TWN Info Service on Finance and Development (Sept07/02)

28 September 2007


Problems and dangers face developing countries if they open up their financial services before the right conditions are present, and these countries should therefore be cautious about financial liberalization, including commitments at the WTO and regional agreements.

This warning was given in a paper by the UNCTAD Secretariat presented at an UNCTAD expert meeting on development implications of financial services on 20-21 September. The paper lists major concerns that developing countries have in opening up their financial services (FS) to foreign banks and other institutions. It shows the dominance of developed countries over global financial services, a rising FS trade deficit of developing countries, and destabilizing risks caused by new financial instruments and actors like derivatives and hedge funds.

The following is a report on the UNCTAD paper. It was published in the SUNS #6330, Tuesday 25 September 2007.

With best wishes
Martin Khor

Development Dangers in Opening up Financial Services
By Martin Khor

Problems and dangers face developing countries if they open up their financial services before the right conditions are present, and these countries should therefore be cautious about financial liberalization, including commitments at the WTO and regional agreements.

This warning was given in a paper by the UNCTAD Secretariat presented at an UNCTAD expert meeting on development implications of financial services on 20-21 September.

The paper lists major concerns that developing countries have in opening up their financial services (FS) to foreign banks and other institutions. It shows the dominance of developed countries over global financial services, a rising FS trade deficit of developing countries, and destabilizing risks caused by new financial instruments and actors like derivatives and hedge funds.

UNCTAD also surveys the current WTO Doha negotiations on services, giving some details of the requests and pressures by developed countries and their financial institutions on developing countries. It warns of their implications, given the far-reaching nature of these proposals, the importance of FS and the cost of failure.

It also warns of the higher FS commitments that developing countries have made in bilateral and regional agreements and through their accession to the WTO.

UNCTAD says that financial sector reforms and liberalization can have good development results only if supported by good policies and regulations which are difficult to achieve due to rapid changes in the financial system.

Thus, many developing countries pursue a policy of “selective economic openness” for FS trade liberalization. Though the paper does not spell out the meaning of “selective opening”, it is normally taken to mean that countries are cautious and open up only over a long period, in stages, and only in areas in which they are confident there will be no adverse effects, in line with their capacity to regulate and the capacity of local firms to face the competition.

In theory, there are many arguments for liberalizing FS, but there are concerns about the relative virtues of openness and protection in finance that need to be addressed, says UNCTAD.

It adds that the FS sector is unique in terms of its fundamental importance for a country's economic development and in its broader nature (e. g. potential for imperfect competition and market failures such as information asymmetry).

These characteristics suggest caution when considering financial liberalization. The paper lists the following specific concerns about financial liberalization:

* The role which foreign FS providers would play in the domestic economy. Due to the strategic function of FS for development, developing countries should avoid that their domestic FS system is dominated by foreign providers, possibly allowing for abuse of market dominance.

This approach appears even more valid in situations where large banks (i. e. concentrated economic power in few consolidated banks) effectively obtain a certain degree of political power.

* Effects which foreign FS providers will have on national providers. Entry of foreign firms can lead to a decline in profits of existing firms and lower profit margins create pressure to reduce costs, potentially leading to financial distress among individual domestic firms. Foreign firms can bid lucrative corporate business away from domestic banks.

Case studies showed that foreign entry significantly reduced the profitability of domestic banks and their non-interest income. Entry of more foreign firms would also aggravate problems of “over-banking”/”over-insuring”. The pressure which domestic financial firms would face would depend, among others, on the degree of pre-existing structural problems, including the extent to which the financial system is undercapitalized.

* Some Governments wish to maintain a certain national presence in the domestic market or to provide temporary support to national suppliers. As described in the infant industry debate, national competitors are sometimes much less advanced compared to foreign FS providers entering the market.

In certain FS segments (e. g. investment banking), domestic providers simply cannot compete. There is, therefore, a need to encourage infant FS in developing countries, including by allowing for learning by doing that will ultimately reduce local cost of production and improve quality of output.

Sometimes, local suppliers are particularly drained - for example, when burdened by a large portfolio of non-performing loans - or they are impeded by their small size. Frequently, foreign companies do not face these detrimental factors. Domestic firms need time to adjust to new/unequal competition and, accordingly, trade liberalization could be phased in over time.

* Concerns relating to universal access. On the one hand, there is the concern that foreign FS providers would engage in cherry-picking and cream-skimming. They will operate only in very profitable market segments and not serve all sectors of the economy and local market, leaving aside, for example, retail banking in rural areas.

