from the region who are actively engaged in reforms in banking and education, officials from the multilateral development institutions, and scholars.

The Carnegie Endowment gratefully acknowledges support and assistance provided for this CERN meeting by the Economic Development Institute of the World Bank, the Inter-American Development Bank, the Tinker Foundation, and the Ford Foundation. This report is published in cooperation with the Economic Development Institute.

Summary

Political support for market-oriented economic reforms in Latin America has been, on balance, encouraging. Nonetheless, the risk of a slowdown—or even a reversal—of reforms should not be underestimated. The most important danger is that many people in the region feel increasingly insecure—about their own jobs in a more competitive, volatile, and globalized economy and about prospects for their children. To consolidate support for market-oriented economic policies, the near-term political priority in most countries of the region should not be "more of the same." Instead, policy-makers should focus on reforms designed to decrease potential macroeconomic volatility and to reduce prevailing insecurities. Two important means to pursue these broad objectives are strengthening domestic banking systems and advancing education reform.

Many banking systems in Latin America remain vulnerable to economic shocks. This increases the risk of macroeconomic volatility, which undermines political support for market-oriented policies. The region's banking systems would be strengthened by further progress in opening the sector to foreign bank participation, building competent and independent superintendencies of banks, complementing public supervision by market mechanisms to penalize bad bank performance, developing clear laws and transparent processes for exit of insolvent banks and for bankruptcy of firms, and establishing limits on insurance for depositors and enforcing bank shareholder losses. To overcome potential political opposition to such measures, reformers should consider the following lessons of experience:

A banking crisis is itself the moment of greatest opportunity for introducing reforms.

Policy-makers should make use of the competitive pressure from foreign banks to win support for stronger domestic regulation and supervision.
Policy-makers should take advantage of international institutions and their associated norms as allies for reform and for the enforcement of good policies.

In this policy area, coalition-building within the relatively limited set of political and economic elites can be sufficient to achieve change.

The basic elements of the system should be embedded in law—not only in regulation.

Improving education is crucially important in both economic and political terms. The sustainability of political support for market-oriented policies depends in part on whether or not the middle classes feel hopeful about the future of their children, and this depends to a significant degree on the availability of quality education. There are now reasons for optimism about reforming education in Latin America, but the process will be long and uneven, and political leadership will be essential. A political strategy should emphasize the following principles:

Empowering the "consumers," i.e., the parents and local community groups.

Increasing the autonomy of schools and of community-level authorities.

Ensuring long-term political leadership for the reform by retaining a good minister of education.

Building support for education reform within the business community and within the economic policy-making team by stressing its contribution to competitiveness and growth.

Spending political capital to overcome resistance to reform from the teachers' union leadership.

Keeping the middle classes in public schools by investing resources in quality enhancements.

Finding additional resources for public primary and secondary education from outside of the sector, not from public higher education.

Building on local successes instead of striving for an all-at-once,nationwide reform.

Overview of the Political Status of Market-Oriented Reforms

Political support for market-oriented economic reforms in Latin America has been, on balance, encouraging, although its durability is at risk. The conclusion of a 1996 report by the Inter-American Development Bank (IDB) remains valid: "The process of structural reform has proven to be sustainable. In almost all countries of the region, the reforms survived periods of economic crisis and changes in government." ₁ The results of presidential elections in major countries of the region during recent years support this favorable assessment. ₂ In the largest country of the region, Brazil, a reform-oriented leader, President Cardoso, was elected in 1994; according to the latest polls, he is likely to be reelected in October 1998. In Mexico, the ruling PRI party selected a pro-reform presidential candidate, Ernesto Zedillo, in 1994, rather than revert to the more economically conservative wing of the party. And the severe economic crisis that hit Mexico in 1995 did not bring about a reversal of previous liberalization policies. In 1995, both President Menem in Argentina and President Fujimori in Peru won reelection after pursuing aggressive and successful economic reforms designed to stop hyperinflation. Even in countries in which opposition parties have replaced reformist administrations, as in Bolivia in both 1993 and 1997, the new administrations campaigned to improve, not to reverse, the basic economic policies. In short, the evidence in Latin America in recent years is that broad political support for the market-oriented reform agenda has been reasonably robust.

Nevertheless, there is substantial risk that political pressures will lead to a slowdown in the process of economic reform throughout the region. As a general proposition, the reform process is easier at the beginning. This is especially true if an initial economic crisis has generated a strong political will to change. But reform becomes more difficult when the initial crisis is overcome and when the reform threatens deeply rooted interests and requires more thorough institutional change.

A slowdown in reforms is not, however, the only danger. The risk of a backlash against the currently dominant economic model and of backsliding in key areas of reform should not be underestimated. Over time, the gap between expectations and reality may widen. Initial progress in reform has generated high expectations that in many countries have not yet been matched by growth in real wages, employment, and public services. Those who have been hurt by the reforms to date may remain more vocal—and hence politically potent—than those who have won. Rent-seekers may become more dangerous to sustained reform than the political opposition itself. For all of these reasons, the risk of significant policy reversals must be taken seriously.

