The extensive reforms and liberalization of financial services in emerging markets worldwide call for cutting-edge strategies to capture the benefits of new investment opportunities. In Open Doors, a volume of papers from the third annual Financial Markets and Development conference, multidisciplinary financial sector experts analyze current economic and political trends and prescribe practical advice to the financial development community. The book addresses the key issues of concern regarding the emerging markets, including the trends, motivations, and scope of FDI in finance; policy options that will best capture the opportunities of foreign entry; and the role of foreign institutions in e-finance innovation. The authors focus on specific topics such as foreign participation in emerging market banking systems and securities industries, WTO policies and enforcement, the role of foreign banks, liberalization of insurance markets, the need for capital markets, and the policy, regulatory, and legal issues associated with e-finance. For policymakers and financial practitioners affected by the WTO's Financial Services Agreement, this timely book should be of particular interest. Contributors include Donald Mathieson (International Money Fund), Pierre Sauvé (Trade Directorate, OECD), George J. Vojta (formerly with Bankers Trust and Citibank), Harold D. Skipper (J. Mack Robinson College of Business, Georgia State University), Benn Steil (Council on Foreign Relations), Morris Goldstein and Edward M. Graham (Institute for International Economics), Nicolas Lardy (Brookings Institution), Phillip Turner (Bank of International Settlements), and Robert Ledig (Fried, Frank, Shriver & Jacobson).
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About the Author
Robert E. Litan is a senior fellow in Economic Studies at Brookings and vice president for research and policy at the Kauffman Foundation. Paul R. Masson is a nonresident senior fellow at the Brookings Institution, and research fellow and adjunct professor at the University of Toronto. Recently retired from the International Monetary Fund, he has published widely in international finance. Michael Pomerleano is lead financial specialist in the Financial Sector Operations and Policy Department of the World Bank.
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Open DoorsForeign Participation in Financial Systems in Developing Countries
Brookings Institution PressCopyright © 2001 Brookings Institution Press
All right reserved.
One of the more noteworthy financial developments in developing countries of the past decade is the enormous growth of foreign direct investment (FDI): from $36 billion annually in 1991 to $173 billion in 1997, according to the World Bank's 2001 Global Development Finance report. Although the growth in FDI flows cooled off somewhat after the Asian, Russian, and Brazilian financial crises of 1997-98, in 2000 they still stood at an estimated $178 billion, not only higher than before these crises but well above the level at the beginning of the decade.
Given the importance of finance to economic growth, it is natural to ask how important FDI has become in that particular sector in emerging market countries, what benefits and costs have been associated with it, and what changes in policy toward foreign financial firms would be in the economic interests of developing countries in the years ahead. Another important issue facing these countries is how not to be left behind by the coming wave of e-finance that some say will revolutionize financial sectors in both advanced and developing countries.
These were the questions posed at the third annual conference on emerging markets finance conductedby the World Bank, the International Monetary Fund (IMF), and the Brookings Institution on April 19-21, 2001, in New York and attended by 170 financial experts and policymakers from around the world. This volume brings together the papers presented at the conference and provides a summary of two panel discussions: one by representatives of various large foreign financial institutions with operations in emerging markets, the other by experts in the burgeoning field of e-finance.
Among other things, the following chapters confirm the rising presence of foreign firms in financial sectors in key parts of the developing world, although Asia and Africa still lag significantly behind other emerging markets in this respect. In a number of countries, the foreign presence has increased from less than 10 percent to 50 percent or more within the past decade. The chapters also document the important benefits foreign firms bring to the markets they enter: added investment; cutting-edge technologies and managerial practices (especially risk management); and, because they tend to be more diversified than local institutions, more financial stability. At the same time, the globalization of finance raises new policy issues that must be addressed, most prominently the coordination of regulation and supervision across national borders.
On balance, however, foreign financial institutions provide net benefits to the countries in which they invest. For this reason alone, it is in the interest of countries that now restrict foreign entry in some form to drop those limitations, whether unilaterally or through multilateral negotiations. A crucial issue is how best to sequence that liberalization. What are the regulatory practices that need to be put in place? Should domestic financial institutions be made solvent first? This has been a particularly difficult problem in many economies that were formerly centrally planned, where state-owned banks held a large portfolio of nonperforming loans. Although conference participants did not settle the sequencing issues, several of their comments generated an animated discussion of the topic. Many argued that waiting until domestic institutions' problems were settled before opening up was a recipe for endless delay.
How Important Is Financial Sector FDI?
As Donald Mathieson and Jorge Roldos of the IMF point out in chapter 2, entry by foreign firms in the financial sectors of emerging markets increased significantly during the 1990s, especially in banking. In the Czech Republic, Hungary, and Poland, foreign ownership of banks (including banks that were at least 40 percent owned) rose from an average of 14 percent in 1994 to 57 percent in 1999. A similar trend occurred in Latin America, where by the end of the decade foreign banks accounted for 40 percent or more of the banking systems of Argentina, Chile, and Venezuela. Foreign bank penetration remains far lower in Africa and Asia, although even in Asia, it increased markedly during this period (from 1.3 percent to 13.2 percent).
