Not so foolproof GATS safeguards and prudential rights

by Chakravarthi Raghavan

GENEVA: The ability of developing countries to safeguard their financial sectors in future throug

h restrictions on capital transfers or temporarily abating their services commitments, in the face of external-payments problems or financial difficulties, may not be as fool-proof as is being made out in the WTO negotiations on financial services.

Most trade officials and negotiators of developing countries do not seem to be fully aware of the macro-economic aspects of their negotiating trade rules which may be used to lock them into a particular type of external relationship permanently. And the IMF, as revealed in its conditionalities in Asia, is now moving to lock developing countries into the private capital markets of US and Europe.

The two major service suppliers in the financial services sector, the US and EC, are seeking liberalization of banking, securities, insurance and other services - to enable their service providers to establish themselves and provide services through firms with 100% equity ownership, and with national treatment (that is, treatment no less favourable than to domestic firms).

Leading developing countries of Asia and Latin America are under pressure from the leadership of the WTO, as well as by the US and the EC, to commit themselves now, or within a specified period, to full liberalization of their financial services markets. And many in Asia, already hit by the crisis, and those in Latin America hoping to weather it, think that by their commitments they would reduce their crises.

But whether or not this happens, they may be laying the ground-work for future problems.

WTO Secretariat report

A WTO Secretariat report produced to influence the negotiations has however, argued that this is not so. According to that report:

  • the GATS commitments of countries would not affect their ability to engage in macro-economic policy management in general and that these fall outside the ambit of the GATS;

  • they could protect their financial sectors, and the stability of the economy and welfare of consumers through prudential regulations - such as capital adequacy ratios and solvency margin requirements, restrictions on credit concentration or portfolio allocation, requirements for preserving asset quality, liquidity ratios, controls on market risk, management controls and disclosure and reporting requirements;

  • they can maintain other regulations, not prudential in nature, that can affect conditions of operation and competition in a market - such as requirement for lending to certain sectors or individuals, and on the basis of preferential rates;

  • GATS allows countries (Art. XVI and XVII) to protect their financial sectors from excessive competition from foreign firms; and

  • the GATS Balance-Of-Payments provisions (Art. XII) which enable a country to impose temporary restrictions on trade in services, involving non-fulfilment of commitments under GATS.

Other WTO, US and EC officials have also been suggesting, in the context of the current crisis in Asian markets (that is now becoming a rolling crisis with no end in sight) that liberalization of financial services should be seen as a solution and not the problem made out to be and that the various provisions of GATS enables them to safeguard their capital markets.

Cornford and Brandon's paper

But according to Mr. Andrew Cornford - UNCTAD's Economic Adviser, and an expert tracking banking and capital markets, and the WTO/GATS negotiations during and after the Uruguay Round - the situation may not be so clear-cut, and actions of countries could be challenged at the WTO.

This view is in a paper by Cornford and Jim Brandon (an UNCTAD consultant) prepared for the Annual Conference of the European Network on Debt and Development (EURODAD), in Vienna, Austria.

The paper, reflecting the views of the authors, notes that in terms of financial services, there are three categories of developing countries with some overlaps:

  • those with highly rudimentary banking sectors, many with low per capita GDP, and frequently with restrictive regimes for capital transactions (often dictated by limited foreign exchange reserves and access to external financing), who want to attract the commercial presence of foreign financial firms for their contribution to the country's banking sector;

  • countries with higher levels of per capita GDP and more developed financial sectors including with large commercial banks and organized, but still small, financial markets and limited range of financial instruments; These countries tend to balance benefits of increased foreign competition with the objective of developing indigenous firms, but sometimes subordinating this last in the pursuit of making their country into a financial centre. They have varying restrictiveness on their exchange control regimes, but a number of them are steadily increasing IMF obligations for current account convertibility, though capital transactions are still subject to controls. The lack of attraction of these countries to foreign banks have little to do with their regulatory regimes and more to do with their inadequate communications and small size of their middle classes.

  • a third category of countries with more diversified, but till recently, tightly controlled financial sectors where because of higher levels of income and savings, the potential profits to foreign firms participating in the markets are generally larger and would be enhanced by increased market openings. In such cases for example, profitability of participation in the securities business is enhanced by access to membership on stock exchanges, and is linked to freedom of inward and outward portfolio investments for non-residents, and a regime for capital transactions (that will garner revenues for asset management, if outward capital transactions are not restricted).

Activities attracting foreign suppliers

The stakes involved feeding the appetites of foreign firms, and pushing the US and EC to negotiate openings for them is seen by the fact that investment banking activities in just six Asian economies alone (Hong Kong, India, Indonesia, Korea, Taiwan and Thailand) are reported to have generated commissions in 1996 in excess of almost $6 billion. Besides these, direct investment opportunities bring in revenues from underwriting and advisory work in connection with securities issues and mergers and acquisitions and revenue from derivatives activities.

Other activities attracting foreign suppliers, are substantial growth expected in the asset management business in Asia - with its high savings and increases in net worth in personal sectors, management of pension funds and non-life insurance business and investment opportunities related to them.