Perhaps the most important danger for market-oriented economic policies is that many people, especially the politically potent middle classes, seem to feel increasingly insecure in several dimensions. Some reforms have contributed directly to insecurity for certain groups. Trade liberalization has exposed many firms to more intense competition and hence to pressures for cost efficiencies, although its impact on income distribution in the region remains unclear (see box 1).

Box 1. Openness and Inequality

The relationship between economic openness resulting from trade liberalization and income inequality is far from clear in Latin America.* On the one hand, those best able to take advantage of the new economic environment have so far gained the most from economic openness. They include modern firms that can compete in the export market, wealthy individuals who can pursue new investment opportunities, and professionals who can sell their skills in the global marketplace. On the other hand, the very high degree of income inequality in Latin America is an historical legacy of closed economies that were based on the exploitation of natural resources and on import-substitution policies. These systems created massive rents, suggesting that perhaps the most important source of income inequality has been the capture of these rents by elites. Since market-oriented liberalization destroys or greatly diminishes opportunities for rent-seeking, it may lead to improved distribution over time.

In this respect, there is a great contrast between Latin America and Eastern Europe. These regions started the economic liberalization process from opposite ends of the spectrum of income distribution. The formerly communist countries of Eastern Europe had relatively even income distribution, and their liberalization policies of recent years, including economic openness, will almost certainly be accompanied by an increasing degree of income inequality. This may be the necessary outcome of stronger incentives for individual effort and entrepreneurship. For Latin America, starting from extremely high inequality, the impact of liberalization and openness is not clear.

* For a fuller discussion of this issue, see Inter-American Development Bank, Latin America after a Decade of Reform: Economic and Social Progress Report, 1997 (Washington, D.C.: 1997), p. 74.

Privatization has eliminated the assumption of lifelong tenure for the many employees of the previously public enterprises. The fiscal retrenchment required by macro-stabilization programs has generally resulted in a decline in subsidies and in some public services. Increasing integration into global capital markets has exposed economies to macroeconomic volatility, as evidenced most dramatically in the Mexican peso crisis of 1994–95 and its "Tequila effect" throughout the region. People also feel insecure because of the inability to obtain adequate education for their children, increasing crime in many parts of Latin America, and, in some cases, the rising prices of essential goods and services previously subsidized by government. Perhaps most responsible for this insecurity is the fear of unemployment. According to a 1997 survey by Latinobarometro, ₃ 19 out of 100 Latin Americans think that the biggest problem today is unemployment, and 7 out of 10 rate themselves as concerned or very concerned about losing their jobs in the next twelve months.

Economic insecurity and volatility threaten to undermine political support for the prevailing market-oriented economic policies in Latin America. They cloud hope for the future, which is essential if people must cope with the disruptions of economic reform and the on-going changes inherent in a market economy. What must be done to alleviate these concerns? First, any return to high and volatile inflation would severely aggravate current insecurities. This means that the recent gains in fiscal and monetary discipline—which have been at the core of reform in many countries in the region and provide a foundation for long-term growth—must be preserved. But a second conclusion is that "more of the same," i.e., further advances in the "first stage" reforms of trade liberalization, privatization, and fiscal retrenchment, will not secure the progress to date toward market-oriented reforms. For countries that have already moved forward significantly in these areas, the near-term political priority should not be further steps in these same directions. These might only aggravate actual and perceived insecurity and thereby bring about political backlash. Instead, the next stage of reforms must be designed to reduce the prevailing insecurities and to decrease potential volatility.

It should be recognized that, in some countries in the region, much remains to be done to complete the agenda of "first stage" reforms. ₄ For example, the privatization of inefficient public enterprises and banks has barely started in Brazil; the recent privatization of Telebras is an important step forward. In many countries, the consolidation of good tax regimes and administration that must underpin long-term fiscal management remains incomplete. In these countries, further progress in the early reform agenda must be undertaken in parallel with a next generation of reforms designed to mitigate insecurity and volatility.

Reducing economic insecurity will require better policies and programs to increase social protection and to improve key social services. These include: unemployment insurance, expanded health care coverage, better police protection and other measures to reduce general crime, broader and more secure pension systems, and education to provide skills for competing in the increasingly global marketplace. Progress in these areas—which few of the countries of Latin America have achieved—would not only contribute directly to the quality of life but would also secure continued political support for the market-oriented reforms already in place. Arguably, progress in social protection is necessary so that a society can endure the vagaries associated with a market-driven economy (see box 2). In this sense, defense of existing market-oriented policies may require, as a priority, a good offense in these areas of social protection and services.

Box 2. Social Protection and Economic Openness

Cross-country data indicate a strong and positive correlation between the share of GDP spent on social protection and the openness of an economy to international trade. But how should this correlation be interpreted? It is argued by some that expenditures on social protection increase in order to offset the insecurity and volatility associated with open economies.* From this perspective, social protection is a necessary public good for capitalist societies. The implication for Latin America is that, as economies are increasingly integrated with the world economy and subject to more rapid economic change through their active participation in global markets, they must necessarily increase expenditures on social protection in order to offset the negative aspects of such participation.