What accounts for these increases? Banks in source countries, mainly in the developed world, have pushed outward into emerging markets by and large in search of higher profits. There is another reason: foreign banks have followed corporate customers that have opened foreign operations. This, in fact, was the reason Deutsche Bank was founded in the nineteenth century, with its original four offices in Shanghai, Yokohama, London, and Bremen. But banks cannot expand abroad unless destination countries let them in. Over time, many emerging market governments have taken this course. Since the early 1990s, Mathieson and Roldós report, attitudes toward foreign banks and other financial firms have experienced a sea change in much of the developing world arising out of periodic financial crises, or in the case of Eastern Europe, because new governments learned that formerly state-owned banks were in effect bankrupt. Foreign banks have been welcomed to help reduce the costs of resolving these financial problems.
For the most part, foreign banks have helped increase the competitiveness and efficiency of the domestic banks in the markets they have entered. The results are reflected in lower operating costs and smaller margins between interest rates on loans and deposits, not just among the foreign banks but among domestic banks as well. Mathieson and Roldos do not believe the verdict is as clear, at least not yet, as to whether foreign banks have contributed to more stability. In certain cases, foreign banks have pulled out in times of trouble, and in others they have remained. Nor do the authors find unequivocal evidence that foreign banks have reduced market volatility or increased the availability of credit to local borrowers.
Nonetheless, there is some evidence to suggest that most retail foreign banks have not pulled back from emerging markets hit by financial crisis. Where they have done so, it has been due more to problems in their home countries (especially Japan). The latest proposed Basel capital standards-which, if adopted, are scheduled to become effective in 2005-may encourage foreign banks to pull back from emerging countries in the future, however. This is because the proposed standards rely heavily on ratings agencies to determine how much capital international banks must maintain for various types of loans. In the aftermath of financial crises in particular countries, ratings agencies tend to lower their ratings on all emerging market debt simultaneously, and this could curtail bank lending in these markets across the board.
Foreign banks have not been the only financial firms to wade into emerging markets in recent years. In chapter 4, Harold Skipper of Georgia State University documents a similar, although less extensive, trend among foreign insurers. Insurance, Skipper explains, is important to economic development because it spreads the cost of risk, promotes economic stability for both families and firms, and mobilizes savings. Nonetheless, insurance in emerging markets remains less well developed than banking, especially in property-casualty lines, although life insurance is significant and rapidly growing in Southeast Asia, South Africa, and other selected countries where savings rates are high and public pension systems are weak or nonexistent. In several Asian countries, foreign insurers now account for about half of the life market, and a bit less of property-casualty, despite various noninstitutional and cultural barriers to foreign firms. Like foreign banks, Skipper reports, foreign insurers tend to have stimulated improvements in productivity in the markets they have entered. Moreover, the importance of internationalizing insurance risks is illustrated by the sinking of the forty-story Petrobras oil platform in Brazil in 2001, a facility that produces 6 percent of the country's entire national oil output. No one country's market can provide cover for such loss exposures.
Still, many emerging markets maintain some restrictions against foreign insurers, with only four countries having committed to "full liberalization" under the General Agreement on Trade in Services (GATS) implemented as part of the Uruguay Round trade agreement of 1995.
What Do Foreign Financial Institutions Do in Emerging Markets?
It is important in designing policy regarding the entry of foreign financial institutions to understand what lines of business they tend to emphasize. Michael Pomerleano of the World Bank and George Vojta of the Financial Services Forum examine the behavior of the largest multinational or global banks in chapter 3. These institutions are capable of offering cutting-edge wholesale and retail services, generally at lower cost than purely domestic banks. Allowing such institutions to enter a market brings much greater competitive pressure on local banks to consolidate and reach a scale at which they can effectively compete.
At the same time, as Thomas Fischer of Deutsche Bank also confirms later in this volume, global banks tend to concentrate on the largest corporate customers that have the greatest need for their sophisticated services (including foreign exchange and risk management, derivatives trading, underwriting of securities, and cross-border mergers and acquisitions). Although local banks worry that the global banks will run them out of the business of lending to individuals and small and medium-sized enterprises (SMEs), these concerns have proved to be unfounded. As a result, global banks tend to complement-and not substitute for-the banking services of the locally oriented institutions. Moreover, for countries that have experienced banking problems, foreign institutions help in restructuring, either through outright purchases or joint ventures and alliances.
There is a dichotomy in the operations of large foreign banks in emerging markets, however. Some large multinational banks-the local subsidiaries of Citibank, HSBC, and Standard Chartered-have developed strong and profitable local franchises with a wide range of services. Others, including JPMorgan-Chase and Deutsche Bank, are much more selective and in some cases are narrowing their activities in emerging markets, refocusing on investment banking and private banking activities.
