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Global Financial Trends, the WTO, Foreign Investment, and
Financial Services in Emerging Economies: An Overview*
Principal
E-mail: misimbabi@capitalresearchers.com
August 1999
Comments are welcome
*This essay is a revised and updated extract from a monograph originally written by the author for the U. S. Agency for International Development's Equity and Growth through Economic Research--Trade Regimes and Growth (EAGER/Trade) project. The interpretations and opinions expressed in this paper are those of the author only and should not be attributed to the U. S. Agency for International Development.
Following substantial financial liberalization and deregulation in both developed and developing economies, and spurred by rapid advances in communications and information technology, financial markets and services have become increasingly globalized over the last decade. The global financial system that has consequently emerged is characterized by: the high speed, volume, and sophistication of financial transactions and information flows; rapid and sometimes volatile cross-border capital flows; increased co-movements of securities markets; intense competition in many financial markets; increased globalization of the activities of financial institutions; worldwide sourcing of capital for firms; global investment opportunities for individual and institutional investors; the immense resources and influence of institutional investors; remarkable strides in financial innovation, such as derivatives and securitization, resulting in a greater variety of financial products; etc. (O’Brien, 1992; Isimbabi, 1992; The Economist, 1995; Smith and Walter, 1997; World Bank, 1997, 1999; Williamson and Mahar, 1999).
Until the Asian financial crisis in 1997, private capital flows to emerging economies surged during the 1990s as these countries, particularly in Asia and Latin America, recorded high rates of economic growth (World Bank, 1997; Calvo et al, 1996; Fernandez-Arias, 1996). The capital flows occurred primarily through emerging market funds that were largely driven by international (primarily institutional) investors seeking higher returns and international diversification (Claessens, 1995; Feldman and Kumar, 1995). Inflows of capital to developing countries were largely in the form of portfolio investment in securities markets and foreign direct investment (FDI).
A 1997 World Bank report characterized the substantial growth in portfolio investment flows to developing countries as "most striking", noting that FDI had "responded most vigorously to the improving economic environment in developing countries. The driving factor for FDI has been a sustained improvement in domestic economic fundamentals" (World Bank, 1997). The nature of FDI changed from investment in extraction of natural resources and import substitution industries to investment in production facilities motivated by lower costs of production (especially labor) and production efficiency. Commercial bank lending to developing countries, which had declined substantially following the debt crisis of the 1970s and early 1980s, had also re-surged to significant levels in recent years. And, governments and firms in countries with good credit ratings were able to raise capital in the international bond and equity markets.
However, even before the Asian crisis, only a small proportion of developing countries benefited from substantial inflows of foreign capital. As the World Bank (1997) noted, most developing countries faced major challenges with regard to their ability to attract and/or manage foreign capital:
"First, for the twenty or so countries that have been the major recipients, the management of private capital flows has not proved to be easy. It is not just the volume of flows, but the speed at which such investment pours in--and can be withdrawn--that present particular challenges to these economies. Governments need to build the kind of macroeconomic, regulatory, and institutional environments that channel this private capital into broad-based and sustainable growth. Second, the overwhelming majority of developing countries, in particular the smaller low-income economies, still need to create the conditions to attract private capital and must depend on declining official flows."
The financial crises of 1997-98 resulted in a substantial reduction in capital flows to emerging markets (World Bank, 1999). While the decline was initially limited to East Asia, the subsequent spread of the crises to Russia, Latin America, and other emerging economies led to a world-wide withdrawal from emerging markets as investors moved their funds to safer markets in the industrialized countries. The contagion observed during the crisis also showed that, even a country with good policies is still susceptible to volatility in capital flows in circumstances where international events result in the type of herd behavior that occurred during the Asian crisis.
Recent reports indicate, however, that foreign investors are returning to some emerging markets that are executing policies expected to put their economies back on track, though with greater caution (World Bank, 1999). As countries, the multilateral financial institutions, and investors learn lessons from the recent crises, foreign capital will return to some countries, but investors are likely to be more discriminating about where to invest their capital. Nevertheless, the process of global financial integration will continue and a strong level of integration of a domestic financial market with international financial markets remains essential and inevitable for all nations—no nation that seeks economic prosperity can afford to keep its financial system closed.