Right to exercise control over capital movements

In the paper, Cornford points out that the right of countries to exercise control over international capital movements was a central issue in the Uruguay Round negotiations on financial services. At various stages, proposals were submitted which, as part of the liberalization of cross-border transactions, would have required removal of restrictions on capital transactions.

But developing countries resisted this and the eventual GATS text acknowledged the need of governments for autonomy in this area.

Art. VI of GATS specifically provided that nothing in the agreement "shall affect rights and obligations" of IMF members under its Articles of Agreement, including use of exchange actions in conformity with the IMF Articles. It was further provided that a country shall not impose restrictions on capital transactions inconsistently with its specific commitments regarding such transactions, except under Art. XII of the GATS or at the request of the IMF.

Under the IMF Articles, members are precluded from using the Fund's general resources to meet large or sustained outflow of capital (except to the extent of using the reserve tranche of its quota), and the IMF can ask a member to exercise controls on capital to prevent use of the general resources of the Fund.

Developing countries felt re-assured at the time GATS was being negotiated, that the references to the IMF fully protected them. Several leading Third World negotiators in talks with this writer, for example, drew specific attention to this.

The IMF also lobbied at that time to get specific references to its own powers written into the GATS.

Cornford points out that under Art. XVI of the GATS, if a country undertakes a commitment to market access with respect to cross-border transactions of which cross-border movements of capital are an essential part, then the country is also committed to allow such movements.

The commitment to liberalization of capital movements is thus linked to a commitment on market access.

However, says Cornford, while the commitment to liberalization is thus clearly circumscribed, the autonomy of governments regarding control of capital movements under the GATS is not completely clear-cut, and the autonomy "may be further limited as a consequence of the current initiative to extend the IMF's authority to capital movements".

Proposed amendments to IMF's Articles

At the recent Hong Kong IMF/World Bank meetings, the IMF Interim Committee invited the "Executive Board to complete its work on a proposed amendment to the IMF's Articles that would make the liberalization of capital movements one of the purposes of the IMF, and extend, as needed, the IMF's jurisdiction through the establishment of carefully defined and consistently applied obligations regarding the liberalization of such movements."

[The IMF Managing Director, Michel Camdessus, proposed this at the 1995 meeting in Spain (on the occasion of the 50th anniversary of the Bretton Woods Institutions) and has been pushing it. After Hong Kong, he and his officials have been quoted as saying that the IMF has now received a broad mandate to work for capital liberalization, but that the intention is not to force developing countries to move quickly, but to do so over time. In other private discussions, he is reported to have said he envisages something like the OECD guidelines for capital liberalization, where countries would move step-by- step in this direction.]

[Other experts have however, noted that even such a step would mean that a developing country cannot reverse its position, if it finds the policy not promoting its development.]

[One former finance official of a leading Third World country told this writer that whatever autonomous steps a developing country might take, any binding commitment in an international fora may prove disastrous in the current stage of their development and the fragility of their external sectors.]

Cornford and Brandon point out in their paper that controls over capital transactions may be challenged in the WTO in cases where the link between the transactions and a country's commitment is less direct than in the case of prohibition of their use in the circumstances outlined in Art. XVI of GATS.

For example, controls or taxes to safeguard balance of payments could be challenged, even when action of this type restricting trade in services in which a country has made commitments is allowed under Art. XII of GATS.

This Article allows countries to determine the incidence of such restrictions (for BOP reasons) and "give priority to the supply of services which are more essential to their economic or development programmes". But there is a proviso that restrictions "shall not be adopted or maintained for the purpose of protecting a particular sector."

The use of "purpose", Cornford points out, is important since incidence of measures to deal with capital movements framed without discriminatory intent may nevertheless be discriminatory in fact, between firms supplying different financial services, and thus may have implications for competition between domestic and foreign firms.

[GATT and now, the WTO dispute settlement panels often invoke this idea of conditions of "competition" between domestic and foreign firms, and expectations of trading partners to interpret WTO rules and as a catch-all to knock down trade measures in countries even when they don't specifically violate a rule. And currently, the differences in language between English, French and Spanish versions, are being used against developing countries, who have placed their actions on their understanding of the English version.]

Cornford points out that in such cases, the de facto discriminatory impact of such measures might be questioned under Art. XVII(3) of the GATS on the grounds that although they are "formally identical" in their treatment of suppliers, they modified "the conditions of competition in favour of services or services suppliers of the country imposing them compared to like services or services suppliers (of another country)".

[This view about a foreigner having to receive better treatment than nationals has been a contention of the US even in the 1960s in its attempts to formulate codified international law. But it is resurfacing as part of the neo- liberal economic order, buttressed by the US-dominated UN political order.]

US study of national treatment

Cornford cites the US Treasury's 1979 report to Congress on foreign government treatment of US commercial banking operations for the view about de facto discrimination as a ground for challenge. That report said in relation to the financial services trade, that an "even-handed application of foreign exchange controls may affect foreign bank operations which are more heavily involved in foreign lending than their domestic counterparts".

In a more recent, 1994 national treatment study, the US has also said that exchange controls in countries can prevent foreign banks from fully exploiting their competitive strengths and capacity to innovate.

Cornford underlines that this point is potentially capable of becoming an issue of contention under GATS since deployment of new financial instruments is increasingly common in association with international investment, though its use is often still concentrated among a minority of banks with extensive international operations.

Any measure directed at or having a major effect on such instruments, adopted as part of restrictions on capital inflows or outflows, might be queries by the home country or countries of such banks as having a de facto discriminatory character modifying the conditions of competition under Art. XVII (3).

This point, Cornford argues, may prove to be far from academic. The pace of transactional innovation which has recently characterized the financial sector has already had implications for measures that governments adopt towards the capital account of the BOP.

In 1995, for example, Brazil restricted participation by non-residents in the country's derivatives market. The objective was to prevent them from using such instruments as a vehicle for avoidance of tax payable on fixed income investments. As a result, there was a contraction in the use of interest-rate derivatives.

Instruments of financial engineering can nowadays be routinely employed to produce "synthetic" instruments or portfolios whose cash flows through time (inflows and outflows) match or mimic those of other more traditional instruments, such as the Brazilian ones, of debt investments yielding fixed incomes.

But if a government wants to target such a traditional instrument for reasons of tax, or for other purposes in connection with controls on capital movements, it may need to extend the scope of the action to these "synthetic" instruments or portfolios.

Differences between domestic and foreign firms

But owing to differences in capabilities between domestic and foreign firms (which was not the case in Brazil), the supply of these "synthetic" instruments or portfolios may be carried out exclusively by foreign firms which may take the view that restrictions on these instruments or portfolios are de facto discriminatory or damage their competitiveness in financial markets of the host country.

The recent Asian crisis, Cornford points out, illustrates the processes involved in external BOP crises and the policy choices which confront governments and raises the question of whether GATS rules could constrain the governments, though GATS does provide leeway to countries.

A government action in response to a crisis involving both external payments and the banking system may include a lender- of-last resort operation as well as provision of other types of financing to the firms affected - finance and mortgage companies and securities firms, as well as commercial banks.

Under the financial services annex of GATS, governments do retain considerable discretion as to the type, scale and distribution of support they provide. However, the extent of allowable discrimination between domestic and foreign firms in the context of this support is still uncertain.

Government's policy response also generally includes measures to restructure the financial sector and enhance competitiveness. Here again, the issue of differential treatment of foreign and domestic firms may have to be faced.

While it is difficult at a general level to be precise where GATS commitments could begin to restrict freedom of action of governments, "the challenges to policy posed by external-payments-cum-banking crises bring out the multiple connections between macro-economic policy and other policies towards the banking sector - including those bearing on openness to foreign participation and the commitments of countries under GATS."

[In this view, even the seemingly innocuous request to "grandfather" existing rights of existing firms, may prove very difficult for governments to act in the future, since they could be challenged on the basis of vague "grandfathered" rights.]

Cornford acknowledges that the "case law" under GATS makes prognostication particularly difficult. The GATS provisions about measures that can be taken to safeguard BOP, but not for the purpose of protection, would imply that all such measures would be carefully scrutinized (in the BOP Committee) for presence of discriminatory effects on business of foreign suppliers covered by a country's schedule and might be a source of contention even in the case of those measures taken in response to emergencies.

GATS, and the annex on financial services, give governments broad latitude for measures taken for prudential reasons, but such measures are not to be used "as a means of avoiding (a country's) commitments or obligations under the Agreement".

The references in the annex to measures intended "to ensure the integrity and stability of the financial system" would appear to cover a broad range of policy responses to crises when they actually occur, and it is difficult to anticipate which measures of this type might lead to contention with other countries on grounds of incompatibility with those commitments.

Such cases would be infrequent in normal times, but might be more likely to arise regarding government actions taken in response to external BOP-cum-banking crises.

A problem that the Cornford paper has not touched is the more general one relating to the GATT and now, WTO practices in disputes.

A practice or measure long tolerated or accepted by a trading partner does not mean it may not be challenged at a future point, by the government of a home country of a powerful corporation or interest.

Nor can assurances or understandings of parties during negotiations be of great value, as the EC has discovered vis- a-vis the banana ruling, and the particulars it entered in its schedule of commitments.

There have also been other GATT disputes where one major party or the other has challenged, and won a dispute involving practices that have been accepted for a long time.

This would be particularly nerve-wracking for a developing country finance minister, who has to take some swift actions, when his actions and motivations would be subject to "second guessing" at the WTO as to whether the minister could not have achieved the same objective through other measures and means open to the country - a frequent argument used in cases where "exceptions" are being invoked by a country, and issues of protection and conditions of competitivity are used by panels.  (Third World Economics No.175, 16-31 December 1997)

The above article was originally published in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.