In parallel, there is the concern that internationalization - through lower profit margins and pressure to cut costs - would result in closing/streamlining branches, relying on automatic service provision and reducing services to the poor. Facing increasing competition, domestic FS providers tend to target their focus on most profitable clients, including big firms and the rich.

* Structural concerns that opening to foreign FS providers may lead to capital flows abroad and that liberalization of FS trade worsens a country's balance-of-payments position. Foreign FS providers are more likely to invest domestic savings abroad rather than in the local economy, and in so doing may exacerbate difficulties regarding domestic savings.

Regarding potential benefits of portfolio-equity flows, openness to foreign providers might also increase the probability of capital flight and volatility accompanying such benefits. Foreign providers are said to be better equipped for shifting capital abroad, possibly lacking commitment to the domestic economy; domestic providers in turn might have a sense of patriotism, thus withstanding incentives for moving money abroad.

* The difficulty of properly managing the liberalization process. Experiences with liberalization are mixed, and premature liberalization has proven to cause considerable costs. This is compounded by difficulties of - and lack of experience in - regulating international FS markets/transactions. In many developing countries, weaknesses of institutions and domestic regulatory frameworks make it difficult to monitor more complex financial institutions.

UNCTAD says that the above concerns have induced countries to pursue a policy of selective economic openness for FS trade liberalization.

The paper also lists counter-arguments put forward against caution with financial liberalization. They include that: (a) The specificity of the FS sector does not justify a move away from the overall liberalization paradigm; (b) Infant industry protection has thus far not led to efficient and competitive FS; ( c) Weaknesses of the domestic financial system are best improved through importing foreign know-how and allowing foreign banks to establish; and (d) In terms of policy choices, protection (barriers to foreign competitors) is never the best alternative.

UNCTAD concludes that for FS reform and liberalization to generate pro-development outcomes, it needs to be supported by appropriate policies, including macroeconomic, prudential, regulatory and supervisory frameworks and adjustment policies.

For many developing countries, designing and implementing such policies remain a challenge, further compounded by difficulties of properly managing capital-account liberalization.

The UNCTAD paper distinguishes between two types of “financial liberalization” - liberalization of the domestic financial system and the current and capital account liberalization, which can entail wide repercussions on the stability of the economy and growth prospects.

On global market trends, the paper says that world FS exports were $200 billion in 2005, and grew at an average annual rate of 14 per cent from 2000 to 2005. The dominance of developed countries' firms is clear from the paper. Developed countries accounted for 90 per cent of all exports in 2005.

Developing countries account for only 10 per cent of global FS exports (about $18 billion). FS exports accounted for only 4 per cent of developing countries' commercial services exports in 2005, while FS account for roughly 7 per cent of commercial services imports.

Developing countries' FS imports underwent particularly rapid and high growth, outpacing their exports of FS. Also, developed countries are net exporters of financial services and their exports nearly doubled from $97 billion to $182 billion (from 2000 to 2005).

The report's information implies that (1) Developing countries are net importers of financial services; (2) Their deficit has increased between 2000 and 2005 since their imports outpaced exports.

In the global insurance market, developed countries also dominate with a 88% share. Global insurance premiums stood at $3.4 trillion in 2005, life insurance contributing 58 per cent and non-life-insurance 42 per cent.

In a section on market characteristics, the paper says that the era of financial globalization is characterized by greater privatization, liberalization and financial sophistication.

The financial sector is also getting more consolidated through mergers and acquisitions, especially in the European Union, which is expected to eliminate by 2010 hundreds of banks and make a small group of pan-European giants rise and dominate the European landscape.

On the proliferation of financial instruments, UNCTAD says the creation of innovative retail financial products (e. g. derivatives, swaps, etc.) and financial entities (hedge funds) entail higher risks, especially when traded over the counter and not subject to stringent regulation. Derivative instruments raise the possibility of potential risk for domestic and international financial systems.

Many hedge funds operate in derivative markets, which are estimated at $17 trillion. This raises fears about shocks. Following five years of 20 per cent average annual growth, an estimated 7,000 global hedge funds hold assets of $1.3 trillion. The sector remains lightly regulated and concerns of developing countries resulting from the late 1990s crises remain unaddressed.

On regulation, the paper says that the risks of failure of domestic legal and regulatory institutions became evident through financial crises. The role of external FS suppliers in destabilizing developing countries' economies or in increasing the fragmentation/segmentation of developing countries' financial sector is highlighted in many studies.