Financial integration ensures that firms, individuals, and governments have easy access to global capital at the lowest possible cost and under the best possible terms obtainable in the global markets. The debate essentially centers on the best policy approaches toward achieving integration, such as the appropriate degree of integration and the speed at which a country should proceed to achieve it.
Much of the recent emphasis on global financial integration has been on capital flows in the form of portfolio investment, primarily because this is the area that has witnessed the most profound developments in recent years, including the Asian crisis.1 Thus, financial integration has often referred to capital account liberalization, i.e., the elimination or reduction of barriers to international capital flows. In this regard, the policy issues primarily have to do with the benefits and costs of inflows of foreign capital (Williamson and Mahar, 1999; The Economist, 1999; Haque et al, 1997).
Another aspect of financial integration, however, involves financial intermediaries and the financial sector as an industry. This emphasizes international trade and investment in financial services -- largely FDI and cross-border transactions -- and its interaction with capital mobility as also central to financial market integration (Gavin and Hausmann, 1997; Kono et al, 1997; Lewis, 1993). Gavin and Hausmann, for example, argue that liberalization of explicit barriers to capital mobility, while crucial, is not sufficient for achieving the "deep" financial integration that will enable a country to overcome fundamental problems in the local intermediation of domestic and foreign financial resources.2 They stress that fostering capital inflows and the efficient allocation of capital to users are critically dependent on the existence of a stable, efficient, and well-functioning financial industry. Thus, domestic as well as external financial liberalization are critical to facilitating the integration of a country’s financial system with international financial markets.
In this regard, Gavin and Hausmann recommend three approaches that Latin American countries can use in order to achieve financial integration and address the region's problems of scarcity of capital and volatile, crisis-prone financial systems:
1. Encourage the establishment of branches by international banks domiciled in countries with strong supervisory frameworks;
2. Create a regional structure to facilitate the production of the required regulatory and supervisory services, and foster coordination of efforts;
3. Encourage domestically-chartered banks to expand abroad.
Investment by foreign financial firms in the financial services sectors of emerging economies can be in the form of subsidiaries, joint ventures, or full branches. The potential benefits of allowing such foreign investment includes the following:3
In effect, these benefits lead to a modernized, competitive, efficient, and well-functioning financial sector, the reduction of the systemic risk of the financial system, and ultimately enhanced economic growth. Users – households, businesses, and governments -- benefit by (a) getting faster, efficient, high-quality, and competitively priced services; (b) having access to a greater variety of products, services, and providers; and (c) having the ability to diversify risk more easily and effectively.
In line with these arguments, Warren Lavorel, Deputy Director-General of the WTO, observed that "there are a number of recent cases where liberalization in developing countries--and the participation of foreign banks--helped accelerate the required restructuring of financial institutions. There are also cases where allowing domestic banks to diversify abroad would improve their competitiveness at home. Through liberalization, financial institutions almost invariably become more resilient and more efficient. And even those countries experiencing financial problems will need to look abroad for the capital and expertise necessary to revitalize their financial systems" (Lavorel, 1997).
Thus, the WTO Agreement on Financial Services, which was concluded in December 1997 and went into force in March 1999, is expected to provide immense benefits to both developing and developed economies alike:
"Developing countries have a growing interest in liberalizing their financial sector and deregulating their investment regimes in order to build the kind of competitive financial infrastructure they need for future growth. At the same time, developed economies have a clear interest in an agreement which will open the fastest growing markets to one of their fastest growing industries. And all sides in this negotiation have an interest in building a strong global financial system to support a strong global economy" (Ruggiero, 1997).
The WTO expects that the most evident practical change in many countries will be the appearance of more foreign banks, securities firms, and insurance companies in markets; the availability of banking, securities and insurance services sold across the border by overseas companies; and the provision of asset management and other financial services by wholly, or partially, foreign-owned companies. And, for countries that are actual or potential exporters of financial services, opportunities for their banks, securities firms, and insurance companies will be considerably enhanced.4
As financial services firms in the developed economies face saturated markets, intense competition, and slow growth in their domestic markets, they have increasingly looked to emerging markets with high growth potential to expand and diversify their markets and establish global networks.5 They (and their governments) have been pushing to get emerging economies to implement liberal policies that will allow greater access to their markets.