But it may be that the observed correlation between the levels of social protection and openness reflects a very different process. Openness means more rapid growth and higher per capita income; and, as countries become wealthier, they may be willing to allocate a higher share of total income to social protection programs. From this point of view, social protection is more like a luxury good, not an essential commodity of open economies. A variation of this interpretation might be that public expenditures on social protection programs always involve costly and inefficient bureaucracies and that a society’s tolerance for such inefficiency increases as its income level rises.

* On this point see Dani Rodrik in "Sense and Nonsense in the Globalization Debate," Foreign Policy (Summer 1997).

The second broad focus for the next stage of reform should be policies designed to reduce macroeconomic volatility, which results in part from fuller participation in the global economy, including global capital markets. ₅ The Mexico crisis in 1994–95 and the Asian crisis in 1997–98 show that even the most successful emerging markets are vulnerable to volatility, which may be triggered—or simply aggravated—by huge movements on the international capital markets. Although the volatility associated with capital market movements is to some extent likely to be an inevitable part of participation in the global economy, there is much that national governments can do to reduce the probability and magnitude of recessions caused by this volatility. The required measures include better fiscal management and much healthier, more resilient banking systems. ₆

Within the broad range of policies that would reduce macroeconomic volatility and economic insecurity, strengthening domestic banking systems and advancing education reform are critically important in most countries of the region. The rest of this paper will consider in detail these two key goals. These two challenges are not necessarily the most important pending reforms in every country of the region. For many countries, reforms in labor market regulation and practice, for example, may be even more important and urgent. ₇ Labor market reforms are essential both for accelerating efficient growth in an open economy and for ensuring some level of social protection (e.g., unemployment insurance) to offset the negative consequences of such openness. Civil service reforms are also critical in most countries ₈ (see box 3). But strengthening banking systems and improving education are certainly important goals throughout the region. They have been chosen for close examination in part because they represent reforms at different ends of a spectrum. Strengthening banking systems is a "state-centered problem" that involves the direct engagement of a relatively small set of political and economic elites. In a sense, the necessary reforms can be pressed successfully in a top-down manner. Advancing education reform, in contrast, is a "society-centered problem" that involves broad participation not only from political elites but also from communities and parents at all levels of society. It can only be achieved through successful work at a grassroots level and through much bottom-up effort.

Box 3. The Central Importance of Civil Service Reform

The "second stage" of reforms discussed here—increased social protection and services and policies to reduce macroeconomic volatility—require a competent state. Providing higher quality public education, regulating private pension funds, supervising banks, and managing fiscal resources in a counter-cyclical way all require a level of institutional capacity that now eludes most Latin American governments. Achieving broad progress in these areas will therefore require some type of civil service reform. The creation of a new class of professional, non-corrupt civil servants would have a tremendous impact on the evolution of political and economic debate in the region. It would transform the present, often sterile debate about the appropriate size of the state and turn it toward issues of how the state can complement and improve a market-driven economy.

Strengthening Banking Systems

A key factor in reducing macroeconomic volatility is strengthening domestic banking systems. The recent crises in Asia have shown that a poorly regulated and supervised banking system can become exceedingly overextended and vulnerable, especially during a period of rapid economic expansion. In an era of mobile international capital, such vulnerability can lead to a rapid financial collapse. The Mexico experience in 1994–95 also demonstrated that an unhealthy banking sector can seriously aggravate a crisis that is triggered by a sharp depreciation in the currency. Whether a banking crisis triggers economic recession or aggravates a recession that is set off by other factors, it is clear that a fragile banking system contributes significantly to macroeconomic volatility. Conversely, a sound banking system that can absorb shocks—in particular, a sudden weakening of asset quality and/or a loss of deposits due to a currency crisis—is necessary to reduce the frequency and amplitude of macroeconomic fluctuations.

Many Latin American countries have been working to reform and improve their banking systems. Financial markets have been liberalized so that lending and deposit rates are set by market forces and competitive pressures are at play. In many countries, public banks have been closed or privatized. New laws and regulations are in place that require banks to adhere to the standards of the Basle Accords—although many argue that even higher standards, especially with respect to capital adequacy ratios, are needed in Latin America. In most countries, however, the agencies responsible for the supervision and enforcement of these new laws and regulations are weak. Accounting standards are low. Judicial system support for the superintendent is fragile. In many countries, the quality of bank capital is low, asset classifications are not sufficiently conservative, and consolidation of off-shore activities remains problematic. As a result, some banking systems in the region remain vulnerable to economic shocks, and their weakness would increase the severity of any downturn.

The banking systems in Latin America ₉ would be strengthened by further progress on the following fronts:

