Strengthening Financial Sectors in Emerging Markets
Keynote speech at conference on
"Further Liberalization of Global Financial Services Markets?"
Institute for International Economics
It is a pleasure to join you today for this important and timely discussion on global financial services liberalization.
I recently returned from the Far East, where strengthening financial sectors was at the top of my agenda.
Beyond private talks in Malaysia, China, and South Korea, and bilateral talks with a broad range of countries at the Annual Meeting of the Asian Development Bank, I publicly announced a new Bush Administration international economic policy initiative. The initiative aims to spur financial sector reform in developing economies by encouraging greater financial sector openness and better, sounder financial regulation. Our goal is to help developing countries transform their domestic financial sectors into economic "engines of growth."
Financial sector reform and liberalization of financial services markets are closely connected. So, I'd like to review with you the message of my Asia tour. And I'd like to preview a tentative strategy for producing results in the area of financial sector reform in that region and in others.
Our policy toward financial sector reform in emerging markets is evolving, and we are still at an early stage in development process. Therefore, another of my goals here today is to pose questions—not to suggest that we have all the answers. Treasury can learn from the many experts IIE has assembled here, and I am looking forward to an informed and spirited discussion.
In our understanding, strong, efficient financial sectors are essential for developing countries seeking to post productivity gains and protect their economies against global shocks. But the importance of an efficient financial sector is not up for debate. The questions how to build such a financial sector, at what pace, in what sequence, and in what configuration are those which require careful consideration. As a baseline judgment, we at Treasury believe that openness to foreign direct investment in the financial sector coupled with improved financial supervision and regulation—is a clear path to economic growth and stability.
Let me define my terms. To me, financial sector openness means establishing an environment in which foreign-owned financial firms can compete on equal footing with domestic ones. And it means a clear and transparent financial regulatory regime. For participation will often take the form of foreign direct investment in domestic financial services businesses. It may also take the form of cross-border trade—although such trade tends to account for a much smaller portion of trade in financial services than in goods.
I should note that allowing foreign-owned financial firms to compete on equal terms with domestic-owned firms is distinct from a country's decision to open its capital account. It is not U.S. policy to encourage any country to maintain capital controls. After all, no developed country maintains them. It is countries that allow a foreign presence in banking, brokerage, asset management, investment banking, and insurance industries stand to benefit substantially—even those countries that choose to open their capital account at a slower pace.
Perhaps some of you will disagree with my definition of openness, and certainly I expect some debate on the significance of capital account restrictions.
Less controversial, I think, is that foreign financial institutions can introduce business practices, technology, products, and risk management systems honed in the more developed markets. And, of course, foreign financial institutions can bring their own financial resources to bear as well.
Our message in Asia was that financial sector openness offers two fundamental benefits to those who undertake it.
First, a more open and well-regulated financial sector is more efficient, more robust. It acts as an "engine of growth" for the entire economy. The financial sector has an economy-wide effect. All other sectors rely on financial intermediation for growth. Second, perhaps more than in any other economic sector, a stronger, deeper financial sector can protect an economy from external as well as domestic shocks. Therefore, financial sector openness can promote stability.
How does financial sector openness lead to growth? Well, we know that the world's best financial institutions are better able to identify productive investment opportunities and then more quickly move domestic savings into them—in short, the better they perform their capital intermediation function, the faster an economy can grow.
In our view, one of the best ways to improve financial sector intermediation is to expose domestic firms to the best practices of world-class financial institutions, so that domestic firms can learn from the best, and begin to compete. There are examples.
Take Spain, which opened its financial sector to freer trade in 1986. In 1986, foreign banks held just a 9.3 percent share of the Spanish market for commercial banking, as measured by total assets. Challenged by foreign competition, domestic financial firms were forced to restructure, cut overhead costs and improve efficiency.
To compete, they expanded into new national markets and merged with other banks to take advantage of economies of scale. They also began operating in international markets.
As a result of these and other factors associated with openness and EEC accession, Spain's growth rate rose to 4.8% and gross capital formation rose to 14.1% for the period from 1986-1989. Such growth stood in sharp contrast to previous five years.
Another benefit of a competitive foreign presence is that competition forces all financial firms operating in an economy to offer the highest returns to savers, and the lowest cost of capital to investors. Under the right conditions, competition from international firms leads to narrower spreads, and stimulates both savings and investment.
As financial institutions aggregate capital, they must move it into the businesses and industry sectors where they can earn the best risk-adjusted returns for their savers. That means investing in the businesses that can make the best use of their capital—in other words, those that offer the highest productivity. And rising productivity—output per worker—is at the root of rising living standards.
The positive effect of openness has been documented by the World Bank, another fact we highlighted for Asian policymakers. In 2001, a World Bank study found that countries with fully open financial service sectors grow, on average, one percentage point faster than other countries. These results corroborate an earlier World Bank study which estimated that more open and competitive financial services markets—in developing markets - helped increase growth rates by 2.0 to 2.5%.
Another fact we asked Asian policymakers to consider was that a stronger financial sector enhances economic stability: that is, that a financial sector reduces risks for savers and investors, and acts as a hedge against global economic cycles.
In my view, the growing interdependence between emerging markets and developed markets—globalization—brings new challenges to all economies, even as it opens new opportunities. Increasingly, our economies pedal in tandem. When the United States moves forward, so do many developing economies, especially those most dependent on exports to the U.S. The reverse is true as well.
For emerging markets, the consequences of this economic integration are profound. Access to markets abroad means greater exports for developing economies and greater profits for their firms. But economic integration also has its downside, and the turbulent winds of the global economy can swing a boom hard, fast, and unexpectedly. The slowdown in U.S. high tech manufacturing in the last few years hit Asian electronic component manufacturers in just that way, for example. While export-led growth is attractive to many developing countries, recent events demonstrate its downside.
One way a stronger financial sector can make an economy more resilient to such shocks is by helping to buoy domestic demand when export demand falls off. Though it has yet to be quantified, the recent and widespread use of credit cards in Korea likely has helped drive consumer demand. Likewise, an introduction of new home mortgage products has surely influenced a rising demand for new housing starts.
Conversely, a weak and inefficient financial sector may limit a government's ability to run counter-cyclical macroeconomic policies to offset shocks. This is true in developed and developing economies alike. In some economies, most notably Japan, a significant easing of monetary policies has not translated into significant credit growth because the banking sector is already supporting too much bad debt, and is unable or unwilling to add new loans to balance sheets.
By contrast, a healthy financial sector is able to inject new credit into the economy as the central bank expands the money supply. Foreign-backed financial institutions in developing markets often have stronger balance sheets, and a greater ability to lend, especially during slowdowns.
For example, a recent study of emerging Latin American markets showed that during periods of crisis, foreign banks actually increased their local lending relative to their competitors. With an international capital base, foreign banks have the ability to continue extending credit to local businesses, which is often essential for stabilizing the economy.
Finally, with regard to regulation, we pointed out to Asian leaders that sound and transparent regulation and supervision, with consistent national treatment of foreign-owned financial institutions, essential in strengthening financial systems. Every effort must be taken to use transparent methods for drafting and applying regulations, with input from all relevant parties. Regulators must seek out the experience of the private sector and especially internationally active firms before creating the rules of the game.
U.S. Financial Sector
It is always perilous to hold up oneself as an exemplar of virtue, but I believe that the United States has one of the most open and, therefore, competitive financial sectors in the world.
As evidence of U.S. financial sector openness, consider that U.S. imports of financial services, including insurance, totaled $19.3 billion in 2000. This accounted for 10 percent of all cross-border service imports into our country that year. Sales figures of foreign-owned financial firms operating in the U.S. were even more substantial. In 1999, the latest year available, sales of services in the U.S. by majority-owned finance and insurance affiliates of foreign companies totaled $94 billion. These affiliates account for more than ten percent of total U.S. revenue in these sectors.
Because the U.S. economy is open to these firms, consumers and businesses can choose from the most advanced, best-priced financial services in the world. Entrepreneurs and major corporations alike can finance expansion; and they can better survive periods of contraction.
Consider U.S. financial sector contributions to U.S. economic stability during last year's slowdown. Clearly, the breadth and depth of our financial sector—in addition to well-timed tax relief and monetary easing—abridged the contraction. In particular, widespread access to home mortgage products and rapid, low-cost refinancing kept U.S. consumers spending until businesses could clear their inventories and begin to rebuild.
Advanced financial risk management practices also served their purpose. As Federal Reserve Chairman Alan Greenspan put it, "New financial products—including derivatives, asset-backed securities, collateralized loan obligations, and collateralized mortgage obligations, among others—have enabled risk to be dispersed more effectively to those willing to, and presumably capable of, bearing it. Shocks to the overall economic system are accordingly less likely to create cascading credit failure."
With regard to regulatory practices, the U.S. Federal Reserve regularly publishes proposed regulations and asks for comments from the private sector in a reasonable time period. During the implementation of our Gramm-Leach-Bliley bill—which fundamentally reformed the U.S. banking, securities and insurance sectors—the U.S. Federal Reserve sought out and received hundreds of comments from foreign banks. As a result, it made several significant changes to accommodate the many international banks doing business in the United States. Rules that specify how regulations will be implemented and how applications for licenses will be granted or denied are equally as important.
Questions for IIE Conference
The opinions I have expressed thus far are preliminary. They are reasonably well-informed, I hope, but nonetheless subject to refinement. That is why I welcome so heartily this IIE conference today.
We need your help in understanding the best approaches, and highest priorities, for financial sector liberalization. How much can liberalization boost growth? And in which subsectors will it be most effective?
How should we look at the least developed countries in the respect? Secretary O'Neill has just returned from a tour through Africa, where he was collecting data on how to improve economic growth in the poorest nations. Can low-income nations benefit as much from financial sector reform as middle-income countries? How might the approach differ for different levels of development, and different regions?
Further, many in the developing world have, rightly or wrongly, come to associate financial liberalization with financial crisis. Are these phenomena linked in fact, or just perception? Here again we need to distinguish the effects of more foreign direct investment in financial services from the question of opening the capital account. And we need to distinguish foreign portfolio investment from foreign direct investment in financial services.
There are so many more questions—but we'll get to them in time. I am glad that the Institute is devoting an entire day to the subject.
My Asia trip was just the beginning of our commitment. There is much more to our strategy.
As we identify the most important target countries, we will plan more visits to raise these issues in a bilateral context. We will also hope to promote discussion at multilateral, regional, and bilateral economic meetings. We will continue to work with international financial institutions such as the World Bank and the IMF to make sure financial sector openness is more closely related to their core missions.
We are considering other approaches as well, and I welcome your input on these.
I can say, without equivocation, that the Treasury Department, and this Administration, intend to place financial sector openness high on the international economic agenda. And we want to do it right. Your insights today will make an impact on our policy.
In conclusion, I believe that a major challenge for emerging markets, in this decade, will be financial sector restructuring and development. The bigger question, of course, is how to get there.
I believe the record shows that when policymakers understand the importance of financial sector openness, and are firmly resolved to take the necessary steps, they can succeed in strengthening their country's financial sector. And succeed they must—prosperity in the 21st century will depend on it.