However, while many developing countries strive to attract foreign capital and develop their financial systems, they still maintain a high level of protection of their financial sectors. National financial systems are inextricably linked with monetary and financial policies and economic activity. Thus, many governments prefer that financial services, by virtue of their strategic importance to the economy, remain under domestic ownership and control. They therefore remain cautious and are reluctant to open up their financial markets and implement other liberalization policies that may reduce their control over their financial systems.6
Developing countries are also concerned about "exploitation" by foreign financial firms, which they often perceive as having objectives that are not necessarily consistent with national objectives, for instance, reaping large profits at the expense of domestic firms without providing financial services in areas that will foster economic development. Protectionism is also driven by domestic political considerations and the self-interest and influence of bureaucrats and domestic businesses that fear the loss of their bureaucratic and monopolistic or oligopolistic control of the financial sector. Furthermore, there are also genuine concerns that the dangers of liberalization may outweigh the likely benefits: liberalization is difficult and does entail risk, and an empirical reality is that, in both developed and developing countries, banking and financial crises have been associated with financial liberalization and internationalization. (However, such crises often have more to do with poor management of the financial system and the liberalization process than liberalization per se.)
For these reasons, the WTO negotiations on financial services were difficult: As Wang (1996) notes, this was due to the "pervasive and complex relations between financing, payments and economic activities. The sensitivity of national financial and monetary policies and policies designed for the allocation of credit rendered the commitment-making much more prudential and tentative, particularly with respect to market access either through cross-border supply or commercial presence."
At the end of the Uruguay Round in 1993, 82 governments (counting the then 12 nations of the European Union individually) included financial services in their schedules of individual market-opening commitments. The negotiations on financial services, which were not finalized at the end of the Round, continued for more than four years until they were concluded on 12 December 1997. In July 1995, the U.S. declined to participate in a final Agreement on the grounds that the offers made by some countries (primarily Japan and the Asian emerging economies) were inadequate. An interim Agreement, which did not include the U.S., was agreed upon and it remained in effect until December 1997 when the final Agreement was concluded.
Because (a) the negotiations were so problematic and (b) the Asian crisis was worsening toward the end of 1997, the conclusion of the agreement was in doubt even at the late stage. By September 1997, a sense of urgency to reach a final agreement was developing and, as Melloan (1997) reported, it was assumed that "if no deal is made by mid-December, financial services liberalization will be dead for this century."
According to the Wall Street Journal, European and American WTO negotiators "failed to engage" the Asian 'tiger' nations and India in the negotiations because they were preoccupied with resolving the crisis (Bahree, 1997). The crisis apparently made these countries even more wary of opening up their markets: "Skittish" Asian officials felt "particularly vulnerable to foreign financial power...many of the countries think their financial institutions aren't strong enough to compete in the U.S. and Europe. Indeed, they are hard-pressed to see what's in the pact for them. At the same time, they would be putting their own financial institutions at risk by opening the doors to big, competitive American and European firms" (Cooper and Sesit, 1997). European and American negotiators, however, argued that the crisis underscored the need for the WTO agreement, since in the long run, open and competitive financial markets may help avert financial crises and opening markets would not lead to any loss of control over financial systems (Bahree, 1997).
One view was that, while the benefits of more openness to foreign competition as required by the WTO Agreement may have been evident, the reluctance of the Asian countries was largely due to political considerations. Melloan (1997), for example, observed: "It is not easy to sell developing country politicians on the idea of spreading risks by allowing foreigners access to the financial sector. After all, that’s where the money is and influence over money flows goes hand in hand with political power. If lenders are making decisions purely on the basis of credit risk analysis--as they should be--there is very little room for politicians to direct it to politically-favored credit seekers."
Following the conclusion of the negotiations, the WTO's then Director-General noted that, in spite of the financial crises, 102 (out of 135) member governments (including the Asian countries in crisis) made binding commitments in the December 1997 agreement, and none threatened to withdraw from the negotiations or withdraw offers already tabled because of the crisis. He attributed this to the countries' "belief that stronger competition and greater openness will make their national infrastructures stronger, not weaker" (Ruggiero, 1998). Dobson and Jacquet (1998) also opine that, paradoxically, while the crisis may have threatened to derail the agreement, it appeared to have facilitated the conclusion of the agreement on schedule: the agreement was concluded in spite of the crisis perhaps because the governments hoped that their offers would signal their determination to undertake reforms that would help to restore credibility and stability. However, in some cases, the Asian countries may have adopted certain policies largely due to pressure from the IMF and Western governments as conditions attached to the financial assistance provided to stem the crisis. Thailand, for example, agreed to allow foreign investors to hold majority stakes in banks as part of its IMF bail-out package (The Economist, 1997a; Sherer, 1997a,b).