Opening up the banking sector to foreign participation. In much of Latin America, this is already a reality, not an option. In Argentina, for example, foreign banks have bought controlling interest in a large share of the banking system. Most recently, a Dutch bank bought Brazil's fourth largest bank. Such foreign participation has many advantages: it increases competitive pressure; it brings new operational technologies; it creates a bulwark against the traditional forms of government intervention in credit allocation; and it means that the foreign banks will be subject to the supervisory authorities from their home countries. ₁₀ A substantial foreign bank presence may therefore contribute to the stability of the system; depositors are less likely to lose confidence in a foreign bank with deep pockets and the oversight of its home country authority. Foreign participation is not, however, a panacea. In some countries there is evidence that the quality of the loan portfolios of foreign banks is not better than that of local banks, and often the foreign banks only seek involvement in limited or specialized financial markets. And, in any case, in most countries there are likely to be political limits to the tolerance for foreign control of such a critical sector. These political limits may vary widely among countries. At one extreme, Argentina has accepted that foreign banks will play the dominant role. Nationalistic sentiments may preclude such a policy in some countries. ₁₁ In most, however, a mixed system involving some foreign banks and a set of large domestic banks is evolving.
Building competent and independent superintendencies of banks. Even when modern laws and regulations are in place, they can only be enforced by a competent superintendency that will not yield to political pressures for excessive "regulatory forbearance." ₁₂ In creating such an institution, the following measures may be useful. ₁₃ First, to ensure adequate budget resources so that the institution can pay sufficiently high salaries and avoid the vagaries of legislative appropriations, a transaction tax on banks can be earmarked for support of the superintendency. Second, to increase the political autonomy of the superintendency, the tenure of the superintendent and the supervisory board should not coincide with that of the country's chief executive. Furthermore, a superintendent should be protected from removal except by the judicial branch for cause. Third, the superintendency should be placed within the governmental structure in order to strengthen its prestige, professional standards, and sense of independence. The best placement will vary among countries. In countries in which the central bank has a reputation for high professional standards, the superintendency might be established within the central bank. In other countries, it may be best to make the superintendent fully autonomous. Fourth, every effort should be made to build up the professional linkages between the national superintendency and foreign banking authorities. Such linkages will be needed to allow supervision of overseas branches of domestic banks, which is crucially important so that banks can be evaluated on a consolidated basis. All of these measures will contribute to stronger supervision. But it should be recognized that strong supervision is a necessary but not sufficient condition to prevent a banking crisis. In a strong boom-bust cycle, even well-supervised and well-managed banks can get into trouble, and no amount of supervision can compensate for bad macroeconomic management. Furthermore, a strong superintendent can be only one element in maintaining a reasonable balance of political and economic power within a society. Nevertheless, a healthy banking system requires a strong and competent superintendency, and any delays in creating such capacity can be very costly.
Complementing public supervision with market mechanisms to penalize bad bank performance. Market mechanisms that help to monitor bank behavior, reward good performance, and penalize poor performance have a distinct advantage: they do not depend on the institutional competence or the political independence of the supervisory authorities. Possible mechanisms have been pioneered in Chile and Argentina. Perhaps most important, both countries have greatly increased the transparency of their banking systems. In Chile, auditors review banks three times a year, and their summary ratings are published in newspapers. Argentina has created and disseminated a detailed computerized database on bank borrowers. It has also required banks to issue subordinated debt, and the price of these debt instruments in the secondary market becomes a barometer of each bank's health. It remains to be seen which mechanisms will prove to be most effective. However, experience to date in the region suggests that the rating of banks by private credit agencies has thus far been relatively ineffective in increasing transparency and promoting market discipline. This may reflect the poor quality of accounting and hence inadequate information about banks, and these problems will plague virtually all of the market mechanisms. It should also be recognized that, if depositors count on blanket deposit insurance and shareholders count on the government's protection against loss, none of these market mechanisms work well. In short, the mechanisms can complement but not substitute for other measures discussed here.
Developing clear laws and transparent processes for the exit of insolvent banks and bankruptcy of firms. ₁₄ A healthy banking system—indeed, a healthy market economy—needs mechanisms for closing down failed businesses. ₁₅ Such mechanisms are a necessary part of Schumpeter's "creative destruction" of capitalism. Without such mechanisms, an economy's capacity to ensure continuing best use of productive assets is severely hampered. And yet few Latin American countries have made progress in establishing bankruptcy laws and in developing the administrative and judicial capacities to enforce them. ₁₆ As a result, loans to comatose firms remain on the books of otherwise healthy banks, restricting their capacity for new lending. Because of the lack of good processes for the resolution of insolvent banks, it is much harder for supervisory authorities to intervene. Consequently, after a banking crisis, the system can remain unhealthy for years. This seems to be the case in Mexico. The crisis that started in 1994 is, in an important sense, not over. Bank restructurings have not been completed because of weaknesses in the judicial system for dealing with restructuring issues and because of political debate over the terms of bank resolutions. As a result, domestic banks in Mexico can provide very limited new lending, and this impedes economic recovery. The same fate is likely to await the Korean banking system unless resolutions of bankruptcies of firms and of banks can be undertaken quickly.
Establishing limits on insurance for depositors and enforcing bank shareholder losses. The tradition in much of Latin America is that governments bail out banks that become insolvent. This usually has involved full compensation for all depositors, and it has often allowed bank owners to avoid significant losses of capital. These traditional practices create a very real moral hazard: depositors need not monitor the soundness of their banks; and, most important, bank owners and managers can take excessive lending risks. ₁₇ The consequent risks to the public treasury are huge. In the wake of a banking crisis involving widespread insolvencies, the fiscal costs of bailouts can amount to a significant share of GDP. This often forces governments to run fiscal deficits that ultimately can be financed only by a substantial inflation tax. To avoid these problems, it is a priority throughout the region to enact new laws and associated regulations that clarify and limit deposit insurance and that set procedures for the rapid resolution of insolvencies under which bank shareholders lose their capital.