Ranjit Singh (a member of the Securities Commission in Malaysia and chairman of an emerging markets securities market working group of the international organization of securities regulators, IOSCO), Attila Emam, and Kar Mei Tang present the results of a similar study of foreign entry into the securities business in chapter 5. They find that developing countries have become more welcoming of foreign firms in this business because they see the need to finance their nonfinancial enterprises and feel pressure to liberalize under the GATS. Singh and his colleagues also report the preliminary results of a survey of foreign firms operating in seventeen emerging markets, of which nine (including nearly all Asian countries in the sample) explicitly allow foreign majority ownership of domestic securities firms (and seven allow 100 percent ownership). The survey broadly revealed that foreign firms did not "run" from-and in some cases actually increased-their participation in local markets that had suffered financial crises. As for securities exchanges, in four of the seventeen markets at least one of the exchanges had been demutualized, a trend now evident among security exchanges in developed countries (as discussed by Benn Steil in chapter 11)-and another four are looking to do the same soon.
In chapter 6, Paul Masson summarizes the experiences of several financial institutions already involved in emerging markets. One such institution is the International Finance Corporation (IFC), which has made broad investments in private firms in emerging markets. Half of these are in domestic banks and the rest in private equity, venture funds, asset-based financing, and other related activities. In the IFC's view, financial institutions arise in response to the development of a middle class in emerging markets. The IFC has concentrated its investments in building secondary markets for mortgages to encourage home ownership, promote various savings vehicles (pension plans, insurance, and contractual savings systems), and facilitate retail banking, which, as Pomerleano and Vojta document in chapter 3, is still largely the province of domestic banks in these markets. Although Latin America is the IFC's largest region, the institution views Africa as a potentially large market, as liberalization and privatization proceed in that part of the world.
By contrast, Deutsche Bank's emerging markets strategy has historically concentrated on Asia. The bank located there in order to follow its corporate customers and plans to continue that function. Though it provides full banking services and has an extensive local presence, after the experience of the Asian crisis it no longer tries to compete with local banks in collateralized lending to smaller companies. Another global investment firm, Goldman Sachs, has found that technology makes it possible to avoid having to establish a major local presence in most emerging markets. Through New York or a limited local office, Goldman Sachs is able to offer global products for which it has a comparative advantage. The firm has become a leading underwriter of sovereign and corporate bonds issued from emerging markets, and non-U.S. activities now account for more than half of its revenues.
AIG, a global insurer founded in Shanghai, also has strong Asian roots. In addition to pursuing worldwide insurance activities, the company has recently sponsored more than twenty investment funds with assets in emerging markets. Unlike some other fund sponsors, AIG provides roughly 10 percent of the capital of each of the funds it sponsors, looking to exit (like the IFC) through initial public offerings and sales either to strategic buyers or to local managers. At AIG, a decision to invest depends on several aspects of the local environment: macroeconomic stability, a pro-market orientation, rule of law, and transparency of government bodies and regulations.
Regional Case Studies
Three chapters in this volume outline the experiences of countries and regions that have recently welcomed significant foreign investment in their financial sectors. The Czech Republic, as Donald Simonson of the University of New Mexico notes in chapter 7, privatized its formerly state-owned banks in the early 1990s but initially restricted share purchases by large foreign banks, hoping that Czech ownership would evolve. Emphasizing fairness toward its citizens, the government gave them vouchers, which maintained domestic ownership. Foreign interest was also deterred by the absence of effective legal support for creditors: weak laws and judicial administration. By the end of the decade, however, the main Czech banks were paralyzed by large holdings of nonperforming loans, so the government turned to foreign banks to mount a rescue and strengthened bank supervision by adopting international standards. Today, the Czech banking sector is significantly stronger and more competitive as a result.
In chapter 8, Jennifer Crystal, B. Gerald Dages, and Linda Goldberg of the Federal Reserve Bank of New York report similar positive results from the rapid increase in foreign ownership of banks in Latin America during the 1990s. For the most part, the team finds that local banks acquired by foreign owners became financially stronger in comparison with their domestic counterparts. Foreign banks in Argentina, Chile, and Colombia demonstrated higher and more stable average loan growth and higher risk-based capital ratios. Surprisingly, however, their profitability was only comparable to or weaker than that of domestic banks. This latter finding, coupled with the fact that foreign banks had higher loan loss provisions than domestic competitors during the period studied, suggests to the authors that foreign banks have not "cherry-picked" their loan customers but instead have taken more aggressive actions to deal with bad loans when they deteriorate. On average, the foreign institutions also did not "cut and run" when certain Latin American countries encountered financial difficulties during the decade. Because large-scale foreign ownership is a fairly recent phenomenon emerging in a rather inhospitable macroeconomic environment, however, the authors think it may take more time to gauge the true competitive dynamics of increased foreign ownership.
Excerpted from Open Doors Copyright © 2001 by Brookings Institution Press
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