Widespread failures in banking practices and international systems of control; insider trading, fraud; connected lending; poor asset quality; distorted management incentives; corruption and regulatory incompetence, in some cases exacerbated financial crises and threatened the stability of the international financial system. The scale and scope of gaps in regulatory/supervisory structures came close to systemic failure.

Currency crises and banking failures are often preceded by financial liberalization, especially in developing countries, adds UNCTAD. Most of the financial crises in the post-Bretton Woods era were characterized by nominal interest rate differentials and the resulting portfolio investment.

The costs of banking crises are large, the average cost of currency crisis being 8 per cent of the pre-crisis GDP and the average cost of a simultaneous banking crisis being 18 per cent of pre-crisis GDP. In Russia, the crisis resulted in a shrinking GDP (by 4.9 per cent in 1998) and an estimate of the cost of the 1980 Argentina crisis amounts to 55.3 per cent of pre-crisis GDP. Thus, developing countries need to carefully weigh the costs and risks with the potential gains of FS liberalization.

On the WTO's GATS agreement, the paper says that FS-related provisions are included in the GATS Agreement, Annex on FS, Understanding on Commitments in FS and individual members' schedules of specific commitments.

FS have been the subject of extended sectoral negotiations after the Uruguay Round. GATS objectives and principles (e. g. progressive liberalization, flexibility, increasing participation of Developing Countries in international services trade) also apply to FS.

Among the 11 services sectors, the FS sector ranks second regarding numbers of commitments. As of July 2007, 121 members have commitments in at least one of the FS sub-sectors.

In making FS commitments, members use two scheduling approaches: (a) Positive-listing of commitments (choosing any number of sub-sectors/modes of supply and scheduling any type of market access/national treatment (MA/NT) limitations); and (b) Understanding on FS, an alternative mechanism for deeper commitments by giving details about the sectoral/modal scope/nature of commitments and by containing additional obligations (e. g. standstill, government-procurement, new FS, transfer/processing of information and non-discriminatory measures); two developing countries used this.

Para 7 of the understanding requires members to permit any Mode 3 FS supplier to offer any new FS. Given the proliferation/rapid development of new financial products, concerns arise about difficulties to anticipate the exact scope of commitments. Accordingly, members carefully limit respective commitments.

The understanding also addresses Mode 4, providing for temporary entry for senior managerial personnel and specialists in the operation of the FS supplier, and - associated with commercial presence - specialists regarding computer, telecommunication, accounting, actuarial and legal services.

Developing countries' FS commitments in GATS enshrined recent FS reform and liberalization. Mode 3 is the mode in which members prefer allowing access to domestic markets for direct insurance services and, apart from Asia, also for banking.

This preference for Mode 3 over Mode 1 could originate in expectations that (a) positive effects of liberalization may be weaker in Mode 1 than in Mode 3; (b) Mode 1 liberalization may create more risks for domestic financial systems (e. g. regulatory control is easier for banks established within borders); and ( c) that implementing Mode 1 commitments may require cross-border capital flows.

On the WTO's Doha negotiations on GATS, the paper says that the FS negotiations saw numerous bilateral requests and one plurilateral (February 2006) request, coordinated by Canada. The plurilateral request was submitted by 10 countries with strong FS sectors, directed to mostly developing countries (Argentina, Brazil, India, China, ASEAN, Egypt and South Africa).

Bilateral/plurilateral requests called for enhanced commitments on: Modes 1 and 2 (e. g. for all sub-sectors mentioned in the annex, for a specific set of sectors, or for a minimum cluster of commitments as per understanding); Mode 3 (e. g. eliminating certain sectoral and horizontal limitations); and Mode 4 (e. g. seeking greater freedom for intra-corporate transferees and contractual service suppliers).

Despite its far-reaching nature, numerous countries have also requested developing countries to subscribe to some parts, if not all, of the understanding or to use the understanding as a reference point for commitments. Interestingly, the FS plurilateral request does not refer to the understanding.

Two model-schedules were put forward by the FS industry (e. g. Financial Leader Group) aimed at deeper commitments. The model-schedule for investment banking, trading and asset management aims at opening markets in the respective services by binding most favourable current market access conditions and amending current laws and regulations for bringing them in line with the model-schedule.

The insurance model-schedule aims at effective access for insurance providers, through MA/NT and additional commitments, covering domestic regulation-type measures (best practices).