Further strengthening banking systems in Latin America by implementing the above measures presents an important political challenge. The community of bank owners constitutes a politically powerful group within any country—developed or developing. If bank owners cannot be persuaded to support reforms in the system, their united opposition will be difficult to overcome. Given the potential political obstacles, how can Latin American policy-makers pursue this remaining agenda for banking sector reform?

Before considering political tactics, two general points merit mention. First, maintaining a reasonably stable macroeconomic environment is almost certainly a prerequisite for further improving the banking system. Low inflation contributes to the transparency of the entire financial system, helping banks determine the health of current and potential borrowers. A low-inflation environment with prospects for reasonable growth is necessary to attract significant investment by foreign banks. Most important, relatively low real interest rates can do more to strengthen the health of the economy and hence the banking system than anything else, making them more amenable to stronger supervision and to foreign competition. Second, there are no easy and "quick fixes." Building up elements of an efficient financial market infrastructure, such as a competent superintendency and better accounting practices, takes time. Good banking system management is hard even in developed countries, as illustrated by the massive savings-and-loan debacle in the United States and by the continuing troubles in Japan's financial sector. In any case, the health of the banking system depends on the health of the underlying economy, which is fragile during periods of dramatic reforms. Policy-makers in developing and transitional economies therefore should understand that strengthening banking systems is a "long march" during which setbacks and crises should be expected.

Nevertheless, past experience suggests some useful lessons and guidelines for making progress on the above-outlined agenda:

A banking crisis is itself the moment of greatest opportunity for introducing reforms. This was the experience in Chile in 1982, in Argentina in 1990 and 1994, and in El Salvador in 1997. ₁₈ When crisis hits and the need for reform is acutely evident, it is most feasible to obtain Congressional approval for new laws to underpin improvements in the system. Policy-makers must act quickly to seize the moment. To be able to do so, it may be wise to do the necessary technical work in advance—for example, to draft any necessary new laws in a technical committee while waiting for the political opportunity to seek their approval. Following a crisis, political support for strict enforcement of the new laws and regulations may persist for years. This has been the case in Chile.
Policy-makers should make use of the competitive pressure from foreign banks to win support for stronger domestic regulation and supervision. Given the internationalization of banking, a strong domestic regulatory framework and a credible supervisory capacity are necessary for domestic banks to be competitive. An analogy to airline supervision is useful: If customers can choose between a domestic airline for which safety is supervised by a weak domestic agency and a foreign airline for which safety supervision is done by a well-regarded and competent agency, which will they chose? In the same way, depositors will choose banks that can boast good regulation and supervision. Domestic bank owners should therefore be persuaded that, given the presence of foreign banks within the national financial system, they cannot survive unless they subject themselves to good supervision. This is how policy-makers should "sell" the need for a strong and independent superintendency.
Policy-makers should take advantage of international institutions and their associated norms as allies for reform and for the enforcement of good policies. The Basle Committee, the Bank for International Settlements, the supervisory authorities in OECD countries, the IMF, the World Bank, and the Inter-American Development Bank can provide standards for and/or technical assistance in the design of better regulations and institutions. In some circumstances, these institutions can also be useful in persuading political and business leaders of the need for reform. Moreover, the international norms and the institutions that propagate and monitor them can become important allies in the enforcement of good laws and regulation. As the process of internationalization expands, domestic banks and supervisory authorities become increasingly embedded within a structure that reinforces good national policies and practices, and this makes enforcement more feasible.
In this policy area, coalition-building within the relatively limited set of political and economic elites can be sufficient to achieve change. Political support must be created among the leaders of the business (both bank and non-bank) community. In seeking support for reforms, policy-makers' natural allies are the relatively strong banks that can expect to survive under the rigors of international competition and good supervision and also the relatively strong firms that expect to be their clients. For this reason, reformers may need to "divide and conquer" the banking community. In the non-bank business community, a fairly broad alliance may be possible: large firms that already enjoy access to bank lending can expect to gain from lower spreads and lending rates; and firms that do not enjoy sufficient access can hope to gain it. The losers and hence opponents of reforms will be the firms whose relative lack of creditworthiness would be penalized by a more efficient banking system.
The basic elements of the system should be embedded in law—not only in regulation. Putting the foundations of the banking system, including the superintendency, into law approved by the legislature reduces the likelihood of reversals and enhances the long-term credibility of the system. Nevertheless, some useful actions—for example, strengthening regulations governing asset classifications—may involve only a "stroke of the pen" within the executive branch rather than legislative action. Even in the absence of crisis, a minister of finance or a central bank president may be able to make some progress by using the strength of the office to push through such regulatory change. Such incremental steps in the right direction should be pursued whenever an opportunity to do so arises.

Advancing Education Reforms

Throughout Latin America, improving education is crucially important in both economic and political terms. In an era of increasingly open economies, Latin America needs to create a more highly skilled and competitive labor force in order to grow more rapidly. Better education for the children of the poor is essential to provide them with opportunities to improve their incomes. Accelerating growth and reducing poverty depends on better education at all socioeconomic levels. From a political perspective, the sustainability of support for market-oriented policies depends in part on whether or not the middle classes feel hopeful about their children's future. And that depends to a significant degree on the availability of quality education. In the survey by Latinobarometro cited above, inadequate education ranked second behind unemployment as the greatest source of concern among Latin Americans.