According to the WTO, the total commitments in the December 1997 agreement brought over 95% of world trade in banking, securities, insurance, and financial information under the jurisdiction of the WTO, within a broad Most-Favored-Nation (MFN) framework and under a dispute settlement mechanism.
In general, while the December 1997 Agreement improved upon the July 1995 agreement in terms of commitments by members, market opening was still not much more beyond the status quo.7 In an analysis of the Agreement, Dobson and Jacquet (1998) conclude that the agreement usefully locked in prior reforms in a number of countries but achieved little new liberalization in the sector: "While it was a milestone for the WTO because a significant number of WTO members agreed to a legal framework for cross-border trade and market access in financial services and to a mechanism for dispute settlement, ... the agreement is less than meets the eye...it simply formalizes the status quo...there is a significant agenda of market opening measures still to be taken in the future."
Although protectionism and the unfavorable investment climate in many developing countries will continue to constrain investment by foreign financial services firms, some developing countries are increasingly inclined or forced to open up their markets, albeit cautiously. In its 1997 Survey of Banking in Emerging Markets, The Economist (1997b) observed that "the past couple of years have seen an unprecedented opening of opportunities [for foreign banks in emerging economies], despite some pockets of resistance in Asia and elsewhere. Sometimes the opening has been voluntary; sometimes it has been prompted by disasters that left the emerging-country banks desperately short of capital and showed up their lack of expertise."
Countries such as the Phillippines, Panama, Uruguay, Mexico, Argentina, Venezuela, Hungary, Poland, and other Eastern European countries have undertaken substantial privatization of their banking sectors and allowed foreign entry. As a result, their financial systems have reportedly been significantly internationalized and improved: major foreign banks have purchased interests in domestic banks (including troubled ones) or established new ones, and their presence has fostered greater competition, efficiency, and innovation in the banking sectors.8
According to the Financial Times, Latin American banks were resilient to the global financial crisis of 1997-98 because of the restructuring they had already undergone following the banking crises in the region in the 1980s and early 1990s (Lapper, 1999). This resilience evidently was in part due to the presence of foreign banks, which had invested significant capital in the region’s banks during the restructuring process, and controlled substantial proportions of bank loans and deposits in the region. Though the region is still considered risky, major U.S. and European financial institutions have recently stepped up competition for the provision of financial services in many Latin American countries (Engen, 1997, 1999; Lapper, 1999).
The activities of foreign banks in emerging economies tend to be skewed toward large firms, governments, and wealthy individuals, but this appears to be changing as the banks continually seek to expand their markets. For example, according to the Wall Street Journal, U.S., European, and Asian banks that have set up branches or affiliates in Latin American countries are shifting their focus from providing services to big corporations, governments, and the very rich. They are now "scrambling to provide the kinds of services to Mom and Pop savers and borrowers that are taken for granted in the industrialized world, yet practically nonexistent in most of Latin America" (Vogel, 1997). The banks are offering services such as consumer loans for automobiles and appliances and mortgages, and are providing more efficient services, including some as basic as cutting down the amount of time it takes to wait in line for service at a bank.
Also, Albright and Parker (1998) report that Latin America is witnessing a transformation of retail banking, which has re-emerged in the 1990s as a dynamic, innovative force in the business environment. In the 1980s, a distrust of banks – due to fear of hyper-inflation, several bank failures, frozen accounts, etc. – discouraged retail customers from using banks. Following banking reforms in the 1990s, banks responded with new products and services and now provide retail consumers with access to various services such as checking accounts, credit and debit cards, and financing for homes and automobiles.
And, according to Institutional Investor, Citibank, which has always been a leading global financial services firm, has been remaking itself as a global marketer and spreading the gospel of American-style consumer finance (Klee, 1997).
Over time, the success of foreign investment in bringing about substantial improvement in the financial services sectors in those developing countries that have been aggressive in this regard will encourage more countries to allow greater access by foreign financial firms. This trend would be further enhanced if foreign firms make even greater efforts to ensure that their business practices are consistent with host countries' economic and social development goals and cultural sensitivities.