Given the far-reaching nature of these proposals, the importance of FS for development and the cost of failure, UNCTAD calls for in-depth analysis of their implications on Developing Countries.

Regarding transparency, the plurilateral request on FS flags transparency in development and application of laws and regulations; transparent and speedy licensing procedures have been suggested.

The April 2007 text of the Chair from the WTO Working Party on Domestic Regulation (WPDR) addresses transparency in terms of publication requirements, a priori comment procedures (on a best endeavour basis) and due process-related implementation questions. Some suggested pursuing FS sector-specific work in parallel with WPDR horizontal work.

On RTAs, the paper says that FS commitments in RTAs tend to be more far-reaching than those in GATS. Sometimes, RTA FS commitments exceed not only offers made in the context of the Doha Round (particularly in the case of the United States Preferential Trade Agreements) but they also match/exceed demands made in multilateral requests.

For instance, Latin American and Caribbean FTAs exhibit market access/national treatment FS commitments that tend to have significant additional liberalization comments compared to GATS. Some FTAs tend to reflect liberalization provisions contained in the WTO understanding.

Many RTAs exhibit a rise in commitments for cross-border supply of FS, often going beyond the traditional concept of GATS Mode 1, to include Mode 2 and in some cases even Mode 4 (e. g. Republic of Korea-Chile and the North American Free Trade Agreement - NAFTA, which defines cross-border trade in services to include three of the four GATS modes, i. e. cross-border supply, consumption abroad and the movement of natural persons).

Recently acceded countries made FS commitments in nearly all sub-sectors, the breath and depth of which raise questions about their sustainability, particularly in the light of these countries' comparatively weak regulatory frameworks, practices and institutions, says UNCTAD.

Other GATS provisions central for members' financial systems are Articles XI (payments/transfer for current transactions relating to specific commitments) and XII (balance of payments exception). According to Article XI, members shall not impose restrictions on any capital transaction inconsistent with their specific commitments.

When making FS commitments, it is important to consider possible linkages between FS liberalization and capital-account liberalisation. While GATS rules/obligations are designed to decouple financial trade liberalization from capital-account transactions, certain practical linkages exist.

These include situations where capital-account transactions are key for complying with GATS commitments. For example, the effective implementation of certain FS commitments in Mode 1, e. g. in deposit services, can require capital-account liberalization, the scope and extent of which are hard to anticipate. Liberalizing capital accounts prematurely without adequate institutions and prudential regulations in place can induce economic and social distress and financial crises.

Unlike trade in goods, capital flows are more subject to information asymmetry, agency problems, adverse selection/moral hazard; price-formation in asset markets may often be dominated by speculation; capital-flows to developing countries are volatile (without links to the receiving country's economic fundamentals); substantial empirical evidence suggests a close link - particularly in developing countries - between liberalization of the financial system and economic and financial crises; and selective policies (e. g. selective economic openness) are needed. More research is needed on connections between FS in WTO and other areas of the international FS system.

The paper concludes that for FS reform and liberalization to generate pro-development outcomes, it needs to be supported by appropriately designed, paced and sequenced policies, to be determined only on a case-by-case basis adapted to the specificity of each country.

This remains a challenge, further compounded by difficulties of properly managing capital-account liberalization. Developing countries need time to adopt and properly implement the respective legislation and regulations.

Developing countries also face difficulties in efforts to strengthen the international regulatory system, including the limited institutional role of international regulatory initiatives; difficulties to effectively participate in international regulatory initiatives; lack of tools for facing new complex financial products, technologies, and management techniques; cross-border insolvency; and expansion of consolidated firms.

 Finally, a developmental approach to FS liberalization in GATS is needed:

* Demands for market commitments need to be cognizant of flexibilities for developing countries to carefully choose the extent of bindings according to the maturity of financial and regulatory systems; phasing-in commitments or a possibility to roll-back commitments could facilitate Developing Country participation.

* Commercially meaningful commitments in sectors/modes of export interest to Developing Countries, e. g. niche opportunities including in Mode 4, advisory services, computer-related services, information technology-enabled services, off-shoring, micro-finance and Islamic finance.

* Disciplines on regulatory issues (including transparency) would give primacy to the right to regulate and universal access, consider developing countries' resource and administrative constraints and preserve the prudential carve-out.

* Binding obligations need to be conditional upon the existence of effective regulatory frameworks and supported by clear commitments for capacity-building/technical assistance, focusing on both improving developing countries' regulatory and institutional framework and their supply side.