The existing problems with education in Latin America have deep historical, cultural, economic, and political roots (see box 4 on contrasts among world regions). Since the colonial period, the elites in the region have relied primarily on private schools for their own children. Public schools for the majority of citizens were given low priority because, in these closed and traditional economies, an educated work force was not regarded as an important factor in development. In the weak public education systems that did develop, the central education bureaucracies and the teachers' unions became bilateral monopolies, managing the system with a view toward their corporate interests and neglecting the interests of their "consumers." ₁₉ The teachers' unions also became very politicized and often politically powerful. The middle and upper classes captured a large share of available public funds for universities and college-preparatory schools and did not support reallocations in favor of mass primary education. More recently, during the "lost decade" of the 1980s, many Latin America countries cut education expenditures as part of the fiscal retrenchment needed during the debt crisis.

Box 4. Regional Contrasts in Education Sector Problems

lthough Latin America, Eastern Europe, and East Asia share many of the same problems in their banking sectors, these regions face very different circumstances with respect to education. In the formerly communist states of Eastern Europe, education levels are very high—in part because public education had long been a state expenditure priority. A key challenge now is to open up opportunities for private provision of education. In many countries of East Asia, governments have been successful in giving sufficient attention to public primary education, reflecting in part a strong recognition of the links between education and economic growth.

There are now reasons for optimism about the prospects for reforming education in Latin America. Within the region, there is growing recognition that competitiveness in the global economy and rapid technological change require a well-educated and dynamic labor force. ₂₀ Indeed, it is increasingly clear that opening up the economy and improving education are mutually reinforcing reforms. Partly for this reason, education reform is on the political agenda in most countries of the region, demanding the attention of finance ministers and presidents. Considering the better fiscal management in the region and more favorable demographic trends, ₂₁ larger financial resources for education may become available. But there is still considerable debate about exactly what must be done to improve education, and there are many stakeholders. Despite the pressure for change, it is therefore likely that the reform process will take a long time and will proceed at different speeds among and even within countries.

Improving education in most countries requires overcoming these three key obstacles to reform: ineffective and costly central bureaucracies that control public education, powerful teachers' unions that have vested interested in the current systems, and middle- and upper-class resistance to allocating sufficient public resources for basic education.

Although there will almost surely be a diversity of approaches to education reform, a political strategy for reform should in most cases embrace the following principles:

Empowering the "consumers," i.e., the parents and local community groups. To play a more powerful and constructive role, parents need information and "voice." As the potential beneficiaries of the reform, they need to be mobilized to provide necessary political support and to provide feedback about what is working. A good public communications strategy is essential—especially when reforms designed to increase local control are initiated from the top—to enable parents and local communities to learn about their new rights and responsibilities. In some countries, parent-teacher associations have been instruments for change at the local level. Empowering consumers also means reducing or eliminating restrictions on private schools so that they can increasingly provide a competitive alternative to public schools.
Increasing the autonomy of schools and community-level authorities. In order to break the monopoly of the education "producers" and overcome their vested interest in the current system, it is essential to devolve power and responsibility to lower levels within the education system. ₂₂ The key is to increase the autonomy of individual schools in managing their resources (including hiring and firing of teachers). ₂₃ Experience in some countries, for example El Salvador and Costa Rica, suggests that it may be important to empower local community groups below the level of local governments; the latter are often weak and ineffective.
Ensuring long-term political leadership for reform by retaining a good minister of education. The common curse of reform in the sector is the low political profile and the high turnover of education ministers. Since reforms take a long time, the education minister—who must almost always be the lead person for the reform—must remain in office long enough to make progress. If he or she does so and can provide strong leadership, it is possible to overcome the inertia within a central bureaucracy and to overcome its normal resistance to change. In Brazil, for example, even the relatively simple task of speeding up the process of textbook production and delivery could not be achieved during the years when there was a new minister every few months; the current minister, who has remained in office for several years, broke through bureaucratic obstacles to efficient textbook delivery.
Building support for education reform within the business community and within the economic policy-making team by stressing its contribution to competitiveness and growth. Although involved parents are likely to be the "drivers" for reform at the local level, adequate political support for education reform will also require broad support from the private sector. Such support is perhaps most likely to come from those business leaders who are striving to become competitive in global markets and who feel the need for a more educated work force. The core team of economic policy-makers—within the Ministry of Finance in particular—must also be convinced of the long-term importance of this effort. Education reformers need to cultivate the support of both groups. In Colombia during the early 1990s, the inability of the reformers to get their agenda through Congress was in part due to the failure to mobilize support among the powerful business associations. ₂₄
Spending political capital to overcome the resistance of the national teachers' union leadership. In most of the region's countries, the national teachers' union leadership is a major obstacle to reform. The union leaders typically resist decentralization that undercuts their authority, seek to capture any incremental financial resources for teacher salaries and benefits rather than for other inputs, and even oppose performance standards for teachers. Almost no serious reform can take place until the unions' resistance is diminished. Ideally, a government could work constructively with the more progressive elements of the union leadership. But when this is not possible, at an early stage in the reform process, the government must face a nation-wide teachers' strike. The lessons of experience in the region indicate that only a strong and determined government can endure such a strike. Often parents—eager to get their children out of the house and back to school—quickly take the side of the teachers. So it is critical that the government prepare for this battle in two ways. First, it must effectively communicate to the public the issues at stake and gain as much support as possible from parents as well as from local governments and community groups that would benefit from decentralization. Second, in exchange for any decrease in existing teacher benefits and work rules—e.g., very high pension rights and tenure without performance standards—it must offer benefits of value to the rank-and-file of teachers. These might include better training, freedom from excessive bureaucratic control of classroom activities, and opportunities for salary increases based on performance. Even with these elements in place, a government should seek a showdown with the teachers' union only at a time when it is politically strong.
Keeping the middle classes in public schools by investing resources in quality enhancements. It is impossible to build adequate political support for a public system that only serves the poor. The middle class needs to perceive that the reforms will make the public system better for their own children. They need to be attracted to the system by its quality, not forced into it by restrictions on private schools. This means that resources cannot be invested only toward improvements in coverage in poor areas and in primary schools.
Finding additional financial resources for public primary and secondary schools from outside the education sector, not through cuts in expenditures on public higher education. In many countries, a significant share of public financial resources within the sector is devoted to public universities. Tuition is very low, and this constitutes a massive subsidy for middle- and upper-class students. Equity considerations might suggest that cost recovery should be increased and public resources transferred from higher education to primary and secondary education. However, higher education is also essential for Latin American countries to train a cadre of professionals who can help the economy compete in the global marketplace. Usually public universities—despite the large share of the public education budget—are inadequately funded. Tuition should be increased to reduce subsidies to higher-income students, but these additional resources should be used to strengthen the universities themselves. Financial resources for improving primary and secondary education should be found elsewhere, e.g., by substituting private investment for public financing of large infrastructure projects or by using the financial resources of Social Investment Funds. Such Social Investment Funds have been effective ways to channel resources for school construction by local communities in El Salvador and Bolivia.
Building on local successes instead of striving for an all-at-once, nationwide reform. Learning how to involve the parents, to increase school autonomy, to reward teachers for good performance, and to reduce the administrative burden of central control takes good leadership as well as time. Initiatives for successful reform may first succeed at a municipal, departmental, or provincial level. Such local efforts should be nurtured by the central government, which will need to relax or eliminate national controls and norms; the elements of success can then be emulated elsewhere within the country. In some countries, this is a more likely pattern of reform than a wholesale, national, top-down campaign.

Strengthening banking systems and advancing education reform in Latin America will depend on good political strategies by reform-minded leaders. The lessons of experience from reform efforts throughout the region can help in the design of these strategies. Successful reforms in these two areas would contribute significantly to the broader purposes of reducing macroeconomic volatility and improving social protection and services in the increasingly open economies in the region. Progress toward these broad purposes is necessary to preserve political support for market-oriented economic policies.

Endnotes

Note 1: Inter-American Development Bank, Economic and Social Progress in Latin America, 1996 Report (Washington, D.C.: 1996), p. 70. Back.

Note 2: An econometric analysis of the electoral performance of the incumbent administrations in Latin America during 1982–95 concluded that "fiscal and monetary orthodoxy and market reforms have led to much better electoral results for the incumbent administrations than heterodoxy and statism." See the dissertation by Carlos Gervasoni, "Economic Policy and Electoral Performance in Latin America, 1982–95," Center for Latin American Studies, Stanford University, September 1995. Back.

Note 3: Inter-American Development Bank, "Employment in Latin America: What is the Problem and How to Address It?" Papers for Seminar at the IDB Annual Meeting, Cartagena, Colombia, March 15, 1998. Back.

Note 4: For a discussion of the stages of reform in the region, see Moisés Naím, "Latin America: The Second Stage of Reform," Journal of Democracy, vol. 5, no. 4 (October 1994). Back.

Note 5: Regarding the political impact of economic volatility, Ricardo Hausmann, Chief Economist at the Inter-American Development Bank, writes: "The many benefits of globalization will not compensate for the costs of volatile capitalism quickly enough to build, much less sustain, a strong social consensus around the policies that facilitate global integration. If volatility remains unchecked, a backlash will build against the market-oriented, democratic reforms that are essential to consolidating the remarkable political and economic progress of the last decade." See Ricardo Hausmann, "Will Volatility Kill Market Democracy?" Foreign Policy (Summer 1997). Back.

Note 6: An outline of policies required to reduce the impacts of international capital market volatility can be found in Ricardo Hausmann, op. cit., and Inter-American Development Bank, Latin America After a Decade of Reform: Economic and Social Progress Report, 1997 (Washington, D.C.: 1997), pp. 63–70. Back.

Note 7: On the lack of progress in labor market reforms, see Shahid Javed Burki and Guillermo Perry, The Long March: A Reform Agenda for Latin American and the Caribbean in the Next Decade (Washington, D.C.: The World Bank, 1997), pp. 37–44; and the IDB, Latin America after a Decade of Reform, op. cit., pp. 46–47. Back.

Note 8: On the importance of civil service reform and other improvements in governance capacity, see Shahid Javed Burki and Guillermo Perry, Beyond the Washington Consensus: Institutions Matter (Washington, D.C.: The World Bank, forthcoming). Back.

Note 9: For an excellent review of these issues, see Liliana Rojas-Suarez, ed., Safe and Sound Financial Systems: What Works for Latin America (Washington, D.C.: Inter-American Development Bank, 1997). For a broad assessment of banking system issues, see International Monetary Fund, Toward a Framework for Financial Stability (Washington, D.C.: IMF, 1998). Back.

Note 10: For a discussion of the benefits of and issues surrounding foreign participation in Latin American banking systems, see Michael Gavin and Ricardo Hausmann, "Make or Buy? Approaches to Financial Market Integration," in Rojas-Suarez, Safe and Sound Financial Systems, op. cit., pp. 133–162. Back.

Note 11: Reformers may be able to counter such nationalist sentiments by arguing that the banking sector is crucially important to the growth of the whole economy, and that this sector needs to import bank management skills. Back.

Note 12: Regulatory forbearance means that the superintendent hesitates to intervene in a bank that is technically insolvent—perhaps in the (usually false) hope that the bank will be able to recover, or perhaps due to political pressure. On the importance of both political independence and technical capacity of the superintendent, see Stephan Haggard, Chung H. Lee, and Sylvia Maxfield, eds., The Politics of Finance in Developing Countries (Ithaca: Cornell University Press, 1993). Back.

Note 13: These measures are well reflected in the recent legislation in Panama. Back.

Note 14: In the short run, it may be useful to develop arbitration procedures to which debtors and creditors can resort without awaiting resolution through the judicial system. Back.

Note 15: Such mechanisms should also cover the rules and processes for mergers and acquisitions, which are often the best approach for dealing with a bankrupt firm or insolvent bank. Back.

Note 16: Argentina made important and rapid progress in this area during the Tequila crisis in 1995. Back.

Note 17: Some argue that excessive risk-taking by bank managers and owners cannot be avoided as long as the government stands ready and able to be a lender of last resort. This argues in favor of a currency board arrangement, as in Argentina and Estonia, in which that government's capacity to lend to the banking system is severely restricted. Back.

Note 18: On this point, Aristobulo de Juan writes: "Bank crises are great. We all need a good banking crisis in order to ignite the engine and to undertake serious banking reforms. This may sound like black humor, but, in fact, it is only when a country has a serious crisis that its governments reacts thoroughly and addresses key areas as bank restructuring and crises resolution." From his article, "Clearing the Decks: Experiences in Banking Crisis Resolution," presented to the Fourth Annual Bank Conference on Development in Latin America and the Caribbean, Banks and Capital Markets: Sound Financial Systems for the 21st Century, San Salvador, June 28–30, 1998. Back.

Note 19: For an excellent diagnosis of problems of education in the region and a review of proposed reforms, see "Education: The Dynamics of a Public Monopoly," Chapter 4 in the IDB, Economic and Social Progress Report 1996, op. cit. Back.

Note 20: A recent survey indicates that employers in Latin America find it more difficult to get skilled workers than employers in Asian countries and that "the employers feel that the deficiencies in the labor supply are rooted in the educational system. In their view, education is unable to meet the needs of a competitive economy." See IDB, "Employment in Latin America," op. cit., 1998, pp. 4–5. Back.

Note 21: During the coming decades, following a period of declining birth rates in many countries, both the ratio of students to workers and the average number of children per working parent will fall in Latin America. This demographic change will provide an opportunity for the region to increase its public and private expenditures on education. Even a stable share of income per worker devoted to education would mean an increasing expenditure per student. Back.

Note 22: On the broad issues involved, see E. Mark Hanson, Educational Decentralization: Issues and Challenges, Program to Promote Education Reform in Latin American and the Caribbean (PREAL), Occasional Paper Series No. 9 (Washington, D.C.: Inter-American Dialogue, November 1997). On the political obstacles, see especially Edward B. Fiske, Decentralization of Education: Politics and Consensus (Washington, D.C.: The World Bank, 1996). It notes that political leaders in the central government should be willing to reduce their control of the educational system for the sake of gaining political legitimacy as a result of better educational services. In a broader context, Rudolf Hommes makes a similar argument in "Conflicts and Dilemmas of Decentralization," in the Michael Bruno and Boris Pleskovic, eds., Annual World Bank Conference on Development Economics 1995 (Washington, D.C.: The World Bank, 1995). Back.

Note 23: This is also a key recommendation in The Future at Stake: Report of the Task Force on Education, Equity, and Economic Competitiveness in Latin American and the Caribbean, Program to Promote Education Reform in Latin American and the Caribbean (PREAL) (Washington, D.C.: Inter-American Dialogue, April 1998). Back.

Note 24: On this point and on the role of the teachers' union in Colombia, as well as other excellent lessons of that country's reform effort, see Armando Montenegro, An Incomplete Educational Reform: The Case of Colombia, HCO Working Paper, no. 60 (Washington, D.C.: The World Bank, August 1995). Back.