While countries can, of course, unilaterally undertake further liberalization to spur foreign investment in their financial services sectors, it is generally acknowledged that such liberalization within the multilateral framework of the WTO provides the best approach toward the establishment of a well-integrated and sound global financial system. Thus, proponents of more substantial liberalization beyond the 1997 WTO Agreement advocate much more aggressive efforts in order to achieve this goal, given the difficulties associated with financial liberalization. Dobson and Jacquet (1998), for example, note that reform is a gradual process -- not just a one-shot policy decision -- that requires constant on-going commitment; however, because such gradualism allows opposing interest groups to organize and oppose liberalization, commitment to reform must be bound in the WTO to prevent the gradual process from slipping into stagnation or reversal. They suggest that, in the next round of negotiations starting in 2000, financial services should be made part of the discussions on FDI and competition policy. They acknowledge of course that, as the failure of the OECD's Multilateral Agreement on Investment (MAI) has shown with just a small group of industrialized countries, consensus on substantial commitments in the financial services sector among a larger and more diverse WTO membership will be difficult indeed.
NOTES
1. The World Bank’s 1997 report, for example, focuses primarily on portfolio investment in its analysis of international capital flows because of "its growing importance as a channel of financial integration" (World Bank, 1997, p. 15).
2. Gavin and Hausmann define "deep" financial integration as the existence of a financial market "in which domestic residents--households, major corporations and small businesses alike--would have access to financial products on terms similar to those offered to similarly-situated users of such products in the developed financial markets such as the United States, Europe, and Japan."
3. For detailed discussions of potential benefits and costs, see: Dobson and Jacquet, 1998; Kono et al, 1997; Gavin and Hausmann, 1997; Noland, 1997; Sorsa, 1997; World Bank, 1996; Lewis, 1993.
4. "The WTO Agreement on Financial Services," WTO Press/18, 26 July 1995, WTO Internet Web site (www.wto.org).
5. For reports on this trend, see, for example: Engen, 1997; Schifrin, 1997; Klee, 1997; The Economist, 1997b; Crane and Bodie, 1996; Marray, 1996; Pilling, 1996; Shale, 1996; Shari, 1996; Spiro, 1996; Jenings, 1996; Hanway, 1995.
6. For example, prior to the Asian crisis, the Economist (1997c) reported that Malaysia, one of the so-called Asian tigers, sought to become Asia's international financial capital. However, it was reluctant to let foreign financial institutions compete on an equal footing with domestic institutions. Despite some liberalization, the response from foreign financial firms was below expectation, since alternative opportunities were still available in more liberalized competitor markets such as Hong Kong and Singapore.
7. See Dobson and Jacquet (1998) and Mattoo (1998) for detailed analyses of the 1997 Agreement.
8. See, for example: Lapper, 1999; The Banker, 1999; Kraus, 1999; African Business, 1999; The Economist, 1997b; Vogel, 1997; Reed, 1997; World Bank, 1996; Pilling, 1996; Caplen, 1996.
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The Author -- Michael J. Isimbabi
Dr. Isimbabi holds a Ph.D. in Business/Finance from Temple University, Philadelphia, as well as MBA and Bachelor of Engineering (Electrical) degrees. His professional background includes extensive experience as a consultant, economist, professor, banker, and engineer.
Dr. Isimbabi's consulting, research/analysis, writing, teaching, and management experience spans several areas: Financial Markets; Investments; Banking/Financial Services; Corporate Finance; International Business & Finance; Emerging Markets; E-commerce; High Technology Business/Finance; and Electricity/Energy Markets.
His publications include Contemporary Portfolio Theory and Risk Management [Co-authored] (West Publishing, 1994) and articles in journals such as the Journal of Banking and Finance, Recent Developments in International Banking and Finance, the Atlantic Economic Journal, the SAIS Review: A Journal of International Affairs, and others. The Recent Developments... paper, "Comovements of World Securities Markets, International Portfolio Diversification, and Asset Returns: A Survey of Empirical Evidence", was extolled as "a first-class summary reading for the portfolio manager" in a Journal of Banking and Finance review.
Dr. Isimbabi's professional experience also includes the following: