Financial Liberalization: Managing Risks and Opportunities by Ronald Yacat

alli~

ffIiIil~

edited by

Ponciano S. 'ntal Jr.

PASCN

PHILIPPINE

APEC

STUDY CENTER

NETWORK

PHILIPPINE INSTITUTEFOR DEVELOPMENTSTUDIES Suriansa mga Pag-aaralPangkaunlaran ng Pilipinas

Cop~ght2005

By the Philippine APEC StudyCenterNetWork(PASCN) andthe PhilippineInstitute for DevelopmentStudies(PIDS)

Printedin the Philippines.All rightsreserved

Thefindings, interpretationsand conclusionsin this volumeare those ofthe authorsand do not necessarilyreflect those of PASCNand PIDS and other institutions associatedwith the PASCNproject onfinancial liberalization. The publication of this volumewasfunded by PASCNandPIDS. Themembers of PASCNinclude: Asian Institute of Management, Ateneode Manila University, Central LuzonState University,De La Salle University,Foreign Service Institute,Mindanao State University,Philippine Institutefor Development Studies (LeadAgencyand Secretariat),Silliman University,University ofAsia and the Pacific, University ofSan Carlos, University of the Philippines and Xavier University.

Pleaseaddressall inquiriesto: PHILIPPINE APEC STUDY CENTER NETWORK SECRETARIAT PHILIPPINE INSTITUTE FOR DEVELOPMENT STUDIES NEDA sa Makati Building 106AmorsoloSt. LegaspiVillage 1229MakatiCity,Philippines Tel.no.:(63-2)8939588,8925817,8935705,8924059 FaxNo: (63-2)8939588,8939589,8161091 E-mail:pascn@pidsnet.pids.gov.ph; publications@pidsnet.pids.gov.ph URL: http://pascn.pids.gov.ph; http://www.pids.gov.ph

ISBN971-564-081-8 RP04-05-500

Table of Contents vii

UstofTables list of Figures, Boxes and Appendices

xii xiv

Foreword

CHAPTER I ManagingRisksand Opportunities of FinancialliberaJization and Integration: A Macro-Micro AnalysisIntegrative Report PoncianoS.IntalJr.

CHAPTER II Financial liberalization and Integration in the APEC Region: Performance and Comparisonwith Chile and the EuropeanUnion PoncianoS. [ntat Jr., Victor C. Pontines andJitendra S. Mojica

CHAPTER ill Human ResourceRequirementsof the YmancialSectorUnder a liberalized Regime Leila Y. Calderon, CherylVillanuevaandTeresa S. TullaoJr.

185

CHAPTER IV Foreign-BankEntry, Bank Spreadsand the Macroeconomic Policy Stance George N. ManzanoandEmilioS. Nen:

CHAPTER

251

Reac1ionsto the Entry of Foreign Banksin the Philippines: A Cri1ical Studyof Local SelectedBanks ReneB.Hapitan

283

CHAPTER VI The Impact of libera1ization of Foreign Bank Entry on the Philippine Domestic Banking Market AngeloA. Unite and MichaelJ SuUivan

309

CHAPTER VII The Role of the General Agreement on Trade in Services (GATS)-FmancialServicesAgreement (FSA)in the Fmancialliberalization Efforts of APECEconomies VzctorC. Pontines

339

About The Publishers

387

About the Authors

388

LIST OFTABLFS CHAPTER I Table la External financing in thefive mostaffectedAsian countries International claims held by foreign banks,disTable lb tribution by maturity and sector Foreign Direct Investment inflows, 1980-1999 Table 2 Table 3 Trade intensity of selected Asia Pacific economies; 1990 Table 4 Portfolio investmentsof APEC and other countries; 1993-1997 Table 5 Macroeconomic performance of 10 countries during inflow episodeschangefrom immediately preceding period of equal length Table 6 SelectedASEANcountries: Economicand financial indicators Table 7 Policy responsesto capital surge Table 8 Indicators of the efficiencyof the banking industry in APEC economies Table 9 Indicators of institutional framework banking sector Table 10 Indicators of institutional framework (mid 1997) Table 11 Time period for overdue criteria for interest suspension and loan classification Table 12 Loan provisioning requirements: Comparative

12 15 1.6

25 27 29 45

50 50 52

inform,;-:ttion Comparisonof major banking sectorregulations

53 54

Table I Table 2a

Magnitude and composition of capitalflows External financing in the five mostaffectedAsian

countries

Table 2b

International claims held by foreign banks distribution by country of origin International claims held by foreign banks distribution by maturity and sector FDIinflows, 1980-1999(B.O.P.Basis) FDI outflows, 1980-1999(B.O.P. Basis)

Table 13

CHAPTERn

Table 2c Table 3a Table 3b

vii

78 80 83 84

Table 3c

Table 3d Table 4a Table 4b Table 5a Table 5b Table 6a

Table 6b Table 7a Table 7b Table 8al Table 8a2 Table 8b Table 9 Table 10 Table 11 Table 12 Table 13 Table 14 Table 15 Table 16 Table 17 Table 18 Table 19 Table 20

Shareof APEC toworld foreign direct investment flowsAPECforeign direct investment inflows and outflows APEC foreign direct investmentinflows and outflows Total foreign direct investmentflows:.Japan AverageshareofJapan foreign direct investments to APEC member countries Total foreign directinvestmentflows:United States Averageshareof U.S. foreign direct investments to APEC member countries Totalforeign direct equity investmentflows:Philippines share distribution of total foreign direct equity investmentflows: Philippines Averageshare of foreign direct investmentflows to the Philippines from APEC member countries Total Malaysianequity investmentflows Average share of Malaysian foreign equity invesmentflows to APEC member countries Total portfolio investmentpayments: Malaysia Total portfolio invesmentreceipts: Malaysia Average share of portfolio payments to APEC member countries: Malaysia Trade intensity of selectedAsiaPacificeconomies Portfolio invesmentsof APEC and other countries Feldstein-Horioka regression results Indicatorsof institutional frameworkof the banking sector Indicators of institutional frameworkof the propertysector Consumer price inflation: Europe Macroeconomicindicators: Italy Short-term interest rates:Europe Growth rate of real GDP:Europe How competitive wasUnited Kingdom? Frenchand German economies Timetables and motivations for changesin Unremunerated reserverequirement (URR): Chile viii

85 87 88 89 89

9 92 94

95 96 97 98

101 102 106 133 ]35 136 137 ]38 139

140 141 149

CHAPTERm Table I Table 2 Table 3

Employed workers in financial sectorby educational attainment (1988-1998) Demand and supply of manpower Human resource requirements of the financial sectorand CHED circular requirements

CHAPTER IV Table 1 List of foreign bank branchesand subsidiarie~ Table 2 Concentration ratios (Assest,depositsand loan) Table 3 Performance indicators of banking sector Table 4 Total loan lossprovisioning Table 5 Quarterly loan growth rates Table 6 Averagereal depositgrowth rate (in percentage)

231 232

257 258 259 274 275 277

CHAPTER V Table la Philippine Table lb Table 2a Table 2b Table 3 Table 4 Table 5 Table 6 Table 7 Table 8 Table 9 Table 10 Table II Table 12

commercial banking industry, local banking sector (as of December 2000) Philippine commercial banking industry foreign banking sector Philippine commercial banking industry, market share summary: total assets Philippine commercial banking industry, market share summary: total deposits Profile of respondent banks Description of the overall competitive environment Area of operations where competition was most significant Products or serviceswhich have been significantly affected Other significant factors affected Specific products or services which have been significantly affected Potential business revenues lost (current year) Steps being done to meet competition and time frame Nature of "no competitive impact" Steps being done to prepare for competition and time frame

291 291 293 293

294

295 295 296 298 298

Table 13 Table 14 Table 15 Table 16 Table 17 Table 18

What would change the bank's perception on the present"no competitiveimpact" presentation General assessment of foreign banks and financialliberalization Summary of total loans and depositsof selected foreign banks Return on equity of selectedforeign banks Total capital accountsof selectedforeign banks Nonperforming loans of selectedforeign banks

299

301 303 304 304

vs.indusuy CHAPTER VI Table I Description of dependentand independent variables Table 2 Descriptive statisticsfor Philippine commercial banks for the period 1990through 1998 Table 3 Descriptive statisticson selectedvariablesfor 16 publicly traded domesticexpanded commercial banks (ECBs)for the period 1990through 1998 Table 4 Descriptive statisticson ownershipvariables for 15 publicly traded domestic expanded commercial banks (ECBs) Table 5 Foreign bank entry, foreign bank penetration, bank assetconcentration and domestic banks' interest rate spreads,operating performance, and risk CHAPTER VII Table 1 Top 20 exporters and importers of banking and financial seIVices1999 (US$ million) Table 2 Top 20 exporters and importers of insurance seIVices1999 (US$ million) Table 3 Exports of financial seIVicesfor selected Asian economies, 1988-99(US dollar million) Table 4 Imports of financial seIVicesfor selected Asian economies, 1988-99(US dollar million) Table 5 Share of foreign banksin domestic banking sys-

315

322

323

325

345

347 347

tems: 1988-1995

Table 6

Insurance penetration premiums as a share of grossdomestic product (1998) x

350

Table 7 Table 8 Table 9 Table 10 Table 11 Table 12

Table 13

Table 14

Table 15

Foreign participation in AsianinsUI'ancemarkets, 1997 Market accesscommitments in banking (deposits and lending) Market accesscommitmentsin insuranceservices (life and non-life) Market accesscommitments in securities Grandfather provisions in banking, insurance and securities Degree of openness/restrictivenessto trade in financial servicesof APECeconomies (banking: lending and deposits) Degree of openness/restrictivenessto trade in financial services of APEC economies (insurance: life and nonlife) Degree of openness/restrictivenessto trade in financial servicesof APEC economics (securities) Financial servicesagreement: market accessin APEC economies

351 354 354 355 356

360

LIsT OF FIG~,

BOXFSANDAPPENDICES

CHAPTER n

Figurela

Figurelb Figure 1c

Figure Id Box! Appendix

IS-LM model with pegged exchange rates, perfect capital mobility and perfect substitutabilityof domesticand foreign financial assetsand a small economy: an expansionary monetarypolicy IS-LM model under fixed exchangerate regime and given perfect capital mobility: an expansionaryfiscal policy IS-LM model under a flexible exchange rate regime with perfect mobility: an expansionary monetary policy and interest parity IS-LM model under a regime capitalcontrols with fixed exchange rates The concept ofN-l problem in fixed exchange rates Model specificationand frameworks:A reviewof banking and currency crisismodels

CHAPTER IV Figure 1 Intermediation costand bank spreads Figure 2 Difference between risk-free T-bill and cost of funds Figure 3 Open capital account policy was mixed with virtual currency peg Figure 4 Peg did not hold Figure 5 Incentive to fund loans from abroad Figure 6 Peso'sfloat erasedforeign borrowing Figure 7 Changing liability structures ofKBst Figure 8 Macro policy mix and financial market imperfections led to persistentarbitrage Boxl Alternative measurements of intermediation

spreads Box 2 Box 3 Appendix

A policy bias for tightening How did arbitrage opportunities persist The role of foreign banks in times of crisis

xii

112

113 113

42 169

263 263 264 264 267 267 269

259 265 271

CHAPTERVI Appendix

List of the 16 domestic expanded commercial banks (ECBs) in the Philippines between 1990 and 1998

CHAPTER VII Figure 1 Openness/restrictivenessof APECeconomiesin financial servicestrade (banking: deposits) Figure 2 Openness/restrictivenessof APECeconomiesin financial servicestrade (banking: lending) Figure 3 Opennesss/restrictivenessof APEC economies in financial servicestrade (insurance: life) Figure 4 Openness/restrictivenessof APECeconomiesin financial servicestrade (insurance: nonlife) Figure 5 Openness/restrictivenessof APECeconomiesin financial servicestrade (securities)

XIII

334

362 362 362 363 363

FOREWORD The onsetof globalizationand revolutionarychangesin infonnation an(i communications technologies made financial liberalization inevitable for all previouslyfinancially-repressedcountries. Through liberalization, an allocation of world savingsto the most productive userscan occur, thus boosting investment and economic growth. Open or liberalized capital markets assurea more efficient allocation of savings,increasedpossibilities for diversification of investment risk, faster growth, and the dampening of businesscycles.However, opening the market of intangible goods,or financial assets,is a complicated and challenging development for any country, bringing about consequencesthat are generallyconsideredto be more uncertain, vagueand risky compared to the trade liberalization effects.This book discussessomeof these and puts them in the proper content so that policymakersmayact acco(dingly and in the light of the overall effect on the configuration of the financial sector. On behalf of the PASCN,I would like to expressmy sincerestgratitude and appreciation to the authorsfor their contribution to this publication. We hope that they will continue to support our efforts in providing more venues for greater understanding and appreciation of national aswell asAPEC-x;elated issues.

~~of.2~~ Mario B. Lamberte,Pq.D. President, PillS and Lead Convenor, PASCN

xiv

CIIAPTER

Managing Risks and Opportunities of Financial Liberalization and Integration: A Macro-Micro Analysis Integrative

Report

PoncianoS. IntalJr.

Abstract T he paperprovidesan overviewof the researchproject entitled "Impacts, Risksand Opportunities of Financial Liberalization and Integration: a Macro-Micro Analysis,"focused on four interrelated aspectsofthe~tructural and institutional foundations to effective risk managementand exploitation of opportunities in an open economy.The paper drawslessonsand insights on (a) the macroeconomic managementin an open economy,(b) the liberalization of the banking industry, (c) the human resourceimplications of financialliberalization and integration, and (d) the behavior of Asia-PacificEconomic Cooperation (APEC) member economies toward the Financial Services Agreement (FSA) under General Agreement on Trade in Services (GATS). Introduction The 1980sand the 1990shave seen the growing financial liberalization and integration of the countries in the Asia Pacific region among themselvesand with the restof the world. This is a correlate of the expanding trade relations of the Asia Pacific countries among themselvesand the rest of the world during the pasttwo decades.This reflectsthe complementaritiesamong trade, direct investmentand finance in the dynamicsof outward oriented growth in EastAsia that underpins the so-calledEastAsian miracle. However,the recent EastAsian crisisshowsforcefully that economic opennessand financial integration has its risksas much asopportunities. The challenge for policymakers

FINANCIAL LIBERALIZATION:MANAGINGRISKS AND OPPORTUNITIES

is to manage the risks at the same time that the opportunities are exploited. This would mean improving macroeconomic policy regime as well as strengthening the structural and institutional foundations of effective risk management. At the same time such foundations also help expand the opportunities for the country to exploit. The research project "Impacts and Opportunities of Financial Liberalization and Integration: a Macro-Micro Analysis" focused on four interrelated aspects of the structural and institutional foundation to effective risk management and exploitation of opportunities in an open economy. The first relates to macroeconomic management in an open economy, drawing from the analytical perspectives on financial liberalization and integration as well as the varieties of experience in the world especially those from Chile, East Asia and the European Union. At the heart of the macroeconomic challenges of financial liberalization and integration is the so-called "impossible trinity" (or "incompatible trinity") of monetary independence, capital mobility and fixed exchange rates. Sooner or later the incompatibility of the three eventually leads to currency crises as the recent East Asian crisis attests. Understanding the analytic perspectives and the various experiences can provide lessons and insights on the policy challenges on the Philippines of financialliberalization and integration. The second aspect deals with the liberalization of entry of foreign banks in the country. An important means of managing the shocks from increased international financial linkages is the deepening and increased efficiency of the domestic financial system. The entry of foreign banks is meant to contribute to the deepening and improved efficiency of the local banking industry. Three of the papers in the project examined the impact of the entry of foreign banks on the industry-wide bank spread as well as on the operational performances and strategies of domestic commercial banks. The papers can help us determine whether the entry of foreign banks contributed to improved efficiency of the banking industry, increased resilience of the industry to external shocks, and possible expansion of the country's opportunity set especially through technology transfer and possibly also through improved financial market and information linkages. The third aspect is on the human resource implications of financial liberalization and integration. Specifically, one paper in the project looked into the curricular offerings and training programs of educational institutions and other HRD organizations in the country. Is the country's human capital ready for the demands of improved risk management and for the expanded opportunities arising from stronger financial linkages internationally?

MANAGINGRISKSAND DPPDRTUNITIES DF FINANCIAlliBERALIZATIDN AND INTEGRATIDN

The last aspect examined in the project is on the Financial SeIVices Agreement (FSA) under the General Agreement on Trade and SeIVices (GATS), specifically the comparison between commitments and practice of APEC member economies to the FSA.The future negotiations in the GATS provide a mechanism that can complement the unilateral liberalization efforts in the country, primarily through the opening up of financial seIVice sectorsin the APEC economiesto potential Philippine exporters and seIVice

providers. The integrative paper consistsof five sections. Section I servesas an introduction to the paper. SectionII discussesthe benefits and risksof financialliberalization and integration. SectionIII examinesmacroeconomicmanagementoffinancialliberalization and integration. SectionIV looks into the microeconomics of financial liberalization and integration. The last section, SectionV, spells out policy implications toward managingthe risksand opportunities of financial liberalization and integration. Benefits and risb of financial liberalization and integration BenefitJ

Financial liberalization, in one sense, is a sine qua non of financial integration. Financial liberalization can be interpreted in three component senses.The first one is domestic deregulation, best exemplified by the deregulation of domestic interest rates. The second and third senses relate to the opening up of the financial sectorto the restof the world; that is, internationalisation of financial selVices.The second one is the opening up of a country to international capital movements,which is the essenceof financial integration. The third senseis the opening of the financial sector to foreign equity participation. The lasttwo are meant to increase competition and/or contestability of the domesticfinancial markets.The focus of the paper is on the financial opening and internationalisation of the financial selVicesof a country. Nonetheless, it needs to be pointed out that the presumed benefits from financial opening and integration necessitatedomestic financial deregulation, especiallywith respectto interest ratesand bank branching. The arguments for financial liberalization and integration stem from presumed benefits to the economy; they include (see Fischer and Riesen 1993; Claessensand Glaessner1997): .Reduction in the cost of financial intermediation (increase in operational efficiency of the financial institutions), .Improvement in the range of financial servicesand products adapt-

FINANCIAL LIBERALIZATION:MANAGINGRISKS AND OPPORTUNITIES

able to the changing tastesand requirements of consumers and industries (dynamic efficiency), The increased potential for savingsto be allocated to the highest yielding investmentsfor the economy (improvement in allocative efficiency). Better accessto foreign capital, and Better domestic financial infrastructure. The allocative efficiency effect of financial deregulation (that is, reduction in price and quantity restrictions from portfolio structures of financial institutions) is further enhanced with the opening up of the economyto the international capital market. Specifically,the expanded opportunities for borrowing or lending domesticallyand internationally allows for improved intertemporal distribution in the consumption and saving mix and in meeting the varied demands and liquidity preferences of domestic saversand investors. Improved allocative efficiency involves deregulation of the financial sector in tandem with the internationalisation of financial services. The internationalisation of financial servicespotentially increasesthe pressuresfor improved regulation and supervision,better disclosurerules and generalimprovementsin the legal and regulatoryframework for the provision of financial servicesand improved screening of projects and monitoring of firms. It also improves the credibility of rules as the country enters into international agreements. It is also argued that foreign financial institutions encourage adoption of bestpracticesand transfer of skills to the domesticfinancial institutions, strengthen the capability of the financial institutions to measure and manage risk, reduce the overall risk and vulnerability of the financial sectorbecauseforeign institutions havemore diversified portfolios and have their parent companiesto run to (Pontines2001.).Overall,the opening up and internationalisation of financial servicesof an economywould increasepressure for, and contributes toward, an improved financial infrastructure in the country (Claessensand Glaessner1997). Indeed, improved prudential regulatory environment is needed in order to maximize the benefits from, and at the sametime minimize the risksfrom, financial opening and integration. The net effect is the stimulation of economic growth. First,positive real interest rates encourage savings.Second,accessto the international capital market easesup on the domestic savingconstraint; that is, domestic investment can be larger than domesticsaving.Finally, an efficient (and prudently managed) financial systemfacilitates the allocation of financial resourcesto the bestyielding investment projects.

MANAGINGRISKSAND OPPORTUNITIES OF FINANCIALLIBERALIZATION AND INTEGRATION

With the liberalization of capital movements,increased competitive environment facing the financial institutions and the growth in the economy, there would be financial market deepening with more and higher quality financial products for liquidity and risk management of consumersand industries. Risks The recent EastAsianfinancial crisisand other financial crisesin developing countries as well as developed countries pointed out starkly that financial liberalization and integration entails risks, both macroeconomic and microeconomic risks. In the pasttwo decades,the macroeconomic risksand challengesrelated to managing surgesin capital flows. In virtually all cases, currency and financial criseswere preceded by surges in capital inflows. The macroeconomic challengesare besthighlighted by the so-calledincompatible (or impossible) trinity. That is, in the long run it is not possibleto have an equilibrium in the context of (perfect) capital mobility, fixed exchange ratesand an independent monetarypolicy, that is,domestic interest rate (of a domestic asset)higher than foreign interest rate (of a comparable foreign asset)adjusted for minor transactionscosts).The basicpolicy challenge then is "how to designmacroeconomicpolicy coherent with increasing integration (such as) how to prevent overheating (and) limit vulnerability to large reversalsof capital flows" (Lopez-Mejia 1999). The microeconomic risks,linked especiallyto banks,relate to the additional risks attendant to cross-bordertransactions,especiallyexchange rate risk, interest rate risk, and credit risks.! There are also concerns that the opening of the financial sector to foreign bankswould mean foreign banks

, Johnston and Otker-Robe

(1999) list down the additional risks that banks face with cross-

border transactions as follows: a) credit risk (i.e., failure of a counter party to perform according

to a contractual

Obligation) .Transfer risk'when the currency of obligation becomes unavailable to the borrower" .Settlement risk"risk in the settlement of foreign exchange operations that arise due to time zone differences" .Country risk"risk associated with the economic, social and political environment of the borrower's country" b) Market risk i.e., risk of losses in banks's on-and off-balance sheet positions arising from movements in market prices that change the market value of an asset or a commitment. .Foreign exchange risk

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

would "cherry pick" and target the most lucrative segment of the domestic market, therebyforcing local banksto move towardsservicing the riskier customers. Thus, other things being equal, the domestic bankswould become more vulnerable to negative shocksin the economy (Pontines 2001). The abovementioned concerns, like the expected benefits,would have to be ultimately empirically validated. Perhaps the most important risk from financial liberalization and integration is in the interplay of the macroeconomicand microeconomic factors. Specifically,the macroeconomicvulnerabilityof an economyto large reversals of capital flows is heightened by financial sectorfragility and inadequaciesin that economy. The financial market is inherently imperfect exacerbated by problemsof asymmetricinformation. Moreover,in developingcountrieswhere family type corporations are the norm (for example, in EastAsia), the disciplining power of the market on corporate governance of borrower firms is weak. Then, banks and the security market face tremendous challenges in being outside monitors. Moreover,inadequate regulation and supervisionof financial institutions would encouragefinancial institutions to finance riskier and low-profitability projects, in many cases,corporations in which the banks are members of a businessgroup. In addition, a lending boom can lead to assetprice bubbles, which, in viewof the general practice of using real estate as collateral for loans, ultimately undermines the stability of banks and the financial sector. From the point of view of prudential regulation, what is of primordial concern is that banks may take ex:cessiverisks, partly becauseof loss in the charter value of banksresulting from financial deregulation and liberalization and partly becauseof expectationsof bailout of banks. The recent EastAsianfinancial crisishighlights the interaction between the macroeconomic environment and microeconomic behaviour. Thus, for example, the relative stability of the exchange rate has encouraged greater domestic demand for foreign borrowing in view of the higher interest rate domesticallyvis-a.-vis abroad. At the sametime, the increasedaccessof domestic firms and banksto the international capital market encouraged significant loan exposure in sectors prone to assetbubbles, especially the real estate~

.Interest rate riskwhen there is a mismatch between the bank's interest sensitive assets and liabilities , .Risk in derivatives transactionsas banks increasingly use derivatives as means of taking or hedging risks. Johnston and Otker-Robe's list are primarily the risks that lender-banks take on in cross-border transactions. For the borrower banks (and firms) especially in the developing countries, what may the most important are foreign exchange risks and interest rate risks.

MANAGINGRISKSAND DPPDRTUNITIES DFFINANCIAlliBERALIZATIDN AND INTEGRATIDN

sector. In the process, the economybecomesvulnerable to macroeconomic riskslike terms of trade reversalsand exchangerate pressures. In view of the interaction of the macroeconomic environment and microeconomic behaviour,it is apparent that preventing the recurrence of an EastAsian financial crisisnecessitatesimprovement in macroeconomic mtnagementand the prudential regulatory environment. It alsoimplies the need to strengthen the institutional capacityto manage the macroeconomic and microeconomic risksof financial liberalization and integration. Macroeconomic managementof financiallibera1ization and integration Capital flows in the APEC region

Intal et al. (2001) present dataand previousstudiesthat indicate the growing international financial integration of APEC member economies during the late 1980sand the 1990s.The financial liberalization stemmed from the easing of barriers to capital flows and opening of capital accountsof most of~e APEC member economies during the pasttwo decades.The opening up, of the capital accountsoccurred in tandem with the surge in capital flows into the so-calledemerging markets,primarily the EastAsian, Latin American and EastEuropean developing countries. Lopez-Mejia(1999)showsthat sixof the top eight largest recipients of net private capitalflows among the developing countries during 1990-1997are APEC member economies (that is, China, Mexico, Thailand, Indonesia, Korea,and Malaysia).Chile is also a major recipient since the latter 1980swhile the Philippines also experienced a surge in capital inflows especiallyby the mid-1990s. EastAsia led all developing areasas destination of private capital flows. The region's share to the total capital flows to developing countries increasedsubstantiallyfrom 12 percent during the early 1980sto 43 percent during the 1990s(Alba et al. 1998). The surge in capital flows is shown starkly in Tables 1.a and 1.b. The tables present only the ending yearsof the decade-longsurge in capital flows especiallyto the Associationof South EastAsian Nations Four (ASEAN-4) countries.Notice the more than doubling of private flows in two years time right before the EastAsian crisis,caused primarily by the near-tripling of flows from commercial banksand non-bankprivate creditors, much of this of short-termnature. The flowswerefar larger than the requirementsfor financing the doubling of the current account deficit during the 1994-1996period. The large magnitude of increasesin capitalflows in so short a time, with such flows increasingly borrowings of increasingly short-term maturity, raisesthe issueof the "absorptivecapacity"of the concerned countries in the one hand,

MANAGINGRISKSAND OPPORTUNITIES OF FINANCIALLIBERALIZATION AND INTEGRATION 9

Table 1 b. International claims held by foreign banks distribution and sector(ln US $ Billions)

by maturity

FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

Table 1bcant'd. Total Public Nonbank Short. Short. D. End1995 Outstanding Banks Sector Private tenn Reservesterm/Reserves China 63.1 27.1 7.1 28.9 31.5 143.4 0.2 Chile 21.2 --3.6 1.8 15.7 Indonesia 58.2 11.7 6.9 39.7 32.9 17.4 1.9 9.9 1.7 15.9 Malaysia 28.8 14.9 20.9 0.7 Papua NewGuinea0.3 0.0 0.0 0.3 0.2 0.4 0.5 Peru 9.9 3.3 0.6 6.0 --Philippines 19.7 8.9 2.4 8.4 11.8 8.7 1.4 Thailand 58.5 17.8 1.8 39.2 34.8 26.9 1.3 Korea 93.4 55.9 3.9 34.2 53.8 20.4 2.6 Vietnam 1.7 0.5 0.1 1.0 2.3 2.1 1.1 354.8 E. End 1996 China 58.4 Chile 22.2 Indonesia 44.8 Malaysia 20.8 PapuaNeNGuinea 0.4 Peru 10.6 Philippines 16.1 Thailand 40.7 Korea 65.3 Vietnam 1.7

281.0 F.End1997 China 46.6 Chile 20.7 Indonesia 40.7 Malaysia 18.1 PalXJa NellGuinea0.3 Peru 10.3 Philippines 16.7 Thaland 28.4 Korea 60.7 Vietnam 1.7 Total

244.2

138.7 21.5 3.8 5.1 5.7 0.0

2.9 6.0 8.8 37.1

0.4

26.3

6.9

1.7 6.7

1.8 0.0 0.7

2.1 1.9 5.4 0.1

189.3 29.8 16.7 33.0 13.2 0.4 7.0 8.1 30.0 22.7 1.2

91.3

27.3

162.1

15.8 1.8 4.2

6.4

24.4 17.4 28.0 11.6 0.3

3.9

0.0 2.7 5.1

1.4 8.4

2.6 0.0

0.9

6.6 8.6

35.0 0.2

3.0 2.0 5.2 0.1

22.8 20.3 1.3

72.2

30.0

141.3

3.5

27.9 149.8

0.2

20.1

0.9 0.3

0.2

23.5 25.7 0.2

7.2 23.5 28.1 2.2

10.8 29.5 52.0 2.1

0.7 0.8 0.5

17.7 158.3

0.1

20.0

0.7 0.2 0.5

8.6

7.6 0.4

5.7 23.4 34.7 2.4

27.2 30.6 0.2

1.0

15.0 34.8 74.0

0.7

2.9

0.8

0.4 0.5

MANAGINGRISKSAND Of'f'DRTUNITIESOFFINANCIALLIBERALIZATION AND INTEGRATION

Table 1 b cant'd. Total F.End1995 Outstanding China 58.3 Chile 22.3 Indonesia 40.3 Malaysia 20.8 P~a Na'IGuinea0.2 Peru 13.2 Philip~nes 16.5 Thailand 26.7 Korea 58.8 Vietnam 2.2 Total

Short-

term Reservesterm/Reserves

168.9 23.3 29.6 0.3 5.9

15.3 32.7

0.4

96.2

259.3

especially in the late 1990s.There have been shifts in the destination of foreign direct investment (FDI) between developed and developing countries. Much of the FDI flows went to developed countries during the 1980s. The surge in FDI flows into the developing world occurred during the earlyand mid-1990s,especiallyto developingAsia.The EastAsian crisishasled to a redirection ofFDIs back to developedcountries in the late 1990s,centered primarily in North America (specifically,the United States).Behind the surge in FDI flows to developing APEC was the sharp rise in net investments in China and to a lesserextent Mexico aswell as the steadyrise in the level of net investmentsin Chile and Malaysia during the period. Note that the level of net outward investmentsfromjapan and the United Statesstagnated or declined during the latter 1990sascompared to the early 1990s. Much of the surge in capital flows during the period came from within the APEC region itself. The surge in capitalflows is not only in net terms but also in grossflows, with significant inflows and outflows in a number of countries. (This is best exemplified by the United Stateswhich is both a major sourceof capital outflows aswell asbeing in fact the world's largestnet recipientof capital inflows during the latter 1990s).A key reasonfor this is that the region hosts one of the world's largest savers,that is,japan. The growing financial integration within the region is a correlate of the deepening trade relations among the APEC countries. This reflects the complementarities among trade, direct investment and finance in the dynamicsof outward oriented growth especiallyin EastAsia that underpins the so-called EastAsian Miracle. Yoshitomi (1999)noted that that the stockofjapanese foreign direct

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investtnentis a significant explanatoryvariablepromoting "natural economic integration in Asia." The recent EastAsiancrisisdoes not only highlight the risks of open capital accountsand financial integration but also, somewhat perversely,validates the growing economic integration in the EastAsian region. The growth in intra-East Asian investment flows became more pronounced since the mid-1980safter the PlazaAccord led to the appreciation of theJapaneseyen initially and later on of the Korean won and the Taiwanese NT dollar in the latter 1980s.Japaneseforeign direct investmentswasgeared primarily to the United Statesand Europe during the late 1970sand early 1980sin order to counteract rising protectionism in those regions (Chen 1994). The appreciation of the yen and the rising costof labour and land in japan forced theJapanesefirms to develop export basesin other EastAsian countries,including Korea,Taiwan,the SoutheastAsian countries and China. The liberalization in China, initially centered on the specialeconomic zones in coastal China, paved the way for the massivetransfer of manufacturing facilities from Hong Kong to the nearby Guandong province. Taiwan and South Korea also expanded outward foreign direct investmentssince 1987, primarily to the United States,SoutheastAsiaand China. The investmentsin the United Statesappeared primarily aimed at securing accessto the United Statesmarket and at acquiring technology; the investmentsto SoutheastAsia and China involved shifting labour intensive manufactures to reduce labour cost (Chen 1994). Kawai and Takagi (2001) estimated the FDI flows to EastAsia during 1990-1998.For the ASEAN countries,55.5 percent of total FDI inflows during the period came from japan, the United States,Asian Newly Industrialized Economies (NIEs), and ASEANcountries themselves.For China, the shareof other EastAsian countries is evenhigher: 62.4 percentalone for Korea, Hong Kong and Taiwan and an additional 19.6 percent from japan, the United Statesand the ASEAN countries. japan and the United Statesare the major foreign investorsin Taiwan,accounting for 40 percentof the total FDI inflows; the ASEAN, Hong Kong and Korea contributed an additional 12.3percent. Interestingly, the United Statesand Europe dominated FDI inflows into Korea with each of them accounting for one third of the total; japan, ASEAN countries, Hong Kong and Taiwanaccounted for an additional one fourth of the total inflows into Korea. Thus, at leastfor much of developing EastAsia, the FDI flows were largely amongAPEC member economies although Korea is somewhatof an exception in the sensethat Europe is a major sourceofFDI flows. (The FDI flows for the developed economymembers of APEC differ

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

significantly from those for the developingAPECmember economies.For the former, best exemplified by the United States,there is tremendous two-way investment flow among them and Europe). The growing foreign direct investmentflowswithin the region is consistent with the trade intensity in the Asia Pacific region. Estimates of trade intensity are availablefor 1980and 1990(seeTable3). The estimatesindicate that the direction of trade of APEC economiesis biased towards the APEC region, asindicated by a value of more than unity in most cases.There are a few casesof intense trade relationships, as for example the North America Free Trade Agreement countries, the Malaysia-Singapore-Indonesia linkage (with Singaporeservingas transhipment point), and the ANZERTAcountries of Australia and New Zealand. In virtually all of the APEC countries, the trade intensity measurefor the European Communityis lessthan unity. It may be noted though that there is no one-to-one relationship between the intensityof trade and intensity of foreign direct investment.This is becausea major reasonfor the flow ofFDI into developingAPECcountries (especiallySoutheastAsia and China) is the use of the latter as export basesnot only for the home country of the foreign investorbut perhapsmore importantly as export basesfor third markets, both within and outside the APEC region. The flow of portfolio capitalwithin the APECregion is alsoindicative of the growingfinancial integration in the region. Indeed, more than FDI, there hasbeen a sharp rise in portfolio equity and debt flows to the region. Table 4 indicates that there hasbeen a sharprise in the grossflows, both inflows and outflows, in the APEC region. The International Monetary Fund (IMF) BOP dataleavesmuch to be desired; nonetheless,the dataindicate that the APEC region is a net recipient of portfolio equityand debt flowsfrom the restof the world. Indeed, even the United Statesis a major net recipient of portfolio flows, primarily in debt securities. It wasjapan that was the only major net portfolio investor for much of the 1990samong the APEC member economies. Analysisof bilateral flows of portfolio capital among the APEC economies cannot be undertaken becauseof data constraints, except for Malaysia. Nonetheless,a significant shareof portfolio flows in the APEC region comes from the region itself. At the sametime, Malaysia'sdata brings out clearlythe role of Hong Kong and Singaporeasthe two major intermediaries in portfolio investmentsin the emerging economies in the region. The flows of portfolio funds havebeen influenced also by the interest rate regime especially in the United States.Specifically, the lower interest rates in the United Statescontributed to the increased flow of funds to the emerging markets in developing APEC in the early1990s.Similarly, the rise

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in the United Statesinterest rates in the latter part of the 1990scontributed to the retreat of portfolio funds from EastAsian emerging markets. Dasgupta and Ratha (2000) showed in their regression results that globa lliquidity factors, as indicated by the "world interestrate" proxied by the United States dollar UBOR 3-month,are indeed a major influence on capitalflowsto emerging developing economy markets (manyof which are APEC member economies). The sensitivity of portfolio funds to interest rate movements in the United Statesis indicative of the (deepening) financial relations within the APEC region and the increased financial openness of the APEC member economies to the rest of the world. In summary, the large and growing capital inflows and outflows in the APEC region are indicative of the growing financial opennessof the APEC economies and the growing linkages of domestic financial markets in the region with the international and regional financial markets. Fmancial integration in the APEC region The surge in capital flows into and within the APEC region can be expected to contribute towardsfinancial integration in the region. Studiesdo suggest that financial markets in the region are not yet fully integrated and that there are substantialinter-country differencesin how the national financial markets are integrated with the rest of the world. Nonetheless,there are indications that indeed the APEC member economies are increasingly financially integrated among themselvesand with the restof the world. One measure of financial integration popularised by Feldstein and Horioka is the useof savingand investmentcorrelations through the so-called Feldstein-Horioka type regressions.Underpinning this measure is the neoclassicalframework that in a closed economydomestic investment is determined by domestic savingwhile an open economyloosens that binding constraint. Thus, according to this framework the most open economies canbe expected to have low, if not zero, correlation betweeninvestmentand saving. A number of APEC member economieswere included in the FeldsteinHorioka testsconducted by Montiel (1994) using data for 1970-1990.The regression results indicate that Singapore had high degree of financial integration while Chile, Malaysiaand Mexico had intermediate financial opennessbut not "necessarilystrong financial integration" (Montiel 1994). Indonesia, Korea and Thailand followed in terms of financial integration. The Philippines wasat the opposite end of Singapore,with strong financial autarky. Given that the surgein capitalflows to developingAPECmember economies wasat its highest during the 1990-1997period, Intal, et al. (2001) esti-

MANAGING RISKSANDDPPDRTUNITIES DFFINANCIAL LIBERALIZATIDN ANDINTEGRATIDN19

mated Feldstein-Horiokatype regressionsfor Indonesia, Malaysia,Korea,the Philippines and Thailand for the 1980sand the 1990s. The regression resultsindicate that while Korea, Indonesia, the Philippines and Thailand were relatively financially closed in the 1980s,they becamemore open financially in the 1990s.The regressionresultsalso indicate that Malaysiawas relatively open financially even during the 1980s. In summary,the Feldstein-Horiokaregressionsindicate varying degrees of financial integration among the APEC developing member economies during the 1970sand the 1980s.Indeed, the Philippines wasestimated to be most financially closed among the APEC member economies in the Montiel sample (China and Vietnam were not included in the sample). Nonetheless, there are indications that the APEC member economies,including the Philippines, became more open during the 1990s. The more common, and theoretically more appealing and stringent, measure of financial integration is the test of interest parity. The interest parity condition is satisfied when the return from a domestic financial asset is equal to the return from a comparablefinancial asset(in terms of default, liquidity and maturity characteristics)in a foreign country plus the expected exchange rate depreciation of the domestic currency (or the forward cover under covered interest parity). The estimatesof covered interest rate differentials by Chinn and Dooley (1995) showlow and declining mean differentials for Canada,japan, Hong Kong and lessso,Australia and New Zealand during 1982-1994.This meansvery high and deepening financial integration of these countries with the rest of the world. The differentials for Singaporeand especially.Malaysiawere higher, suggestinglessfinancial integration. Similar estimatesof uncovered interest differentials for 1982-1988 were done by Fischer and Riesen (1993) for Hong Kong, japan, Malaysia, Singaporeand Thailand. like in Chinn and Dooley,Fischerand Riesenfound low differentials for Hong Kong and japan, suggestingthat indeed the two nations are very well integrated with the world financial markets. The mean differentials'for Singapore, Malaysiaand Thailand were somewhat higher, suggestinglessfinancial integration of these countries in the 1980s. For countries without forward exchange markets,it is uncovered interest parity that is used to examine the extent of financial integration with the restof the world. Montiel (1994) testeduncovered interest parity by examining the differential between the domestic interest rate and the foreign interestrate adjusted for exchangerate change.Specifically,he posited that uncovered interest parity implies that the interest differential above has a mean value of zero and that the deviations from the mean value are serially

FINANCIAL LIBERALIZATION,MANAGINGRISKS ANO OPPORTUNITIES

MANAGIMGRISKSAND OPPDRTUNITIES DF FINANCIALLIBERALIZATION AND INTEGRATIDN 21

Surgein capital flows and macroeconomicvulnerability: the impossible (or incompatible) trinity Financial integration, and with it capital mobility, has significant implications on macroeconomicpolicy and management.The basicanalyticsof macroeconomic policy in a small open economybrings out that monetary policy does not have a lasting impact on output and employment in the lo~g run when there is perfect capital mobility and fixed exchangerate. That is, the pursuit of an independent monetary policy (suchassetting a domestic interest rate significantly differe~tfrom the foreign anchor country's interest rate adjusted for transactions costand exchangerate risks) for a smalland open economy with a fixed exchange rate and faced with perfect capital mobility is not sustainable over the long run. Otherwise,asthe recent EastAsian crisis suggests,there would be a paymentsor currency crisis.This is the essenceof the so-calledincompatible or impossible trinity. Internal policy consistency,and therefore sustainability,involvesbreaking one of the following three conditions: perfect capital mobility, independent monetary policy and exchange rate stability (that is, a fixed exchange rate). Thus, the sustainablepolicy options are the following: .Maintaining monetary independence in the face of perfect capital mobility necessitatesa flexible exchangerate regime, .The pursuit of exchange rate stability in the face of perfect capital mobility demands that domestic monetary policy (of a small open economy) be subsumed under the monetary policy of the anchor country, or .Putting barriers to capital flows (that is, imperfect capital mobility) allows for some monetary independence at the same that there is exchangerate stability. Given the long run direction towardsgreater capital mobility aseconomies become more open and integrated with one another, it is apparent that it is the fist two options that are the most viable in the long run. That is, countries would have to move overtime towardsa truly flexible exchangerate regime or towards a hard peg with no monetary independence (suchasunder a monetary union, currency board or dollarization). Indeed, more and more developing countries have chosen to move awayfrom soft dirty pegs towards either greater exchange rate flexibility or a hard peg (for example, dollarization, currency board) in recent years in the aftermath of the East Asian crisis.

FINANCIALLIBERALIZATION, MANAGING RISKSANOOPPORTUNITIES

Nonetheless,the third option remains anilIiportant one, primarily in the transition, for developing countries where the financial systemsremain underdeveloped and the prudential environment, including the institutional capacityof the monetary authorities to monitor and supervise,leaves much to be desired. The relative successby Chile and Malaysiain the use of capital control measureshasprovided someimpetus for the useof suchmeasuresfor macroeconomic management. Capital flows and macroeconomicvulnerability: experiences from Southerncone and EastAsiancountries A number of currency and financial crisessince the mid-1970shave brought out the incompatible or impossible trinity in starkterms.Perhaps,the starkest was the experience of the Southern cone countries (especiallyChile and Argentina) during the late-1970sand early-1980s. Very high real interest rates and/or government exchangerate guaranteesled to sharp capital inflows, in large part in the form of aggressiveforeign borrowing by domestic firms. At the Same time, imprudent macroeconomic policies, especiallylarge fiscal deficits (especially in Argentina) together with the capital inflows fanned inflationary pressures in these countries with indexed wages. As a result, there occurred substantialreal currency appreciationand (for Chile, together with terms of trade deterioration) large current account deficits. There ensued capital flight as the sustainability of the exchange rate under the socalled tablita systembecame increasinglyin doubt. Chile and Argentina both went into a currency crisis in 1982. The most recent currency crisis that had significant impact on the international policy arena and on the international economicsliterature wasthe EastAsian currency and financial crisis.The EastAsian crisis highlights the macroeconomic challengesof surgesin capital inflows much more than the experience of the Southern cone countries. This is becausethe affected East Asian countries followed much more prudent macroeconomic policies than the Southern cone countries. Nevertheless,the EastAsian crisis also highlights the impossible (or incompatible) trinity albeit in a more nuancedway. For behind the apparently robust macroeconomicfigures wasan increasingly fragile financial sector in the affected countries in the face of the surge in capital flows but which eventually boiled over through massiveand abrupt reversalin the capital flows. The macroeconomic vulnerability from surgesin capital inflows stems in part from the nature of the capital flows and in part from the policy responsesto such inflows and the impact of such policies on the macroeco-

MANAGINGRISKSAND DPPDRTUNITIES DF FINANCIALLIBERALIZATIDN AND INTEGRATIDN

nomic variables. It is generallyagreed that foreign direct investment inflows do not impart as much macroeconomic vulnerability as short-term capital inflows. As the East Asian crisis countries, but most especiallyThailand and Korea, show,a significant sourceof macroeconomic vulnerability is the preponderance of short-term capital in the country's total capital inflows that were used for long-term investmentsincreasinglyin real estateand construction aswell asin margin loans for stockpurchases.Thailand, the trigger country of the EastAsian crisis,had short-term debt accounting for more than two fifths of its total external debt and that the total short-term external debt was larger than the country's international reserves.Korea, at the tail end of the currency crisesin the region, alsofell victim to the currency attacksbecauseof the preponderance of short-termfinancing for long-term, low-profit factories. Asan aftermath of the EastAsiancrisis,the ratio of short-term debt to the gross international reservesof a country hasbecomean important indicator used in analysesof macroeconomic vulnerability to external shocksand speculative currency attacks. At the heart of the macroeconomic vulnerability arising from the surge in capital inflows, however,lies the impactsof suchinflows on the economy. This is dependent in part on the policy responsesto such inflows. Under a free float, a surge in capital inflows has virtually no monetary effect. Under a fixed exchange rate regime with no sterilization, the capital inflow resultsin increased international reservesand domestic money supply thereby raising inflationary pressures.In intermediate regimeswith imperfect capital mobility, the usual case in emerging economies,a country defends its exchange rate and pursues a monetary target. In this case,reserve accumulation is a policy choice such that the more aggressivethe accumulation, the higher (lower) the pressures on inflation (nominal exchange rate) (Lopez-Mejia 1999). The extent of sterilization affectsthe monetary impact of the capital inflows. The greater the extent of the sterilization, the lower is the monetary and inflationary effectsof capitalinflows. However,the domestic interest rate stayshigher than the international interest rate longer thereby encouraging capital inflows further. Table 5, drawn from Lopez-Mejia (1999) and Rajan (2000), presents someindicators of the macroeconomic impactsof the surge in capital inflows in selecteddeveloping countries. The table indicates that a number of developing countries appear to have succeededin tempering the adversemacroeconomic impacts of the surge in capital inflows in the late-1980sand early1990s.The table showsthat the grossdomestic product (GDP) growth rate of the recipient countries increased significantly during the capital inflow pe-

FINANCIAL LIBERALIZATION: MANAGING RISKSANOOPPORTUNITIES

riod, the inflation rate barely increasedand in fact declined in a number of cases,and the investment rate increasedand the current account deficit widened. The table also suggeststhat sterilization efforts were on the whole successfulin the sense that the countries were able to limit the impact of the capital inflows on domestic moneyand inflation. A closer review,asexemplified by the caseof Thailand, brings out that the surge in capital inflows eventuallyreared its ugly head and brought macroeconomic vulnerability to Thailand. Specifically,the induced overheating of the Thai economy led to assetinflation (which is not captured well in standard price indices) and sharp rise in labour costswith the concomitant real exchange rate appreciation. The latter contributed to the loss in the international competitivenessof the Thai labour-intensive exports. This, together with the slowdownin the world electronics trade, led to the decline in Thailand's export volume and value in 1996. A more important factor wasthe eventualmacroeconomicimpact of the bursting of the assetprice bubble in 1994and the continued softnessof the real estate market during the next two years.The result wasthat a number of finance companies,which had heavyexposuresin the Thai real estatemarket, folded up despite attemptsby the Thai authorities to provide some short-term lifeline as bestexemplified by the caseof one. Thai bankswere also adversely affected becausethe bankswere major investorsof finance companies. As a result, there wasa sharp slowdownin the rate of growth of private sectorcredit in 1995and 1996. The Thai government's efforts to prop up the financial system,especiallyin 1996,led to the sharprise in the contingent liabilities of the Thai government. Consequently!the expectedfiscal burden in the future increased sharply (Rajan 2000;Dasguptaand Ratha1999). The deterioration of the current account situation, the failure of a number of finance companies and the sharp rise in the contingent liabilities fed the speculativeattackson the Thai baht in latter part of 1996and the early part 1997.The near depletion of the country's usable international reservesin an effort of the Thai government to support the baht in the face of the speculativeattackseventually forced the Thai government to float the baht in earlyJuly 1997, thereby triggering the EastAsian financial crisis. Macroeconomic vulnerabilities, themselvesalso significantly shapedby the surge in capital inflows, led other EastAsian countries to succumb to speculative currency attacks after the flotation of the Thai baht. As Table 6 indicates, the Philippine peso experienced the largest real currency appreciation among the SoutheastAsiancurrencies in the early 1990s.At the same time, the Philippines had the worst export growth performance in the late-

.29.4 .24.5

MANAGINGRISKSAND OPPORTUNITIES OF FINANCIALLIBERALIZATION AND INTEGRATION

Table 5. Macroeconoic performance of 10 countries during inflow episodes change from immediately preceding period of equal length

Brazil

1992-95

3.1

.93.5

0.6

7.4

Chile

1989-95

5.7

-4.1

-4.9

-25.5

Columbia

1992-95

-4.8

4.9

14.7

Indonesia

1990-95

2.2

0.2

Korea

1991-95

-2.5

0.8

5.0

Malaysia

1989-95

4.0

1.4

2.9

Mexico

1989-94

2.9

-74.4

7.1

20.0

Philippines

1989-95

2.2

0.7

-10.7

-3

4.4

Source: World Bank 1997 in Lopez-Mejia 1999

1980sup to 1993among the SoutheastAsiancountries; it continued to have slowerexport growth rates than Thailand and Malaysiaup to 1995. Thus, the Philippine trade performance is vulnerable to the sharp drop in export price competitivenessarising from the sharp devaluationof the Thai baht. Hence, the speculative attack on the Philippine peso came almost right after the flotation of the Thai baht. Similarly,Indonesia wasvulnerable to speculativeattack againstthe rupiah. By mid-1990s,Indonesia had a very high external debt serviceto export ratio (seeTable 6), which wasalmost comparable to the Philippine casebe-

FINANCIAL LIBERALIZATION:MANAGINGRISKS AND OPPORTUNITIES

fore the Philippine payments crisis in the early-1980s. At the same time, Indonesia's export performance faltered in the mid-1990s,in part becauseof the appreciation of the real effective exchange rate by 18 percent during 1990to 1996 (Nasution 1999,seeTable 1). Thus, the Thai baht devaluation posed a challenge to Indonesia's non-oil exports, worsening further the country's external debt serviceburden. This is especiallyso becausethe capital inflows into Indonesia shifted towards short-term capital flows since the early-1990s(Nasution 1999). The macroeconomic variables for Malaysiaindicate a relatively more robust macroeconomythan the other affectedSoutheastAsiancountries (Table 6). Its external debt structure, external debt service burden, extent of real currency appreciation and trade performance were better than the other countries. Although affected by the EastAsian crisis, Malaysiawas able to handle the crisis better than Indonesia or Thailand. Like Chile, Malaysiawas more willing than its SoutheastAsian neighbours to undertake lessorthodox capital control measuresin order to manage capital flows. For the most part Malaysiaappeared to have succeeded.The issueof capital controls and the experiences of Chile and Malaysiaare discussedfurther in the next section. The macroeconomic vulnerability of South Korea also stemmed from the largely unbridled foreign borrowing of Korean firms in the 1990sas a result of the liberalization of Korea's capital accountand the improvement in Korea's credit standing after its admission into the OECD. While foreign borrowing was largely for investment purposes,the macroeconomic vulnerability stemsfrom over-investmentsuch that the returns from the investment were lower than the cost of capital (Corsetti et al. 1999). Becausethey were highly leveragedand the rate of profitability extremely low, Korean chaebols became vulnerable (as well as the Korean economy given the tremendous importance of the chaebolsto the whole export economy)to external terms of trade shocksand from the shocksfrom the United Statesdollar/Japaneseyen exchangerate. In 1996,both negativeshocksoccurred, thereby contributing to the failures of a few Korean large firms (for example, Hanbo Steel). The growing corporate problemsand the currency turmoil in SoutheastAsiamade foreign banksmore skittish about lending to foreign firms and Korean merchant banks. With significant deterioration in the country's terms of trade, large decline in export growth, high shareof short-termdebt to total debt,and short-term debt larger than the country's international reserves,South Korea eventuallyhad to float and devalue the Korean won and worked out an IMF program in exchange for a large multi-country loan support and external debt restructuring.

MANAGINGRISKSAND DPPDRTUNITIES DF FINANCIAlliBERALIZATlDN AND INTEGRATlDN 27

Table 6. Selected ASEAN countries: economic and financial indicators (averages, in percent of GDP unless otherwise indicated) Indonesia Malaysia Philippines' Thailand 1991-951996 1991-9519961991-951996 1991-951996 Growth,investment andsavings GDPgr<7Nth rate Investment Private Public National saving Private Public Tradeorientation Exportsofgoodsandnonfactor services Manufactured exJX)rts Exportgrowthrate(valueinU.S Dollars Exchange rate Realeffective exchange rate(percent change overthepernid; appreciation (_))2 Balanceofpayments (in percent ofGDP) Current account deficit Capitalinflows (net)'"",.

7.8 310 23.1 7.9 28.6 20.9 7.7

7.8 32.7 27.4 5.3 29.3 230 6.3

8.7 38.7 25.3 134 32.3 16.1 162

8.2 41.2 28.6 12.6 36.0 21.5 14.5

2.2 21.9 16.8 5.2 18.2 15.0 3.2

5.5 23.9 19.2 4.7 19.8 155 4.3

8.4 41.5 34.8 8.1 34.8 22.3 12.5

6.7 42.5 33.0 9.5 34.5 21.2 13.3

26.5 26.2 12.8 13.3 11.4 10.3

84.9 92.0 26.3 333 55.9 63.5 15.5 19.8 20.3 5.8 16.6 17.8

42.5 40.9 25.6 24.7 19.7 1.3

-3.3 -5.1

-7.8

-4.7

-2.4 4.0

-3.6 5.2

Foreigndirectinvestment (inpercent) 34.6 ofcapitalinflows) Reserves (inmonthsofimJX)rtsofgoods andservices) 6.5 Basedmoney-reserves 0.5 Broadmoney-reserves 4.3 Debt Externaldept(inpercentofexJX)rts ofgoodsandservices) 191.5 Short-term debt(inpercent ofexternal debt) 7.7 Debt-service ratio(inpercent of exportsofgoodsandservices) 32.4 Financialstability Inflation (annual average; percent change) 8.9 Private sectorcredit(percent change) 21.0 Centralgovernment balance (inpercent ofGDp) -0.2 Publicdept(inpercentofGDP) 37.2

53.8

-6.5 -5.2 -3.6 -4.1 11.5 7.7 3.8 -8.9 81.5 50.7 51.1 16.0

Source:

6.0 0.6 48

4.3 0.5 3.7

-4.2 -36.9

3.4 0.7 4.9

2.5 1.1 3.2

-5.9

2.8 0.9 2.9

-5.2

-6.7 -8.0 10.4 9.2 11.4 10.2 5.2 0.4 3.8

5.1 0.5 3.8

178.5 438 40.3 168.2 103.6 105.5 118.6 8.5 18.2 23.7 15.2 13.8 44.4 43.6 32.8

6.7

25.4 15.4

10.9 114

7.9 22.4 1.0 27.7

4.0 3.5 10.5 8.4 18.2 26.5 43.1 51.0 0.1 0.7 -1.6 -0.4 21.8 15.9 113.0 88.0

4.8 5.9 23.8 14.6 2.8 2.3 17.2 10.1

5.7

IMF, World Economic Outlook: A Study by the Staff (Washington, various issues) and IMF staff estimates. (http://www.imt:orglexlernaVpubslnftlmacroioverview.hlm)

The examplesdiscussedaboveindicate that the surge in capital inflows pose considerable macroeconomic challenges.Surgesin capital inflows tax the "absorptivecapacity"of recipient economies.With relativelyundeveloped financial markets and inadequate institutional capacityto monitor, regulate and supervise the financial sector,developing countries become more vulnerable to the macroeconomic risks from the surge in capital inflows; for example, assetprice bubble, resource misallocationand real currency appre-

FINANCIAL LIBERALIZATION:MANAGINGRISKS AND OPPORTUNITIES

ciation. Not surprisingly, it has been the emerging developing economies which had mostly succumbed to various paymentsand currency crisesafter their periods of surgesin capital inflows. The limits of monetary and IlScalpolicies For most of the emerging developing economies that experienced surge in capital inflows in the late 1980sand the 1990s,the macroeconomic policy responsehasbeen to dampen the impact of the capital inflows on the money supply and aggregate demand. The macroeconomic policy measuresconsisted primarily of sterilization through open market operations, increase in bank reserverequirements,and fiscal contraction to generatefiscal surpluses or at leastreduce fiscal deficits (Table 7). There are limitations to the use of these macroeconomic policy measureshowever.Sterilization through the saleof high costCentral Bankbills or Treasurybills in exchange for low interest earning international reservesimpose costto the central bank or theTreasury.Moreover,aggressivesterilization of capital inflows raise domestic interest rates,which encourage greater inflows of capital especially short';term portfolio capital. Leung's (1998) estimatesof offset coefficientsfor Thailand and South Korea are particularly high at about 0.7 while those for Indonesia and the Philippines are between0.4 to 0.5. (The offset coefficient measuresthe extent by which a domestic monetary policy is offsetby capital flows.) Thus, it is not surprising that the emerging economiesrelied primarily on sterilization through open market operations only briefly, although a few countries including the Philippines used sterilization (through open market operations as a measure for partial sterilization of capital inflows) during the 1990s(Lopez-Mejia

1999). Monetary tightening through generalizedincreasein the bank reserve requirement and fiscal contraction were alsoresorted to by many developing countries in responseto the surge in capitalinflows (seeTable 7). Both measuresare to some extent preferable to open market operations becausethey do not entail quasi-fiscalcoststo the government. Nonetheless,an increasein the reserverequirement increasesthe costof financial intermediation, thereby raising the domestic lending rate and inducing domestic firms to borrow abroad.Fiscalcontraction doesnot imposedistortions on the financial system, and thus preferable to both open market operations and increasing bank reserverequirement asa meansof preventing the overheating of the domestic economy from the surge in capital inflows. Indeed, fiscal conservatismis increasinglybeing emphasizedasan important complement to financial inte-

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MANAGINGRISKS AND OPPORTUNITIES OF FINANCIALLIBERALIZATION AND INTEGRATION 29

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FINANCIAL LIBERALIZATION:MANAGINGRISKS ANO OPPORTUNITIES

gration and capital mobility becauseit lends greater credibility to the macroeconomic environment of a country (Lopez-Mejia1999). However,there are limits to the use of fiscal contraction as a counter cyclicalmeasure againstsurgesin capital inflows. A significant rise in the tax effort and/or significant reduction in government expenditures in order to generate fiscal surplusesinvolve political costs.This is especiallythe casein developing countries with poor tax administration and inequitable tax burden. In addition, the benefitsof financial integration and capitalflows t~nd to benefit the better off social classes.This meansa corresponding increase in political pressure to use the fiscal systemas a redistributive device in the sense that the government would need to increase expenditures (in infrastructure, education, public housing) geared especiallyto the poor regions and social classes. In short, unless there is an unexpected revenue windfall, fiscal contraction cannot be expected to be used sustainablyasthe key counter cyclical measureto the surge in capital inflows. As theSou,theast Asian experience suggests,the fiscal surplusesof the SoutheastAsian countries in the early 1990swere not enough to prevent the overheating of the economies and the occurrence of the eventual currency and financial crisis. Thailand, the origin of the EastAsian crisis,showsthe limits of sterilization policy and the difficulties of managing surgesin capital inflows. Thailand wasaggressivein using fiscal policy in managing capital inflows. Thailand shifted from a central governmentfiscal deficit of about four percent of GDP prior to the surge in capital inflows into a fiscalsurplus averaginglabout three percent of GDP from 1988 to 1994 (Schadler 1994; Park and Song 1997). The government tightened fiscal policy in order to reduce the inflationary pressuresarising from the surgein capitalflows. In addition, Thiiiland had to resort to frequent open-marketoperations primarily through repurchaseof government and stateenterprise bonds and through the issuanceof central bank securities in order to control excessliquidity and reduce the volatility of domestic interest rate. Thailand wanted to dampen the inflationary pressure from the capital inflows at the same time that it prevented a significant nominal appreciation of the baht in order to maintain Thailand's export competitiveness. However, as a result, domestic interest rates were persistently higher than those in the developed countries, thereby encouraging further Itapital inflows. It maybe noted that the bulk of capitalflowsinto Thailand during the surgeperiod consistedof short-termborrowing of commercial banksand nonresident baht account deposits (Parkand Song 1997).The short-term nature of much of Thailand's capital inflows during the capital surge period1ed to

MANAGINGRISKSAND OPPORTUNITIES OF FINANCIALLIBERALIZATION AND INTEGRATION 31

the level of short-term debt being much higher than the levelof international reserves,and to the increased vulnerability of Thailand to negative foreign investmentsentiment.Thailand resortedto other measuresin order to dampen the inflationary effectsof the capital inflow, for example,easingup on capital outflows. Nonetheless,the Thai economyoverheatedasreflected in the high current account deficit and the real estatebubble. When the bubble burst and the export sectorstagnatedfrom the downturn in the international electronics market and the rise in domesticlabour costby 1996,foreign sentiment turned progressivelynegativeand pressureson the baht increased. By mid1997,Thailand had to resortto a large currencydevaluationafter somemon ths of an eventuallylosing battle of propping up the baht. from the downturn in the international electronics market and the rise in domestic labour costby 1996,foreign sentiment turned progressivelynegativeand pressureson the baht increased. By mid-1997,Thailand had to resort to a large currency devaluation after somemonths of an eventuallylosing battle of propping up the baht. The possibilities of capitalcontrols, floating exchangerates and currency tmions In viewof the inadequaciesof monetary and fiscal policy tools, a number of developing countries used other balanceof paymentsmeasuresto help contain manage the surge in capital inflows. These measuresinclude reduction of official borrowing, acceleration or prepayment of loans, liberalization of trade and liberalization of capital outflows. These measures,nonetheless, have also limitations. For many developing countries, a drastic decline in official borrowing for sometime carriessignificant opportunity costsbecause official development assistancecarries low interest rates and much longer maturity than commercial funds. Such development assistancefunds are especiallyimportant for funding infrastructure and socialdevelopmentprojects, which most developing countries are in greatneed of. Similarly,liberalization of trade effectivelymeans reduction in tariff and non tariff barriers. However,a substantial trade liberalization at the sametime that there are pressuresfor currency appreciation can have significant adverseimpact on a country's tradable goods sector,especiallymanufacturing aswasthe case in the Philippines during the 1990s.Thus, liberalization of trade asa tool for managing surges in capital inflows has only limited effectiveness. Indeed, liberalization of trade may end up encouraging greater capital inflows, although likely more of foreign direct investments,which potentially can contribute to the further overheating of an economy.This perverse effect ()f in-

FINANCIALLIBERALIZATION, MANAGING RISKSANO OPPORTUNITIES

ducing further capital inflows,insteadof helping managethe surge in capital flows, is also a possibility for the deregulation of capital outflows. This is becausethis reflects greater capital market liberalization; as such, the greater freedom to bring out capitalservesasan inducementto comeinto a country to seizeopportunities for profitable investmentshowevershort-term. In Table 7, notice that manyof the emerging economiesimposed capital control measureswhile a few also undertook someexchangerate flexibility, essentiallyof currency appreciation. It is interesting to note, nonetheless, that among the emerging countries which had relatively high financial integration with the restof the world (that is, the SoutheastAsianand Latin American countries and Korea), only two countriesstand out ashaving utilized both capital controls and currency appreciation in addition to the array of other macroeconomic and balance of paymentspolicy tools. These two countries are Chile and Colombia. Malaysiahasalsobecome known for its useof capital controls especiallyin the light of its responseto the EastAsian crisis. Nonetheless,whereasMalaysiaused capital control asa temporary measureto addresssurgesin capital inflows (in the early-1990s)or outflows (asan aftermath of the EastAsian crisis in 1998-1999),Chile used it as an integral part of its macroeconomic strategyfor nearlya decade.Givenits relative successduring the 1990sdespite the Mexican crisis and the EastAsian crisis, Chile has become the "poster country" for the use of capital control measuresfor macroeconomic management as well as for the merits of tempering international capital mobility for the benefit of a country. One key lessonfrom the experiencesof emerging economiesis that in a world of growing capital mobility a rigid adherenceto a fixed exchangerate and monetary independence is a recipe for an eventualeconomic crisis.This brings three alternative options for the macroeconomicpolicy stance;namely: (1) adherence to a truly freely floating exchange rate regime, with capital mobility, (2) adoption of de facto or dejure currency union where the domestic currency is pegged to an anchor country and the domestic monetary policy is dependent on the monetary policy of the anchor country (currency board or monetaryunion), or the domestic currency is replaced by the currency of the anchor country ("dollarization"), or (3) imposition of barriers to capitalinflows and/or outflows aspart of a country's macroeconomicpolicy. The standard presumption is that a truly freely floating or flexible exchange rate regime allows a country to set its interest rate on the basisof its

MANAGINGRISKSAND OPPORTUNITIES OF FINANCIALLIBERALIZATION AND INTEGRATION 33

overall macroeconomic and development strategydespite capital mobility. Moreover, it is viewed that a flexible exchange rate "insulates" an economy better from external shocks than a fixed exchange rate regime. Finally, a flexible exchange rate regime, where there is little or no intervention by the government, mayencourage the developmentof risk-managementfinancial instruments like futures or options. However, it is increasingly acknowledged that there are problems related to flexible exchange rate regimes especiallyin developing countries. Perhapsthe most important is that in a world of internationally mobile capital the exchangerate can change evenwithout any relationship with changesin the current domestic interest rates.This is becausethe current exchangerate is also affected by expectations of the future domestic and foreign interest rates. Where the financial market is still thin and relativelyundeveloped, the exchange rate can end up being very volatile. This can be a disincentive to investtnentsand to economic growth. Moreover, there may be problems of exchange rate overshooting, which in economies with thin markets would result in large swingsin the exchangerate with the attendant negative effect on the economy. Moreover, the presumption that a flexible exchange rate better insulatesan economyfrom external shocksis tenuous when the external shock is financial such as an increase or decreasein the foreign interest rate(s). Again the volatility in the exchangerate may hurt the economy. On the samevein, stabilizing the exchangerate in the face of such foreign interestrate shock may end up in a volatile domestic interest rate, which also has negativeimpacts on the economy.Finally, it is alsosometimesadvancedthat a flexible exchange rate regime especiallyin a developing country does not provide as much pressuretoward greatermacroeconomicdiscipline asa fixed exchange rate regime. It must be emphasized however that the pros and cons of a flexible exchange rate regime for developing countries discussedabove are in the end theoretical. This is becausedeveloping countries have historically been under (adjustable) pegs or heavily managed dirty floats rather than really flexible exchange rate regimes. Nonetheless,it bears noting that Chile, despite its capital control measures,alsoallowed the peso to appreciate during the surge in capital inflows. Chile, which valuesthe ability to impose higher domestic interestsin order to dampen inflationary pressures(given that wages are indexed), pragmatically used both capital control measuresand some flexibility in the exchange rate (an exchangerate appreciation). These two measuresallow for someindependence of domestic monetary policy. That is, a significant and persistentsurge in capitalinflows mayneed to be accommo-

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

dated, not only sterilized, through an appreciation of the domestic currency. By not "leaning againstthe wind" with respectto the exchange rate, Chile was able to manage better the economic effectsof the surge in capital inflows. At the end of the spectrum from a flexible exchangerate regime is the adoption of a hard peg through dollarization,currency board, currency union or a monetary union. In all these cases,domestic monetary policy follows that of the anchor country or, asin the caseof the Euro zone,follows the rules and dictates of a supranational monetary authority. The idea of a hard peg or optimal currency area has become popular in recent years. It is viewed for example that dollarization provides the needed macroeconomic discipline and credibility for inflation-prone countries (usuallyreferring to Latin American countries). Fixed exchangeratesamong the currency union membersor the useof the currency of the anchor country could reduce transactionscosts among firms and other economic agents,thereby encouragingfurther trade, investment and economic integration among the currency (and monetary) union members. Finally, it is increasinglyargued that the loss of monetary independence may not be that significant anywayif the domestic economyis strongly tied to an anchor country and therefore its businesscycle moves alongside that of the anchor country. Nonetheless,dollarization (the useof the United Statesdollars as legal tender in a country outside the United States),despite its increasing popularity in the academic circles (Alesina and Barro 2000)is generally regarded as the option of the desperate,of countries that seemto have lost their capability to manage their macroeconomy (some Central American country like Ecuador or El Salvador),or the option of the very small,almostappendageeconomies (for example, Liechtenstein,Luxembourg, a number ofCarribean countries). The successstories of currency boards are also far and between; the contrasting performances of Hong Kong and Argentina bring out the demands of currency boards. Specifically,open economies under a currency board must haveflexible labour, goodsand assetmarkets,well regulated and managed financial sectors,and conservativefiscal policy in order to successfully ride out external shocks. Hong Kong has those. In some respects,the Philippines during the colonial period under the American regime, under a currency board, also fits the bill in termsof a conservativefiscalpolicy,flexible markets,and trade relations tightly linked with the United States.Argentina and most developing countries at present,including the Philippines, do not have them all. The successof currency areasdepends on the full coordination of macroeconomic policies of the member economies in the currency area. The

MANAGINGRISKSANO OPPORTUNITIES OF FINANCIALLIBERALIZATION ANO INTEGRATION

FINANCIAL LIBERALIZATION MANAGINGRISKS AND OPPORTUNITIES

4) anoninterest-bearingdepositrequirement for banksagainstringgit funds of foreign banking institutions. In addition, Malaysiaimposed prudential reserveand liquidity requirements to foreign currency deposits,foreign currency borrowing from foreign banking institutions, and interbank borrowing (Parkand Song 1997). Malaysiaimposed direct and market-basedcapital control measuresto help contain the flow of capital especiallyso-calledspeculativeshort-termcapital.The shortterm capital inflows consisted mainly of external borrowing by commercial banksand placementsof ringgit depositsby foreigners with Malaysianbanks (Ariyoshi et al. 1999). Malaysiaresorted to capital controls becauseof the growing costof monetary sterilization. Moreover,the monetary sterilization led to high domestic interest rates than abroad, thereby encouraging further capital inflows that speculate on possible ringgit appreciation. Malaysiacurtailed monetary sterilization when it imposed direct and market-basedcapital control measures. Malaysia again imposed selectivecapital controls, this time on capital outflows, in 1998-1999in the aftermath of the EastAsian crisis. Malaysiaresorted to the capital controls in conjunction with its shift in macroeconomic policy stancefrom a tight monetaryand fiscal regime during the latter part of 1997to the early part of 1998towardsan expansionarymacroeconomicpolicy regime since mid 1999. Since the policy called for lower domestic interest rate while money market rates in Singaporewere much higher, Malaysiahad to impose controls on capital outflows especiallybecausemuch of suchoutflowswere in ringgit. In effect, the money marketsof primarily Kuala Lumpur and Singapore needed to be delinked at that time in order for Malaysian monetary policy to be effective (Piei and Tan 1999;Athukorala 2000). MalaysIa'scontrols on capitaloutflows in 1998-1999were asfollows (Piei and Tan 1999): .Controls on ringgit-denominatedtransactionsamong nonresidents via nonresident external accounts, .Controls on outflows of short-term capital with the requirement that suchinflows neededto remain for one yearwithin tHecountry. This regulation wasmodified into a graduated exit levy with the rate depending on the nature and duration of the inflow, .Prohibition of import and export of ringgit, and Imposition of a government approvalfor any Malaysianinvestment abroad.

MANAGINGRISKSAND OPPORTUNITIES OFFINANCIALLIBERALIZATION AND INTEGRATION 37

Malaysia'scapitalconttols did not include: current account transactions, foreign direct investment inflows and outflows, and repatriation of interest, dividends, fees,commissionsand rental income from portfolio investments and other ringgit assets. Chile's major regulations on capital movementswereasfollows (Le Fort and Budnevich 1997): .Direct investment inflows: minimum stay of one year for the principal, .Portfolio investment through American Depository Receipts (ADRs): minimum credit ratings by three internationally recognized rating agencies(that is,BBB or better for nonfinancial companies,BBB+or better for financial companies);minimum amount condition; unremunerated reserverequirement (URR) , .Other portfolio capitalflows:URR to be kept with the Central Bank in dollars .Loans and bonds: URR; minimum credit-rating and minimum amount requirements,and .Deposits and credit lines: URR. Chile's capital control measuresare meant primarily to raisethe costof foreign borrowing and tax short-term capitalinflows,ensure credit worthiness of Chilean firms and banks borrowing abroad, and bias the composition of capital inflows toward foreign direct investment. With the exception of the credit rating requirement, Chile's major price-basedcapital control measure (that is, URR) is similar to Malaysia's.The major difference between Chile and Malaysiais that the imposition of the reserverequirement wastemporary in Malaysiaand decade-long in Chile. The evolution of the implementation of the unremunerated reserve requirement in Chile showsthat the coverageof the URR wasexpanded over time in order to coverloopholes. Chile's experienceis typical: market participants find waysof circumventing the regulations, which make such restrictions increasingly ineffective unless the loopholes are plugged. Chile reduced the URR rate to zero in the aftermathof the crisis,asthe pressuresfrom capitalinflowseasedup and reversedto pressuresfor capitaloutflows (Ariyoshi et al. 2000). Malaysia succeeded overall in its use of capital control measures. Malaysia'simposition of the capital control measuresin 1994wasmeant to be for a short time to addressthe sharprise in what wasperceivedto be destabilizing capital flows. The immediate market responseto the capital control mea-

FINANCIAL LIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

sureswas a ringgit depreciation and the cooling off of the Kuala Lumpur StockExchange. Thus, the capital control measuressucceededin easingthe pressuresfor appreciation of the ringgit and in cooling off of the fast rising stockprices. With the successfulstabilization of the Malaysianeconomyduring the year asthe interest differential betweendomesticand foreign interest rate decreasedand the inflationary pressureseased,the capital control measureswere lifted within the year (1994). Malaysia'scontrols on capital outflows in 1998-1999also largely succeededbecause they contributed to the implementation of the expansionarymacroeconomic policy in 1998-1999. Malaysia'seconomic recoveryfrom the EastAsian crisis in 1999wassubstantially faster and the Kuala Lumpur Stock Exchange wasmore robust compared with the other adverselyaffected SoutheastAsiancountries. Malaysia'sexperience with the use of capital controls againstspeculative capital flows is instructive. While Malaysiadid not escapethe contagion from the baht devaluation and the EastAsian crisis, Malaysiaproved more resilient than Indonesia or Thailand. When the standard sterilization measures proved expensive and ineffective in curtailing short capital inflows, Malaysiaimposed capital controls. Its successmeant that short-term debt is a low share of total external debt in Malaysiaas compared to Thailand and Indonesia. Moreover, the preponderance ofFDI in its capital inflows underscoresthe underlying soundnessof Malaysia'seconomicfundamentals. Thus, Malaysia'seconomy waslessvulnerable to capital flow reversals.Moreover, its successfulexperience in utilizing capital controls asa tool of short-term macroeconomic management in 1994explains why Malaysiarelied on capital measuresagain in 1997-1998to stemcapitaloutflows. Asin 1994,Malaysiaalso succeededin its use of capital control measuresin 1997-1998. There havebeen a number of studiesevaluating the impact of the Chilean experience with capital controls. The evaluations are generally mixed. The resultsof the studiesindicate that the capitalcontrols allowed for a higher domestic real interest rate, which suggeststhat the capital flow barriers provided some monetary independence for Chile. The evidence seemsto indicate that the controls affected the composition of the flow of capital towards longer-term flows. This is important becauseEastAsia's vulnerability to currency speculation by 1997stemsin part from the high proportion of shortterm capital inflows (primarily debt). Indeed it is likely that Chile's requirementsbefore local firms could borrow abroad mayhavehelped dampenshortterm borrowing from abroad. The studies remain unsettled with respectto the impact of the capital control measureson the volume of capital flowsand on the real exchangerate (Nadal-DeSimoneand Sorsa1999). Nonetheless,it

MANAGINGRISKSAND DPPDRTUNITIES DF FINANCIALLIBERALIZATIDN ANDINTEGRATIDN 39

is worth noting that the real currency appreciation arising from the capital inflows during the 1990soccurred overa longer period than during the late1970sthat culminated in the 1982currencycrisis.Thus, the Chilean economy had more than time to adjustmore smoothlyto the real currencyappreciation. In contrast, the sharp real appreciation in the late 1970swasdisruptive resulting in substantial loss in export and import competitiveness,and thereby in large current account deficits that eventuallyled to the currency crisis. The Chilean and Malaysianexperiences seemto indicate that capital control measurescan be useful tools in managing capitalflows,although they cannot be a panacea. Nonetheless, it is worth noting that there are some structural conditions that mayhavehelped to make the capital conu:ol measures relatively successfulin these two countries. Both have stronger structural foundations. Both are strongly export oriented, with low tariffbarriers. Both have comparativelybetter performing and better-trained central banks. Chile, and to a lessextent Malaysia,have relativelystrongerprudential regulations than most developing countries. And Chile allowed the peso to appreciate to some extent in responseto the surge in capital inflows. In short, it is likely that the basisfor the successin the useof capital control measuresasa tool for macroeconomic management in these two countries is that the two countries have comparatively stronger structural and institutional foundations with lessdistorted economies to startwith. Moreover, both countries were pragmatic in their useof capital control measures,reducing or eliminating them as the conditions warranted. In summary,the discussionaboveindicates that there are pros and cons for eachof the options for managingsurgesin capitalinflows. That is, there is no ideal solution that is applicable to all. Eachcountry would haveto assessits own needs,strengths and weaknessesin designing the appropriate macroeconomic strategyfor itself. Still, it appearsthat at leastin the meantime that developing countries are still building up their financial systems,the packageof macroeconomicpolicy measuresto managesurgesin capitalflowswould include not only the standard monetary, fiscal policy and trade policy measuresbut also flexibility in the exchangerate and the pragmatic useof capital control measures.For after all, the baseof the currencycrisesis the problem of "too much too fast" for (short-term) capitalflows. And both the currency appreciation and (implicit or explicit) barriers to capital inflows help temper the flows to more manageablelevelsovera more manageableperiod of time. Nonetheless,asimplied in the casesof Chile and Malaysia,the successin the useof the packageof macroeconomic policies hinges also on the strong economic fundamentals of export orientation and low distortion and prudent

FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

fiscaland monetarypolicies. In addition, both countries (but especiallyChile) rank verywell among developing countries in terms of the institutional capacity on their Central Banksand in terms of prudential regulations and (less so,for Malaysia) bank supervision. The issue of prudential regulationsand bank supervision is discussedfurther in the section on the microeconomics of financial liberalization and integration. Differentiating capital flows, orderly liberalization and crisis prevention One important difference between the caseof Chile and Malaysia on the hand and Korea,Indonesiaand Thailand on the other hand is that the former vigorously restricted short-term capital inflows while in the latter short-term capital inflows were either allowed freely or were even encouraged. In the light of the recent currency crisesincluding the EastAsian crisis,it is increasingly acknowledged that there is a need to differentiate various kinds of capital flows. The various capital flows have different probabilities for sudden large reversalsof flows (that is from inflow to outflow) and therefore the government may need to sequence the liberalization of the capital account accordingly. For example, Reisen (2000) that the most volatile capital should be liberalized lastand only after a stronglyenforced regulatoryframeworkis in place while the leastvolatile or most autonomous and permanent should be liberalized the first. The most autonomous and permanent flows are longterm bank loans (which are mainly syndicatedEuro loans) and foreign direct investment;theseare followed by portfolio investmentsmadeby pensionfunds and insurance companiesbecausethey follow a buy-and-holdstrategy rather than a trading strategyin the emergingmarkets.The mostcyclicaland volatile flowsare short-termlending and borrowing facilities (for example,Euro commercial paper), leveragedassetpositions suchashedge funds, and borrowing through corporate or government bonds (Reisen2000).2 Apartfrom the historical experienceson currencycriseswhere the shortterm borrowing problem wasan important determining factor for the crises, Reisen (2000) points out that a policy bias againstshort-term bank lending corrects an international regulatory distortion inherent in the 1988 Basel Accord, which is biased in favour of short-termloans. Specifically,the current risk weighting for short-term bank credit up to one year to a nonOrganisation for Economic Co-operation and Development (OECD) bank carries a low 20 percent weighting while long-term loans of over one year maturity to the samenon-OECD bank have 100percent riskweight. Similarly, 2 This section draws heavily from Reisen (2000),

141

MANAGINGRISKSAND OPPORTUNITIES OF FINANCIALLIBERALIZATION AND INTEGRATION

risk weights for loans to banks (at 20 percent) are much lower than loans to the private sector (at 100percent). A lower risk weight implies lower borr wing cost. Thus, the current risk weighting systemfollowed in internatio al finance as agreed upon in the 1988 BaselAccord encourages cross-bor er interbank short-term lending as well aslending to hedge funds. As the E t Asian crisisshows,both short-term bank lending and hedgefunds are parti ularly volatile capital flows. (Hedge funds invest with borrowed funds at m tiple of own funds. They are volatile becauseabrupt portfolio changes re made when banks make "margin calls", that is, call in the credits when price of the collateral drops below a specified level). (Reisen2000). At base,the policy issue on the sequencingof liberalization conce the productive use of capital inflows and effective macroeconomic mana ement. Viewed from this perspective,capital controls on long-term capital nflows and trade-related inflows need to be liberalized immediately beca se theyare central to the developmentprocessand overall economic efficien . Fiscalconsolidation is an important prerequisite to capital account liberali tion in order to prevent the use of capital inflows to finance unsustaina Ie fiscal deficits and to prevent capital outflows from forcing up domestic int restrates that exacerbatesthe fiscal deficit problem. Thus, it is recommend d that controls on long-term and short-term capItaloutflows only after ther is sound fiscal position, bad debtsproblems are resolvedand domestic inter st ratesderegulated. Prerequisitesfor relaxation of entry of foreign banks i to the domesticfinancial sectorare the liberalization of the financial systema d the resolution of the weaknesses of the domesticbanks. Finally,liberalizati n of short-term capitalinflows needsto wait until there is sufficient competiti n in the banking sectorand there is a sound systemof banking regulation supervision. Based on the abovementioned schemaof liberalization of the capi account items, it is worth noting that Chile and Malaysia seemto be m h more in accord to it as compared with Indonesia, Korea, Thailand or e n the Philippines. Thus, for example,Chile and Malaysia,together with land and the Philippines have promoted FDI while Korea has not. Eq ly important, both Chile and Malaysiahave more liberal policies on FDI, in terms of foreign equity restrictions, than the Philippines or Thailand. Si .larly, despite the fact that Chile and, to a lessextent, Malaysiahave institu ed tougher prudential regulations and have stronger institutional capacitiesin their Central Banksthan Indonesia,Koreaand even Thailand, both coun .es havebeen much more waryof short-termcapitalflowsand, in the caseof Ch e, short-term external borrowing.

FINANCIAL LIBERALIZATION:MANAGINGRISKS AND OPPORTUNITIES

The

capital

discussion

above

inflows

and

the

merit

sequential

differentiating

various

liberalization

forms

process

for

the

flows

ity

duce

lights

leads

volatile

the

number

capital

flows,

probability

the

crises

reducing

caPital

vul

inflows,

and

Specifically,

small

erabil-

the

Reisen

eby

re-

(2000)

tion

investors,

high-

and

comfortable contingency

international

liquidity

Monetary

Fund,

Policies

World

that

unremunerated

surers

example.

Most

impose

they

penalties

are

requirement

policy

1988

the

Basel

best

and

reversals

reaches

risks

ratio

when

has

raise

the

finance

stability. structure

Also,

pru~ential

pose

the

towaIid

country

asset

capi~

flow

international

rcserves

liberalization

for

and

trade-

with

little

financial

sector

strengthening

system

supervision)

nriority

and

growth

and

and financial

first

ofFill

necessary

building

domestic

process

the

management

process

regulation

opening

Thus,

are

objec-

sljability,

account)

the

"Fi-

ultimatel

compromising

(capital

infl째fs.

its

institutions".

they

sound

achieve

without

macroeconomic

the for

disclosure,

capital

sequential

because

effect

liberalizing

growth

process

negative

flows

chance

prerequisite

liberalization

best

and

building

the

reserve

inherent

debt

the

efficiency

combining

with

but

sequence

opening

tive,

hence,

Chile's

leveraged

in-

and

"Capacity-building"

nancial

life

investors;

distortions

short-term

except

and

example.

distortion

vulnerability

the

unity,

that

increased

when

erna-

ile's

inflows

for

regulatory

nks

tional

funds

withdrawal

not

inflows.

capital

pension

funds

the

early

capital

all

funds

hedge

seen

light

Accord,

bubbles

for

preferable

Bank),

mutual

Ofi

Intern

Development

requirement

ortiza-

terms foreign

example,

withdrawal

reserve

Fill

Asian

early

limita-

types

private

(for

Bank,

penalize

li-

with

institutions

lirnits

currencies

position loans

financial

that

delibera

profile

across

ation

currency,

for

maturity

finance

oating

system

calls

;

The

good

anchor

This

sound

diversification

reserves

natural

management

risks.

borrowing,

ts,

peg.

with

debt

rollover

short-term

paymen

adjustable

economies

and

external

and

the

open

system

currency

tion

ing,

future.

financial

comprehensive

quality

instead

shaky

quidity,

(4)

the

rate

preferable

record,

(3)

the

exchange

rate

of tional

aimed

of.

floating

(2)

prescriptions

improving

importance

(1)

policy

(accounting

needs

auditinfra-

nder-

MANAGINGRISKSAND OPPORTUNITIES OFFINANCIALLIBERALIZATION AND INTEGRATION 43

taken in earnest because they take time to build. These can be !enhanced through the entry of financial market expertise. The libe ization of portfolio equity and long-term bond investments can en be pursued together with the fostering of the infrastructure for 0mestic stock, corporate debt and mortgage instruments which 11 deepen the domestic money markets and thereby allow govemm nt authorities to smoothen shocks tb domestic liquidity. Finally, with d epened domestic financial markets and tough prudential regulati ns and supervision, controls on short-term borrowing can be dismanded. "?, ;.

The microeconomics of f"manciallibera1izationand integration ~ Financialliberalization,contestabilityandfinancial sectorefficiency Financial liberalization and integration has two important considerati ns: competitivenessand efficiency in the one hand and financial stability in e other, Financial liberalization, and with it the implied increasedcontestabi ity of the financial sector, is expected to increase the pressure for impro ed operational efficiencyof the financial institutions, It alsomeansgreater abi ity of the financial institutions to meet the demands of households and fi s especiallyas financial deepening continues with the growth of the econo y, The standard operating ratios in bankspose problems with respec to international comparability given differences in equity capitalization of ' ferent banks, differences in mix of high-margin and low-margin busines es and differences in accounting practicesacrosscountries (Fischerand Rei en 1993),Despite the problems of international comparability, a compariso of net interest margins and operating costsin a number of APEC coun 'es (Table 8) suggeststhat cross-countrydifferences in interest margins refl ct differences in banking efficiency rather than for different risks (Dickie d Bond 1999), Note from Table 8 thatJapan and the AsianNIEs seemto h ve the lowestoperating costsand net interestmargins,suggestingthat they seem to be to be the most efficient. The high net interestmargins for Chile, Mexico and possibly the Philippines may reflect the high inflation rates in th se countries. The much higher operating costsratio in the Philippines than other SoutheastAsian countries is particularly striking, Empirical evidence on the impact of financial liberalization on the e ciencyofthe financial sectoris mixed and hamperedby dataproblems. No etheless,empirical studies on the intermediation margins maybe suggestiv of the impact of financial liberalization on the costof financial intermediati n. In Malaysia,one studyindicates that the intermediation margin incr e ed after financial liberalization becauseof the oligopolistic banking structure

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

and

the

sion

rise

and

the

1993)

the

ing

led

the

banks

the

banks

big

Claessens

countries.

Their

gins

and

tries

that

the

expenses

for

foreign

show

financial

sector

profits.

for

the

most

trading

that

payback

relatively

The

and

that

open

experience

also

corroborates

integration.

open

is,

but

high

not

European

Specifically,

the

increased

the

Asia,

has

effect

openness

and

region

t~nd

and

with

tional

Eas

Glaessner

exception

(Claessens

countries

Singapore

Glaessner

1992

for

be-

Claesse,s

the

ope

Similarly,

with

and

stud-

estic

and

markets

efficient

efficiency-inducing

and

Claessens

come

the

industry

region.

efficiency,

the

banks,

settlement

insurance

try

ofTerr

securities

ratio;

the

according

system

the

margins

the

The

in-

rhead

banks

studies

gross-interest

openness

which

inefficient

high

lower

banks

cost

arlier

the

respectively.

operating

domestic

local

foreign

industry,

the

Philippines,

found

lower

securities

with

the

Glaessner

banks

that

the

find-

forces

from

forced

also

improve

which

lead

countries,

efficiency

alization

rate

net

and

profit

Argentina

participation

tends

developed

fore-tax

and

increased

coun-

profitability

noted

the

that

arising

also

Asian

mar-

Thus,

found

lower

and

Glaessner

countries

the

is,

and

stability

profit

head

report

the

conte

and

developed

that

except

rate

Claessens

Arriazu

the

ove

margins.

Huizinga

that

the

reign

overhead

Glaessner

Assuming

then

reduced

efficient.

resul

number

That

lower

and

banks.

rents,

banks

Programme

domestic

monopoly

contestability

and

banks

the

between

have

encourages

foreign

in-

tage.

and

higher

Demirguc-Kunt

between

sector.

Claessens

Claessens,

the

margins

banking

have

opening

included

banks

Similarly,

net

tend

foreign

financial

efficient.

done

crease

have

banks

the

1993).

foreign

bank

adva

correlation

sectors

dur-

foreig

especially

sector

negative

openness

financial

closed

suggests

study

the

open

those

ing

the

with

ssure

Spai

competitive

Reisen

indicates

overhead

with

margins;

the

finding

business

compared

inter-

Specifical

have

banking

and

institutions.

and

(1997)

services

economy

banking

(Fisher

Glaessner

banking

the

banks

wholesale

the

experience

financial

foreign

banks

and

the

local

wholesale

the

expenses

ies

the

eisen

competitive

The

xpan-

and

reduction

increased

opening

where

competition

and

the

branch

(Fischer

banks.

operations

Thus,

repositioning

rapid

indicates

foreign

the

emphasized

ternational

from

programs.

study

because

that

arising

credit

indicates

presence

foreign

part

presence

1980s

banks

the

increased

the

selective

Indonesia,

margin,

the

cost

case

mediation

from

overhead

continuation

1997).

financia Single

and

liber-

rket

peti-

MANAGINGRISKS AND OPPORTUNITIES OF FINANCIALLIBERALIZATION AND INTEGRATION 45

Table 8. Indicators

Economy

of the efficiency

of the banking industry in APEC economies

Share of State- Operating Net Interest Commerical Bank owened Banks Costs (% of Margins (% Reserves (% of (% share of total assets) of total loans to nonassets) assets) government sector)

Average Inflation Rates

1994

1990-94

1994

1995

Australia

0.0

3.5

3.7

1.7

1.6

1990-94 2.0

Chile

14.0

3.0

6.1

6.7

5.3

15.2

Hong Kong

0.0

0.8

1.6

0.1

9.6

looonesia

48.0

2.4

3.3

0.5

1.1

8.8

Japan

0.0

0.8

1.1

1.3

1.2

1.7

Korea

13.0

1.7

2.1

6.4

6.6

Malaysia

8.0

1.6

3.0

11.1

11.0

4.1

Mexico

28.0

3.9

5.1

1.6

20.4

13.7

New Zealaoo

0.0

3.0

3.3

2.4

2.3

1.7

Philippines

23.0

3.9

25.2

17.3

11.7

Singapore

0.0

1.4

1.6

6.7

6.5

2.8

Chinese Taipei

57.0

1.3

2.0

9.9

8.7

3.8

Thailaoo

7.0

1.9

3.7

2.4

2.9

4.6

United States

0.0

3.8

1.5

1.4

Source Dickie and Bond 1999

tion in the EU's financial markets led to the greater influence of external market forces on banking strategiesin the EU, improvement in the retail loan and mortgage pricing in some countries,widened the range of financial servicesand channels of delivery to consumers,and realization of economies of scale and economies of scope. In Greece,Ireland and Spain, the entry of foreign banks eventually reduced margins, improved servicesto consumers in quality and breadth, and increased efficiency with the reduction in staff costs(Claessensand Glaessner1997). The impact of financial liberalization and entry of more foreign banks in the Philippines in the mid-1990s wasexamined in three of the papers under the current Philippine APEC Study Center Network (PASCN)project on financial liberalization and integration. Manzanoand Neri (2000)looked into the impact of foreign bank entry on bankspreadsfrom a macroeconomic perspective.Unite and Sullivan (2001) examined the effect of foreign entry and ownership structure on a number of individual bank-basedindicators of bank performance. Hapitan (2001) surveyeda few domestic banks on their responsesto the entry of foreign banks in the Philippines.

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

Manzano and Neri (2001) examined the bank spread for the whole commercial banking industry before and after the entry of the new reign banks in the mid-1 990s.They found that the spreadsdid not narrow espite the entry of foreign banks. One possible reasonfor this is that the lib ralization wasnot enough and the reduction in the concentration of the co mercial banking industry not substantialenough such that the implicit mo opoly could not be reduced significantlydespitethe entryof foreign banks.M zano and Neri examined the spread puzzlefrom a macroeconomicangle i stead. Specifically,the authors present the view that the continuation of th bank spread despite the entry of foreign bankswascausedby the macroec nomic policy of the government. Before the EastAsian crisis,the Philippine overnment sterilized capital inflows resulting in comparativelyhigh interest rate at the same time that banks could source low cost foreign funds (in te s of deposits or loans) with little exchange rate risk. Thus, banks' spre ds remained high before the EastAsian crisis. Similarly, the Philippine overnment maintained a high interest rate regime during the height of e East Asian crisis in 1997and 1998in order to prevent capital outflows. Asa result, banks lending rates remained high. It wasonly in 1999when forei funds started to return to EastAsia and the dangerof capitaloutflows eased at the Philippine government allowed domestic interest rates to go down t single digit levels.The change in the macroeconomic policy stance of the overnment also sawthe reduction in the bank spread of the commercial'banks. Although only indicative, the eventualreduction in the bank spread s~ggests that the foreign bank entry liberalization increased competitivenessI in the banking sector.The macroeconomic policy regime that relied on hig interest rates initially to sterilize capital inflows and later on to prevent pital outflows merely maskedthe competitivenessimpact of the foreign ban entry liberalization. Unite and Sullivan (2001) examined the impact of foreign ban entry liberalization from a more microeconomic, bank-levelperspectiveusing bank operating performance measureslike accounting profits, operating expenses and non-interest income from a sample of 16 domestic commerci banks publicly traded in the Philippine StockExchange.Unite and Sullivan'sfindings complement and modify the Manzano-Nerifindings. Thus, Un te and Sullivan found that interest rate spreads narrow with the entry of reign banksbut only in bankswhich have high levelof group ownership. Un te and Sullivan found the group-affiliated banks to have higher interest s reads, which they surmisedis causedby the ability of the banksto extractweal from group member firms.

MANAGINGRISKSAND DPPDRTUHITIES DFFINANCIAlliBERALIZATIDN AND INTEGRATION 47

Unite and Sullivanalsofound that profit did not decline with the e uy of foreign banks.There are possiblytwo compelling reasonsfor this. One the macroeconomic policy stance which resulted in high domestic inte est ratesasManzano and N eri highligh ted. Unite and Sullivan indirectly refe to this in terms of the positive relationship between rate of profit and res rve requirements. And two, the competition from foreign banksencouraged domestic banks to improve their efficiencies, although lessso for the gr upaffiliated banksas well as the larger banks.The weak impact of foreign banks enuy on the efficiency of group affiliated banks may not be surprising if indeed the group-affiliated bankscould extractwealth or rents from their gr?UP members. It is also likely that the larger banks did not register signifi~ant improvements in their efficiencies in the face of the enuy of foreign banks becausethe bankswere on an expansionbinge in terms of branching dut ng the

period.

The

aggressive

branch

expansions

can

considered

their responsesto the liberalization of the financial sector, including the enuy of foreign banks. I The results of the interviews and questionnaires of Hapitan (2op1) elaborate further on the perceptions and responsesof domestic banksto Ithe enuy of foreign banks.Although the samplesizeisvery small,Hapitan's survey indicates that the enuy of foreign banksincreasedthe competitivenessof!the banking sector but primarily in wholesalebanking. This is probably not surprising since the new foreign banksdid indeed focus primarily in wholesale banking, especiallyin foreign exchange, investment banking and lending. The enuy of the foreign banksacceleratedmanyof the stepsthat the domestic bankshad been doing in responseto the general liberalization and expected increasedcompetition, from both the domesticand the newforeign ban , in the financial sector resulting from the financial liberalization. These s ps included investments in new technology (greater computerization and expansionof automotive teller machines,or ATMs), introduction of newfi ancial products, manpower developmentand advertisingand promotion ac .vities. A few of the banksalso moved to other markets or niches and reviewed their pricing to match competition (Hapitan 2001). The survey resultsalso indicated that thebanks survey respondents (who are bank officials) did not t on that the foreign increased the variety of financial services (at leas el top of what the domestic bankswere undertaking anyway)and new "forei

technologies and processes.The surveyrespondents felt that "most of the product development (either in terms of new products and services)be~ng made in (the) market are indigenous

local banks."

and is mostly made to compete

with

case

e ancial

likely

ex-

fi-

re-

ave

are

and

indi-

째th

and

are

banks

eased

untry

the 2001).

led

there

the

there

conclusive

of Moreover,

has sector Sullivan

cials

ban

banking

in banks system.

domestic

the

not banks

nicheso banking

and

Unite

wholesale

foreign

market

efficiencies

Nonetheless,

are

financial

international world spread.

Philippines

the

managers

resource

reflect

bank

Philippi

the

probe,

foreign

of local

not

did

entry

transfer

pirating

survey

the primarily branches/subsidiaries

managerial stints

in the

operational the

2001;

Hapitan

additional

other

the

rate

for in

interest toward

entry

banks the 2001;

liberalizing

knowledge

for

and reason

rely new had

Filipino

the

have

of innovations

results

the spread improvement some

that

contestability Neri

and

indications

some

bank

the

many

whom

Philippine

their

Although

major

technology

man

strategy

country.

one

the

with

lack

banks' short,

acknowledged

banks

new summary, the of

cognizant

many

the

local

the

into

odds

seems institutions

that from tent nance abroad. been spect cations redirection also competition (Manzano

FINANCIAL LIBERALIZATION,MANAGINGRISKS ANO OPPORTUNITIES

The

Macroeconomicconditions, prudential regulationsand Imancial stability The recent EastAsian financial crisishighlighted the critical role of the interplayof the prudential environment and macroeconomicconditions in determining the stability of the financial sector. Weakprudential regulations or inadequate implementation of such prudential regulations, implicit guarantee on deposits, and high domestic interest rates in tandem with relatively fIXed exchangerateshad led to lending booms and an increasein short-term debt and foreign exchange exposuresof banksand the corporate sectors. The lending boom led to riskier loan portfolios especiallyin the real estate and securities markets, which in the caseof EastAsian economieswere particularly susceptible to assetbubbles. The macroeconomic environment encouraged short-term and unhedged foreign borrowing at the sametime that the loans to domestic firms in local currencieswere longer term. The sharp rise in capital flows stretched local bank's risk assessment capacity.THe overborrowing of EastAsia stemmed also from the "herd behavior" of foreign lenders asreflected inadequate of borrowers (WorldinBank 2000). pricing of risksand lack of full e] uation Weak prudential regulation, either in design or enforcement, ncouragesbanksto exploit the existenceof moral hazard.Moral hazard in th banking system arises theand presence of costless and full The deposit in~ tion either implicit or from explicit, asymmetric information. expec rance, of bailouts by the government encouragesexcessiverisk taking and th refore

Thailand,

percent

than

crisis

the

before

loans

performing

rate

high

was

there

that

noted

also

(1998)

al.

Corsetti

percent.

300

than

high

very

was

sector

corporate

Korea's

ratio

leve

the

and

mid-1997,

bankrupt

jure

and/or

facto

were

Korea

conglomerates

largest

the

out

eight

capital;

cost

the

below

was

which

capital

invested

return

rates

had

Korea

conglomerates

est

the

them,

According

crisis.

the

before

Korea

investment

over

indication

present

(1998)

al.

Corsetti

long-term.

investing

and

short

borro

is,

that

vulnerability,

source

important

one

with

sector

goods

tra

the

investments

excessive

was

there

Thailand,

extent,

some

even

particularly

Korea,

South

case

the

property.

real

collateralized

proportion

large

the

well

loans

property

proportion

large

because

risks

sector

property

the

terms

rating

"high"

merited

sia

Indon

and

Malaysia

Thailand,

that

shows

Table

bubble.

property

fed

that

market

property

the

especially

sector,

tradeable

non

the

ments

st-

high

were

There

projects.

low-profitability

and

risky

investments

sive

es-

led

countries

Asian

East

affected

the

rates

growth

high

historically

euphori

the

and

costs,

borrowing

low

supervision,

bank

weak

The

n.'

supervisi

bank

fair

weak

had

Philippines)

the

and

Korea

Malaysia,

sia,

ne-

(Ind

countries

affected

other

the

while

supervision

and

regulation

bank

judged

was

crisis

Asian

East

the

triggered

that

country

the

Thailand,

shows

Table

countries.

Asian

East

affected

the

mid-1997

banking

framewor

institutional

the

indicators

presents

(1999)

study

ADB

ly.

domestic

investments

and

loans

unhedged

and

riskier

undertake

tions

'tu-

ins

financial

non-bank

and

banks

encouraged

other

the

home)

than

abr

rate

interest

lower

the

and

currency

the

stability

the

(because

nts

investm

and/or

relending

domestic

for

funds

foreign

rely

increasingly

institutions

financial

nonbank

(and

banks

for

incentive

macroeconomic

the

and

hand

one

the

banks

supervision

Weak

crisis.

Asian

East

recent

the

heart

the

was

sector

financial

the

that

agreed

generally

because

Th's

crises.

currency

future

off

staving

sector

financial

the

regulations

tial

prude

importance

the

highlighted

has

crisis

Asian

East

The

1993).

Reisen

and

(Fischer

prises

e1ter-

and

banks

ownership

interlocking

well

liberalization

bank

~om

arising

banks

value

charter

loss

the

fostered

also

banks

taking

risk

increased

The

sectors.

riskier

the

towards

credit

allocation

the

leads

MANAGINGRISKSANO OPPORTUNITIES OF FINANCIALLIBERALIZATION ANO INTEGRATION 49

, This paragraph and the succeeding two paragraphs were taken from Intal et al. (2001).

FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

Table 9. Indicators

of institutional

framework

(mid 1997)

GS Fragility BankRegu- BankSup. Qual. Qual.

Country

0 = best 24 = worst Transparency

GS Camelot 1 = best 10= worst

HongKong

VG,

3.5

India

Sat,

5.8

Indonesia

Sat,

Sat

4.6

Fair

Sat

4.5

Korea

Sat,

Malaysia Philippines

Fair

Sat

3.7

Singapore

Poor

Thaila1d

W,I

Weak

Note:

Source:

5.2

VG = Very Good; G = Good; Sat = Satisfactory; F = Fair; P = Poor, I -Improving GS Fragility = Goldman Sachs Fragility Score GS Camelot = Goldman Sachs Camelot Score for domestic banks only, for asset quality (25%), management (20%), capital adequacy (15%), earnings operating environment (15%), and Transparency (5%). ADB 1999

(15%),

Table 10. Indicators of institutional framework (mid 1997) Property

Country

Risks

Sector

Exposure % of Total

Loan % of

Loan

Collateral

Moderate

40-55

50- 70

High Moderate

25-30

80- 1001

10-15

60- 100 00

Malaysia

High

30-40

80-

Philippines

Moderate

15-20

70-

Singapore Thailand

Moderate

30-40

70-

High

30-40

80- 100

Hongkong Indonesia Korea

Note: Source:

High Risk because of large proportion collaterised by real property. Morgan 1998, cited in ADB 1999.

of loans and large proportion

of loans

MANAGINGRISKSANO OPPORTUNITIES OF FINANCIALLIBERALIZATION AND INTEGRATION 51

nesia,Korea and Malaysia.Indeed, the three authors highlighted asthe indicator of financial fragility the caseof rising non-performing loans accompanying a lending boom (1999). According to the authors, the growing finandial fragility in tandem with the growing current account imbalance as weIllas foreign reservesinadequacy eventuallyled to the EastAsian crisis. An inditation of current accountimbalanceis a large current account deficit in tandem with the ratio real currency of foreignappreciation. debt serviceburden Indicators to foreign of foreign reserves reserves and adequacy the rati~ re of money supplyto foreign reserves(Corsettiet al. 1999). In short, the EastAs an crisisis interplay of financial fragility and macroeconomic imbalances. i It is the interplay of weak prudential regulatory environment andm~croeconomic shocksor macroeconomic instability that is the hallmark of countries undergoing financial liberalization that experienced financial crises. Thus, the challenge in the managementof risksof finandalliberalization and policy integration environment does notbut rest also solely on the on improvement the improvement of the ofprudential the macroeconO regulat~ ry iC environment. The EastAsiancrisishas especiallyhighlighted the importa ce of strengthening prudential regulation and supervisionin the managem nt of the risksof finandalliberalization and integration. ' Toward strengthened

prudential

environment

and improved

risk management

There are three pillars to a strengthened prudential standards,namely,prudential regulation and supervision,internal practicesand controls, and market discipline. Prudential regulations attempt to limit risk exposuresof finflncial institutions relative to their risk taking and managementcapability. ~dential regulations need to give importance to banksbecauseof their large role in the provision of credit and intermediation of international capital flows, their central role in the paymentssystem,the systemicimplications of their high leverage and the mismatch in the liquidity of their assetsan4 liabilities (Ariyoshi et al. 2000). As a result of the EastAsian crisis, EastAsian countries have stren~ened prudential regulations. Regulationsconcerning loan classification,~rovisioning and income recognition have been brought closerto internatiopal bestpractices.The period overdue for interest suspensionwasshortened Jnd tightened in the affected countries (Table 11). Loan-loss provisioning requirementswere alsotightened (Table 12). Minimum capital-assetratios have also been raised. Thus, for example, Indonesia raised the capital adequ1iCY ratio from 4 percent to 12 percent by 2001; Malaysiafrom 8 percent toll0 percent (World Bank 1998,Table 3.2). !

MANAGINGRISKS AND OPPORTUNITIES OF FINANCIALLIBERALIZATION AND INTEGRATION

Table 12. Loan provisioning requirements: comparative information (in percent) Country

Unclassified Standard

Special Mentioned

Substandard

Doubtful

Loss

Indonesia Old New

05 1

n.s 5

10'

50'

1003

100

754

1001

100' 100'

Korea Existing Proposed

No changes currently proposed

Malaysia Old'

New'

0 0

506

25"

506

0 0

25'

0 1

0 2

Philippines Old

New'

1001

Thailand

Old New"

15,..11

20'.

100'. SO'.

100'0 100'0

IMF Notes: 1 2 3 4

Based on uncollateralized portion Effective at the end of 1996 for Substandard and 1993 for Doubtful and Loss. Classified as precautionary loans. That portion of a loan classified doubtful or loss that is fully secured will normally

classified substandard to the extent of the market value of the collateral. 5 Effective 1998 general provision increased from 1 percent to 1.5 percent of total outstanding loans (including interest), net of interest in suspect and specific provisions. 6 Provision computed against uncollateralized portion. 7 For collateralized; 25 for uncollateralized 8 Effective October 1997 a general provision of 2 percent on gross loan portfolio

to be

phased in through October 1999 adopted. 9 For both collateralized and uncollateralized. ~ Provision computed against uncollateralized. " Since June 1997. 12Stricter criteria for secured loans. Source:

IMF 1999

Table 13 presentsa comparisonof the major banking regulations in the five countries mainly affected by the EastAsian crisis. Prudential supervisionhasalsobeenstrengthened in the affected countries. Central Bankshave beengiven greatersupervisoryauthority or independence. The countries haveupgraded their supervisorycapacityand strengthened the powers of supervisors.Countries rely more on onsite examinations.

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

Table 13. Com parison of major banking sector regulations Country Regulations 1. LoanClassificationand Provisions Indonesia Current (05%),specialmentioned (125%grossofcollateral), substandard 3.75%netofcollateral) Korea Normal(05%),precautionary (2%),substandad (20%),doubtful (75%,estimated loss(100%) Malaysia Substandard (20%),doubtful (50%),andbad(100%) Philippines Unclassified (O%), loansspecially mentione (5%),substandard (25%),doubtful(50%),loss(100%) Thailand Pass(1%),specialmention (2%),substandard (20%), doubtful (50%)doubtful oflossandloss(100%) 2. SingleCustomerLimit Indonesia 20%of equitycapital(10%for related party) Korea loans:15%oftheequitycapital; guarantees: 30% Malaysia 25%ofbank'sshareholderfunds Philippines 25%ofunimpaired capital Thailand 25%of Tier1 ca ital 3. GroupLimit Indonesia 50%of equitycapital Korea current-45% ofbank'sequitycapital;June1999-50%; andendof1999-25% Malaysia 50%oftotalcreditfacilities Philippines 30%ofunimpaired capital Thailand 25%ofTier1ca ital 4. Creditsfor Smalland MediumEnterprises Indonesia 20%ofcredittosmallbusinesses Or25%ofloangrowthfromsmallbusiness credit Korea 45%ofanincreaseoftotalloans(regional banks-60%, foreignbanks-35%) Malaysia DuringApriI1g98-March 2000,asgroup;commercial banks-RM 1billion,financial companies-RM 240 million Philippines Outoftotalloans;smallenterprises-6%, medium-sized industries-2% Thailand Noregulations (inprocessofclassifying SMEasprioritysectors) 5. Lendingto the PropertySector Indonesia Nonewloansforlandpurchase or property development, exceptinthecaseof low-cost housing. Korea None Malaysia Exposure tothebroadproperty sectorlimitedto20%ofoutstanding loans;nobridging financeforthe development ofproperties exceeding RM250,000 Philippines 20%of totalloanportfolio Thailand Lending growthis monitored bythecentralbank(Low-cost housing is classified asa prioritysector; landaccumulation, condominium, and olfcoursesareclassifed asanon- rion sector 6. Lendingto Stockand SharePurchases Indonesia Prohibited fromunderwriting CPs Korea Nolending forspeculation purpose Malaysia Nolendingbasedoncollateralof itsownstocksor in excessof20%oftheissuedstocksofanyother corporation Philippines QrtriWoottandW1g~:ammoabanksand~CXJT'4>a1ie5-2O% merch~t banks -30%

Thailand Forfinanceandsecurities companies, marginloanisclassified asa non- nori sector 7. CapitalAdequacyRatioTarget Indonesia 4%;endof 2001-8% Korea March1999-6%; March2000-8%; endof2000-1 0%(Forthebanksnotdoingintemational businesses, applylowerratiosby2%.) Malaysia 8% Philippines 8 % (BISstandard), 10%of totalriskassest Thailand Commercial banks:8.5%(4.25%forTier1capital);Finance companies

SupelVisorscould now demand corrective actions like additional loan-loss provisioning and other corrective measureswhen problems are detected. Countries are also phasing out supelVisorydiscretion waiving compliance with regulations on a case-to-case basis(IMF 2000).

MANAGINGRISKSANO OPPORTUNITIES OF FINANCIALLIBERALIZATION ANO INTEGRATION 55

Table 13 cont'd. Country

Regulation.

8. Openingthe FinancialMarketto ForeignParticipants GeneralOwnership BankOwnership Indonesia Restrictions sharply 99% reduced,excepta few

Remark. World's200biggest banksabovetheratingA areallowedtoopenbranches inJakarta

Kaea

Nogeneral restriction 10%byreporting (domestic Nodifference inbusiness between domestic (30%for39publicinterest investors areallowed onlyup andforeignbanks corporatioo) to 4%)

Malaysia

30%(49%fortelecoms)

30%

.,-

I -~

NO new license Issued since 1983 (bOtt, domesticandforeignbanks) Foreignbanks are allowed to extend financing to non-resident controlled companies (NRCCs)upfomaximumof40 percentoffolal financingrequirementof theNRCCs Restrictionon openingof branches,including off-branchATMs,for foreignbanks

Philippines

Various(40%formining andtelecoms

30%(40%onapproval)

Foreignbanksmay a(X!uire,purchaseor own up to 60% of the voting stock Foreignbanksmay set up branches withfull

bankingauthority No differencein busines betweendomestic and foreignbanks 100%for 10 years

9. OtherRegulations Indonesia

No differencein businessbetweendomestic andforeignbanks

Netopenposition:25%ofbankcapitalfortheweeklyaveragenetpositionof bothonandoffbalance sheetpositions Loandeposit ratio:maximum 110%

Kaea

Loansexceeding 15%ofcapital500%oftotalcapital(Loansexceeding 10%ofcapital:500%oftotal capitalbyMarch2000)

Malaysia

Loans10Bumiputra Community: 30%ofIotalloans. eachforcommercia! banksandfinancecompanies asagroup

Philippines

30%liquidcoveronallforeignexchange liabilities Ceilingon equityinvestment varyingacrosstypesofbanks Umitsonaggregate insiderloans:15%ofIotalloans or 100%of networth

Thailand

Netopen foreignexchangeposition:the higher of 5% of Tier 1 or $5 million

Source: Adhikari and Soo-Nam 2000

Market discipline on the conduct of banksdemandsmeaningful, timely and accurate information. Well-informed market participants complements banks' incentives for prudent behaviourand effective supervisionand regulation. Greater transparency helps prevent herd behaviour of market participants and thus promote greater financial stability (IMF 1999). Toward this end, East Asian countries have taken measuresto improve disclosure and transparency.For example, the Philippines now requires bankslisted in the

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

stockexchangeto disclosekeyindicators on their soundnessto the public on a quarterly basis.Korea is now promoting consolidatedfinancial reporting and disclosureby corporate groups (chaebols).Banksin Korea and Indonesia are nowrequired to report their financial statementsto the public more frequently. The quality of datahasalsoimproved in the affected countries becauseof the newloan classification,provisioningand income recognition rules (IMF 2000). At the international level, there are ongoing efforts to enhance bank transp~rencyand market discipline. Thus, for example,the BaselCommittee releaseda guidance note on enhancing bank transparencythat provides recommendations in six broad categoriesof information, including: financial performance, financial positions (including capital), risk managementpractices, risk exposures,accounting policies, and managementand corporate governance. Another group, the G-10 Committee on the Global Financial SystemWorking Group on Enhanced Disclosureby Individual Institutions, is alsoworking on a model template for public disclosurethat includes information on credit, market and liquidity risks (IMF 1999). There are also on-going discussionsand initiatives at the international level to strengthen risk managementand internal control systems.This is in responseto the 1997-1998world financial disturbances that revealedweaknessesin counterparty credit risk and market risk assessments.The weaknessesinvolved inadequacies in the key assumptionsunderpinning techniques of risk assessmentand the insufficiency of what were seeminglyadequate amounts of collateral and margins. These developmentsindicate the need for improving and adapting risk managementtools and internal controls to global and interrelated markets,financial innovations,and potentially volatile market conditions. Some of the ongoing efforts include review of credit risk models, examination of operational risk events,and the use of tolerance limits at the level of the firm and trading deskscovering market, credit, and operational risk aswell as liquidity and legal risk (IMF 1999). The Report of the TaskForce on Risk Assessmentby the Institute of International Finance also contains recommendations for financial institutions, including (IMF 2000): .comprehensive stresstesting (done) regularly to assessthe potential impact of extreme eventson portfolios ~d risk profiles, .Integration of country economic analysiswith stresstesting and scenario analysis, .establishment of a strong independent risk control unit, and .Development of models to improve the integration of market and credit risk.

MANAGINGRISKSAND OPPORTUNITIES OF FINANCIALLIBERALIZATION AND INTEGRATION

Nonetheless, the quality of risk managementis not dependent on ~e quality of risk assessmentmodels but also on experience and sound judgment. Thus, adequate communication betweensenior management,portf~ lio managersand line managersis important. Similarly,it is important toha~e more intensified information sharing among counterparties. Finally,Ariyoshi et al. (1999)note that "countries with weak supervisorY agencies(tend to) also suffer from relativelyweak skills in the private financial sector,and thus from seriousshortcomingsin the ability and incentives ~f financial institutions to adequatelymanage risk." Symptomsof this are directed and connected credit and excessivecredit concentration,compound~d by weaknessesin the legal systemand impedimentsto effectivemonitoring by counterpartsand shareholdersaswell asto loan collection efforts.This pro~agatesa weak credit culture or a foundation fo.eventual financial crisis (Ariyoshi et al.; Ibid.), thus, the importance of capacitybuilding for the regulatorybodies,human resourcedevelopmentfor the financial institutions, improvemeqts in the legal infrastructure, phasing out of directed credit, and the geneI[al strengthening of a "credit culture."

Policy implications toward improved management of risks and opportunities for f"mancialliberalization and integration

Managementofthe risk\'and opportunitiesoffinancial liberalization and integration The paper brings out that the management of the risks and opportunitiesiof financial liberalization and integration involves the following: Soundmacroeconomicpolicies This involves generally tight fiscal policy and prudent monetary policy. It also means internal consistency of monetary and exchange rate policies. Where a fixed exchange rate regime is viewed to be very important, then it is necess'{lry that monetary policy must be subordinated to the demands of a fixed ~xchange rate regime. However, where some monetary independence is deemed important for both growth and macroeconomic objectives, then it is preferable to have a more flexible exchange rate regime. For the most part, "getting the foreign exchange right" (Yoshitomi 1999) would involve a flexible exchange rate. This is especially for countries that are relatively open with low inflation but with weak financial systemsand have no natural anchor currency (Rei,en 2000). A flexible exchange rate allows for the development of risk management instruments by the market. It will also force market participants to ~e cognisance of the exchange rate risk in cross-border financial transactions.

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

Getthe compositionofcapital inflowsright Yoshitomi's (1999) dictum is borne by the recentcurrencyand banking crises, most importantly the EastAsiancrisis.The variouskinds of capital flows have different vulnerability to suddenflow reversals,where afew are more autonomous and permanent while others are more volatile. There is merit in pushing more ofFDI, long-term loans and portfolio equityinvestments.Be waryof short-term bank lending, short-termmoneymarket instrumentslike commercial papers in the international market, and hedge funds. As the EastAsian crisishas clearly brought out, liberal entry and exit of short-term capitalflows require strong prudential regulation and supervisionto prevent moral hazard problems. It also requires deep domestic financial markets that can withstand sudden shifts in investor sentiments. Reisen(2000) points out that the current international banking rules under the 1988BaselAccord provides a regulatory distortion in favor of crosscountryinterbank short-termloans and bank lending to hedge funds. Thus, policies like Chile's unremunerated reserve requirement and penalties on earlywithdrawal provide the counterpoint to the bias for short-term bank lending. Sound external debt management.\)'stem

This is related to "getting the composition of capital flows right" discussed above.This is becausefor most developing countries bank financing would likely remain the most important source of external finance in addition to internally generated funds. The EastAsiancrisisis to a large extent an external debt problem because much of the short-term capital inflows into the affected countries consistedof short-termbank loans. AsReisen(2000) points out, sound external debt managementlimits the liquidity,currencyand rollover risks that a country faces. Thus, the need for: the deliberate limitation on short-term debt, a closelook at the maturity profile of debt, the diversification in the sourcesof finance acrosscurrenciesand investors,a comfortable level of international reservesand a contingency loan window, and the development of a domestic treasury market for domesticinstitutional investors. Strong prudential standards in regulation and superoision,internal control systems and market disciPline whetherunder flmble orfixed exchangeregimes The special nature of finance where asymmetric information is endemic and where there is mismatch in the maturity structure of sources of funds (mainly short-term deposits) and uses of funds (short-to medium-term loans) necessitates strong banking regulation and supervision. An important consideration here is the recognition that crossborder financial transactions carry specific

MANAGINGRISKS AND OPPORTUNITIES OF FINANCIALLIBERALIZATION AND INTEGRATION 59

risksinherent in the transactions,someof which include: foreign exchanger risk, basisrisk, repricing risk, transfer risk and risk in derivative transactions. That is, the prudential regulations seekto managethesespecificrisksthrou,h, for example, the establishmentof appropriate prudential limits and the !incorporation of such risksin loan classification,provisioning, capitaladequ4cy, disclosure and reporting requirements for banking institutions (Johnstbn and Otker-Robe 1999). Measuresto strengthen prudential regulations include: stricter definitions of non-performing loans, raisi~g loan-lossprovisions,raising capital adequacyratios,limiting bank exposure to the property sector,and strengthening lending guidelines (Adhikari and Oh 2000). Other recommendedspecificmeasuresinclude the following (GochocoBautistaetal.2000): .Strengthen risk managementand internal controls in banks, .Strengthen role of market discipline through greater disclosure and transparencyrequirements, .Upgrade prudential regulatorystandardsto international standards. This includes useof international accounting standards,apart from loan classification,provisioning and income recognition rules,and .Strengthen bank monitoring and supervision including legal responsibilities of bank officers and authority of supervisors. Johnston and Otker-Robe (1999) also point out the need for central banksto adopt a prudential approachto the managementof foreign exchange liabilities and assets.Specifically,the central banksneed to measureand monitor in a comprehensive way,their foreign currency exposuresto include <i>fIbalance sheetactivitieslike interventions in the forward exchange marketSas well asderivative transactions like call and put options on foreign currency liabilities and assets.In addition, Johnston and Otker-Robe noted the growing practice of contingency planning by central banks for crisis situations through, for instance, contingent lines of credit for a specified interest rate, which can be drawn down during a crisis. The BaselCore Principles for Effective Banking Supervision,prepared by the BaselCommittee on Banking Supervision,provide the basicreference for government authorities. Countries need to aim for adoption and implementation of the core principles. Malaysia,for example,has alreadyadopted 22 of the BaselCore Principles and is working on adopting the remainder (Yaacob2000). There is likely some cost on banksto stronger prudential regulations. For example, an increase in loan-lossprovision reducesthe potential returns

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

of banks and, other things being equal, could result to a higher intermediation cost on depositors and borrowers. At the same time, the stability of the financia1systemis important thereby reducing the systemicrisks to depositors and borrowers. Thus, the balance between cost and risk reduction needs to be struck. CaPital controls camwt bea substitutefor sound macroeconomicpolicies and stronger prudential regulation, supervision, monitoring and disclosure

Nonetheless,capi~ conttols canbe an important prudential tool to manage surges in capital flows when sterilization efforts prove inadequate. As such, capital controls should be viewed and crafted not as separate from put in tandem with the rest of macroeconomic and structural reforms. EvenlChile used, not only tight monetary and fiscal policies as well as capital c~ntrol measures,but also some appreciation of the peso in order to manage the surge in capital inflows in the early1990s.It is also important to be pragmatic in the useof capital conttol measures.Chile reduced to zero the unremunerated reseIVerequirement against capital inflows when the EastAsiaq crisis occurred when the capital flow issueturned from an inflow problem into an outflow problem. Malaysiadiscontinued the barriers to capitalinflows i1j11994 when the capital control measureswere no longer warranted. Chile used capital conttol measuresprimarily for prudential purposes while Malaysiaused capital control measuresprimarily for macroeco.:lomic managementpurposes. Thus, Chile required the use of international 'credit ratings for itslocal firms borrowing abroad not only to limit aggregateforeign borrowing but also to limit it to local firms that have the capabilityto manage the cross-borderriskswell. Similarly,Chile used the unremunerated reseIVe requirement primarily asa way of biasing the flow of capital inflows toward longer- term investments, thereby reducing Chile's vulnerability to volatile short-termcapital. Nonetheless,Johnstonand Otker-Robe (1999)pointed out that ascountries developtheir regulatoryframeworksand implementation capacities,there would be lessreliance on capital controls but greater reliance would be put on international best practice prudential measures.This is because capital conttol measures:largely do not addressthe specific risksfrom cross-border capital flows,are prone to circumvention over time, and discouragethe development of a deep and liquid financial market. (Robustand well-functioning spot and forward foreign exchange marketsare important components of a deep and liquid financial system.)Thus, capitalconttols can bestbe viewed in terms of the transition, as developing countries develop and deepen their financial systems.Becausecapital controls can derail the development of the

MANAGINGRISKSAND DPPDRTUNITIES DF FINANCIALLIBERALIZATIDN AND INTEGRATlDN 61

domesticfinancial system(ifsuch measuresare not managedwell), the imposition of capital controls needs to be temporary, market-sensitive,and well monitored. Improving institutional capacity in tenns ofhuman skills, refined risk management toolsand greater internal communication within bank\'and regulators is critical Financial liberalization and integration also brings out the importance of human resource development. Especially important with respect to assessment of credit, market and liquidity risks arising from international transactions. It can be argued that weak regulatory environment and poor skills in both the private sector and the public regulatory agencies breed a weak crett culture and the foundation for an eventual financial crisis. The importance lof human resource development includes training of current bank person~el to the new demands of risk management in a financially integrated world.11t also has implications on the design of curricula in finance related courses lin higher education institutions in the country. Calderon et al. (2001) examined the various course and training off~rings in the country that are finance-related. They also interviewed leaders lin the industry on the industry's human resource requirements. A number of observations are worth mentioning. First, there are too many college graduates but too few with the requisite skills for the finance industry. Second, the skills most needed by the industry especially for entry-level positions involve primarily oral and written communication skills and analytic skills rather than specialized skills. Third, the preference of the industry for Certified Public Accountant and accounting graduates rather than finance graduates refl4ct the role of the licensure examinations as a screening device for general in~llectual ability of applicants. (Because accountancy is the preferred course rather than finance, accountancy graduates, especially those who passed the licensure examination, have better intellectual and analytic ability than the average finance graduate.) Fourth, the preference of the industry for graduates with strong communication and analytic abilities implies that specialist training is done on the job, which is the current approach. Fifth, the "secopd class" standing of finance undergraduates can be a reflection of the genetaJ weakness of the finance curricula. Thus, for example, finance students h~ve weak grounding in economics, statistical theory (not basic statistics), and mathematics. As a result, it is unlikely that the students can successfully grapple with the nuances of risks in ever-newer forms of financial instruments like various kinds of options, interest rate and exchange rate swaps, futures and forwards. Sixth, underpinning the weaknesses of the finance curricula is the

FINANCIAL LIBERALIZATION:MANAGINGRISKS ANO OPPORTUNITIES

lack of faculty with the requisite academicqualifications at the gradua~elevel or even with part-time faculty with enough industry experience. As a result, with the exception of an extremely few institutions, virtually most of ~e colleges and universities are producing graduates that are largely incap~ble of doing risk analysisand management,which is the essenceof finance. i Calderon et al. (2001) recommend improvements in the underkraduate by including topics that are essentialin ainternational world of derefi$ ance, andcurricula open financial markets suchas risk management, ated mergers and acquisitions, hedge and mutual funds, and others. Th y also recommend strengthening qualifications of the faculty as well asexpanding and deepening the use of computer-basedfinance software programs for understanding the various finance servicesand tools of analysis.The authors also recommend continuous improvement in the training and development programs given the dynamic nature of global finance. ' Deepeningand wideningfinancial market\'

Although not well discussed in this paper, it is clear that deepeni~g the domestic financial systemis the foundation of a sound managementlof the risks and opportunities of financial liberalization and integration. 'lrhis is becausea robust growth in banking, the various foreign exchange markets (spot, forward, futures, options), and securitiesand bond marketswould allow firms to have the various hedging instruments necessaryto manage the various risks involved in a more liberalized and internationally integrated financial system.The deepening of the financial systemnecessitatesflexibility of interest ratesand exchangeratesaswell as the developmentof appropriate market infrastructure suchas paymentsand settlement systems,codesof conduct ad technical infrastructure (Johnstonand Otker-Robe1999).A deepened domesticfinancial systemrequires,and at the sametime contributes to, the improvement in corporate governanceof the domestic firms. Regional level The policy implications of financial liberalization and integration at the regionallevel involves primarily those that have economiesof scaleand externalities. They include: Harmonization ofprudential regulationsandpracticestowardsbestinternational practice

This is to prevent regulatoryarbitrage. An exampleof this is regional e*orts at meeting the BaselCore Principles for Effective Banking Supervision.1It also

MANAGINGRISKSAND OPPORTUNITIES OF FINANCIALLIBERALIZATION AND INTEGRATION 63

meanscontinuing comparativeexaminationof the comparative"costs"ofb~king regulations among the countries in the region. Regional surveiUance mechanism and stronger regional macroeconomic consultation

This isThe because much of contagion is regional in scope, not global (l Oan 2000). growing economic interdependence among the APEC memb rs, especiallyamong EastAsian economies,callsfor regional mechanismsto elp prevent the recurrence of currency and banking crises that engulfed Ithe region during 1997-1999. Regional surveillance includes regular regi~nal monitoring and researchefforts on the region's financial sectors,macroeconomic policies and capitalflows. It includes the institutionalization of an early warning systemamong the member economies in the region. The regional surveillancemechanismand macroeconomic consultationhavebeen em~hasized in APEC meetings. The implementation canbe acceleratedin the context of the establishment of an "Asian Monetary Fund (AMF)" asa complement to the International Monetary Fund (IMF); indeed the regional surveillance mechanism and macroeconomic consultation could be the most important contribution of anyproposed Asian Monetary Fund. This is becausein order for the Asian Monetary Fund to become an effective tool for crisis prevention (while the IMF focusesmainly on crisismanagement),accessto the AMF funds needsto be "... tied to member economiesmaintaining pre-determined standardsof macroeconomic and financial stability; ..oandwhere necessary,.0.to peer reviewto undertake policy adjustments" (Rajan2000). Human resource development

Shortageof skills in the financial sectoris region-wide. Regional exchangFof experiencesand expertise is useful. This is being done to some extent under the IMF and World Bank training programs mainlybasedin Singapore.Nqnetheless,more can be undertaken. Regional associationsof academic institutions like the ASEAN Universities Network can contribute in strengthening the academicprograms related to finance. The last regional concernis rÂŁlated to the issue offurther openingup of the financial sector It is recommended to further open up the financial sector, perhaps on a regional level as a start. This is related to the issue of the FSAunder GATS. Pontines (2001) showedthe varying levelsof opennessof the APEC member economies in banking (both lending and deposits),insurance (both life and

FINANCIALLIBERALIZATION, MANAGIItG RISKSANDOPPORTUNITIES

nonlife) and securities.He alsoshowed the large gapbetween comm tments to the FSAunder GATS,in the one hand, and actual practice in the 0 er, in somecasesamong the APEC member economies.APEC member eco omies made only few commitments in cross-bordertrade asa relevantmod of supply in financial services.In the light of the East Asian crisis where capital mobility with weak supervisionand regulation of the financial sectorc lead to paymentsproblems, complete liberalization in cross-bordertrade ffinancial servicesmay not be warranted especiallyfor developing APEC ember economies.What maymore important is the issueof liberalization in c ercial presence as a mode of trade in financial services. The APEC ber economies committed primarily to increasing the participation of oreign providers on existing local financial institutions rather than opening new ones (Pontines 2001). Indeed, Sauve(1999) notes that Asia's commitments in banking are on the whole lessmeaningful in terms of commercial presence in domestic markets than the commitmentsof Latin America in the FSA. While the extent and pace of opening the financial sector to-foreign competition is ~ndamentally a national prerogative, the discusS.io~-,in ~is paper largely pOIntstoward greater opennessto the entry of foreIgn Instttutions into the local economies of the APEC member economies.Whereas, before the EastAsian crisis,a number of EastAsiancountries were characterized by a relatively open capital account at the same time that there were restrictions to entry of foreign institutions into the EastAsian countries. Asa result, East Asian banks were relatively inefficient with inadequate skills in credit and risk analysisin the one hand, and EastAsian countries were more vulnerable to large shifts in capitalflows in the other. What the discussionin this paper suggestsis that it maybe preferable to have it otherwise.That is, to have greater openness to foreign equity in the financial service~sector and greater caution in further liberalization of the capital account (dr more accuratelyto put more "sand in the wheelsof short-term capital inflows into the country). This means that it would be useful to push for strengthening commitments to the FSAunder GATS,especiallywith respectto the mode of commercial presence in supplying financial servicesinternationally. It may be noted that the APEC member economies have agreed under th Bogor Declaration towardsfree movementof capitaland investmentwithin th APEC region by 2020. At the sametime, it is important that the liberalizatio of the financial servicessectorwould need to be undertaken in tandemwhile ensuring that the supervisoryand regulatory environment aswell asthe capabilityof the regulatory agenciesof the governmentsare strengthened. Thus, it is best that the multilateral liberalization processin the financial servicessectorbe

MANAGINGRISKSANO OPPORTUNITIES OFFINANCIALLIBERALIZATION ANO INTEGRATION 65

done in tandem with a multilateral effort at strengthening the supervisory and regulatory capabilities of the authorities, especiallyin developing c~untries. Finally,it is apparent that in the light of the lessonsfrom EastAsia,Chile and other countries (for example, Mexico), the deepening of the FSAin the future round of negotiations under the World Trade Organization (WTO) is not enough in addressing the risksand opportunities of financialliber~ization and integration. The focus ofFSAis primarily the liberalization of entJjyof foreigners into a country's financial sector.Needed also are concerted i~ternational or regional efforts at strengthening the institutional capacitie~of developing country authorities in monitoring, analyzing, regulating an4 supervising financial marketsand institutions. Useful also are internation~ or regional mechanismsthat expand risk managementinstruments (for example, futures, swaps,options) availableto developing country firms at reasonable cost. In short, the negotiations under GATS-FSAneed to be done in tandem with an international technical and economic cooperation progra~ to strengthen the capacityof developing countries to manage the risksandlopportunities of financial liberalization and integration. This is akin to an ~EC approach to the usualWTO negotiations. I

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

Bibliography Asian Development Bank (ADB) 1999. Asian developmentoutlook. Ney.York: Oxford University Press. I Alba, P., A. Bhattacharya S. Claessens, G. Swati and L. Hernandez. 1998. Volatility and contagion in afinancially-integrated world: lessons from East Asia's recentexperience.New York: World Bank and Cen tral Bank of Chile. Adhikari and Oh. 2000 .Banking sector reforms:recovery prospects and policy issues. In Achieving financial stability in Asia, edited by R. Adhikari and U. Hiemenz. Paris: Organization for Economic Cooperation and Development. Alesina, A. and R Barro. 2000. Dollarization. Paper prepared for ~~ 2001 meeting of the American Economic Association, 30 Decemb~r, New York. Ariyoshi, A, K. Habermeier, B. Laurens, I. Otker-Robe,J. Canales-Krijenko and A. Kirilinko. 2000. Country experiences with the use and liberalisation of capital controls. Occasional Paper Np. 190, Washington, D.C.: International Monetory Fund. Athukorata P.2001. Crisesrecovery in Malaysia: therole ofcapital controlf.UK:Oxford University Press. Calderon, L., C. Villanueva and T. Tullao. 2001. Human resource requirements of the financial sector under a liberalized regime. PASCN Discussion Paper Series No. 2001-10. Makati City, Philippines: Philippine Institute for Development Studies. Chen, Edward. 1994. Foreign direct investment in the Asia-Pacific. Asian DevelopmentReview45(1): 127-146. Chinn, M. and M. Dooley. 1995. Asia-Pacific capital markets: integraqon and implications for economic activity. Working Paper Nol 5280. Cambridge, MA: National Bureau of Economic Research (N~ER). Claessens,S. and T. Glaessner. 1997. Internationalization of financial ~ervices in East Asia. Paper presented at the conference in investment liberalization and financial reform in the Asia-Pacific Region. 29-31 August, Sydney, Australia. Corsetti, G, P. Pesenti, andN. Roubini.1999. Fundamental determinants of the Asian crisis: the role of financial fragility and external imbalances. Paper presented at the NBER tenth annual East Asia in eco~omics, 9-12 Tune. Mauna Lani Bay Hotel. Hawaii.

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DasguptaD. and D. Ratha.2000. What factors appear to drive private capital flowsto developing countriesand how doesofficial lending respond? Policy ResearchWorking Paper No. 2392. Washinton D.C.: World I

Bank.

De Brouwer,G. 1995.The liberalization and integration of domesticfinanci~ markets in Western Pacific economies. ResearchDiscussion Paper No. 9506,Australia: Economic ResearchDepartment, ReserveB~k of Australia. I Dickie, Paul M. and Marian ~o~d. 1999. Creation 0: .mark~t-basedfinan~i~ structures and polIcy mstruments to facIlItate mcreased capItal mobility in the APECregion. In Financialliberalisation in Asia: analySis and prospects edited by D. Brooks and M. Queisser .Paris: Asian Development Bank and Organization for Economic Cooperatiqn and Development. Fischer,B. and H. Reisen.1993. Financialopening:policyissuesan experience in developing dountries.Paris: Organization for Economic Cooperatiqn and Development. I Gochoco-Bautista M., S. Oh and S. Rhee. 2000. In the eye of the Asian financial maelstorm: banking sector reforms in the Asia Pacific region. Japan: Asian Development Bank. Hapitan, R 2001.Restrictionsto the entry offoreign banksin the Philippines: a critical study of selected local banks. PASCNDiscussion Paper Series No. 2001-09.Makati: Philippine Institute for Development Studies. International Monetary Fund (IMF). 1999. International markets: developments, prospects and key policy issues. Wahington: International Monetary Fund. .' 2000. Financial sector crisisand restructuring: lessonsfor Asia. Occasional PaperNo. 188. Washington: IMF. Intal, P., V. Pontines and J. Mojica. 2001. Financial liberalization and integration in the APECregion: perspectivesand the SoutheastAsia, Chilean and European experiences.PASCNDiscussionPaperSeries No. 2001-06.Makati: Philippine Institute for Development Studies Johnson R. and I. Otker-Robe. 1999. A modernized approach to managing risks in the crossboarder capital movements.IMF Policy Discussion Paper.Washingon D.C.: IMF. Lamberte M., M. Milo and V. Pontines. 2001. NO to 짜E$? Enhancing integration in EastAsia through closer monetary cooperation. Asia PacificSocialScience Review3(1) :52-105.

FINANCIALLIBERALIZATION MANAGING RISKSAND OPPORTUNITIES

Le Fort, G. and C. Budnevich. 1997. Capital account regulations and macroeconomic policy: tWo Latin American experiences. International Monetary and Financial Issuesfor the 1990s,8: 37 -58. Leung, S. 1998. Capital flows, monetary policy and exchange rates in the Asian egion. In Financial deregulation,caPitalflows and macroeconomic managementin theAsiaPacific.EDAP Joint Policy Studies No.5, Seoul, Korea: Korea Development Institute. Lopez-Mejia, A 1999. Large capital flows: a survey of the causes,consequences and policy responses. Working Paper No. 99/17. Washington: International Monetary Fund. Manzano, G. and E Neri. 2001. Foreign bank entry, bank spread ~d the macroeconomic policy stance. PASCN Discussion Paper Series No.2001-O7. Makati: Philippine Institute for Development Studies. Montiel, P.1994. Capital mobility in developing countries: some measurement issues and empirical estimates. World Bank Economic Review,8(3) : 311-50 Nadal- De Simone F. and P Sorsa. 1999. A review of capital account restrictions in Chile in the 1990s. IMF Working Papers No. 99. Washington: International Monetory Fund. Nasution, A. 1999 Recent issues in the management of macroeconomic policies -Indonesia. In rising to thechallengesofAsia: a study offinancial markets Indonesia: ADB. Park, Y and C. Song. 1997. Managing foreign capital flows: the experiences of Korea, Thailand, Malaysia and Indonesia. In International monetary and financial issuesfor the 1990s. Research Papers for the Group of 24 Vol. 8, Geneva: UNCTAD. Pontines, V. 2001. The role of the general agreement on trade and ~ervices (GATS) -financial services agreement (FSA) and the financial liberalization effort of APEC economies. PASCN Discussiop Paper Series No. 2002-03. Makati: Philippine Institute for Develppment Studies. Radelet, S. and J. Sachs. 1998. The onset of the East Asian financial crisis. Cambridge: Harvard Institute of International Development. Piei, M. and T. Tan. 1999. Steps towards economic integration: theiASEAN free trade area. Manila: Konrad Adeneur Stiftung. Rajan, R. 2000. (IR) Relevance of currency crisis theory to the devaluation of the Thai Baht. Policy Discussion Paper No. 0030, Washington: Center for Internation Economic Studies.

FINANCIAL LIBERALIZATION MANAGINGRISKS AND OPPORTUNITIES

Le Fort, G. and C. Budnevich. 1997. Capital account regulations and macroeconomic policy: two Latin American experiences. International Monetary and Financial Issuesfor the 1990s,8: 37 -58. Leung, S. 1998. Capital flows, monetary policy and exchange rates in the Asian egion. In Financial deregulation,caPitalflows and macroeconomic managementin theAsiaPacific.EDAP joint Policy Studies No. 5, Seoul, Korea: Korea Development Institute. Lopez-Mejia, A 1999. Large capital flows: a survey of the causes,consequences and policy responses. Working Paper No. 99/17. Washington: International Monetary Fund. Manzano, G. and E Neri. 2001. Foreign bank entry, bank spread ~d the macroeconomic policy stance. PASCN Discussion Paper Series No.2001-O7. Makati: Philippine Institute for Development Studies. Montiel, P. 1994. Capital mobility in developing countries: some measurement issues and empirical estimates. World Bank Economic Review,8(3) : 311-50 Nadal-De Simone F. and P Sorsa. 1999. A review of capital account restrictions in Chile in the 1990s. IMF Working Papers No. 99. Washington: International Monetory Fund. Nasution, A. 1999 Recent issues in the management of macroeconomic policies -Indonesia. In ruing to thechalllmgesofAsia: a studyoffinancial markets Indonesia: ADB. Park, Y and C. Song. 1997. Managing foreign capital flows: the experiences of Korea, Thailand, Malaysia and Indonesia. In International monetary and financial issuesfor the1990s. Research Papers for the Gro~p of 24 Vol. 8, Geneva: UNCTAD. Pontines, V. 2001. The role of the general agreement on trade and ~ervices (GATS) -financial services agreement (FSA) and the ~nancial liberalization effort of APEC economies. PASCN DiscussiotI Paper Series No. 2002-03. Makati: Philippine Institute for Devel~pment Studies. Radelet, S. and j. Sachs. 1998. The onset of the East Asian financial crisis. Cambridge: Harvard Institute of International Development. Piei, M. and T. Tan. 1999. Steps towards economic integration: the ASEAN free trade area. Manila: Konrad Adeneur Stiftung. Rajan, R 2000. (IR) Relevance of currency crisis theory to the devaluation of the Thai Baht. Policy Discussion Paper No. 0030, Washington: Center for Internation Economic Studies.

MANAGINGRISKS AND OPPORTUNITIES OF FINANCIALLIBERALIZATION AND INTEGRATION 69

Reisen H. 2000. Pensions,savingsand caPitalflows:from ageingtoemergingmarkets. Cheltenham: Edward Elgar. Schadler S. 1994. Surge in capita inflows: boom or curse?Financeand Development 31 (1) 229-260. Sauve, P. 1999. The benefits of trade and investmentliberalisation: financial services. In Financialliberalisation in Asia: analysis and prospects edited by D.H. Brooks and M. Queisser. Paris: Asian Development Bank and Organization for Economic Cooperation and Development. Unite, A. and M. Sullivan. 2001. The Effect of Foreign Entry and Ownership Structure on the Philippine Domestic Banking Market. PASCN Discussion Paper Series 2001-08. Makati: Philippine Institute for Development Studies. World Bank. 2000. Herd behavior in financial markets: a review. World Bank Working Paper No. 48. New York: World Bank. Yamazawa I. And Okuda S. 1994. Basic trade statistics for APDC project on changing conparative advantage patterns and intraregional trade expansion in Asia and the Pacific. Tokyo: Institute of Developing Economies. Yaacob F. 2000. Formal old age finanacial scheme in Malaysia. In Socialwelfare East and Westedited by j. Doling and R. Omar. United Kingdom: Ashgate. Yoshitomi, M. 1999. Capital-account crisis and credit contraction. ADB Institute Working Paper No.2. Tokyo,japan: Asian Development Bank.

CIIAPTER

Financial Liberalization and Integration in the APEC Region: Performance and Comparison with Chile and the European Union PoncianoS. Intal Jr., Victor C. Pontinesand Jitendra S. Mojica Abstract

he paper examines the growing financial integration in the APEC ~e gion; reviewsthe theoretical and analytical perspectiveson financial Uberalization and integration; discussesthe EastAsian, Chilean, and Europe Union experiences; and drawslessonsand insights on the macroecono ic management of the risks and opportunities of financial liberalization d integration. Clearly, the policy question is not one of "to integrate or not to in tegrate" but rather to define a strategyof financial in tegration, so asto m age the risksand optimize the benefits from financial integration. The c ntrasting experiences of the European Union, Chile, and EastAsia provi e lessonsand implications for the choice of the strategyof financial integrati n in the country and the region. Capital flows and f"manciaI integration

in the APEC region

The 1980sand 1990shave seenthe growing financial liberalization and in~egration of the countries and economies in the Asia-Pacificregion. The grQWing financial integration is a correlate of the deepening trade relations amorg the AsiaPacificEconomicCooperationcountries.This reflectsthe comPlemen ty among trade, direct investment,and finance in the dynamicsof outward riented growth especiallyin EastAsia that underpins the so-calledEastAsi n miracle. The recent EastAsian crisisdoes not only highlight the risksofop~n capital accountsand financial integration but also,somewhatperversely,~datesthe growing economic integration in the EastAsian region. This paper consistsof four parts.Part One discusses the growingfinan~al integration in the AsiaPacificEconomic Cooperation (APEC)region (pri$a-

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

rily EastAsia). Part Two discussesthe analytical framework of the Incoinpat:' ible trinity and a brief literature reviewon currencyand financial crashcts.Part Two also discussesthe famous Southern Cone experience and the Southeast experience in illustrating the incompatibility theorem. Part Three extiiDines the experiences of Chile and the European Union in the macroeconomic managementof financial liberalization and i~tegration. The concludipg part drawslessonsand insights on the macroeconomic managementof ri$ksand opportunities arising from increasedfinancial integration and liberalization. Measuresof financial integration There are a number of measuresof financial integration. A popular measure of growing financial integration is the volume of capital flows in the region. The presumption is that the larger the volume of capital flows the grcater is the degree of financial integration. Although imperfect, the measur~spells out that when differences in interest returns acrossopen economie~ exist, capital flows would helpequilibriate the interest returns. In theory,lcapital flows reduce to zero when interest rates (adjusted for risksand trans!ictions costs)are equilibrated. However,economiesare usuallybuffeted by d~mand, supply, and even policy shocks; as such, capital can be expected t<llmove accordingly.Moreover,a significantpart of capitalflowsis internationallylinked to trade and investment decisions.Thus, for example, to some extent the increased trade and economic integration of the EastAsian econom~eswith each other and with the rest of the world engendersincreased capital$ows in the EastAsianregion. Feldsteinand Horioka (1980)popularized the useof savingand investment correlations asa testof financial integration. It washypothesizedlthat in a closedeconomyor in an economywith capitalcontrols,a country'sinv~stment rate is virtually determined by the country's savingrate. With the assu~ption that no official development assistancewaspresent in a country, thu~, there wasa strong correlation betweena country'ssavingand investmentrate$.However,a country which was perfectly integrated with the internationallcapital market had its investment rate not constrainedby its domestic savingtate. In effect, there would be no relationship between a country's saving ntte and investment rate. The Feldstein-Horiokaregressionsare of the form:

(I/Y),=a+p(S/Y),+s

where p=o

meansperfect financial integration for a smalleconomywhile a value1 f unity implies closed capital account.

;)

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION 73

Nonetheless, the most common measuresof financial integration involved cifically, comparisons this includes of testing expected thereturns interest of parity domestic conditionscovered, and foreign assets. unc Sf veered, and the real (Fischerand Reisen1993; Montiel 1994). Covered interest parity yields on comparable assetsin different co ntries denominated in different currencies but with forward cover for fore~gn exchange risk. Assuming awaytransactions costs,differences in applicable taxesof the home country and the foreign country, and the forward market margin requirements, perfect financial integration implies that the dome$tic interest rate is equal to the foreign interest rate and the forward cover or comparable domestic and foreign assets.That is i=i*+/ where z'*is the domestic interest rate; i* is the foreign interest rate and is the forward cover. Under uncovered (or unhedged) interest parity, interest rates on c mparable assetsare equated given investorstaking open positions in the oreign exchange market. Thus, under uncovered interest parity, the dome tic interest rate is equated in equilibrium with foreign interest rate and the nticipated rate of change in the exchangerate. That is, i=i*+e ~ where e is the expected rate of change in the exchangerate. Real interest parity requires that ex-antereal (inflation-adjusted) in erestratesare equal acrosscountries; purchasingpower parity is also taken i to consideration. Real interest parity is not relevant to developing coun .es becau~ethe assumptionof purchasing power parity is a stringent assump on for developing countries. Moreover,real interest parity hasbeen shownno to hold even in Organisation of Economic Cooperation and Developm nt (OECD) countries (Fischerand Reisen1993). The most often used measuresin empirical testsof interest rate a bitrage involving developingcountries are coveredinterest parity (for those few co~ntries with forward exchangemarkets) and, primarily, uncovered inte est

panty. Montiel (1994)discussedanother measureof financial integration U$ed in the literature, i.e., the Euler equation test.The test, drawn from the E1,iler equation characterizing the optimal behavior of consumption, attempt$ to determine whether residentsof two or more countrieshaveaccessto the ;S e risk-free

asset.

Montiel

considered

this

the

most

direct

test

financial

te-

gration. However,the Euler equation testassumedno differences in the til-

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

ity functions of the domestic residentsfrom thoseof other countries,whether developed or developing (Montiel 1994). Thus, it does not seemparticularly convincing as a measure of financial integration especiallyfor dev~loping countries. Capital flows One of the remarkable developmentsin the 1990sin the world economyhas been the sharp rise in international private flows to developing countries during the decade, in sharp contrast to the mid-1980swhen private capital retreated during the height of external debt crisis in manydeveloping countries especiallyin Latin America. Net private flows in 1995to all developing countries amounted to US$166.4 billion; this was14.3 times the averagein 1983-1988(Helleiner 1997). Net capital flows to all developing countries as a ratio of gross national product (GNP) averaged2.3 percent during 19781982,2.0percent during 1983-1990 and 4. 7 percent during 1991-1996(LopezMejia 1999). Table 1, taken from Alba etal. (1998),comparesthe magnitude and composition of capital inflows to EastAsia,the ASEAN-4countries, South Asia and the Latin American and Caribbean countries. The table showsthe growingvolume of capital inflows in relation to the grossdomestic product in the developing world in the 1990sasindicated in the secularrise in the share of capital flows to GDP. More importantly, the share of net private flows increased secularlywhile that of net official flows declined secularly. Of the private capital flows, foreign direct investmentand portfolio equity increased in importance asshare of GDP in almost all the developing regions. Nonetheless,Table 1 showsthat EastAsia,and the ASEAN-4countries (i.e., Indonesia, Malaysia,Philippines, and Thailand) received the largest level of capital flows in relation to GDP among the developing countries during the 1990s.The table alsoshowschangesin the composition of capital flows to EastAsia during the 1990s.Specifically,there has beena sharprise in portfolio flows (both bond and equity) aswell asshort-term borrowing during the mid-1990s.Bank and trade lending to EastAsiaand the ASEAN-4,surged during the late 1980sand continued to mid-1990s.). EastAsia led all developing areasas destination of private capital flows. The region's share to the total capital flows to developing countries increased substantially from 12 percent during the early 1980sto 43 percent during the 1990s (Alba et al. 1998). The surge in capitalflows is also shownequallystarklyin Table 2a, taken from Radelet and Sachs(1998). The table presentsonly the ending yearsof the decade-longsurge in capital flows especiallyto the ASEAN-4 countries

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION 1S

Table 1. Magnitude and composition (Percent of GDP)

of capital flows

EastAsia ASEAN 4 1985-19881989-19921993-1~~ 1985-19881989-19921993-1~ Net Long Term Capital Flow NetOfficialFlows Net PrivateFlows Bank/TradeLending Portfolio Bond FDI Portfolio Equity

1.4

0.4 1 0.3

0.6 2.4 0.7 0.1

0.7

1.3

0.2

6.2 0.4

2 1.2

4.8 1.3

6.9

5.8

0.8

3.5

0.7 1 3 1.1

-0.3

6.~

0.9

0.2 0.9

-0.1

0.1

2.3 0.4

0.4 0.8

1.~

2.~ 2

1985-19881989-19921993-19961985-19881989-19921993-1996

NetLong TermCapitalFlow NetOfficialFlows NetPrivateFlows Bank/Trade Lending Portfolio Bond FDI PortfolioEquity

2.2 0.9 1.3 1.1 0.1 0.1 0

1.9 1.1 0.8 0.5 0.2 0.1 0.1

2.6 0.4 2.1 0.4 0 0.6 1.1

IMF Credit Other Private Flows of whichshortterm debt

-0.4

0.2

0.3 0.1

-0.1 0.6 -0.2

Source:

0.4

1.3 0.5 0.8 0.3 0.2 0.7 0

1.7 0.3 1.4 0 0.2 0.9 0.3

4.~ b 4.4 0. 1. 1. 1.

0 0.7 0.7

o.~ o.~ o.~

-0.7 -0.1

Alba et al. 1998

a nd South Korea. Nonetheless,the table echoesthe changing composition of capital flows to the region described in Table 1 and provides an intimation of why the EastAsian crisis occurred. Specifically,notice that private fl~ws doubled in two yearstime right before the EastAsian crisis.This wascau$ed primarily by the near-tripling of flows from commercial banksand nonbank private creditors, much is of short-termnature. The flowswere far larger t}i1an the requirements for financing the doubling of the current account deflicit during the 1994-1996period. The large magnitude of increases in capital flowsand more short-term maturity, raisesthe issueof "absorptivecapacity!'of the concerned countries and the possibilityof "herd behavior" among international lending institutions. Kaminsky and Reinhart (1999) highlighted Calvo and Mendoza's (1996) thesis that fixed costsof gathering and proc~ssing country-specific information could result in herding behavior of ratiobal

FINANCIALLIBERALIZATION, MANAGING RISKSANO OPPORTUNITIES

investors. However, compensation of an agent of investors (i.e., the daseof investment fund) that depended on his or her performance relative tolother investor-agents'performance (i.e.,where she or he waspunished for iaving low returns), could end up in herding behavior that was inefficient ~nd inconsistent with optimal risk sharing (Bikhchandani and Sharma2000). Bank lending Table 2b and Table 2c presenlthe updated and expanded foreign ban~ lending to selecteddevelopingAPEC member countries during 1995-1999,classifled acc.ordingto the domiciles of ~e major lender banks (!able 2b.>kd by borroWIng sector as well as the rano of short-term debt to mternanohal reserves(Table 2c). The tablesindicate that foreign bank loan outstanqing to the APEC developing countries grew until the end of 1997. It then dr6pped in 1998and 1999before recovering marginally in 2000. The tablesin~icate that it was primarily Thailand and Korea that experienced substan4al declines in foreign loan outstanding at the outsetof the EastAsian crisisiq1997. But in 1998virtually every EastAsiancountry, including China, experibnced substantial reduction in foreign borrowing. Table 2b showsthatJapaneseand European banks dominatedfbreign lending to EastAsia. Although both theJapanesebanksand the Eurppean bankshave the same top four borrower countries from EastAsia (i.e., China, Indonesia,Korea,and Thailand) ,Japanesebanksweremore focused OrJThailand. European bankswere more exposedto South Korea but on the iwhole the loans of European bank were more spread out among the coun~es in EastAsia.The dominant role of Japanesebanks in Thailand's foreign l~ans is worth noting becauseof the recent studythat have brought out the common bank creditor asa channelof contagionacrosscountries.Specifically,~nsky and Reinhart (1999) presentsthe viewthat "the behaviorof foreign baqkscan both exacerbatethe original crisis,by calling loans and drying credit lin~s, but can also propagate crisesby calling loans elsewhere.The need to reb~ance the overall risk of the bank's assetportfolio and to recapitalize followipg the initial lossescanlead to a marked reversalin bank credit acrossmarketslwhere the bank has exposure'" Kaminskyand Reinhart (1999) noted that liabilities to Japanese,banks accounted for more than one half of all the bank liabilities ofThailan~ asof December1996. The share of Japanesebank loans to the total foreig1!1bank liabilities of Indonesia and Malaysiaaccounted for nearly one-fifth aslof December 1996 (in contrast to only about one-tenth share in the caselof the Philippines). In addition, Thailand accounted for more than one- fifth of all I

FINANCIAL LIBERALIZATION ANOINTEGRATION IN THEAPECREGION77

Table 2a. External financing in the five most affected asian countries' (in billions of US dollars)

Current Account Balance External Financing, net Private Flows, net Equity Investment Direct Equity Portfolio Equity Private Creditors Commercial Banks Nonbank Private Creditors Official Flows, net Int'I Financial Institutions Bilateral Creditors Resident Lending/others,c net Reserves Excludin Gold Note:

Source:

1994 -24.6 47.4 40.5 12.2 4.7 7.6 28.2 24 4.2 7 -0..4 7.4 -17.5 -5.4

1995 -41.3 80.9 77.4 15.5 4.9 10.6 61.8 49.5 12.4 3.6 -0.6 4.2 -25.9 -13.7

1996 -54.9 92.8 93 19.1 7 12.1 74 55.5 18.4 -0.2 -1 0.7 -19.6 -18.3

"Indonesia, Malaysia, Philippines, South Korea, and Thailand bEstimate clncluding resident net lending, monetary gold, and errors and omissions

1997b -26 15.2 -12.1 -4.5 7.2 -11.6 -7.6 -21.3 13.7 27.2 23 4.3 -11.9 22.7 "' ,,(1;'

Radelet and Sachs 1998

the total foreign lending ofjapanese bankswhile both Korea and Indonesia accounted for an additional one-fourth. The shareof the Philippines wasless than one percent while that of Malaysiawaslessthan five percent. Kaminsky and Reinhart found that when a number of the member economiesin a b~nk cluster become infected, the conditional probability of a crisis reaches 78 percent which is far higher than the conditional probability of23 percent. Table 2c showssome variation in the relative importance of the varipU5 borrower-sectorsamong a selectedgroup of APECcountries before the Itast Asian crisis in the 1990s.Specifically,Korea'sborrowings from foreign banks consisted largely of local bank borrowings while those of Indonesia were of the nonbank private sector.Thailand's foreign bank borrowings by the banking sectorand the nonbank private sectorwashigher in share. For the Ph~lippines,sectoralallocation of borrowingsfrom foreign bankswasmore balanced before the crisis. As a result of the crisis,however,Table 2c showsthat l~cal banksin all affectedcountriesreduced their foreign liabilities suchthat sectpral allocation of outstanding foreign loans tilted towards the nonbank pritate revealed sectorandthat thebanks government in affected aftercountries the crisis.(but To afar large lessextent, so for the thePhilippi data Shf es) WD were particularly hard hit by the EastAsiancrisis.

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

Table 2b. International claims held by foreign banks distribution country of origin (in US $ Billions)

A. End 1995 China Chile Indonesia Malaysia PNG Peru Philippines Thailand Korea Vietnam Total

Total Outstandin 48.4 13.6 44.5 16.8 0.1 5.6

Ja an 17.7 1.0 21.0 7.3 0.0 0.2

Claims held by banks fromr-U.S.A. Canada E ro e* 1.7 0.5 20.4 4.1 0.7 6.0 2.8 0.3 15.0 1.5 0.1 6.2 0.0 -.'" 0.1 0.6 0.1 ~ 2.9

8.3 62.8 77.5 1.1 278.7

1.0 36.9 21.5 0.3 106.9

2.9 4.1 7.6 0.1 25.4

0.3 0.8 0.9 0.0 3.7

3.5 14.9 23.6 0.9 93.5

55.0 15.2 55.5 22.2 0.2 8.0 13.3 70.2 100.0 1.5 341.1

17.8 0.8 22.0 8.2 0.0 0.2 1.6 37.5 24.3 0.2 112.7

2.7 4.2 5.3 2.3

0.8 0.7

26.0

0.6

21.0

63.1 21.2 58.2 28.8 0.3 9.9 19.7 58.5 93.4 1.7 354.8

19.6 1.2 22.0

B. End 1996 China Chile Indonesia Malaysia PNG Peru Philippines Thailand Korea Vietnam

Total

7.6 9.2

0.1

0.0

0.1 4.1

1.4 3.9 5.0 9.4 0.2

0.1 0.4 1.1 1.4 0.0

34.4

5.2

19.2 33.8 1.2 128.6

2.5 4.7 4.9 1.8 0.6 2.0 3.2 2.5 9.5 0.1 31.8

1.1 1.0

132.5 11.8

6.2

C. End 1997 China Chile Indonesia Malaysia

PNG Peru

Philippines Thailand Korea Vietnam Total

8.5 0.6 0.1

2.6 33.2 20.3 0.3 108.4

0.9 0.2

13.9

~1.7

~10.4 6.6 0.2

0.1 0.4 0.8

1.7 0.0 6.2

17.1 3.4 1.2 1148.8

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION 79

Table 2b cont'd. Total

D. End 1998 China Chile Indonesia Malaysia PNG Peru Philippines Thailand Korea Vietnam Total

Outstanding

held by banks from

Japan

U.SA

Canada

Europe.

58.4 22.2 44.8 20.8 0.4 10.6 16.1 40.7 65.3 1.7 280.9

15.1 1.2 16.4 6.6 0.0 0.1 2.3 22.4 16.9 0.3 81.5

1.9 4.2 3.5 0.9 0.0 2.2 2.7 1.4 6.3 0.1 23.1

0.6 1.0 0.5 0.5 0.0 0.2 0.4 0.5 1.5 0.0 5.1

29.3 13.~ 19.~ 10.$ 0.$ 7.0 9.2 14.1 26.2 1.5 131.5

46 .6 20 .7 40 .7.1 18 0 .3 10.3 16.7 28 .4 60 .7

11.8 1.2 12.5 6.0 0.0 0.2 2.9 13.1 12.6 0.4 60.6

1.5 3.9 3.5

0.4 1.1 0.6

25.6 12.8 20.6 8.3 0.2 7.6 8.8 11.9 24.4 1.2 121.5

E. End 1999 China Chile Indonesia Malaysia

PNG Peru

Philippines Thailand

Korea Vietnam Total

1 .7 244 .1

1.4 0.0 1.8

0.2

3.0 0.8 7.0

1.8

0.1 22.9

4.1

Note:

* Reporting countries from Europe include Austria, Finland, France, Germany,

Source:

Italy, Luxembourg, Netherlands, Spain, and United Kingdom. Radelet and Sachs 1998

Foreign direct investment Although limited only to foreign direct investments,Tables3a and 3b provide some indication of the APEC role in world capital flows. The tables present foreign direct investmentinflowsand outflowson a balanceof paymentsbasis, which allowsfor comparabilityand additivity amongcountries asvisa vis o~er measuresof direct investments. Table 3c summarizesTables 3a and 3b in terms of APEC's share to the world's total inflows and outflows of fore~gn direct investment as well asthe level of net Foreign Direct Investment (FI1>I) flows into APEC.Table 3c showsthat the APEC region hasbeen a net fore~gn direct investment destination during the past two decades except during 1990-1992.It accounted for more than 50 percent of the world's FDI inflows; except in 1982-1983,1990-1992.and 1998.The significantdeclineinAPEC's

FINANCIAL LIBERALIZATION: MANAGING RISKSANOOPPORTUNITIES

Table 2c. International claims held by foreign banks distribution and sector (in US $ Billions)

Total A.End 1995 Outstanding China 41.3 Chile 12.4 Indonesia 35.0 Malaysia 13.5 PNG 0.2 Peru 3.0 Philippines 6.8 Thailand 43.9 Korea 56.6 Vietnam 0.7 Total B.End1996 China Chile Indonesia Malaysia PNG Peru Philippines Thaland Korea Vietnam Total

213.4 48.4 13.6 44.5 16.8 0.2 5.6 8.3 62.3 77.5 1.1 278.3

C. End1997 China Chile Indonesia Malaysia PNG Peru Philippines

55.0 15.2 55.5 22.2 0.2 8.0 13.3

ThaiICJ1d

702

Korea Vietnam

100.0 1.5

Total

341.1

Obligationby Sector Public Nonbank ShortBanks Sector Private tenn 15.8 12.2 13.3 17.5 3.8 2.8 5.7 -7.8 7.0 20.1 19.4 3.9 2.4 7.1 6.2 0.0 0.1 0.1 0.1 1.2 0.9 1.0 --1.7 2.6 2.5 5.7 14.1 2.8 27.0 29.2 37.0 5.0 146 31.6 0.3 0.2 0.2 2.7

85.6 36.0

91.6

19.4

9.8 2.5

19.2

3.9

8.9

6.7

4.4

2.1 0.0 0.9 2.7 2.3 6.2 0.2

28.8 10.1 0.1

0.0 2.4 2.2

25.8 50.0 0.5

117.5 33.4

22.8 3.7 11.7 6.5

8.5 1.7 6.9

2.0

0.0

3.4 5.2 25.9 65.9 0.6

1.0 2.7 2.3 5.7 0.2

145.7 31.0

22.3

by maturity

ShortReservestenn/Reserves 53.6 0.3 13.2 25.5 0.1

1.5 0.2 0.9

7.1 30.3 25.7 0.9

0.8 1.0 1.2 3.0

76.0

0.3

148

1.8 0.3 0.3

7.2

2.4 3.4 347

21.4 0.4

26.0 7.3

0.1 5.3 41.1 46.6 3.3

23.9 0.3 7.8

36.9 32.7 1.4

0.7 1.1 1.4 2.4

127.7

23.7 9.8 36.8 13.7 0.2 3.6 5.3

41.9 28.3 0.7

164.0

25.4 107.6

0.2

32.2

19.3

1.7

11.1

27.1

0.4

0.0

0.6

0.1

8.0 37.6 66.6 3.8

11.7

38.6 34.1 1.8

0.7 1.0 2.0 2.1

FINANCIALLIBERALIZATION AND INTEGRATION IN THE APECREGION 81

Table 2c. cont'd. Obligationby Sector Total Public Nonbank ShortD.End1997 Outstanding Banks Sector Private tenn China 63.1 27.1 7.1 28.9 31.5 Chile 21.2 3.6 1.8 15.7 Indonesia 58.2 11.7 6.9 39.7 32.9 Malaysia 28.8 9.9 1.7 15.9 14.9 PNG 0.3 0.0 0.0 0.3 0.2 Peru 9.9 3.3 0.6 6.0 --Philippines 19.7 8.9 2.4 8.4 11.8 ThailClld 58.5 17.8 1.8 39.2 34.8 Korea 93.4 55.9 3.9 34.2 53.8

Vietnam Total E. End1998 China Chile Indonesia Malaysia PNG Peru Philippines Thailand Korea Vietnam Total F.End1999 China Chile Indonesia Malaysia PNG Peru Philippines Thail.:rld Korea Vietnam Total

1.7 354.8

0.5

0.1

0.2

20.1

13.2

8.6

0.9 0.3

0.2

0.1

0.4 7.0 8.1 30.0 22.7 1.2

23.5 25.7 0.2

7.2 23.5 28.1 2.2

10.8 29.5 52.0 2.1

0.7 0.8 0.5 1.0

91.3 27.3

162.1

17.7 158.3

0.1

20.0

44.8 20.8

5.1 5.7 0.0

40.7 18.1 0.3 10.3 16.7 28.4 60.7 1.7 244.2

1.1

27.9 149.8

1.7 6.7 1.8 0.0 0.7 2.1 1.9

20.7

2.1

29.8 16.7 33.0

6.9

3.8

46.6

1.4 1.3 2.6

189.3

21.5

281.0

2.3

8.7 26.9 20.4

138.7 26.3

58.4 22.2 0.4 10.6 16.1 40.7 65.3 1.7

1.0

ShortReservesterm/Reserves 143.4 0.2 17.4 1.9 20.9 0.7 0.4 0.5

2.9

6.0 8.8

37.1 0.4

15.8 1.8

5.4

6.4

1.4

24.4 17.4 28.0 11.6

4.2

8.4

3.9 0.0

2.6

0.0

0.3

2.7

0.9

5.1 3.5 35.0 02

3.0 2.0

6.6 8.6 22.8

0.1

20.3 1.3

72.2 30.0

141.3

5.2

1.0

7.6 0.1

27.2 30.6 0.2

0.7 0.2

5.7 23.4 34.7 2.4

15.0 34.8 74.0 2.9

0.4

0.5 0.7 0.5 0.8

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The available data for japan, the United States, Malaysia and the Philippines mayprovide some indication of the relative importance of APEC member economies in the capital flows into the other APEC member economies. Table 4a presentsthe FDI flows from ~d into japan during the 1990s.Table 4b presents the percentage share of FDI flows to individual APEC member economies tojapan's total FDI investmentsabroad.japan's being the key source offoreign direct investmentsin the world in the 1990sis reflected in the tablethere is a large gap betweenFDI flows of japan and FDI flows into japan. The gap was particularly large in 1990 before the contractionary effects of japan's bursting assetmarket bubble fed into the economy. Until the EastAsian crisis,much ofjapan's investmentsabroad was concentrated in APECcountries reaching nearlythree-fourths ofjapan'stota! 1994-1996FDI outflows. Among the APEC economies, the United States dominates asjapan's prime FDI destination, accounting for more than twofifths of all of japan's FDI outflows during the earlyand mid 1990s.Indonesia, Thailand, Australia, China and Singapore are the next five largest FDI destinations for japan. The Philippines accounted for about 1 percent of japan's FDI outflows in the late 1990s,smallerthan the shareof Malaysiaand Hong Kong but higher than those of Korea, Taiwan,Mexico, Vietnam, and Chile. Asia's share as destination of japan's foreign direct investments increased during 1990-1997periodfrom 12.3percent (1990) to 22.9 (1997). However, this ratio dropped to 18.1 percent in 1998. Europe, which was the second largest destination ofjapanese direct investmentsin 1990at 24.1 percent declined in importance in 19.5 percent by 1997but bounced back to 30.1 percent in 1998as the East Asian crisis deepened. Looking into the bilateral FDI flows betweenjapan's FDI flow into a given APEC member economyand the FDI flow from that givenAPECmember economy,japan was a net investor in all APEC member economies during the 1990s. This is probably not surprisinggiven the role of japan asprobably the world's biggest net investor during the 1990s. FDIflows from and into the United Statesfor the period 1994-1998are shown in Table 5a; the share of selectedAPEC member economies to the United Statestotal FDI outflows are shown in Table 5b. The tables show the shift in United States'role from being a net investorto the world in 1994-1996 to being a net investment destination in 1997-1998.The tables also indicate that the outward foreign direct investment of the United Stateswas more focused on Europe, Canadaand Latin America rather than on Asia. In fact, the shareof Asia in the United Statesdirect investmentsdeclined significantly in 1997and 1998presumablybecauseof the EastAsian crisis. In contrast, the

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Table 4b. Observations

about Japan (in US $ billion)

Average share of Japanese foreign direct investmentoutflows to APECmember countries 1991-1993 5.9

Australia Brunei Canada Chile China HongKong Indonesia Korea Malaysia Mexico New Zealand PNG

1.9 0.1 2.7 2.6 3.2 0.6 2.0 0.3

0.3 0.0

Peru Philippines Russia Singapore Taipei Thailand Vietnam United States APEC

1994

-1996

3.6 0.0 1.4 0.1 6.8 2.7 3.9 0.9

1.4 0.7 0.2

0.5 0.1 1.7

0.0 1.3 0.1 2.4

0.9

1.9

2.3 0.4 43.6 72.6

0.0

42.1 67.0

1997 -1998

3.0 1.4 0.0 2.3 1.6 4.0 0.8 1.4 0.4 0.8 0.0 0.0 1.0 0.0

2.6 0.8 3.4 0.4 34.8 58.7

Note:

Values reflecting 0.0 are computed averages of foreign direct investment falling bellow 0.05 and were simply rounded out.

Source:

European Institute for Japanese Studies (http://www.hhs.se/eijs/)

(FDI)

shareof Europe increasedsubstantiallyasdestinationof American investments. There wasa two-wayflow of investments between Europe and the United States.While Europe wasthe main destinationof American investments,Europe wasalso the main source of foreign direct investmentsinto the United States. Indeed, Europe was a net investor in the United Statesduring 1996-1998. Canadais also a net investor in the United States,evenas the shareof Canada in the total Fill outflows of the United Statesincreased modestlyduring the period. In termsof the individual shareof APECmembereconomiesto the total United States foreign direct investment outflows, Canadaand Mexico, the United States partners in the North American Free Trade Agreement

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION 89

Table Sa. Observations Total US Foreign

about the United States (in US $ Million; all industries)

Direct Investment

Outflows

to:

Total US Outflows Total Foreign Direct Investments

Inflows to the US from:

Table 5b. Observation about the United States (in US $ Million; all industries) Average share of US foreign firect invest.

Average share of US foreign direct invest.

ment outflows to APEC member countries&

ment inflows to APEC member countries&

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

(NAFrA) , are the leading investmentdestinationsof the United Statesamong the APEC member economies. Australia,japan, Singapore and Hong Kong are the next important FDI destinationsof United Statescapital during 19941998. The Philippines accounted for 0.58 percent and a measly0.15 percent of the total United Statesforeign direct investmentsduring 1994-1996and 1997-1998respectively. Available data on the bilateral FDI flows between the United Statesand the other APECmembersindicate that in many cases the United Stateswas the Fill investor. The major exception is the caseof japan, where the United Stateswasconsistentlythe net investmentdestination. A few other APEC member economies (e.g., Canada, Australia, Chinese Taipei) also showthat the United Stateswasthe net FDI recipient in a number of years. The United Statesand to a lesserextent japan can be expected to be major sourcesof foreign direct investmentsinto the Latin American members of APEC.Arising more from NAFrA rather than becauseof APEC,the United Statesforeign direct investment into Mexico amounted to US $4.5 billion in 1994and US $ 5.6 billion in 1997,amounting to 41 percent and 44 percent respectivelyof Mexico's Fill inflow. The United Statesis alsoa major investor in Chile, accounting for more than two-fifths of Chile's foreign direct investment inflow during 1994-1997.japan's share to Mexico's and Chile's foreign direct investment inflow during the mid-1990sappears significantly smaller than that of the United States,accounting for less than 5 percent of Mexico's and barely one percent of Chile's. However, it is likely that these sharesare very much understated becausethe investmentscould have been coursed through Cayman Islands, British Virgin Islands, Bermuda, and Panamamaindestinationsofpublishedjapanese investmentsin Latin America probably primarily for tax purposes.2 japan and the United Statesare also the two major sourcesof foreign direct investment in the Philippines. They accounted for nearly fifty percent of all of the Fill inflows into the Philippines during 1991-1993although the share declined to about 36 percent during 1997-1999(Tables 6a and 6b). The decline in the share of the two canbe attributed in part to the rise in the shareof other APEC member economies,especiallySingapore,China, Hong Kong, and Taiwan. But the key reasonwasEurope, which wasin fact the most important source (accounting for more than one-half) of total Fill inflows into the Philippines in 1999aswell asin 1993-1994.Latin America wasalso a 2 The shares were estimated

using the data on Japanese

and US FDI outflows

Mexican and Chilean data of foreign direct investment from balance

and the

of payments statistics.

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FINANCIAL LIBERALIZATION ANOINTEGRATION IN THEAPECREGION 91

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FINANCIAL LIBERALIZATION,I.\ANAGINGRISKS AND OPPORTUNITIES

Table 6b. Observations

about the Philippines

in US $ million

Average share of foreign direct inflows to the Philippines from APEC member countries

1991-1993 United States

14.9

Japan HongKong

35.0

PRO China Australia

8.4

South Korea Taiwan Singapore

2.37

Malaysia

0.25

Source:

12. 7791 24. 13.4608 O.

0.49 0.18 4.52 1.15

Canada

1994-1996

1.06 O. 13

1.33 1.62 5. 87 1.58

1997

-1999

14.27 21.20 3.03 4.65 0.92 0.04 1.27 2.80 4.67 0.83

Selected Philippines Economic Indicators 1998 Yearbook

growingsourceofFDI inflowsinto the country during the 1990s.However,the Latin American sourcesare primarily the offshore tax havenslike Bermuda, Bahamas,British Virgin Islands,and Panama.Hence, it is not clear where is the ultimate source of these Fill flows. There are no available data on the bilateral investment flows (i.e., inflows and outflows) for the Philippines and other APEC member economies.Although presumably,the country is the net investmentrecipient of the major investorcountriesand regions suchasjapan, United States,Europe, Hong Kong. Nonetheless, what is apparent is the widening of the sourcesof Fill flows into the Philippines among the APEC member economies. In addition, the key role of Europe in the country's Fill inflows indicates internationalization of sourcing investment flowsa likely outcome when there are no discriminatory investment policies favoring one investment-sourcecountry or region overanother. The sourcesof foreign direct investments in a number of EastAsian countries during 1986-1992were preponderantly APEC countries. During the period, Europeaninvestments(the majornonAPECsourceofinvestments) accounted for only 4.4 percent ofFill into China, 11 percent ofFDI into the Philippines and Thailand, 16.1 percentofFDI into Indonesiaand 19.6percent ofFill into Malaysia. The largestsourceofFill during the period wasHong Kong for China (63%),japanforIndonesia (36%), the United Statesfor the

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION 93

Philippines (37%), japan and Taiwan for Malaysia (22 % each) and japan (18%) and Europe (16%) for Indonesia. (Riedel 1995). Foreign direct investment in Hong Kong, Taiwan, and Korea during the late 1980swas preponderantlyfromjapan and the United States.For 1990,forexample, the two countries accounted f~r 62 percent of total FDI into Hong Kong and Taiwanand 69 percent in South Korea. (Chen 1994). The available data on capital flows for Malaysiaduring the 1990swas more complete,including portfolio flows.The caseof Malaysiaprovided better perspectiveon capitalmovementsin the APECregion. Malaysia'sequity inflows and outflows in 1991-1998are shownin Tables7a and 7b. Equity investment inflows increased during the early 1990sthen declined with the EastAsian crisis. Equity investment outflows also increased during the 1990salthough slackenedoff in the later years.The total equity outflows were larger than the total equity inflows in 1996-1998.Singapore,japan, and the United States were major sources of Malaysia'sFDI inflows among the APEC member economieswhile Singapore, the United Statesand (during the early 1990s) and Hong Kong are the major APECdestinations of Malaysia'sinvestments. Like in the Philippines, Europe wasa maj or investorin Malaysiatheleading investorin 1996and 1998. Nonetheless,FDI flowsinto and out of Malaysiawas dominated by APEC member economiesfor much of the period. Despite the increase in FDI flows during the period, Tables 8a and 8b bring out that financial integration is most apparent in terms of nonFDI flows like portfolio flows.Malaysia'sportfolio inflowsbalooned from US$ 2.3 billion in 1991 to US$ 29.2 billion in 1994,although it dropped to around US$ 6.0 billion in 1998. The level of Malaysia's portfolio outflows is even more remarkable, rising dramaticallyfrom US$ 7.7billion in 1991to US$85.6billion in 1994,slackenedoff at still a high level during 1995-1997before dropping to a much lower level ofUS$ 14.3 billion in 1998. The figures suggestthat there wasa net portfolio outflow from Malaysiaduring the period. This may reflect the rising savingrate in Malaysiaand the internationalizationof portfolio decisionsof Malaysiansaversin light of the open capital accountof Malaysia.It mayalso reflect the effectof policy actionsof the Malaysiangovernmentduring the period. Specifically, its attempts to temper the level of capital inflows in the early 1990sin order to dampenthe inflationary and exchangerate effects of suchinflows on the Malaysianeconomyand the Malaysianringgit. This is discussedfurther in Section III of this paper. Table 8b shows that the portfolio flows in and out of Malaysia are dominated by Singaporeand Hong Kong, lessof the United Statesand United Kingdom. This reflects primarily the role of Singapore and Hong Kong as

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The bilateral flows between Malaysia and other APEC member economies are indicative of a country not yet developed but surviving as middle income countries. That is, while Malaysia was a net investment destination for the United Statesand Singapore and for Fill, japan, Korea, Canada,and Taiwan during the 1990s,it wasalso a net investor to the lower income APEC member economies like China, Indonesia, Philippines, Thailand and Vietnam. Interestingly, Malaysia was also a net investor in Australia, and marginally, New Zealand. In general, it is not possible to have a definite quantitative estimate of the role of APEC countries in the surge of capital flows in APEC developing countriesSoutheast Asia, Mexico, and Chilebecause of data constraints. Nonetheless,the indications from the previous examplesare that much of the capital flow is intra-APEC although Europe remains an important player in the region but especiallyin the United States.The growing intra-APEC capital flows is probably not surprising becauseforeign direct investments, especiallyfrom japan and the NewlyIndustrialized AsianEconomies (NIES), involved primarily the deepening of production networks in EastAsia and North America. Moreover,overseasbank lending,especiallybyj apanesebanks, waslinked primarily to overseas(Japanese)investmentsin developing APEC region. Portfolio flows within the region appearto be intermediated primarily through Hong Kong and Singapore. The growth in intra-APECand intra-Asianinvestmentflowsbecamemore pronounced since the mid-1980safter the PlazaAccordled to the appreciation of theJapaneseyen initially and later on of the Korean won and the Taiwanese NT dollar in the late 1980s.japaneseforeign direct investmentswasgeared primarily to the United Statesand Europe during the late 1970sand early 1980s in order to counteract rising protectionism in those regions (Chen 1994). The appreciation of the yen and the rising cost of labor and land in japan forced the Japanesefirms to develop export basesin other EastAsian countries, including Korea,Taiwan,the SoutheastAsian countries and China. The liberalization in China, initially centered on the specialeconomic zones in coastal China, paved the way for the massivetransfer of manufacturing facilities from Hong Kong to the nearby Guandong province. Taiwan and South Korea also expanded outward foreign direct investmentssince 1987, primarily to the United States,SoutheastAsia,and China. The investmentsin the United Statesappeared primarily aimed at securing accessto the United Statesmarket and acquiring technology.The investmentsto SoutheastAsia and China involved shifting labor intensivemanufacturesto reduce labor cost (Chen 1994).

100 FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

The growing foreign direct investment flows within the region is consistent with the trade intensity in the Asia Pacific region. Estimatesof trade intensityare availablefor 1980and 1990(Table9). The estimatesindicate that the direction of trade of APEC economiesis biased towards the APEC region, asindicated by a value of more than unity in most cases.There are a few casesof intense trade relationships,asfor example the NAFTA countries, the Malaysia-Singapore-Indonesia linkage (with Singapore serving as transshipment point), and the ANZERTA countries of Australia and New Zealand. In virtually all of the APECcountries,the trade intensitymeasurefor the European Community is lessthan unity. It maybe noted though that there is no one-to-one relationship between the intensity of trade and intensity of foreign direct investment. A major reason for the flow of foreign direct investmentsinto developing APEC countries (especiallySoutheastAsia and China) is the useof the latter as export basesnot only for the home country of the foreign investor but perhaps more importantly as export basesfor third markets, both within and outside the APECregion. The flow of portfolio capital within theAPEC region is alsoindicative of the growing financial integration in the region. Indeed, more than foreign direct investment, there has been a sharp rise in portfolio equity and debt flows to the region. Table 10 indicates that there hasbeen a sharp rise in the grossflows,both inflows and outflows,in the APECregion. The International Monetary Fund (IMF) Balance of Paymentsdataleavesmuch to be desired. Nonetheless, the data indicate that the APEC region is a net recipient of portfolio equity and debt flows from the rest of the world. Indeed, even the United Statesis a major net recipient of portfolio flows, primarily in debt securities. It wasjapan which wasthe only major net portfolio investor for much of the 1990samong the APEC membereconomies.Analysisof bilateral flows of portfolio capital among the APECeconomies cannot be undertaken becauseof data constraints,with the exception of Malaysiaduring the 1990s. Nonetheless,a significant shareof portfolio flows in the APEC region comes from the region itself. It mayalso be noted that bank lending to the region is also substantially drawn within APEC.Specifically,japanesebankshad the largestexposuresin SoutheastAsia and Korea as compared to the European and United States banks.The United Statesbankshad lessand stableloan exposureto Southeast Asia and Korea. Nonetheless,European banksalsoincreased their exposure in the region, especiallyKorea (e.g., Radeletand Sachs1998;Rajan 2000). Studies that examined the reasons for the surge in capital flows to developing countries in the late 1980sand early 1990s,especiallyto EastAsia,

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havehighlighted both pull and pushfactors. The pushfactorsare both cyclical and structural. Specifically, the decline in world real interest rates and the recessionin many developed countries in the early 1990sencouraged fund managers to seek emerging markets for higher profit opportunities. At the same time, improvements in telecommunications and the growing role of institutional investors (e.g., mutual and pension funds) encouraged internationalization of assetmanagementfor riskdiversification.The flowsof portfolio funds havealsobeeninfluenced by the interestrate regime especially in the United States.Specifically,the lower interest rates in the United States contributed to the increased flow of funds to the emerging markets in developing APEC in the early 1990s.Similarly, the rise in the United States interest rates in the latter 1990scontributed to the retreat of portfolio funds from East Asian emerging markets during the period. The sensitivity of portfolio funds to interest rate movementsin the United Statesis indicative of the deepening financial relations within the APEC region. There were also important pull factors for the surge in capital flows to developingcountries, in generaland to developingAPECmember economies in particular. Specifically,improved credit worthinessarising from successful debt restructuring, structural reforms, and confidence on macroeconomic managementaswell as higher economic and trade growth all contributed to the surge in capital flows to developing APEC member economies. (LopezMejia 1999.) Dasgupta and Ratha (2000) have also highlighted the complementarity betweenFDI and nonFDI flows. That is, nonFDI flowstend to be higher in countries that alsoreceivehigher FDI flows. This wasprobably not surprising as reflected in the loans of Japanesebanks to the Japaneselinked firms in Southeast Asia to service the loan demands of such firms. Moreover, higher FDI inflows, especiallyexport-oriented FDI inflows aswas the casein much of SoutheastAsia,improvesthe growth and export potential of the recipient country, thereby improving the pull factors for capital flows. Nonetheless,as noted by Rajan (2000), the composition of the capital flows wasaffected by macroeconomic factors. Specifically,the higher interest rate differential over London InterBank Offered Rate (LIBOR) rate for Thailand despite an extremely stableexchangerate ascompared to Malaysiaexplained the much higher shareof loans to total capitalflows in Thailand ascompared to Malaysia. In summary,the large and growing capital inflows and outflows in the APEC region were indicative of the growing financial opennessof the APEC economies and the growing linkages of domestic financial markets in the region with the international and regional financial markets. At the same

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION10S

time it may be pointed out that in virtually all the currency crises in recent years,they were all preceded by surgesin capital inflows. This suggeststhat the deepening financial integration also posessignificant risks. Investment-savingcorrelations and interest parity conditions Investment-5avingcolTelatioDS Montiel (1994) estimated Feldstein-Horioka regressionsfor more than fifty developingcountries for the period 1970-1990.A number ofAPEC developing countrieswereincluded in Montiel's sample.The resultsare shownin columns 1 to 3 of Table 11. The table also includes regressionresults for a few APEC member countries for the periods 1980-1989and 1990-1999. The Feldstein-Horioka regressionswere typically the grossinvestment ratios of GDP asa function of its domesticsavingratios. Column 1 of Table 11 wasestimated using ordinary leastsquares.Columns 2 and 3 were estimated using instrumental variables. Moreover, the savingratio wasreplaced by the sum of national saving, net nonmarket inflows (i.e., official development assistance) , and reservedepletion asa ratio of GNP.The instrumental variables estimationwasto takeinto considerationthe endogeneityof savingin Ordinary LeastSquare (OLS) regressions.The modification in the savingvariable is to takeinto consideration that developing countries,eventhosewith zero capital mobility, receive nonmarket financial flows primarily through official development assistance(Montiel 1994). In the Feldstein-Horioka regressions,a value of one for 13,the coefficient of the savingratio, implies that a country haszero capital mobility. That is,a country's investmentrate wasdetermined solelyby the country's domestic savingrate. Capital opennessand mobility, and therefore a country's financial integration with the world, breaksdown the savingconstraint on the country's investmentrate. In the extreme caseof perfect capitalmobility, the value of 13 is expected to be equal to zero for small countries or the country's share in world's capital stock for the large countries. The resultsof the Feldstein-Horioka testsin columns 1 to 3 in Table 11 suggestthat Singapore had high degreeof financial integration with the rest of the world while Chile, Malaysia,and Mexico exhibited intermediate financial opennessbut not "necessarilystrongfinancial integration" (Montiel 1994). The Philippines exhibited strong financial autarky. The country is likely to have significant capital controls and is not financially integrated with the rest of the world. The regressionresults,drawn from Montiel (1994),were for the period 1970-1990.Considering that the dramatic rise in private capitalflows occurred

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION107

country as well as not being credit worthy during the 1980sbecauseof the crisisand other problems existing during that time. However,the significant financial sector and foreign exchange market reforms and liberalization in the country especiallyduring the 1990shas strengthened its financial links with the restof the world assuggestedby the Feldstein-Horiokaregressionfor the 1990sand the surge in capital inflows during the first half of the period. Interest parity conditions Capital flows, while indicative of financial linkages between home andforeign financial markets,do not provide information on the degreeof financial or capital market integration. For this purpose, a number of 'studies have focused on interest parity conditionscovered and uncovered interest parity. Specifically, interest parity of comparable domestic and foreign assets(adjusted for exchangerate risk) is indicative of high capital mobility, therefore, high financial integration. Conversely,sustainedcovered interest rate differential (i.e., the gap betweenthe domestic interest rate and the foreign interest rate adjusted for the forward premium or discount on the foreign exchange rate5), is indicative of country or political risk,e.g.,existenceof capital control, differential tax treatment, default risk,localized information, risk of future capital controls (Frankel and Chinn 1993). Similarly,for the countries without forward exchange markets,a large and sustaineduncovered interest rate differential is indicative of the presenceof significant capital contrqls, therefore, low financial integration. A declining interest rate differential4 indicates growing financial integration of the home currencyvis-a-visthe rest of the world (Dooleyetal.1997). Fischer and Riesen (1993) reported estimatesof covered interest differentials for Hong Kong,japan, Malaysia,Singapore,and Thailand for the period September 1982- April 1988. The mean differentials were low for

3 The covered

interest rate differential

is :

CID = I '* -D Where D = (F 5)/ 5 F = forward premium (if positive) or discount (if negative) on the foreign currency I (1*) = domestic (foreign) interest rate 4Uncovered interest rate differential is: UID = I 1* -E

Where E = (8T 8)/ 8 8 = spot exchange rate 8T = expected exchange rate at the maturity date of the financial

instrument

108

FINANCIAL LIBERALIZATION:~ANAGING RISKS AND OPPORTUNITIES

japan and Hong Kong, and somewhathigher for Singapore and Thailand. Malaysia'sdifferential was considerably higher than the rest. The negative value suggestedthe presence of capital outflows. Fischer and Riesennoted that the mean differentials for the five EastAsian economies were actually smaller than a number of European countries, including Denmark, Spain, Portugaland Greece.Thus, the EastAsianeconomieswere more internationally financially integrated than the abovementioned European countries. Frankel and Chinn (1993) examined the covered interest differential during 1982-1992 of APEC economies with well developed forward marketsAustralia, Canada, Hong Kong,japan, Malaysia,New Zealand, and Singapore.Canada,Hong Kong and Singaporehad nearlyzero coveredinterestdifferential vis-a.-vis the United Statesinterest rate (i.e., in the OI.S regression with domestic interest rate asthe dependent variable,the coefficient on the United Statesinterest rate and forward discountrate is almosta unity and the constantis not statisticallysignificant). Australia,Malaysiaand NewZealand had coefficients still far from unity during the period. Nonetheless,Frankel and Chinn found that the coefficientsat ~eend of the period had increased tremendously compared to the beginning coefficients,indicating that much greater financial integration of Australia,Malaysiaand NewZealand internationally at the end of the 1982-1992period. These outcomescorroborate the earlier findings of Frankel and Chinn that during 1982-1988,the covered interest differentials vis-a.-vis the Eurodollar on the averagewere as small as that of Hong Kong, Singapore,japan and Canada for the financially most open European countries. While the differentials were bigger and more variable for Australia, Malaysiaand New Zealand (Frankel and Chinn 1993). Chinn and Dooley (1995)updated the Frankeland Chinn (1993) study and estimated the covered interest rate differentials for sevenAsia-Pacific countries for two subperiodsSeptember1982-Apri11988and May 1988-january 1994.The mean differentials and absolute differentials were low and declining for Canada,japan,Hong Kong and lessso,Australia,and NewZealand. This means high and deepening capital market integration with the rest of the world. Two of the Asia-Pacific countries in Chinn and Dooley's sampleMalaysiaand Singaporeweresomewhatmore insulated than the other five countries, reflecting imperfect capital mobility in the two countries duringthe 1980s. However,as Frankel and Chinn (1993) revealed,while itwas lessfinancially integrated in the early 1980s,Singaporewaslargely financially integrated with the world financial market (United States)by the early 1990s. Montiel (1994) tested uncovered interest parity by examining the differential between the domestic interest rate and the foreign interest rate

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION109

adjusted for exchange rate change. Specifically,he posited that uncovered interest parity implies that the interest differential abovehasa meanvalue of zero and that the deviations from the meanvalue were seriallyuncorrelated. Using monthly data for the period 1985-1990,Montiel's analysisindicated that Chile, Korea and Singaporeappearto meetuncovered interest parity but not Malaysia, Mexico, the Philippines and Thailand. It appears then that Chile and Singapore, especiallyhave high financial integration with the rest of the world. Other empirical studies on capital mobility in the Asia Pacific region using uncovered interest parity attempted to reflect institutional differences between developing and developed countries, especially the existence of capitalcontrols in the former. A widely cited approachwasthat of Edwardsand Khan stating that the unobservedmarket clearingdomestic interest rate wasa weightedaverageof the uncoveredinterestrate parityand the closed economy domestic interest rate: 1= W*UIR

Where

IW)*CIR

VIR = uncovered interest rate CIR = closed economyinterest rate W = a measureof capital mobility

A higher W meansa higher degreeof capital mobility becausethere is greater weight on uncovered interest parity (Fischerand Riesen1993). Estimatesof the Edwards-Khan"index" for five Asia-Pacificeconomies showedhigh degreeof capital mobility for Singapore(i.e., W = 0.92),followed by Indonesia and Malaysia.Although the high estimate for Singapore may have been boosted by the use of the covered interest rate rather than the uncovered interest rate. Estimatesfor South Korea and Taiwan showed low capital mobility (Fischerand Riesen1993).The implied high capital mobility for Indonesia and Malaysia may reflect the openness of the capital account in the former and possibleineffectivenessof capital controls in Malaysia.The lowvalue of the Edwards-Khanindex for Korea and Taiwanseemed to jibe with the historically extensive capital controls and domestic interest regulation in the two countries until the 1980s.A studyby Chinn and Maloney (1994),using a portfolio balance model rather than the Edwards-Khanmethodology, suggestedthat a break towards greaterfinancial opennessand capital mobility occurred in SouthKoreaand Taiwanby the turn of the 1990s.The financial sectorsof SouthKorea and Taiwanbecamemore integrated with the

10 FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

rest of the world as a result of the liberalization of the financial sectors that occurred during the 1990sin the two countries. In summary,financial.opennessand integration wasmixed among the APEC developing countries during the 1970sand 1980s.Nonetheless, the various studiesindicate that for Asia-Pacificcountries with more open capital accounts,capital mobility is high and financial integration hasdeepened. For the countries with historically greater capital controls, there were indications that controls were not effective or that there were some structural break towards greater financial opennessby the turn of the 1990s.The further policy reforms in many countries in East Asia, including Korea, Philippines and Taiwan,toward greater financial liberalization and deregulation point toward greater financial opennessand integration with the rest of the world. Integration of domestic financial markets The financial opennessand integration in the Asia-Pacificregion wasgenerally examined in termsof the volume and prices,ie., interest rates,ofinternationally tradeable financial instruments like government bonds and money market instruments. peeper financial integration wasachieved, however,if there wasincreasedinte~tion of the domesticfinancial markets. That is, the integration of prices of "nontradeable" retail financial instruments like deposit rates and domestic lending rates with the more tradeable financial instrumentslike money market rates. The study by de Brouwer (1995) showed that the increased international financial integration of the Asia-Pacificeconomiesoccurred in tandem with increased internal integration of the domestic financial markets in the region, although there were country differences in the extent of integration. De Brouwer examined the correlation among deposit rates,lending rates,and money market ratesaswell as the adjustment of deposit and lending rates to the changes in the money market rates in severalAsia-Pacific economies during the 1980sand early 1990s.Beloware the findings: .The deposit money market, deposit and lending rateswere strongly correlated to each other in the United States,Canada,Australia,japan, Malaysia,Singapore, Philippines and Taiwan. In contrast, deposit and loan ratesare barelylinked with the money market rates in Korea. The linkage in Indonesia and Thailand wasweak,although it strengthened in Thailand during the 1990s. .Adjustment to changesin the moneymarketrateswasrelativelyfastin Australia, Canada,japan,Malaysia(for deposit only), the Philippines and the United States.Adjustment was slower in Hong Kong and

FINANCIALLIBERALIZATION AND INTEGRATION IN THE APECREGION lIt

Singapore.The sloweradjustmentin Hong Kong mayhaveto do with the banking cartel power of the HKBA. The slower adjustment in Singapore mayhave been causedby inadequate competition in the banking sector due to tight control on bank branching and on foreign bank entry into Singapore. .The correlation and the adjustmentrate of depositand lending rates on money marker rates increased over time for Australia, Canada, Indonesia, japan, Malaysiaand the Philippines. This indicates increasedintegration of domesticfinancial markets. .Deposit rates tend to be more correlated with the changesin money market ratesand adjust faster than lending rates,especiallyfor Indonesia, Malaysia,and Thailand. This may reflect greater difficulty to enforce controls in thesecountries when there were available good substitutesto controlled financial instruments,e.g.,foreign currency depositsversusdomestic deposits. In summary, the 1980sand 1990shave seenthe growing integration of domestic financial marketsin manycountries in the Asia-Pacificregion. Asde Brouwer said,this stemmed from financial deregulation and increased competition in the banking sectorso~ the Asia-Pacificduring the past two decades.The increasing movementof the domesticdepositand lending to the money market rates as wel asamong money market rates in the region (as reflected in the reduction in the mean interest rate differential) mean that there is greater and deeper financial integration in the region. Analitical perspectiveson the macreconomicsof financial liberalization and integration Surgein caPitalJowsand theincompatibletrinity theorem The textbook analysisof macroeconomicpolicies in an open economyunder varying assumptionsof capital mobility and exchange rate regimes provide the basicanalytical foundation of the macroeconomicsof financialliberalization and integration. In Figures la-ld, LM represents equilibrium in the financial sector, IS represents equilibrium in the real or goods sector, BP representsequilibrium in the balanceof paymentsfor a given exchangerate (under fixed exchange rate regime) and IE represents the interest parity condition (under flexible exchange rate regime). Assumingpegged exchange rates,perfect capital mobility, and perfect substitutability of domestic and foreign financial assetsand a small economy, an expansionary monetary policy (a shift in the LMcurve) temporarilyef-

112

FINANCIAL LIBERALIZATION:MANAGINGRISKS AND OPPORTUNITIES

fected an increasing national output and decreasingdomestic interest rate. This is becausethe reduction in domestic interest rate leads to capital outflow, a ~onsequentloss in the international reservesand reduction in money supply.In this simplified world, thefinal equilibrium occurswhenthe economy goes back to its original position (Figure la). Thus, under fixed exchange rate regime and given perfect capital mobility, monetary policy cannot set an interest rate different from the world interest rate and cannot influence the equilibrium level of income. In sharp contrast, fiscal policy is effective in influencing the level of income under fixed exchangeratesand given capital mobility. Induced increasein domestic interest rate from a government fiscal expansion leads to capital inflow and consequently, an increase in money supply that accommodates the increased money demand arising from the increased income (Figure lb). Figure 1a. IS-LM model with pegged exchange rates, perfect capital mobility and perfect slJbstitubility of domestic and foreign financial assets and a sm.

economy

i= i.

v Figure 1 b. IS-LM model

under fixed exchange

capital mobility

rate regime and given perfect

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION113

Figures lc and ld illustrate casesof monetary expansion under a flexible exchangerate regime with perfect mobility and under a regime of capital controls with fixed exchange rates,respectively.As Figure lc showsa reduction in interest rate, increase in income, and a currency depreciation. The reduction in interest rate and currency depreciation encouraged investments and exports which were supportive of the increased output. In Figure ld, monetary expansionleadsto temporaryincreasein income. However,with increased imports and the resultant loss in international reserves,the money supply eventually declines until the economy goes back to its original position. The resultsare similar to Figure la, however,the paceof adjustmentback to the original equilibrium level is likely to be slower in Figure ld. Figure 1c. IS-LM model under flexible exchange rate regime and given perfect mobility

Figure 1d. IS-LM model under a regime capital controls with fixed exchange rates

114

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND DPPDRTUNITIES

The four casesdescribed above bring out the basic policy issuessurrounding the macroeconomicsof financial liberalization and integration. Figure la exemplifies the so-called"incompatible trinity" problem. Meaning, it is not possibleto satisfythe following three conditions in a sustainedmanner (i.e., in equilibrium) namely, perfect capital mobility, fixed exchange rate, and monetary independence (i.e., the capabilityof the monetary authorities to setdomestic interest ratesvery different from the world interest rate). Thus, under fixed exchangerate and given perfect capitalmobility, macroeconomic policymakerswould have to rely mainly on fiscal policy to attain the desired macroeconomictargets. A country has to break one of the three conditions setto haveinternal policy consistency.For example,a country that has an open capital account and wishesto have monetary independencewould haveto institute a flexible exchange rate regime. Similarly, a country that wantsthe benefits of a fixed exchange rate regime and capital mobility would have to adjust to the monetarypolicies of the anchorcountry. Finally,a country that wantsto havesome measureof monetary independence,howevertemporary,but at the sametime does not wish to have a free floating exchange rate,would need to put some barriersto capitalmobility like imposingsomecapitalcontrol measures. The underlying alternative assumptionsof perfect capital mobility, or no capital mobility whatsoever,and perfect substitutability of domestic and foreign financial instruments were obviouslystrong assumptions,especially for developing countries. The theoretical analysisabove presentsstarklythe policy trade-offs that countries face in addressingthe macroeconomic challengesof financial liberalization and integration. The variouscrisesthat many countries have experienced disclosed that managingfinancial liberalization and integration is a difficult and continuing challenge. At the sametime, the various crisesgive lessonsin managing better the risksand opportunities of financial liberalization and integration in the future. Cun-encyand banking crises:a brief literature review The various literature on currency crisesand financial crashesbring out the tremendous macroeconomic and policy challengesposeby financial liberalization and integration. The currency crisesand financial crashesin recent years were seemingly similar but were in fact different from one another. Thus, models that provide the analytic anchorfor policy recommendations for one crisis may not be sufficient for the other crises.The evolution of the models on currency crisesand financial crashesreflects the changing nature and sourcesof such crisesand crashes.They provide analytic anchor for un-

FINANCIAL LIBERALIZATION ANOINTEGRATION IN THEAPECREGION115

derstanding the various crises, and thereby hopefully help analysts and policymakersprt:pare better for, or better still avert, currency crisesand financial crashesin the future. First-generation type models The classic approach to a balance of payment crises is to perceive currency crises as arising from the inconsistency between a fixed exchange rate rule and the pursuit of domestic policies primarily an expansionary fiscal and monetary policy regime. especially the monetization of large fiscal deficits. Within a monetary framework, rational forward looking agents cause a breakdown of a fixed exchange rate regime once there is a general perception that an exchange rate peg is unsustainable. This is especially the case where the regime has been made unsustainable because of policymakers' consistent persistence to monetize its fiscal deficit (Rajan 2000; ERR 1999). Once speculators perceive that an attack is inevitable. Each tries to buy foreign currencies from the central bank before the reserves deplete. which is simply a run on reserves. Thus. one key insight of the first generation model is that the depletion of international reserves is not gradual but rather sudden arising from an speculative attack on the currency. This is best exemplified by a government that embarks on an excessively expansionary fiscal policy, financed by domestic credit creation. Then, under a fixed exchange rate regime, the country's reserves will run down at a rate proportional to the rate of credit expansion. To keep the currency at the fixed rate. the central bank has to mop up the excess money supply by buying the domestic currency and selling foreign currency. Thus, any finite stock of reserves will eventually be exhausted over time. Speculators will anticipate the inevitable sequence of events. involving the depreciation of reserves, and the sharp depreciati on in the value of the currency. as the peg is abandoned. Hence, they will switch from domestic currency into foreign currency. thus bringing about the collapse of the currency peg. This class of models produces a unique and predictable timing for a speculative attack (Rajan 2000; Pesenti and Tille 2000). The first-generation models captured the main features of many past currency criseswell, such as the Latin American crisesin the 1980s.However. they were found to be inadequate in explaining the ERM (Exchange Rate Mechanism) crises in Europe in 1992-1993, where not all the afflicted countries displayed large fiscal and current account deficits. This inadequacy spurred the development of a second-generation crisis models (Pesenti and Tille

2000).

116

FINANCIAL LIBERALIZATION:MANAGINGRISKS AND OPPORTUNITIES

Second-generationtype models The second-generationmodelswere similar to some extent to their first-generation counterpart insofar as to identifying inconsistent government policies, primarily excessivelyexpansionary and monetized expansionary policies, as the cause of currency crises (Flood and Marion 1996). However, "...whereas first-generation models use excessivelyexpansionary pre-crisis fundamentals to push the economyinto crisis,second-generationmodels use the expectation of fundamentals expansionex-postto pull the economyinto a crisis that might have been avoided" (Flood and Marion 1996). The secondgeneration models focus on the dynamicinteractions of market expectations, particularly investors' expectations,and government policy decisions which can lead self-fulfilling crises; the models highlight the role of self-fulfilling expectations in deriving severalpossible outcomes (i.e., "multiple equilibria"). For example, when private agentsstart to give more weight to the probability of devaluation in view of the economy's fundamentals, interest rates would rise. This might eventuallyconvince the government that the social costof maintaining the exchangerate through higher interest ratesis indeed too much, hence, would decide to devalue the currency. Whereaswhen private agentsdo not expect a devaluation, interest rates stay low and the exchange rate remains. A currency crisis is a shift in expectations toward the devaluation outcome. As such, the defenseof the currency peg becomes excessivelyexpensive..Second-generationmodels seembetter able to accommodate the volatility of foreign exchangemarketsthan the first-generation models (Pesentiand Tille 2000; Flood and Marion 1996). Flood and Marion's (1996) example is that ofa government that fixes the exchange rate but also monetizesa fiscaldeficit. The monetary creation eventuallybuilds up pressureon the exchangerate and pushesthe monetary authority toward making an adjustmenteitherto devalueor float the domestic currency. In contrastto the first-generationmodels,in the second-generation models, such inconsistencies in policies were not viewed critical to a crisis. Instead,asnoted earlier, the expectationsof the private agentscould encourage the government to make policy decisions that effectivelyvalidate private sectorexpectations.The reasonwhy governmentrespondsto suchself-fulfilling expectations is to balance the benefits (suchasenhancing credibility) of defending the currency against its attendant costshigher interest rates that maydamagethe weakfinancial systemand higher unemployment (ERR1999). The common feature of thesemodels is that countries pursuing policies consistent with maintaining a fixed exchange rate may come under attack. When this happens, policies may be changed. Now what triggers the

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION117

currency attack that movesa country from a certain equilibrium point to another. There are severalexplanations such as speculation by a single large investor, information frictions in emerging markets,and herding behaviour by international investors. In these models,multiple equlibria and herding behaviour by investors playa key role. From the speculator'sperspective,the probability of devaluation is associatedwith a belief that the peg will be let go in the next period. This uncertainty is attributed to economic fundamentals aswell as the expectations or beliefs of other agents,allowing for 'herding' behaviour and contagion effects.Simpler, a successfulspeculativeattackoccurswhen "the market foresees that an economic indicator will deteriorate beyond an acceptable level becauseof the defenseof the peg" (ERR1999). Unlike the first generation models where the onsetof an attackis predictable, these"escape-clause" second generation models cannot predict the timing of a speculativeattack, particularly becausethesemodels incorporate strategicbehaviourand uncertainty in an economy (Flood and Marion 1996;ERR 1999). Third-generation

type models

The first and second-generationmodels were effective in explaining Latin American crisisexperiencein the early1980sand provided much neededpolicy guidance for the ERM (1992-1993)and the Mexican (1994-1995)crises.However,thesemodelsgaveonly an incomplete picture of the EastAsiacrisis. The EastAsiancrisis caught almosteveryoneunaware. Nobody among those looking at Thailand on the eve of July 2,1997 expected the financial turmoil to snowballinto a full-fledged regional currency and financial crisis.5 Much lessfor the crisisto target shakyfundamentalsof Latin American countries and Russiawhen it jumped the entire length of the Pacific basin and skipped the deep trenchesbordering the Atlantic seaboardonly a few months after it started in Bangkok. This wasmainly becausemost analystshad their attention glued to traditional indicators or fundamentals-basedstructural distresslike government fiscal imbalances,current account deficits, and overvalued exchangerates. Although suggestiveof macroeconomic vulnerability especially for Thailand's large current account deficits, the usualindicators do not provide hints about the susceptibilityof the entire region to succumbto contagion from a currencyand financial collapse.Before the 1997crash,Thai-

5 In this reviews of literature, financial crisis and banking crisis will be used interchangeably while currency crisis, and balanced of payments crisis are also loosely invoked to mean the same situation.

18 FINANCIAL LIBERALIZATION, MANAGING RISKSANO OPPORTUNITIES

land, Malaysia,Indonesia and the Philippines, were at a fiscal surplus position or low fiscal deficits that werefinanciable from high domesticsavingrates (Malaysia). Similarly, the real exchangerate appreciation did seemmanageable and not serious in the light of the historical magnitudes in Latin American countries. Moreover,the EastAsiancountries for the most part had been undertaking reforms that were meant to strengthen macroeconomic fundamentalsliberalization of internal and external markets, stabilization, deregulation, and privatization of governmentowned corporations. The East Asian crisis brought about joint occurrence of banking and currency crisesassociatedwith the Asian financial turmoil This is not a new phenomenon. Glick and Hutchinson (1999) pointed out that in fact the incidence of twin banking and currencycriseshavebeen relativelywidespread in 1975-1997,especiallyin financially liberalized emerging economies. The authors alsofound that in emerging marketsthe occurrenceof banking crises wasa good leading indicator of currency crisesbut no vice versa.Developed markets have of course experienced twin banking and currency crisesbut a noticeable difference between a crisis in emerging economies and those of developed countries is that the latter havebeen largelyable to sustaintheir output (asnoted by Rajan (2000) in Calvoand Reinhart's (2000) paper). Despite the severalcrisesthat occurred, it is still understandableto look at each new crisis in the world as if it is something newand unprecedented, and try to develop a new way of analyzing it (Chang and Velasco1998). Indeed, the caseof the EastAsian crisis wassomething new but to some extent relative to the Latin American experiencesof the 1980s.The bedazzlement arising from the complexities of the East Asian Crisis has resulted in the reassessment of previousformulations on currency and banking models.This hasled to the development of the third generation models,which gavemore emphasison capital account while the previous two were focused on the current account. In addition, the third generation models tend to give more importance on the role of fragility of the banking sector in the generation of the eventual crisis. These two dimensions of the third generation models seemmore attuned to the EastAsian situation. Unlike the Latin American casesbefore, macroeconomic managementin EastAsia wasfar more prudent and banksasintermediaries of international capitalfunds were central to the EastAsian phenomenon. Various economistshavecontributed to the budding literature on thirdgenerationmodels.Theseinclude earlycontributions by PaulKrugman (1998) who focused on the 'moral hazard' problem induced by implicit government guarantees. Government guaranteesto the private sectormagnify the moral

FINANCIALLIBERALIZATION ANO INTEGRATION IN THE APECREGION 119

hazard problem, providing fertile ground for irresponsible banks rooted in the expectation that authorities will intervene in the event of financial distress.Pesentiand Tille (2000)stated it bluntly, "the major fundamental weaknessof the Asian countries consistedof the exposed position of the banking and corporate sectorsin an environment oflimited prudential supervision." Financial liberalization also playsa significant role to EastAsian-type crises becauselow foreign borrowing cost leads to overborrowing in foreign currency of domestic financial intermediaries. At the sametime, with poor prudential regulations, foreign loans are increasinglyfunnelled toward the acquisition of highly risky assetsor to the financing of low profit-yielding investments (Pesentiand Tille 2000). An earlier attempt to formulate a third generation crisis model was done by Chang and Velasco(1998). Chang and Velasco postulated that the EastAsian crisis wasa "classicfinancial crisismade possibleby the illiquidity of the financial sector."The central theme of Chang and Velasco'smodel is the exposureof domestic banksto foreign currencydenominated debt with shortterm maturity, or for that matter,of depositsthat are inherently short-term in character. Banksearn from lending suchfunds to longer term assumingconfidence in the banking sector such that the short-term external debt is rolled over and depositors continue their depositswith the banking sector.The risk ariseswhen creditors refuseto roll overexisting debtsor that depositorsgo on a bank run. The loss in confidence of the foreign creditors and/ or of domestic depositorsresultsin banksbeing forced to scroungeup necessaryresources, even to the extent of liquidating assetswith high yielding potentials (if collected during maturity) at a discount becauseof necessity,or recalling loans just so bankscould make up for their own liabilities. Chang and Velascohighlighted five major characteristicsof the East Asian crisis: .The existence of international illiquidity typified by mismatched international assetsand liabilities of the country and its financial institutions triggered confidence problem. This explains how a country's financial sectoris plagued by potential short term obligations in foreign currency and is unable to raise a great amount of foreign currency in short notice. .An open capital accountarising from a policy of financialliberalization. This exacerbatedthe maturity mismatchbetweeninternational assetsand liabilities. The open capital account provided the channel for capital inflow asforeign fund managersand domestic banks took advantageof opportunities of lowerworld interest ratesrelative

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to domestic interest rates. However, much of the foreign borrowings and funds were largely of short-term maturity. As a result, local banks became very vulnerable to self-fulfilling crisis when creditors panic and refused to rollover short-term loans. Imprudent money-financed deficits before the crisis in affected economies were not much of a factor in the East Asian crisis in contrast to the Latin American crises of the 1980s. The fiscal problem materialized after the crisis primarily from the fiscal costs of the bank bailouts. In this aspect, the EastAsian crisis is similar to Mexico's "tequila crisis" of 1994. A collapse of the fixed exchange rate surfaced because of the policy dilemma of helping banks by pursuing an expansionary monetary policy either by maintaining interest rates low or by being the lender of last resort. In either policy decision, a collapse in the exchange rate will happen because in both cases international reserves are exhausted and diminished. Moderately weak fundamentals of these countries waspartly observed through an overvalued exchange rate and some other external changes like terms of trade and world interest rate.

Chang and Velasco (1998) sawthe fragility of the banking sector as having a cascadingeffect on both defaults of foreign currency denominated debts becauseof depreciation and defaults on domestic currency denominated debtsby local debtors becauseof sky-rocketinginterest rates. Similarly, Caballero and Krishnamurthy (1998) attributed the magnitude of the EastAsian crisis on "the sharp fire salesdone by the market of domestic assets,exchangeratesand the ensuingcollapsein the balance sheets of both financial and nonfinancial sector."To them, the problem stemsfrom a rapid decline in the country'sinternational collateralvaluebrought aboutby its underdeveloped domestic financial markets. These underdeveloped financial markets hinder the correct appraisalsof assetvaluesin both private and social perspectivesthereby enticing uninformed investors. In addition, Caballero and Krishnamurthy (1998) explained the fragility of domesticfinancial marketsworsenedthe crisisbecauseof the collapseof the banks' balance sheets. Domestic financial intermediaries are able to acquire loans from foreign investorsusing their bank balancesheetsasa basisof credit-worthiness,resulting from valuations of available international collateral. Subsequently, foreign funds are then lent by the domestic banks to domesticborrowerswho do not havedirect accessto international credit lines.

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Caballero and Krishnamurthy (1998) alsopointed out the problem faced by a country dealing with international crisis and assetprice collapse, is the deterioration of the "third balance-thebankingsystem"or the banks' balance sheets.This in tum inhibits them from procuring further foreign funds and injecting suchfunds into the domesticfinancial system,thereby further magnifying the crisis. Calvo (1998)attributed the balance sheetproblems of domestic financialintermediariesnot on collateraldeteriorationor refusalsto roll over. Rather, these were merely the outcome of a sudden stop in capital inflows. Noting that a high capital inflow episodemeansa large current account deficit, the sudden stopof capitalinflows necessitatesthe contraction of current account deficits, which in basic terms means a significant drop in the demand for tradeable goods. Given a real exchange rate, the drop in demand for tradeable goods is likely to be followed by a lower demand for nontradable goods. In a flexible world, this leadsto the decline in the relativeprice of nontradables vis-a-vistradeables.Moreover,becauseit is a suddenstop,the "changeis largely unexpected and therefore, loans to the nontradable sector (e.g., real estate) extended under the expectation that previous relative prices were, on the whole, permanent, could become nonperforming." Thus, bankruptcies become a huge possibility. Calvo (1998) emphasized that the concept of sudden stop was wholly independent of maturity structure of capitalflows. To explain this,he brought up the caseof current account deficits (CAD), which are financed by foreign direct investments. The It wasassumedthat FDls are constantly reinvested, making the occurrence of suddenstopsimmaterial and irrelevant. However, this line of argumentation falls short wheneverFDls take the form of acquisition of domestic firms. Wheneverthis happens,revenuegenerated from the salesof existing firms may further exacerbatethe current account position when sellers in tum purchaseforeign assets(Calvo 1998). So it goeswithout saying that if the sale of domestic assettranslatesinto a higher CAD, then "original owners are using the proceeds to increase aggregate spending." Thus, what mattersis not the maturity structure of the capital inflow but rather how the capital inflow is spent. The crux of the problem is: why is there a sudden stop?Calvo argued that "conjectures that originally lead to a sudden stop may come to be true through a self-fulfilling prophesy... because the capital inflow slowdown ...could drasticallylower the averageand marginal productivity of capitalasa result of socially-costlybankruptcy battles following sharp and largely unexpected changesin relative prices." The slowdownin capital flows may destroy

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output and credit channels,therebypreventing consumption smoothing. At the same time, the shorter is the maturity structure of external debt, the greater is the possibility for a sudden stop crisis (Pesentiand Tille 2000). Lopez-Mejia (1999) explained the higher nonperforming loans of banks by hypothesizing that "if capital inflows are accompaniedby an increase in asset prices, the financial sectorwill be more vulnerablebecausehouseholds' debts and consumption rise as appreciated assetsare used as collaterals for new loans." Weakgovernance of banks may unwittingly provide resourcesto fan the increasesin aggregatedemand for both tradeableand nontradeable commodities, resulting in exposure to risks of banks once assetprices of the collaterals go down (Lopez-Mejia 1999). This problem of banks is usually directly simultaneousto increasesin the interest rates,which in turn leadsto defaults on debt paymentsby agents. Becauseof huge drops in assetprices, thesedebtswere not enough to be coveredby the collateralissuedby debtors; ergo bank losses. The EastAsianturmoil alsobrought forward the need to identify mechanismsof crisis transmissionacrosscountries. First, the panic that ensuedinto a "creditor panic," exacerbatedby the lack of coordination and lack ofinformation, turned an illiquidity problem into one of insolvency.Second,flawed financial fundamentals contributed to the progressiveweakening of the financial system,hence, the fallout in Asia.Third, contagion spreadsthe crisis to economies with relatively strong financial systems,either through their trade linkages or when investors are aware of the similar features in these economies (ERR 1999; Pesentiand Tille 2000). Pesentiand Tille (2000)stressedthat insights from the EastAsian crisis which are bestput forward by a third generationmodel. This revolvedaround the supervision,regulation and limitation of excessive borrowing from abroad, especiallythe short maturity types,thereby reducing the risk of temporary liquidity shortages.Pesenticlaimed that a third-generation model is a combination of first- and second-generationmodels. Efforts to build the third generation models are still gaining momentum (ERR 1999). Appendix A presentsthe structure of some of the models discussedin this section. Varitiesof experience on the macroeconomicsof financiallibera1ization and integration: the incompatible or impossible trinity inaction The experiencesof the Southern Cone countries during the late 1970s,the EastAsian countries during the late 1990s,and the Europeancountries in the early 1990sexemplify the imcompatible trinity problem in action.

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Southerncone experience The experience of the Southern Cone countries (Chile, Argentina and Uruguay,) during the late 1970sand early 1980sis one of the well-cited experiencesof developing countries on economic stabilization and liberalization, especiallycapital account liberalization. The experience points out the inconsistencyamong the domestic rate regime, the useof the exchangerate as an anti-inflation device,and pursuit of capital accountopennesscould lead to seriouscurrency overvaluationand an ultimate balance of paymentscrisis. At the heart of the Southern Cone experience was the large capital inflow in the turn of the 1980sbecauseof high real interest rates.The capital inflows were in large part aggressiveforeign borrowings of local firms in the face of very high domestic real interest rates (Chile) or active government encouragement through exchangerate guarantees(Argentina). Real interest rates on peso loans in Chile were between 44-58 percent during 19771978before the liberalization of the capital account. In mid-1979, it fell to about 10 percent with the opening of the capital account, but surgedto near 40 percent by 1981.The initial capitalinflows in Argentina were also primarily portfolio shiftsby Argentinesthemselveswho positivelyrespondedto the property rights reforms undertaken by the Argentine government. The high real interest rates,from 10 percent to even about 40 percent, resulted from the high nominal interest rates and deceleration in the inflation rate. In the caseof Argentina, the large fiscal deficits fanned the inflationary pressure. In both Chile and Argentina, the exchange rate was eventually used as an anti-inflation device by a program of decelerating rate of depreciation (until a zero rate of depreciation, i.e., pegged exchange rate for Chile by 1979). However,in the caseof Chile, a backwardindexation wagesetting mechanism that wasbasedon the inflation of the previous12 months, meant effectivelythat the real exchangerate appreciatedsubstantiallyof about 35 percent within two to three years.For Chile, this led to large current account deficits aggravatedby the deterioration in the country's external terms of trade. In the end, speculative pressures on the Chilean currency transpired. By 1981,in Argentina, the large foreign borrowing encouragedby the exchangerate guarantee largely went as capitalflight. Meaning, the continuing large fiscal deficits amounting to about 10 percent of GDP and the significant real appreciation of the Argentine currency fed doubts on the sustainabilityof the exchangerate. By 1982,faced with large reversalsin capital flows, Chile and Argentina went into balance of paymentscrises (Fischer and Riesen1993).

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The EastAsianexperience Before the EastAsiancrisis,SoutheastAsiancountriesappearedto havesuccessfully defied the incompatible trinity theorem. However,the surge in capital flows in the 1990sand the consequentEastAsiancrisishasproved otherwise. Indonesia Indonesia provides an interesting counterpoint aswell as complement to the Southern Cone countries. In contrastto the Latin American casewhere capital account liberalization was part of the stabilization and structural reform programs,Indonesia had an open capital accountsince1971 well before the country liberalized its trade and financial sectors in the 1980s. Indonesia seemed to defy the usual recommendations related to the sequencing of reform, where capital account opening and liberalization is supposed to be the last to be undertaken after trade liberalization and domestic financial reform. Indeed, the opening of the capital accountby Indonesia in 1971was meant asa credibility-enhancing measure in the light of the massivemacroeconomic mismanagementduring the latter yearsof the Sukarno regime. The open capital accountdid not initially posea macroeconomic problem to Indonesia for more than one and a half decades,in contrast to the experience of the Southern Cone countries. Behind this is the lack of credit worthinessof the Indonesian private sectorin the international capital market (Fischerand Riesen1993) so much so That Indonesia's foreign debt was largely by the government up until thelate 1980s.In effect, the implied substantial risk premium allowed for some monetary independence. In addition, in mid-1987and in early 1991,capital flows were sterilized through requiring state enterprises to convert their bank depositsinto purchasesof government securities as means of sterilizing such capital inflows (Fischerand Reisen1993). As the Indonesian economysurged, as the Indonesian private sectorbecame credit worthy internationally, and asthe ceiling on foreign commercial borrowings by bankswaslifted, there wasa surge in private sector borrowings abroad to beat the higher domestic interest rate. Facilitating the surge in foreign borrowings of short-term maturity was the introduction of a swap facility with Bank Indonesia whereby the domestic lending rate was lower than the LIBOR plus the swappremium. The swap premium wasequal to the deposit rate less the LIBOR (Fischerand Reisen 1993). For example, foreign borrowing by the private sector during 19901993amounted to about US$ 10.6billion ascompared to only US$ 0.5 billion during 1982-1989{Parkand Song 1997).The outstanding foreign bank debt ofUS$ 35 billion in 1994rose dramaticallyto US$58.2 billion in 1997{Table

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2b). The surge in foreign borrowing primarily by the Indonesian private sector,not all of it known and monitored by the governmentauthorities,proved to be a major undoing for Indonesia during the EastAsian crisis. In March 1998,Indonesia's external borrowing amounted to US$138 billion, of which US$ 64.5 billion wasowed by private nonbank corporations and US$13.6billion by private and public banks (Nasution 1999). Indonesia had a policy of maintaining the real exchange rate of the rupiah in the face of the large capital inflow. This means that the rate of rupiah devaluation waspredictable (and historically low) so much so that the foreign borrowing by Indonesian entities waslargelyunhedged. The Indonesian central bank had to resort to continuous monetary sterilization efforts in order to minimize the monetary expansionaryeffect of the capital inflows. Bank Indonesia relied on salesof short-term Central Bank securities and money market securities.It utilized other measuresin order to control excess liquidity, e.g., raise the discount rate on export draft, impose direct controls on banks. Portion of the depositsof State enterprises with the commercial bankswere transferred to the Central Bank (Parkand Song 1997.)However, the central bank's efforts to control excessliquidity led to domestic interest rates higher than the foreign interest rate adjusted fOTthe normal rate of depreciation of the rupiah. As a result, Indonesian firms borrowed more from abroad of increasingly short-term maturity. The percentageof debt instruments in US dollars increased substantiallyduring the 1990sthe ratio of credit in US dollars to total credit grew from 12.2percent in 1990to 30.8 percent in 1997 (Nasution 1999). With the rise in the shareof foreign currencydenominated debt, it was increasinglydifficult to manageexchangerate and monetarypolicies without hurting the viability of enterprises.This wasaggravatedby the high external debt serviceburden of Indonesia that amounted to more than 30 percent of the country's exports during the 1990s.With inadequatemonitoring of external debt, poor prudential regulation of banks,and heavyexternal debt service,Indonesia ended up being the most badlyaffectedby the EastAsiancrisis despitebeing merelya "victimof contagion"from Thailand. Thailand

Thailand, the origin of the EastAsian crisis,illustrates the "impossible trinity" in action. Thailand's monetary policy during 1985-1997wasanchored on its nominal exchange rate, which was pegged to a basket of currencies of Thailand's major trading partnersdominated by the US dollar (Werner 1999). Thailand successfullystabilized the exchange rate for nearly a decade up

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until theJuly 1997crisis.That success,however,wasillusory as the country had increasing difficulty in managing capitalinflows and slowing down an increasingly overheatedeconomy. During the 19805,Thailand could maintain the exchange rate despite a large current account deficit becausethe deficits were financed largely by foreign investment inflows. Moreover, the magnitude of the current account deficit in the 1980swas not as high as that of Singapore during 1975-1982 when it averaged9 percent of GDP which wasconsidered a period of considerable economic successfor Singapore (Shigehara 1999). However, by the mid-1990s,the shareofFDI in financing the current account deficit dropped to only about 10 percent while the slackwasprimarily taken over by foreign debt of increasinglyshort-termmaturity. Underlying the large foreign borrowings was the significant interest differential between the 12-13percent interestrate in Thailand and about 5-6percent for the US dollar during the period at the sametime that the exchangerate remained stable (Yoshitomi 1999). Thailand showed the limits of sterilization policy and the difficulties of managing surgesin capital inflows. Capital inflows dominated the growth of Thailand's monetary base in the late 1980sand the 1990s.Thailand wasaggressivein using fiscal policy in managing capital inflows. It shifted from a central government fiscal deficit of about 4 percent GDP prior to the surge in capital inflows into a fiscal surplus averagingabout 3 percent of GDP during 1988-1994(Schadler1998;Parkand Song1997).The Bankof Thailand (BOT) used dollar-baht swaps,repurchaseof governmentand stateenterprise bonds, and salesand purchasesof government securities for its money market operations. The BOT required banks in August 1995 to maintain a 7 percent reserveagainstnonresident baht depositsby 1996,including all short-term foreign currency liabilities of banks (including the BangkokInternational Banking Facility) and finance companies.The BOT also used direct credit "guidance" through the Credit Planning Schemeasa meansof controlling domestic credit expansion during 1987-1997. However,this schemeinitially excludedthe BangkokInternational Banking Facilities (BIBF) loansby foreign banks,therebycreating another basisfor the shift in sourcing of funds from domestic baht loans to foreign borrowing. A substantial portion of which wascoursed through the BIBF. Moreover,foreign bankswere implicitly encouragedto lend domesticallybecausethe award of foreign banking licenses wasdependent on the performance of foreign banks in lending to the domestic corporate sector.Thus, the incentive structure affecting the BIBF led to a major redirection from undertaking "out-<>ut" or "in-<>ut"deposit-lending operations to one that becameessentially"out-in"

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operations (Werner 1999). BIBF became an important means for sourcing short-term funds for domestic banks, finance companies, and the corporate sector. It has been argued that BIBF "window" effectively extended and worsened the asset market bubble in Thailand central to the emergence of currency and banking crisis in the country. Thailand wanted to dampen the inflationary pressure from the capital inflows at the same time that it prevented a significantly nominal appreciation of the baht in order to maintain its export competitiveness. However, as a result, domestic interest rates were persistently higher than those in the developed countries, thereby encouraging further capital inflows. It may be noted that the bulk of capital flows into Thailand during the surge period consisted of short-term borrowing of commercial banks and nonresident baht account deposits (Park and Song 1997). The short-term nature of much of Thailand's capital inflows during the capital surge period led to the level of short-term debt being much higher than the level of international reserves and increased vulnerability of Thailand to negative foreign investment sentiment. Thailand resorted to other measures in order to dampen the inflationary effects of the capital inflow such aseasing up on capital outflows. Nonetheless, the Thai economy overheated as reflected in the high current account deficit and the real estate bubble. When the bubble burst and the export sector stagnated from the downturn of international electronics market and rise in domestic labor cost by 1996,foreign sentiment tumed progressively negative and pressures on the baht increased. The speculative attack on the baht started in September 1996. Subsequent speculative attacks occurred in December 1996, February 1997, and May 1997. It was only in July 2, 1997 that Thailand decided to devalue the currency. By June 1997, Thailand used up US$ 8.7 billion in reserves and undertook US$ 23 billion in forward contracts (maturing within 12 months) in the ultimately futile attempts to defend the currency. Behind the attempts at defending the baht were fears that the abandonment of the peg would lead to a wholesale run on the baht and therefore an immediate currency crisis. In addition, the large unhedged foreign debt exposure of Thai corporations would force the corporations to close their exposures in case such policy change occurs that can lead to a currency crisis in view of the larger unhedged debt exposure compared to the country's intemational reserves. It is interesting to note, however, that it was the demand for dollars by the local firms in June 1997 to hedge their open foreign exchange exposure that ultimately cleaned up the country's reserves through the Exchange Equalization Fund (EEF) window, thereby setting up the stage for the abandonment of the peg on July 2,1997 (Wemer 1999).

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Bubbles,crashes and crises Thailand, and to a less extent Korea and Indonesia,showed that despite the apparent macroeconomic success,the difficulties of managing the massive capital inflows would rear its ugly head in terms of an overheating economy and assetbubble. The bursting of the bubble eventuallyled to the currency crisis.Yoshitomi (1999) pointed out that the caseof Thailand's large current account deficits in the 1990sbefore the crisiswere not causedby poor macroeconomic fundamentals like large fiscal deficits or low savingrates. Rather, theywere causedby the capital accountsurplus arising from the large capital inflows. As such, the size of the capital account surplus largely determined the current account deficit, not the other wayaround. As noted earlier, the capital inflows were causedby the large interest differential and by the stability of the exchangerate. In addition, the success of the recipient in its growth performance, prudent fiscal regime, and overall inflation performance contributed to further downscalingof risksinvolved in borrowing and lending in countries like Thailand, Korea, and Indonesia. Finally,in the caseof Korea,the historyof governmentbailout of chaebolsand banks in distressled market participants to expect an implicit guarantee by the government. The capital account surplus and the accompanyingforeign reserveaccumulation encourageddomesticabsorptionthrough excessive domesticbank credit and money supply expansion (Yoshitomi 1999). A large part of the increasein domestic absorption led to large current account deficit, thereby, prevented a sharp rise in inflation. The capital inflow and rise in domestic absorption also led to the assetmarket bubble. In the caseof Thailand, the share of loans by commercial banksand finance companies that went to real estate,construction, and consumerloans (including automobile loans, margin loans for stockpurchases,and hire purchaseloans) expanded from about 35 percent of total loans in the early 1980sto about 45 percent by the mid1990s (Werner 1999). The role of finance companiesis particularly significant in the making of Thailand's "bubble". The share of loans for construction, real estate,and personal consumption (primarily margin loans and hire and purchase loans) averagedabout 55 percent in the earlyto mid-1990s. At the sametime the proportion of total loans granted by finance companies to the total loans granted by banksrose from about 21 percent in 1990to about 31 percent in 1995 (Kawai 1999). Thus, when the bubble burst, it wasthe finance companies that were first to be badlyaffected.The banking sectorwas also adverselyaffected becausethey own a considerable number of the finance companies.

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There is some internal dynamic to Thailand's bubble. Banksrelied on collateral-primarily real estateindeciding on loans. Thus, the higher the real estate price the higher is the collateralvalueof the land, the higher loan the real estate can support. The additional loans could be more real estate loans or other sectors suchasmanufacturing. However,in the caseof Thailand, the government pursued a tighter monetary policy in 1995and 1996, implying a high interest rate policy (Werner 1999). This contributed to the bursting of the bubble and the finance companiesbecamesaddled with the rise in nonperforming loans. When the inflow from abroad dried up, the financial institutions became illiquid. In the caseof Thailand, the government plowed in billions of baht in trying to support faltering finance companies in 1996but ultimately to no avail. Moreover,the financial sectorproblems together with the deterioration in the country's export performance led to the speculativeattackson the baht. A bubble is essentiallya caseof overinvestment to the point that the returns to the investment ultimately becomesless than the costof capital. If Thailand's bubble wascentered in commercialreal estate,Korea'sbubble was centered in overinvestmentin factories.As in the caseof Thailand, the investment was increasingly financed by short- term loans, especially short-term foreign loans intermediated by domestic merchant banks during 1993-1996 with the acceleration of capital account liberalization in Korea (Chou 1999). The Korean casewassomewhatunique becauseKorean chaebolshavehistoricallybeen aggressivein investments,which in the late 1970salso contributed to the balance of payments crisis in Korea in 1980. Korean chaebols have largely focused on market share rather than profitability. Thus, the ratio of 'current profit to total assetsfor the period 1989-1.993 averagedonly 2.0 percent in Korea as against3.5 percent in Japan and Taiwanand 6.2 percent in the United States (Chou 1999). There were a number of factors that made the crisis of 1990smore seriousthan that of late 1970s.First,foreign borrowing wasmore liberalized in the 1990sthan in the 1970s.Liberalization of capital accountled to the sharp rise in reliance to short-term loans in the 1990s.For example, the share of short-term loans as a source of financing for the country's top 30 chaebols increased sharply from 48 percent in 1994to 64 percent in 1996while the share of internal financing decreasedsharplyfrom 41 percent to 22 percent during the sameperiod (Chou 1999). The investmentswere long-term for increased capacity at home as well as expansion abroad. Thus, the Korean chaebols were particularly vulnerable to external and interest rate shocks becauseof two mismatchescurrencyand term.

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Second,the Korean chaebolsexpanded significantly during the 1990s in both their core businessesand branching into newsectors.The expansion wasfacilitated by accessto credit using property as loan collateral and crossloan guarantees.The practice of cross-loanguarantees,while allowing access to credit by individual subsidiaries from the loan guarantee of the whole group, exposed the whole industrial group to chain bankruptcies within the same group (Smith 1998),asthe unfolding of the Korean crisisshowed. Third, political liberalization and increased land values led to sharp rise in wageswhich were even higher than the expected labor productivity. This explained the thin profit margin of Korean chaebols but more importantly, this led to greater vulnerability of Korean exports to exchange rate shifts in the yen to US dollar. The labor unions became more powerful and aggressivein the 1990sasa result of political liberalization. In addition, land valuesrose significantly in the 1990ssuch that the ratio of land value to GDP in 1994was 5.4in Korea as against3.5 in Japan, 1.6in United Kingdom, and 0.7 in the United States (Chou 1999). The high land value translates into high rental cost,therefore high wagedemandsfor workers. Trade deterioration and depreciationof theJapaneseyen relative to the US dollar led to worsening fortunes of the Korean chaebolsand the Korean economy in 1996.The depreciation of theJapaneseyen meant that the price advantageof Korean exports competing with Japaneseexports especiallyin third marketswaseroded. Moreover,the rise in unit labor costat home did not provide the needed cushion to allow for export price adjustment to meet the Japanesechallenge in the third markets. Finally, the abrupt fall in the prices of Korea's major export products (especiallycomputer chips) in 1996further weakened the financial position of the chaebols. As a result, the chaebols faced debt servicing difficulties considering a substantial portion of their loans being short-term. The chain of bankruptcies starting with the collapse of Hanbo Steel in January 1997, corruption scandals,and labor unrest dictated a decline in consumer and businessconfidence, rise in interest rates, and vulnerability to the contagion from the SoutheastAsiancurrency crisis. Thefinancial sectorand the EastAsian crisis

The East Asian crisis has highlighted the importance of prudential regulations of the financial sectorin stavingoff future currency crises.Generally,the financial sectorwasat the heart of the recent EastAsian crisis. Weaksupervision of banks and nonbank financial institutions (e.g., finance companies) and the macroeconomic incentive for banksand other financial institutions increasingly rely on foreign funds for domesticrelending and/ or investment

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becauseof the currency stability and the lower interest rate at home than abroad. likewise, encouraged banks and nonbank financial institutions to undertake riskier and unhedged loans and investmentsdomestically. This weak supervisionis manifested by banks,both locally owned and foreign. As Werner (1999) noted, only 15 percent of the total dollar borrowings of Thai corporations wascoursed through Thai banks;the 85 percent wasconducted through foreign banks. Also, a substantial portion of foreign loans to the affected EastAsian countries wascontracted directly with the foreign banks rather than through local banks; in the caseof Indonesia, a predominant

portion.

Regulatory oversightand incentive distortion were two important reasonsfor the rise in short-termfinancing of investmentsin Korea. The government controlled Korean firms' direct borrowing from abroad allowed for the sharp expansionof merchant banks. Manyof them through the conversionof short-termfinance companiesinto merchant banksthat could undertake for.eignexchangeoperations. Merchant banks,however,.largelyborrowed shortterm for long-term assets.Indeed, the term mismatchfor merchant bankswas particularly serious such that short-term foreign assetscould cover only six percent of the banks' short-termliabilities in 1996.This wasa contrastwith the regular bankswhere the ratio of their foreign assetsto their foreign liabilities was about 80 percent. It wasonly in June 1997,that government authorities imposed limits on holdings of long-term assetsthrough short-termborrowing (Chou 1999) Apart from short-termborrowing from abroadindirectly through the merchant banks, Koreanfirms relied on the domestic commercial paper (CP) market for their short-term financing. The CP market grew tremendously becauseit was not subjected to monetary control. Also, commercial paperswere resold in the secondarymarket from short-term finance companies and merchant bankswith guarantees,which wasagainstthe rules. Thus, the risky CP paperswere traded asif risk-freeand led to tremendous growth of the market. In the end, however,the failure of the government to institute proper supervisoryand monitoring mechanismson the commercial paper market raised the overall risk of the CP market and the financial sector (Chou 1999). Indonesia highlights the weakprudential regulation and supeIVision of banks in the affected EastAsiancountries. The Indonesian caseis particularly more seriousbecausegovernment-ownedbanksstill accounted for twofifths of the total assetsof the Indonesiancommercial banking systemin 1996 (Chou 1999). About two-thirdsof the loan problems in Indonesia are concentrated in the state-ownedbanks. Nasution (1999) assertedthat the govern-

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ment ownership led to political objectives intruding in all aspectsof bank operations. Meaning credit worthiness of the borrowers was not given sufficient attention. Instead,state-<>wned bank loanswere used "to extend governmentassistanceto particular industries and a handful of politically well-connected businessgroups" (Nasution 1999). Moreover, the lending skills (including risk appraisal) of the bank officers of state-<>wned banks were also weakbecausethe state assumesthe risksof the state-ownedbanks. EvenIndonesia'sprivate banksalsoleavemuch to be desired in terms of prudentials. A seriousproblem concernsviolations of the legal lending limits on loans and advancesto insiders,a single borrower or group of borrowers. Nasution (1999) pointed out findings of the World Bank in the mid-1990s that 65 out of the 240banksviolated suchlegal limits. About half of theloans were extended to membersof the samegroup of companies,and that in two of the largestprivate banks,over 90 percent of the loans were given to member companies of the samegroup. This suggeststhat prudential rules andregulations follow the CAMEL (capital adequacy,assetquality, management,earning and liquidity) were poorly implemented in Indonesia in the 1990sbefore the EastAsian crisis broke out. This wasexplained by the structural weaknessesin the legal and accounting processas well as the insufficiency of trained personnel in the regulation and monitoring of banking and other financial sectors (Nasution 1999). An Asian Development Bank study (1999)presented indicators of the institutional framework of the banking sector by mid-1997 in five countries heavilyaffected by the EastAsiancrisis (Table 12). Table 12 showsthat Thailand, the country that triggered the EastAsian crisis, can be described as weak in bank regulation and supervision while the other countries (e.g., Indonesia, Malaysia,Korea, and the Philippines) had weak to fair scoring on bank supervision. The weak bank supervision, low borrowing cost,and the euphoria of historically high growth rates in the affected EastAsiancountries led to excessiveinvestmentsin riskyand low-profitability projects. There washigh investment in the non tradeable sector, especiallythe property market which fed into a property bubble. Table 13showsthat Thailand, Malaysia,and Indonesia merited "high" rating in terms of the property sectorrisksbecauseof the large proportion of property sectorloansaswell asloans collateralizedby real property. Corsetti et al. (1998)noted that there wasa high rate of nonperforming loansbefore the crisisat more than 15 percent in Thailand, Indonesia, Korea, and Malaysia.Indeed,the three authorsemphasizedthat rising nonperforming

134

FINANCIAL LIBERALIZATION,MANAGINGRISKS ANO OPPORTUNITIES

the expansionary credit and monetary conditions in the domestic economy thereby generating an economic bubble stopsand reverses.This resultsin a currency and economic crisisas the capital account reversalforces a reversal of the current account from a deficit position to a surplus.This is only possible in the short-term through a sharp reduction in domestic absorption suchas an economic recession. The European experience: The EMS currency crisis of 1992-1993 The European Monetary System(EMS) currency crisisof 1992-1993showed the pitfalls of fIXed exchange rate regimes with free capital movement when there is no full coordination of macroenomicpolicies among the membersin the currency zone. By the late 1980s,virtually all the European Economic Community (EEC) members had eliminated capital controls thereby ensuring free flow of capital within the Community.The financial marketsbecame increasingly convinced that there wasinconsistency between the macroeconomic regime of the lead country (Germany)and the macro-economicneeds of other membersin the EMS such that exchangerate realignments hadw be done. Specifically,Germanypursued a historically high interest rate regime in prder to dampen inflationary pressuresfrom high fiscal expenditures of the German reunification. On the other hand, Germany's trading partners needed lower interest rates in order to reduce their growing unemployment problem. However,the trading partners needed to match Germany'sinterest rates in order to maintain their EMSparities. The financial marketsincreasingly believed that the position of Germany'strading partners wasuntenable and there would be a growing probability of devaluation.The currency attacks on the EMS currencies occurred in September1992 that led to the devaluation of the lira and the pound and the eventual abandonment of the EMS. Spanishwasalso devalued but preferred to stayin the EMS. Speculation on the French franc wasquelled only after sharp rise in interest rate and after heavyintervention by both the Frenchand Germancentral banks.The speculative attacks on the currencies recurred in 1993 until the EMS countries adopted wider exchange rate bands allowing for greater exchange rate flexibility (Blanchard 2000;Arestis et al. 1999). A closerview ofthe EMS currencycrisis of1992-1993: The lira, the pound sterling, and the Frenchfranc

in the 1992-1993 crisis

National authorities in the EEC ushered in their symbolic commitment towards monetary union when nominal exchange rates within the ERM started to be rigidly fixed inJanuary 1987 for nearly the next five years (called as the

.55

LIBERALIZATION AND INTEGRATION IN THE APECREGION 135

Table13. Indicators of institutional framework (mid 1997) Country

Property Sector Risks

Exposure % of Total loan

Hong Kong

Mod.

40.

Indonesia

High

25. -30

Korea

Mod.

10--15

Malaysia

High

30.

Philippines

Mod.

15- .20

Singapore

Mod.

30. -40-40

Thailand

High

Notes

"High" risk because of large proportion of loans collaterised by real property.

Sources:

J.P. Morgan 1998 cited in ADB 1999

-40

of property loans and large proportion

hard or new EMS). In contrary, during period 1979-1987there were 11 realignments that took place in the ERM (called the soft EMS). In addition, the hard or new EMS emerged in a changing environment when restrictions to capital flows within the European Community were beingrelaxedbyvinue of the completion of the Single European Act (SEA) in 1992 (Fratianni and Artis 1996). Thus, when European headsof statemet and finalized the Treaty on European Union in 1991, otherwise known as the Treaty of Maastricht, monetary union in Europe became inevitable. The treaty devised a threestagegradual evolution or transition towardsthe ultimate objective of adopting a single currency. However,as early as 1989and in late 1990,there were signs in the new EMS that the systemwasunder stress,which might imperil the whole process. First, although the new EMS achieved some nominal convergence when double-digit inflation rates beginning in the 1980swere reduced to single digit levelsacrossthe member countries (e.g., France,United Kingdom, Italy and Finland). Inflation rate differentials were accumulating and showing no signsof reversal (Table 14). Second,the Germaneconomic unification wasa major and powerful asymmetricexternal shockthat ultimately exposedcracks and defectswithin the system.Finally,the rejection of the MaastrichtTreatyin the 1992 Danish referendum and its near rejection in France led financial marketsto doubt the whole processof economic and monetary union (EMU) in Europe, insofar asto the political commitment of the countries (Artis and Fratianni 1996). In turn, the awarenessof financial marketsthat political com-

138

FINANCIAL LIBERALIZATION,MANAGINGRISKS ANO OPPORTUNITIES

increasein the public sector deficit led to a very high debt-to-GDPratio, which had exceeded 100 percent by 1990 (Table 15). The combination of high costsand deteriorating competitiveness,a very high public-debt-to-GDP ratio, and high unemployment rate at more than 10 percent, made the Italian lira an excellent and ripe target for speculators. No astute enthusiastof open economydynamics shall miss that in a condition where there is high unemployment and risk of debt explosion, interest ratescould not be raisedand maintained for very long to fend off and parry speculativeattack on the currency.Eventually,in spite of heavyintervention by the Bankof Italy in the foreign exchangemarket,the Italian lira pierced its fluctuation band on September17, 1992,and waspushed out of the ERM on the sameday (Grahl 1997; Masera(1994); Micossiand Padoan (1994). Thepound sterling: thecase ofan overvaluedentry

Prior to the United Kingdomjoining the ERM in October 1990,an excessively lax monetary policy characterized British Thatcherite monetary policy at the end of the 1980s. By 1988, inflationary pressureshad developed and the balanceof paymentswasdeteriorating atan alarming rate.The apparentcause wasthat a very rapid growth of domesticcredit waspermitted and evenencouraged byUnited Kingdom monetaryauthorities. It wasvery clear that monetary policy had to be tightened and in teres t rates ended at 10.3 per cent at the end of 1988. Further increasesin the following year sawthe interest rate climbing to 13.9 percent by the end of 1989(Table 16). However,real economic activity swiftlysloweddown, leading to serious recession between 1990 and 1992 (Table 17). Businessconfidence waned and companyshutdownsbecamemore frequent asthe rate of unemployment intensified. In the housing and construction sectors (a vital sector of the United Kingdom economy), high mortgageratesclosedoff housing demand, and the excesssupply of commercial property asa carryover to the massive

Table 16. Short-term

1987

1988 1989 1990 1991 1992

Gennany 4 4.2 7.1 8.4 9.2 9.5

interest rates

France 8.2 7.9 9.3 10.2 9.7 10.5

Italy 11.5 11.3 12.7 12.4 12.2 14

lI< 9.7 10.3 13.9 14.8 11.5 9.6

140 FINANCIAL LIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

Table 18. How c;ompetitive

was UK?

Export prices relative to

Balanceof payments

world prices

Current account

(1987 = 100)

1986

119.5 116.7 109.5 104.4 100.9 104.1 98.8

1987

100

1988

106.4

1989

103

1990

103.6 102.7 105.9

1980 1981 1982 1983 1984 1985

1991 1992 Source:

as % of GDP

1.5 2.5

1.5

0.9 -0.2 0.5 -0.8 -2 -4.8 -5.4 -4.2

-1.8 -2.7

Grahl1997

interest rateswere more severewhile the expansionary effects of the German unification wasless beneficial for the United Kingdom than for the other European countries. This isbecausethe United Kingdom has stronger trade links with North America and competes with the United States in many international markets. Throughout the summer of1992, a ferocious attack wasmounted on the pound sterling and other vulnerable currencies of the mechanism. Germany offered no relief to its partners. In July 1992 it once again raised interest rates. The crisis broke out in September 13 when the lira was devalued. At the last moment the Bank of England raised its rates from 10 percent to 15 percenton September16.However;the movelacked credibilitybecauseitwashard to believe that such rates could be maintained for long. On that evening the pound sterling along with the Italian lira left the ERM (Grahl 1997; Barrell et al. (1994). This irrevocable decision came to be known as Black Wednesday. The battle oftheFrenchfranc

The caseof the franc was different from that of the lira or pound sterling. There were neither clear evidenceof overvaluation nor clear signs of com-

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION141

petitivenessproblems.There wasno fundamental disequilibrium in the franc/ D-mark exchange rate. France'srate of inflation had been brought into line with Germanyand the French current account wasin a surplus (Table 19). However,a few daysafter the far-from-overwhelming victory of support for the MaastrichtTreatyon september23, 1992,an unsuccessfulattackagainst the Frenchfranc waslaunched. However,in order to support the currency,the Bank of France had to suffer about Fr 80 billion loss in reserves.In addition, capital controls, which were earlier abolished through the Single European Act (SEA), had to be momentarily reintroduced in order to ensure the survival of the French franc inside the ERM and help mitigate the likely repercussionsof a franc devaluation on the French economy. What could have triggered the attackdespitethe fact that Frencheconomicfundamentalswithin the systemwere relativelyhealthy? An offered explanation to the Frenchfranc caseused the conceptof the n-l problem in a systemof fixed exchangerate. Box I provides a basicdiscussion of this fundamental problem. At the startof the 1990s,the combinationof the continent-widerecession and the GermanEconomic and MonetaryUnion (GEMU) posedmajor dilemmasto most members of the ERM, especiallyFrance. A conflict occurred beTable 19. French and Germarl economies France

Economic

GrowtlJ1987 1988 1989 1990 1991 1992 1993 France

2.3 4.5 4.3 2.5 0.7

1.4 -0.9

1987

Economic Growth -1~4-

1988 1989 1990 1991 1992 1993

3.7 3.4 5.1 3.1 2.1 1.4

Inflation Rate 3.2

Current Account % of GDP -0.6

Unemployment Rate 10.5

2.7

-0.5

3.4

-0.6

9.4

2.9 2.9 2.3 2.3

-1.3 -0.5 0.3 0.4

8.9 9.4 10.3 11.8

Inflation Rate 0.6

Curren Account % of GDP 4.1

1.4 3.1 2.6 3.8 4.7 4

4.2 4.9 3.2 -1.2 -1.3 -1.5

Unemployment Rate 7.6 7.6 6.9 6.2 6.7 7.7 7.5

142

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

tweenthe two main driving forcesof EuropeanintegrationGennanyand France, asto the appropriate interest rate policy to be followed in the whole system. Box 1:The Conceptof ~l Problemin F1XedEXCbMgeRa~ How to set tht: system-wideJevel of money stock and the interest rate are two fundanentll problems that every systemoffixed exchange rates confronts. Th,is is known as the so-called n-l proble1n.In a system of n countries, ther.~ ar(~only n- [independent exchangerates,Therefore, n~l monetary autllorities had to adjust their monetary policy in order to maintain CIfixed parity for their exchange rate, TherewiU be one monetary autI-.lority, which is free to set its monemry policy inde. pendently. Thus, tile system has one degree of freedom.. .:Thefundamental problem, tl'en is, how this degree of freedom wiU be used. Two solutions are the so-called asymr:.1etricor hegemonic solution, where one country , ," IS allowed to take a leadershIp role. The choiceoftheJeaderde..' l' b .."".7 . ... fl pen ds on Its reput\uon m mamtaInmga 1owm auon~qulL,num. The so-called symmetric or cooperative solution is where countries in the system decid':C: J'ointl y about the level of their money, supply . and interest rates.

The inflationary pressurescreated by the massiveincrease in government spending and fiscal transfers brought about by GEMU forced the Bundesbankto pursuea contractionaryor restrictivestancein monetarypolicy. The recessionin France,and also in the United Kingdom (asdiscussedearlier) demanded a looser and expansionarytype of monetary policy. As Germany wasincreasingly dominating the systemby becoming the nominal anchor of the system,France and the United Kingdom repeated demands of a looser monetary policy by the Bundesbank,which, however,were unheeded. The policy conflict between Germanyas well as the United Kingdom and France,convinced speculatorsthat Frenchand United Kingdom authorities would later on cut their link with the mark in order to allow more expansionarymonetary. What happened (the so-calledself-fulfilling expectations)

6 The discussion here were mainly drawn from De Grauwe (2000). 7 In the case of the EU, it was widely accepted this role was being fulfilled through the Bundesbank

(BuBa).

by Germany

FINANCIALLIBERALIZATION ANO INTEGRATION IN THE APECREGION 143

was,speculators had started to engage in a one-waybet against the pound sterling and the French franc (Melitz 1994;De Grauwe2000). Capital controls and the Chilean and Malaysianexperiences One wayof addressing the "impossible or incompatible trinity" problem was by "throwing somesand on the wheelsof international capital." This imposed somebarriers to international capitalmovement.This wasin viewof the difficulties of managing capital inflows when the financial sectorwasnot yet well developed,the regulatory supervisoryframework left much to be desired and the monitoring and implementation capability of countries remained weak. Malaysiaand Chile have been successfulin the use of capital controls as a macroeconomic tool. Their successled to a positiverethinking in recent years by analystsand countries on the role of capital controls in macroeconomic management. This is on a temporary and transitional basis,in the meantime that developing countries do not yet have the regulatory, supervisory,and monitoring infrastructure and capability to managea fully liberalized financial sectorand open capital accounts. Malaysia Malaysiaused capital controls temporarily to manage capital inflows in the early 1990sand to manage capital outflows in the wakeof the EastAsian crisis in 1997-1998. Malaysiaexperienced strong surge in capital flows in the early 1990s. Capital account surplus asa ratio ofGDP during 1990-1994averaged10.2 of GDP.This wascompared with Thailand's 10.1 percent, Indonesia's 4.0 percent, and Korea's 2.0 percent of GDP (Parkand Song 1997).Unlike Thailand and Indonesia however,Malaysia'scapital inflow consistedlargely of foreign direct investmentand portfolio investment,and not foreign borrowings. Malaysia,like Thailand and Indonesia, had to resort often to monetary sterilization in order to control excessliquidity and thereby contain the inflationary effect of the capital inflows. It relied on changesin the statutory bank reserve requirement, taking out loans of lessthan 3 months in the interbank market and flotation of Bank Negara bills and Malaysiasavingsbonds. In addition, it ordered the transfer of the depositsof the Employee Provident Fund and those of the government from private banks to the central bank. This is a significant move becausethe fund accountsfor about 20 percent of the total financial assetsin the country. Malaysiaalso resorted to fiscal consolidation with the decreasein the fiscal deficit and eventual surplus by 1993 (Park and Song 1997).

144 FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

Malaysiadid not rely much on the fiscal sector in order to manage the surge in capital inflows, unlike Thailand. Instead, in january-February 1994, Malaysiaimposed direct and market-basedcapital control measuresto help contain the flow of speculative short-term capital. The short-term capital inflows consistedmainly of external borrowing by commercial banksand placements of ringgit depositsby foreigners with Malaysianbanks (Ariyoshi et al. 1996). Malaysiaresorted to capital controls becauseof the growing cost of monetary sterilization and to delink the offshore ringgit market mainly in Singapore from the onshore ringgit market. Moreover,the monetary sterilization led to high domestic interest rates than abroad, thereby encouraging further capital inflows that speculateon possibleringgit appreciation. Malaysia curtailed monetary sterilization when it imposed direct and market-based capital control measures. The capital control measuresincluded (Ariyoshi et al. 1996): .The prohibition of residents to sell short term Malaysian money market instruments to nonresidents; .The prohibition of commercial banksto engagein nontrade related bid-side swapor forward transactionswith nonresidentsand thereby reduce speculativeactivitiesof offshore agents; .Limits on banks' external liability positions with nonresidents excluding trade-related and Fill flows; and .A noninterest-bearingdeposit requirement for banksagainstringgit funds of foreign banking institutions. In addition, Malaysiaimposed prudential reserveand liquidity requirements to foreign currency deposits,foreign currency borrowing from foreign banking institutions, and interbank borrowing (Parkand Song 1997). Malaysia'simposition of the capital control measureswasmeant for a short time to addressthe sharprise in whatwasperceived to be destabilizing capitalflows.The immediate market responseto the capital control measures was a ringgit depreciation and the cooling off of the Kuala Lumpur Stock Exchange. Thus, the capital control measuressucceededin easing the pressures for appreciation of the ringgit and in cooling off the fast rising stock prices. With the successfulstabilizationof the Malaysianeconomyduring the year,where the interest differential between domestic and foreign interest rate decreasedand the inflationary pressureseased,the capital control measureswere lifted within the year (1994). Malaysia'sexperience with the use of capital controls againstspeculative capitalflows wasinstructive.This meansthat, with sound economic funda-

FINANCIALLIBERALIZATION AND INTEGRATION IN THE APECREGION 145

mentals and good administrative capacityof the institution, capital control can be a viable tool for short-term macroeconomic management. Most especially when conventional sterilization measureshave become expensiveand ineffective in addressingpotentially destabilizingspeculativeshort-term flows that respond essentiallyto short-term interest rate differentials and expectation of currency appreciation. While Malaysiadid not escapethe contagion from the baht devaluation and the EastAsian crisis, Malaysiaproved more resilient than Indonesia or Thailand. When the standard sterilization measuresproved expensive and ineffective in curtailing short capital inflows, Malaysiaimposed capital controls. Its successmeant that short-term debt is a low shareof total external debt in Malaysiaas compared to Thailand and Indonesia. Moreover, the preponderance of FDI in its capital inflows underscored the underlying soundness of Malaysia'seconomic fundamentals. Thus, Malaysiawaslessvulnerable to capitaloutflows. Moreover,itssuccessfulexperiencein utilizing capitalcontrols as a tool of short-term macroeconomic management in 1994explains why Malaysiarelied on capitalmeasuresagain in 1997-1998to stemcapitaloutflows. As in 1994, Malaysiaalso succeededin its use of capital control measuresin 1998-1999.Malaysiaundertook selectivecapital controls on September 1, 1998as part of a shift in macroeconomic strategy from a "virtual IMF style" contractionary fiscal and monetary policy at the start of the East Asian crisis in the latter part of 1997toward a more expansionarymacroeconomic policy (Piei and Tan 1999).8The Malaysianeconomy went into recessionin the first half of 1998as aftermath of the depreciation of the ringgit from the baht contagion, high interest rate from the tight monetary policy, and the reduction of government expenditures required of a tight fiscal policy. In the National Economic RecoveryPlan launched in July 1998,Malaysiashifted gearstowardsan expansionarymacroeconomicpolicy in tandemwith fiJlancial restructuring and easingup of foreign equity restrictions in selectedareas. An important component of the macroeconomicstrategywasthe stabilization of the currency in the face of the regional financial uncertainty on the one hand and the reduction in the domestic interest rate (ascalled for by the expansionarymacroeconomic policy) on the other hand. Otherwise, there would be capital outflows given the large negativeinterest rate differential. A high domestic interest to prevent capital outflows wasone of the reasonsfor the Malaysianeconomic recessionin early1998.This necessitatedeffectively

8This paragraph

and the next few paragraphs

draw heavily on Piei and Tan (1999).

146 FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

in insulating the domestic currencyand monetaryregime from the restof the region and the world. Malaysiadecided to peg the exchangerate and at the sametime impose selectivecredit controls. The selective credit controls were asfollows (Piei and Tan 1999): .Controls on ringgit-denominated transactionsamong residentsvia nonresident external accounts; .Controls on outflows of short-term capital with a requirement that such inflows must stayin Malaysiafor at leastone year.This waslater replaced on February 4,1999 by a graduated exit levy (between 10 percent to 30 percent) depending on the duration of the investment and when the funds were brought into the country; .Prevention of import and export of ringgit by travelers, residents, and nonresidents; and .Governmen t approvalrequired for Malaysianinvestment abroad. There were no controls on current account transactions,repatriation of interest, dividends, fees,commissionsand rental income from portfolio investmentsand other forms of ringgit assets,and inflows and outflows of foreign direct investment. One key Objective of the controls wasto ensure stabilityof the exchangerate in the faceof the currencyvolatility in the region. Another objective wasto makethe ringgit a nonlegal tender abroad (note that there wasthen a large offshore market for ringgit especiallyin Singapore),as suchwould encouragethe remittance of ringgit backto Malaysia(Pieiand Tan 1999). This is becausemuch of the capitaloutflows from Malaysiawasringgit (not foreign exchange)flowing into Singaporeto take advantageof the much higher money market rate there. The outflowsamounted to asmuch as50percent of Malaysia'snarrow money in mid-1998,thereby making Malaysianauthorities worried about the "internationalization" of the ringgit, with the attendantloss of the effectivenessof Malaysia'smonetarypolicy (Athukorala 2000). The expansionarymacroeconomicpolicy cum selectivecapital controls succeededin regenerating an economic recoveryof Malaysianeconomy,including that of the Kuala Lumpur StockExchangewhich in 1999wasone of the top performers in the region. The exit levywaseventuallywound down in late 1999. It needs to be emphasizedthough that the implementation of the capital controls wassensitiveto the market: the replacement of the one-year parking period by a more "market-friendly" exit levyoccurred when portfolio funds were starting to return to the region in early1999.There appearsto be not much capital outflow that occurred when the exit levywasstopped. Thus, on the whole the temporary selectivecapital controls and levysucceededin

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGIONl47

insulating the Malaysianeconomyand allowed for the implementation of a macroeconomic strategythat allowed the recoveryof the economyin the face of the prevailing regional financial and economic uncertainty. Chile

While Malaysiaused capital control asa temporarymacroeconomic management tool, it was Chile's apparently successfuluse of capital control as an integral part of its macroeconomicstrategyduring much of the 1990sthat has made Chile's experience a runner-up in the economic policy experiment after the EastAsianfinancial crisis.Chile experiencedrobusteconomic growth during the 1990sdespite the capital control measures.In addition, Chile largely shrugged off the contagion from the EastAsian financial crisis. Thus, the strong worldwide interest in understanding the Chilean experience with capital controls. Chile's use of capital controls wasin responseto its disastrousexperience with surge in capital flows in the late 1970swhich ended up in a serious economic crisis in 1981-1982,popularly known as the Southern Cone experience. Chile undertook major structural, macroeconomic, and prudential reforms in the aftermath of the 1981-1982crisis.The reforms involved greater export orientation, tighter expenditure control in order to dampen inflation and ensure a current account deficit at a manageablelevel, and stricter prudential regulations over bank behaviour.Chile recoveredwell from the 19811982 crisis, such that the economy started overheating by 1989when GDP grew by 10 percent and inflation surged. The government gradually raised interest rates during 1988-1990to help dampen the inflationary pressures. However,the higher domestic interest rate coupled with the decline in world interest rate and the improvement in market sentiment in Chile led to a resurgenceof capital inflows beginning 1989. In order to prevent a significant real appreciation of the Chilean currency, its central bank initially purchasedheavilyforeign exchangeand sterilized much of the intervention in order to reduce the monetary effect of the rise in international reservesfrom central bank's intervention in the foreign exchangemarket. This, however,wascostlyfor the central bank in viewof the large interest differential and thus could not be sustainable (Laurens and Cardoso1998). Monetarypolicy wasnecessarilytight, resulting in real interest rates averaging6 percent per annum in tandem with the deceleration in the inflation rate in the early 1990s(Le Fort and Budnevich 1997). Considering that the primary reason for the massivecapital inflows into Chile in the late 1970swasthe high domestic interest rate over foreign interest rates, Chile

148 FINANCIALLIBERALIZATION MANAGING RISKSANO OPPORTUNITIES

imposed capital controls to regulate or temper its financial integration with the rest of the world in the light of its domestic objectivesand concerns. In addressingthe trade-offs inherent in the incompatible trinity theorem, Chile ultimately decided to impose capital controls rather than allow a significant appreciation of the Chilean currency which would have adverselyaffected the export competitiveness of the its economy. It wasconsidered the country's export-oriented development strategy.It wasalso a responseto the growing concernsvoiced by the country's politically powerful exporters of strengthening the Chilean peso in real terms, in the sameway that it would help the country's export competitiveness(Edwards1999). Chile's major regulations on capital movementsare asfollows (Le Fort and Budnevich1997): .Direct investmentinflows: minimum stayof one year for the principal .Portfolio investmentthrough American DepositoryReceipts(ADRs): -minimum credit ratings by three internationally recognized rating agencies;and -BBB or better for nonfinancial companies, BBB+or better for financial companies, minimum amount condition, unremunerated reserverequirement (URR). .Other portfolio capitalflows: unremunerated reserverequirement (URR) -to be kept with the Central Bankin dollars .Loans and bonds: unremunerated reserverequirement (URR); , -minimum credit-rating and minimum amount requirements .Deposits and creditlines:unremuneratedreserverequirement (URR) Chile's capital control measureswere meant primarily to raise the cost of foreign borrowing and tax short-term capital inflows, to ensure credit worthiness of Chilean firms and banksborrowing abroad, and bias the composition of capitalinflows toward foreign direct investmenLWiththe exception of the credit rating requirement, Chile's major price-basedcapital control measure (i.e., Unremunerated Reserverequirement) is similar to Malaysia's.The major difference between Chile and Malaysiais that the imposition of the reserve requirement wastemporary in Malaysiaand decade-longin Chile. Table 20 (Ariyoshi etal.1996), presentsthe evolution of the implementation of the unremunerated reserverequirement in Chile. Notice that the coverageof the URR wasexpanded over time in order to cover loopholes. Chile's experience wastypicalmarket participants found waysof circumventing the regulations which made suchrestrictions increasinglyineffective un-

150

FINANCIAL LIBERALIZATION,MANAGINGRISKS ANO OPPORTUNITIES

Table 20 cont'd. September 1998: URR rate reduced to zero percent. Requirements for foreign investors to keep their money in the country for at least a year maintained

Adjustment to international capital market environment.

Source IMF, Annual Report on Exchange Agreements and Exchange Restrictions (various issues) Reprinted: Ariyoshi, et. al. (1996)

Table 20 shows that a successful management of capital control measures is a technically-capable administrative machinery (e.g., central bank) that can effectively monitor and make appropriate adjustments in the measures of the dynamic changes in the domestic and foreign financial markets. That is, the implementation of the capital control measures requires strong enforcement capability of central banks (Laurens 1999). Both Chile and Malaysia are known for the quality of the institutional capacity of their central banks, which is considered much better than the average developing country central bank. The goals of Chile's capital controls were to: (a) slow down the volume of capital inflow and bias the composition of capital flows towards longer-term maturities; (b) reduce or delay the appreciation of the Chilean peso in real terms arising from the capital inflows; and (c) maintain the high interest differential in Chile. Corollary to the above three goals wasthe reduction of the vulnerability of the country to international financial instability (Edwards 1999). A number of studies have examined the effectiveness of Chile's capital controls. Nadal-De Simone and Sorsa (1999), after reviewing the various studies on Chile's capital controls especially the URR, concluded: "...there is some evidence that the URR has been successfulin increasing domestic interest rates; there is relatively weaker evidence that the URR has altered the composition of capital inflows in favor of medium-to long-term capital inflows; there is mixed and weak evidence that the URR has reduced the magnitude of capital inflows and actually no evidence that the URRafIected the level of the real exchange rate."

Nadal-de Simone and Sorsa (1999) noted however that the empirical studies they reviewed had significant econometric or misspecification problems that castdowns on the robustnessof the results. URR impact on the domestic real interest rate are significant because capital controls could provide some leeway for an independent monetary policy.This wasespeciallyimportant for Chile's heavyuseof indexation in the

FINANCIALLIBERALIZATION AND INTEGRATION IN THE APECREGION 151

economy. Edwards (1999) pointed out that the independence of monetary policy had one important cost. That is, the resulting high real interest rates meant high cost of capital especially for small and medium enterprises. For example, Edwards noted that the cost of funds in US dollar terms for smaller Chilean firms was as high as 21 percent in 1996 and 19 percent in 1997. The findings on the impact ofURR on the volume of capital flows and the real interest rate are likely the less robust. The volume of capital flows did not only respond to the URR but also to the gamut of costsand opportunities in Chile. It is worth noting that the Chilean peso appreciated in real terms by about 28 percent during 1991-1998 as against more than 20 percent during 1985-1990 (Edwards 1999) and about 30 percent during 1979-1981 (Corbo and De Melo 1987). The average rate of real currency appreciation was lower during the period of capital controls despite the high real interest differentials during the 1990s. It appears therefore that, while capital controls did not significantly affect the real exchange rate in the long-run, the pace of appreciation wasmoderated that allowed Chile's industry to adjust better. Indeed, it can be argued that behind the crisis in the early 1980s in Chile was precisely the too abrupt real exchange rate appreciation that wrought havoc on Chile's real economy and export sector. The mixed evaluation on capital control impacts to Chile revealed that capital controls are not a panacea. Indeed, it is best to view such measures as part of a broad program for macroeconomic and structural reforms in Chile that was on the whole skillfully coordinated (Ariyoshi et al. 1996). The macroeconomic policy environment was one of tight monetary and fiscal policy in order to dampen inflationary pressures, in the light of indexed price usage in Chile. In this context, capital control supported the high interest target consistent with the antiinflationary stance of the government. At the same time, Chile's exportorientation included a reduction in tariffs and trade protection as well as a bias for foreign direct investment in capital inflows. Chile imposed ".. .high disclosure standards, stringent rules for loan classification and provisioning, strict limits on connected lending and on banks' exposure to foreign exchange risks, and clear procedures for correction of liquidity or solvency problems" (Laurens and Cardoso 1998). Thus, to some extent, capital control measures in Chile were also as much for prudential regulation as for macroeconomic management. In short, capital controls are not meant to be a substitute for sound macroeconomic policies, not overly rigid exchange rates, and strong prudential regulations and banking supervisory systems to reduce moral hazard and corruption (Edwards 1999). At the same time, however, a flexible use of taxation of capital inflows is useful when there are signs that the magnitude of inflows would be at variance with the overall macroeconomic policy stance.

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Like in Chile, when the international financial environment changed against emerging marketsduring the EastAsian crisis,the tax on capital inflows could be reduced to zero. Fmancialliberalization and the sequencingissue The conventional view on liberalizing the capital account is that it should follow the opening of the current accountand the domesticfinancial system based on the arguments of Mckinnon, Frenkel, and Edwards. Others have argued for simultaneous liberalization of the Current and capital accounts and have been advancedby Little et al., Michaely and Krueger. It is only recently that the sequencingdebate now encompassesnot just the sequencing of the current and capital account, but is now expanded to other markets. Johnston et al. (1992)emphasizedthat sequencingwasmore complex so that stylizedprescriptions were misleading. Undertaking the liberalization of the capital accountand other aspectsof economicand financial sectorreform are complex and require attention to linkages among specific components of broader reform areas.The emphasisis on the need for an integrated approach towards capital account liberalization, it being a part of the overall reform process (Schnejder2000). What maybe more important is the issueof sequencingin the liberalization of the various components of the capital account. Reisen (2000), for example, pointed out that foreign direct investment and trade related finance need to be liberalized immediately because they are important for growth and yet they have little adverseimpact on macroeconomic management and financial sectorstability.On the other hand, liberalization of shortterm bank lending and other volatile short-term flows (e.g., hedge funds) must be deferred until a country hasstrong prudential regulations and supervision and that the domestic financial sector is deep enough to withstand shocksfrom capital flow reversals.Underpinning the sequencing approach to the liberalization of the variousforms of capitalflowsis to ensureproductive use of inflows for greater efficiency and growth whil e at the same time maintain macroeconomic and financial stability. Selectedcountry experiern:eswith sequencingcaPital accountliberalization 9 TheChilean experience

Prior to 1973,the financial sector in Chile washighly regulated. Interest rate ceilingsand credit restrictionsinhibited the domesticand international move9This section draws heavily from Johnston et al. (1992 and 1997).

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ment of capital. An extensivemultiple exchangerate regime wasusedby the government to direct the flow of capital to preferred sectorsof the economy (Dobson1998). In 1973,GDP fell by 5.6 percent, the fiscal deficit reached21 percent of GDP,and the inflation rate wasapproximately 500percent. The Chilean authorities followed programs of stabilization and sweeping liberalization measures primarily in the financial sector between 1974 and 1981.The multiple exchangerate regime wasabolished and replaced by a crawling peg exchange rate regime. The main elements of the financial sector reform are the following: .All but one of the 20 domesticallyowned commercial banks were privatized. .New financial institutions were created. .Foreign bankswere allowed to open numerous branches and purchaseChilean banks. .Banks were allowed to borrow abroad. .Minimum capital requirements were increasedand penalties were imposed for noncompliance. Restrictionswere placed on the concentration of bank ownership and bank disclosure; however,difficult to enforce and were removed in 1978.Reporting requirements were strengthened. .The jurisdiction of supervisoryauthorities were widened to include all financial institutions. .Initially, the 1974interest rateson short-term capital market transactions outside the commercial banking sector were liberalized. A year later, liberalization of commercial bank interest ratesfollowed. .Quantitative controls on bank credit were abolished and selective credits to priority sectorswere reduced. Although current account wasliberalized and domestic regulatory financial reform wasintroduced at the beginning of the reform process,it was not until 1977 that the government beganto remove capital account controls for the financial sector (Dobson1998). Within two yearsafter Chile fixed its exchangerate in 1979,the degree of overvaluation of the real exchange rate had become significant and ultimatelyunsustainable..Thereal interest ratesrose from 9 percent in 1980to 29 percent in 1981 and then to 48 percent in 1982 (Dobson 1998). The combination of the overvalued peso and the high interest rates led to widespread bankruptcies. Subsequently,a run on a major bank occurred and stockmarket crashed.This left many corporations insolvent, since they had collateralized

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loans with borrowed shares.In 1982,the pesodevalued,further damagingthe solvencyof the businesssector,which wasalready heavilyindebted with foreign loans.The crisisresulted in a temporaryreversalof someof the liberalization measuresand in a strengthening of regulations and supervisoryarrangements. The fixed exchange rate was abandoned in 1982. During the three months that the pesowasallowed to float, it depreciated by 43 percent. The crawling peg regime was subsequentlyreinstituted. The Central Bank attempted to deal with the crisis by making additional funds available to the banking systemand to borrowers, buying nonperforming foreign currency loans, and rescheduling remaining foreign currency loans at favorable exchange rates. In late 1983liberal capital account rules were abandoned. In addition to reinstituting exchange controls, the government raised the uniform tariff rate to 20 percent in an attempt to build the foreign reservesto meet external debt obligations (Dobson1998). Capital account measureshave been gradually relaxed since Chile's recoveryfrom the banking crisis. Although selectiveand initially focused on liberalizing capital inflows, the following were evident: .The central bank's foreign exchangeregulationspermitted foreign direct investmentinflows through debt/ equityswaps.However,capital from these investmentscannot be repatriated for 10 yearsand profits for four years. .Also as an amendment to the foreign exchange regulations, nonresidents were permitted to purchase selective debt instruments, but the sourceof foreign exchangeand the conversionshad to take place outside the official foreign exchangemarket. .In 1986and 1987,nonresidentswere permitted to investin publicly offered instruments with the repatriation of the original capital after five yearsand no limit on profit remittances. .In 1991, residents were allowed for the first time to use foreign exchange obtained from unofficial foreign exchange market to investabroad. At the same time, new restrictions were introduced on capital flows. The central bank introduced a 20 percent resexverequirement on new foreign borrowing. Subsequently,the resexverequirement wasextended to most outstanding foreign borrowing and foreign currencydeposits;it wasincreased to 30 percent. Although, in 1993the minimum period for capital remain in the country wasreduced from three yearsto one year.

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The Southeast Asian experience

Indonesia's experience with capital account convertibility has been unconventional. The capital account wasliberalized prior to financial sector reforms. The capital account wasliberalized as earlyas 1971,when the rupiah wasmade freely convertible, and a managedfloating exchangerate indexed to a basketof currencies. It also had eliminated most controls on capital outflows while retaining controls on capital inflows. Prior to reform, monetary policy wasbased on interest rate controls atstate-Qwnedbanks (interest rates charged by private banks and nonbank financial institutions were not controlled), credit ceilings, and accessto central bank liquidity credits. Financial reform, occurred in two stages.The first stagestarted in 1983. It focused initially on establishing the financial markets, institutions, and instruments for a more market-basedsystem.Credit ceilingswere eliminated, interest rate controls on depositratesat state-ownedbankswere removed,and the modification of the central bank's liquidity credit program. Open market operations using regular auctions of central bank certificates (SBIs)became the main monetary instrument. New money market instruments (SBPUsor banker's acceptances)were introduced. The second stage which was in 1988and known as Pakto, focused on promoting competition in the financial sector. It permitted greater foreign participation in the financial sector through the licensing of new foreign banksand branches. It createda level playing field for foreign and domestic banksand permitted foreign participation in other typesof financial institutions as well as in the insurance business.Moreso, the arrangements eased some requirements for becoming a foreign exchange bank, reduced the required deposit of state-ownedenterprisesin state-Qwnedbanks,and lowered the reserverequirement while raising minimum paid-in capital. Measuresto strengthen the regulatory framework for banking operations only started in 1995-1996when regulations were issued to upgrade the accounting standards to ensure compliance with prudential guidelines to safeguard against excessiverisk taking through derivative tradings. The first phaseof financial reforms in Indonesia did not involve banking systeminstability. However,soon after the 1988reforms, the weaknessin bank supervision and regulation and in banking solvencywere highlighted when two private banks faced short-lived bank runs and liquidity problems that were controlled through lender-Qf-last-resort support from Bank Indonesia. In 1988,Indonesia also liberalized paymentsand transfers for current international transactionsand acceptedthe obligations of Article VIII of the

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IMF's Articles of Agreement. In addition, the selling of swapsin the foreign exchange market wasliberalized. Subsequently,in 1989,domestic banksobtained accessto international markets, through the following: .Elimination of quantitative limits on bank borrowing from nonresidents; and .Foreign direct investorswere allowed to sell foreign exchange directly to commercial banksinstead of through the central bank. During the 1990-1991 period, there were a mixture of liberalization measures and restrictive policies that were pursued by Indonesia. Concerned that the substantial inflows of foreign capital mainly in the form of commercial bank borrowing was excessive, it introduced stricter limits on the open foreign exchange positions of banks and reduced their foreign exchange swap positions as a percentage of their capital base. There was also a limitation on public sector borrowing from abroad, which remained in place until 1996. Nevertheless, Indonesian authorities continued to broaden arrangements for foreign borrowing by private entities. The sales of securities to nonresidents were permitted and foreign direct and portfolio investment through the stock market was liberalized. Indonesia initially seemed poised to weather the 1997 Asian financial crisis because of stronger fundamentals, including a relatively smaller external current account deficit and its decision to widen the trading band of the rupiah. However, after the depreciation of the Thai baht in July 2, 1997, pressures on the fixed rate at which the Indonesian rupiah was pegged went up. On August 14, the rupiah wasallowed to float. The Indonesian rupiah depreciated rapidly, exposing the underlying weakness of the financial sector. The Indonesian government announced in two instancesNovember 1997 and January 1998 that it was availingofIMF-supported economic program. In the context of the IMF program, Indonesia is scheduled to undergo widespread structural reforms and a comprehensive plan to rehabilitate the financial sector. Thailand already has a fairly liberal capital account since the 1970s, while the financial sector reform lagged this process of openness (Khatkhate 1998; Schneider 2000). The passage of The Alien Business Law of 1972 and the Investment Promotion Act of 1977 expanded the sectors open to foreign investment and liberalized the screening requirement for such investments. Portfolio investments were treated liberally although exchange controls applied to the repatriation of interest, dividends, and principal. Likewise, for-

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eign borrowing could be conducted freely but had to be registered with the Bank of Thailand. In 1992, the Bangkok International Banking Facility (BIBF) was established, which greatly eased accessto foreign financing and expanded short-tenD inflows. In 1995, the Provincial International Banking Facility was established, which extended credit in foreign currencies funded from overseas. Meanwhile, Thailand accepted the obligations of IMF Article VIII in 1990, which liberalized the payments and transfers for current international transactions. Further liberalizations also occurred, such as the removal oflimits on the amount of foreign exchange that could be purchased, brought in, or taken out of the country. This broadened the uses of nonresident baht accounts and resident foreign currency accounts. One notable exception was the control on capital outflows, which was subsequently liberalized gradually starting in 1990 when commercial banks were allowed to lend limited amounts to nonresidents in foreign currency. The following year and in 1994 (when the ceiling was raised), Thai residents were permitted to invest abroad or to lend limited amounts to companies that are at least 25 percent Thai-owned. Domestic financial market reforms focused initially on the development of the stock market with the establishment of the Securities Exchange of Thailand in 1975 and the amendment of the Securities Exchange Act in 1984. Interest rates and credit controls were liberalized gradually, and in 1992 the ceilings on savings deposits and lending rates were removed. The composition of capital flows evolved over the period and appeared responsive to incentives for attracting flows. Net portfolio flows became more important due to reforms in the Thai stock markets, the establishment of the BIBF, including the high positive interest rate differential. Consequently, short-term net inflows reached 60 percent of total capital inflows in 1995. This prompted Thai authorities to restrict capital inflows by imposing 7 percent reserve requirement on banks' nonresident baht accounts. In 1996, in the face of an appreciating real exchange rate, capital inflows and exports declined sharply; economic growth and investment levels also deteriorated. Moreover, the 4igh exposure to the property sector and inadequate loan provisioning exposed the financial sector to vulnerabilities. In addition, the high interest rates stance to counteract the flows aggravated the solvency and liquidity position of banks. When the baht devalued in 1997, the prolonged defense of the baht had caused foreign exchange reserves to drop. The depreciation resulted in non performing loans. With an external debt of over 40 percent of GDP, a~

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banking crisis culminated. On 5 August 1997, Thailand agreed to an IMF rescue package ofUS$17.2 billion (Dobson 1998). Malaysia accepted Article VIII obligations in 1968. Malaysia always had a relatively open capital account since the 1970s. Since the mid-1980s, portfolio inflows had been free of restrictions, and the bank's foreign borrowing and lending in foreign exchange had been free (except for net foreign exchange which opened position in limits). Residents' foreign currency borrowing was subjected to limits that required approval when exceeded (Schneider 2000). Financial sector reform in Malaysia followed a severe financial sector crisis in the early 1980s. The central bank of Malaysia reformed its export refinance scheme, reduced liquidity and reserve requirement ratios of commercial banks to lower costs of funds, created investment funds to shift bank lending out of real estate, introduced more flexible interest rates, abolished deposit rate controls, and encouraged the establishment of a secondary mortgage market (Dobson 1998). In the early 1990s, Malaysia faced large inflows of foreign capital, comprising both short- and long-term capital. The significant increase in shortterm inflows (which leaped from 5.3 percent to 8.7 percent ofGDP in 1993), induced mainly by a high interest rate differential and expectations of a ringgit appreciation. Furthermore, this increased concerns regarding sustainability and stability. In 1997, in the midst of a financial crisis, Malaysian authorities initially tried to break the link between onshore and offshore rates by setting limits on ringgit nontrade related swap transactions with nonresidents. But these reinforced large interest interest rate differentials and induced greater outflows. Consequently, Malaysian authorities decided to implement direct exchange and capital control measures in September 1998. These sought to contain ringgit speculation and the outflow of capital by eliminating ringgit market (Schneider 2000).

the offshore

Exchangerate arrangementsand the impossible trinity Two important mechanismsto addressthe impossible trinity theorem are to adopt a truly flexible exchange rate regime or to subordinate the domestic monetary policy to the demandsof maintaining the fixed exchangerate with the anchor country. nexible exchange rate It is generally accepted that developing countries with thin and underdeveloped financial sectorsare not yet ready for truly flexible exchange rate re-

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION1S9

gimesand not just dirty floats in the context of greaterfinancial liberalization and integration. Drawing from the interest parity condition, changes in the expectationsof current and future domesticand foreign interest ratesaswell as changes in the expected exchange rate in the far future will affect the exchange rate today.This means that the exchangerate can change without any modifications in the current domestic interest rate. It also means exchange rate volatility when the financial systemis thin and underdeveloped. Moreover,the problem of overshootingexchangerate can occur in an emerging market. Large variations in the exchange rate can have large negative effect on the economy,both on the assetandprduction sides.On the other hand, attempting to stabilize the exchangerate in the face of changed expectations would involve volatility in the domesticinterestrate. Large movements in the interest rate would also have adverseimpact on the economy. Thus, controlling an economy canbe more difficult under a truly flexible exchange rate in an emerging economy with a still thin and underdeveloped financial sector (Blanchard 2000). Cu"em:Y union

The other extreme option is to peg the exchangerate and follow the dictates of the anchor country or to a supra-nationalmonetaryauthority. However,the Europeran Union countries provide a rich history of exchangerate problems and monetary coordination. From the The Hague summit of the EECheadsof states in 1969 when they made monetary integration an explicit EEC goal (Arestisetal. 1999)to the launching of the euro and the establishmentof the European Central Bank, Europe experienced failed attempts at exchange rate coordination towardsgreater fixity in the intra-Europeanexchangerates as well as greater monetary stability. They included the "snake" aswell as the "snakein the tunnel" in the early1970sand the European Monetary Systemin the 1980s. The snakewasthe first attempt toward the ultimate introduction of one European currency by narrowing the mutual exchangerate margins among the European Economic Community members. It becamea "snake within a tunnel" by April 1972,a fewmonths after the devaluationof the dollarvis-a.-vis the German deutschmark in December 1971.The snake in a tunnel means that the intra-European exchange rate fluctuations are narrower than the fixed margins (the tunnel) vis-a.-vis the US dollar. The snake did not really move the processtoward greater monetary integration becauseit was established during the period when capital control measureswere in fact strengthened in Europe in order to prevent an unwanted appreciation of the Euro-

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pean currencies vis-a.-vis the US dollar and thus lose export competitiveness and Europeanjobs (Bakker1996).The snakecollapsedand transformed into a Deutschmarkzone with the withdrawalof the sterling, lira, Frenchfranc and the Irish punt (Arestis et al. 1999). The other notable arrangement wasthe Exchange Rate Mechanism (ERM) under the EuropeanMonetary System(EMS). In addition to the establishment of a monetary unit (Ecu) and the provision of credit financing, the ERM has a complicated mechanism of adjustments of the parity grid and divergence indicator. "The parity grid tied each currency to every other currency in a systemof mutually agreedexchangerates.When one currency diverged from parity, all other exchange rates also diverge, hence all countries must respond through intervention to re-establishparity" (Arestis et al. 1999). What differentiates the ERM in principle from the standard fixed exchange rate systemsunder the IMF is that there is symmetryin the ERM while the affected country with divergencefrom parity had the sole responsibility to adjust under the standard IMF adjustment programs. In reality, the bulk of the ERM adjustment remained with the high inflation members devaluing their currencies vis-a.-vis other ERM member currencies during 19791987. In these years,there were 11 realignments within the ERM. The newstagein the ERM occurred with the hard pegging of the member countries on their currencies after 1987. However,as the shown by the EMS currency of 1992-1993,hard pegsbecomevulnerable to currency attacks when there is internal inconsistencyin the macroeconomic regimes of the member economies. In summary,the experience of the European Union countries through the yearsindicate the instability of exchangerate parity systemswhen there is no full coordination of monetary and other macroeconomic policies among the member states.This is another of the incompatible trinity theorem especially in the early 1990swhen there was virtually free flow of capital in the Union. As indicated in the Euro zone, maintenance of parities in the Euro zone necessitatedstringent restrictions on the monetaryand fiscal policies of the member countries. In short, monetaryindependence had to be compromised. The lossof monetaryindependence to maintain fixed exchangeratesis exemplified by the conditions setfor membership in the "Euro zone" of the European Monetary Union (the euro is the newsingle currency of the European Union). The conditions include ceilings on the budget deficit asa ratio of GDP,overall government debt asa ratio of GDP,long-term interest rates relative to the averageof the three countries with lowestinflation rates,infla-

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tion rate relative to the averageinflation rate of the three countries with the lowestinflation rate. In addition, the European Systemof Central Banksand the European Central Bankwould assumeresponsibility for monetary policy in the Euro zone. These conditions are in effect restraints on the macroeconomic policy regime of the membercountriesin the Euro zone. Summaryand concluding remarks: key lessonsand implications The essenceof financial liberalization and integration is the increased capital mobility and the relatively open capital accounts. Most of the developing APECmember economiesbecamemore financially integrated with the restof the world during the pastone and a half decades.Much of the foreign capital that went to emerging marketswent to APEC member economies.Indicative of the surgesin capital inflows to the developing countries in the region are the high ratios of net capital inflow asa ratio of Gnp during the latter 1980s and early 1990s.For example, the average ratio of net capital flows to Gnp during 1990-1994was10 percent in Thailand and Malaysia,6 percent in the Philippines, and 3.9 percent in Indonesia (Leung 1998). The major sources of the capital flows are APEC member economies themselves,especiallyJapan, the United States,and the AsianNIEs. This is related to some extent to the economic restructuring in the region, sometimespoetically described in terms of the "flying wild geese"pattern. There are acknowledgedbenefitsfrom financial liberalization and integration, including greater accessto the world capital market at lower interest rates thereby encouraging higher rate of investment,aswell asthe long term advantagesfrom financial development,risk diversification,and efficient provision of financial services(Le Fort and Budnevich 1997). However,there are also attendant macroeconomic and banking challengesand risks from open capital accountsas brought about by a number of crisesinvolving both developing and developed countries. At the heart of the macroeconomic challengesis the so-called"incompatible trinity" of monetary independence, capital mobility, and fixed exchangerates.Sooner or later, the incompatibility of the three eventuallyleadS to currency crisesas the recent EastAsiancrisisattests.Corollary to this is the short-lived effectivenessof sterilization efforts and the rising opportunity cost of such sterilization efforts that, in a number of ASEAN countries included a tigh t fiscalpolicy in order to minimize the inflationary effectof capitalinflows. Estimatesof offset coefficients in a number of EastAsian countries are also high (e.g., Leung 1998), suggestingthat the higher domestic interest rate resulting from the sterilization efforts ended up encouraging further capital

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inflows that further exacerbated the problem of macroeconomic management. At the sametime, however,a currency appreciationattendant to a surge in capital inflow under a flexible exchangerate regime waslargely anathema to SoutheastAsian countries that havebeen pursuing export-oriented industrialization. The problems with the European "snake in a tunnel" exchange rate systemin the 1970sstemmedin part from the "incompatible trinity." Suchwas also the caseduring the EMS 1992-1993crisis.The latter also brings out the vulnerability of members in a currency bloc when there are significant macroeoconomic shocksfrom the anchorcountry. Not only does capital mobility posechallengesto macroeconomic management,it also posessystemicbanking risks. Explicit or implicit insurance to (deposit) liabilities of bankstend to encourage banksto be more aggressive in their intermediation efforts betweenthe foreign capital market (primarily through their foreign borrowings) and local firms (especiallythose without accessto the world capital market except at tremendous interest rate premium and transactionscosts).The recent EastAsiancrisisis acknowledgedto stem in part from the rise in systemicbanking risksarising from open capital accounts in the face of relatively weak prudential regulations. The Chilean currency crisis in the early1980salsoresulted in part from the lack of effective supervisionand regulationsof banks,which at that time were owned mainly by large private conglomerates,called grupos, and which had large grupo-related loans. The accessto international financing exacerbated the bias for "unbridled self-lending." Clearly,the policy questionis not one of "to integrate or not to integrate" but rather to define a strategyof financial integration, soasto managethe risks and optimize the benefits from financial integration. The contrasting experiencesof the European Union, Chile, and EastAsiaprovide lessonsand implications for the choice of the strategy of financial integration in the country and the region. Lessons

The surveyof the historical experiencesand of the analytic literature on the macroeconomic challengesof financial liberalization and integration bring out the following key lessons: .Maintenance of a currency peg in the face of imprudent fiscal and monetary policies and open international capital accountis a great recipe for an eventual currency crisis within a short span of time. As in the caseof the Southern Cone (i.e., Chile, Argentina, Uru-

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guay) experiencesof the late 1970sand early 1980s,comparatively very high domestic real interest ratesattract surgesin capitalinflows (a lot of it foreign borrowings of local residents), thereby raising domestic inflationary pressuresand aggravatedby the monetization of large fiscal deficits. This resulted into real currency appreciation and a decline in the countries' international competitiveness,ballooning current account deficits, and an eventual paymentscrisis and currency crash. In the face of an open capital account and financial integration, maintaining fiscal (and macroeconomic) prudence is not enough to sustain a currency peg. Prudent macroeconomic management that leads to low inflation reducesthe risk premium on a country. Thereby, encouraging greater capitalinflows in responseto a monetarypolicy that resultsin domesticinterestratessignificantly higher than foreign interest rates. As the recent EastAsian crisis showed, the high domestic interest rate and currency peg despite the capital inflows encouragedsubstantial,unhedged,and generallyshort-tenn foreign borrowing, concomitant to the overheating of the economy and increased investments in riskier and longer-term projects in nontradeablesectors.The cumulation of suchinvestmentsfinanced by short-term funds increasinglymake the domestic economymore vulnerable to negativeexternal shockssuchasa significant increase in world interest rate or a substantialfall in exports, and ultimately to speculative attackson the domestic currency. An important lessonis that, a country that is financiallyintegrated with the restof the world and hasgood credibility in itsfiscal managementcannot pursue an independent monetary policy and a currency peg for long without sowingthe seedsfor an eventualcurrency crisis. Similarly, regional currency pegs or currency areasare a breeding ground for currency turmoil unless there is full coordination of monetary and other macroeconomic policies among the member countries. As the EMS crisis of 1992-1993suggests,inconsistency between the macroeconomicregime of the anchor country and the macroeconomic needsof the other members of the currency area would invite speculativeattackson the currencies of the members in the currency area.Maintaining exchangerate parities within the currency area necessitatesthe loss of monetary independence of the member countries in favorof the lead or anchor country or meeting the rigidly fixed rules on macroeconomic managementasis the

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caseunder the euro zone. The European Union decided on a path of fixed exchange rates and a common currencythe curD.The decision wasdespite the earlier troubles with the snakeand the speculativecurrency attacksin 1992-1993.This is expected of an economic and monetary union, with a surpranational centralbank. Giventhe free flow of capitaland people in the EU, a flexible exchangerate regime could introduce market and policy uncertainty as well aspotentials for discredited "beggar thy neighbor" policies. Being under a fixed exchange rate system,the EU member countries must necessarilysubordinate national fiscal and monetary policies to the regional institutions or to the policies of the anchor economy,primarily Germany. Chile (and also Colombia) provided a caseof "gradual and limited financial integration" (Le Fort and Budnevich 1997). Chile (and Colombia) deliberately provided "sand in the wheel" of international financial flowsinto the country in order to minimize. .." interestrate arbitrage,destabilizingspeculation,bubbles,and overshooting behavior of assetprices..." (Le Fort and Budnevich 1997). This Chilean policy is a reaction to the excessesof the late 1970swhich eventually led Chile to succumbto a serious balance of payments crisis in the early 1980s.In addition, Chile imposed stringent prudential regulations, including greater transparencyon bank loans and the stateof health of banks. Thus, capital controls can be, and have been, used successfully as a tool for the macroeconomic managementof capital flows but only on a temporarybasis.Malaysiaand France used them. In both cases,capital control measureswere a complement to the other macroeconomic measuresto temper capitalinflows (Malaysia) or outflows (France,Malaysia). Chile used them on a longer-term basis and appeared, on the whole, to have succeeded in influencing at least the composition of capital inflows and in providing someleeway for monetary independence. It is clear, however,that capitalcontrols are not a panaceaor a substitute to sound macroeconomic policies, not too overly rigid exchange rates,and strengthened prudential regulations. Equally important, a successful managementof capital control measuresrequires a technicallycompetent machinery or central bank that can monitor and make appropriate adjustmentsin the measuresin the light of the dynamic changesin the domestic and foreign financial markets.Thus, capi-

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tal controls are an appropriate component of the arsenalof macroeconomic measuresthat a country, especiallya developing country without a fully developed financial sector,canuse in managing the macroeconomic challengesofinternational capitalflows. Nonetheless,capital controls mayneed to be used only sparinglyand temporarily, or on a longer-termbasissimilar to Chile, adroitly, flexibly and in tandem with sound macroeconomicpolicies and strong prudential regulations. Apart from fixed exchangerates under an optimum currency concept and from putting "sandin thewheels"of international finance, the third policy option in the faceof increasedfinancial integration is to adopt aflexible exchangerate. Standardmacroeconomic texts bring out that it is under flexible exchange rates that a country's central bank canhavesomemeasureof independence from the rest of the world. However,it is generallyacknowledgedthat a trI;llyflexible exchangerate requires a well-developedfinancial sector which developing countries like the Philippines do not have. Under a freely flexible exchange rate, exchangerates are relative to varied expectations on future interest rates. This means exchange rate volatility when the financial systemis thin and underdeveloped. Moreover,exchangerate overshootingcan occur. Large cbangesin the exchangerate can havelarge negativeeffect on the economy.At the same time, stabilizing the exchangerate in the face of changed expectations involve volatility in the interest rate which can also haveadverseimpact on the economy.Thus, controlling an economy could be more difficult under a truly flexible exchangerate regime in an emerging economy with a still thin and underdeveloped financial sector. The East Asian crisis has brought out once more the issue of the appropriate sequencingof liberalization. The general consensusin the literature is that the sequenceof liberalization should preferably be domestic real reform first, followed by domestic financial sector reform, then the external trade sectorreform, and finally the liberalization of the capital account (Brooks and Oh 1999). While there are significant differences in details, most countries have largely followed the broad strategyof liberalization in at least one important aspectliberalizationof the capital account wasusually the lastto be undertaken. The historical experiencehasbeen mixed in part becausethe liberalization processhas tended to be incom-

166 FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

plete in most cases.With respectto the sequencingofliberalization issue,the EastAsiancrisisbrought out are two concerns which were not highlighted before (i) the importance of domestic financial institutional and regulatoryenvironmentand capacitybefore full blown capital account liberalization, and (ii) the greaterbias for liberalization of long-term capitalflows before short-termflows. Specifically, strong prudential regulations, supervision,and monitoring of the financial sector is an important prerequisite before any headlong rush to full liberalization of the capitalaccount. Reisen(2000)points to regulatory distortion in the international financial systemthat give an undue bias to short-terminterbank loansand for bank loans to hedge funds, for example.Yetthese two short-term capital flows are the most vQlatile which contributed to the EastAsian "bubble" and eventual currency and banking crisis.At the sametime, the bias for short-term foreign loans in the EastAsiancrisiswasencouraged by restrictions on foreign direct investmentsand other long-term flows (e.g., bonds, equities) as against the more liberalized shortterm capital movements(Shigehara1999). ImPlications In viewof the discussionsabove,the implications for the Philippines are asfollows: .There is bias for a floating exchange rate. This is likely a relatively dirty float rather than a truly flexible exchange rate regime. As indicated earlier, the Philippines does not yet have a well-established and deep financial sector that offers the wide array of exchange risk management instruments at reasonable cost. This means that the Central Bank cannot likely have a totally hands-{)ff policy in the foreign exchange market. Thus, Central Bank intervention can be expected in the foreign exchange market mainly to prevent exchange rate overshooting and large exchange rate fluctuations but not to "lean against the wind." Note that this kind of dirty float is rather different from a dirty float that largely follows a currency basket approach to exchange rate determination or to a policy of real exchange rate targeting. The bias for a more flexible exchange rate regime. However, somewhat dirty rather than a totally clean free float, it forces the market participants to take cognizance of exchange rate risks, encourages the development of exchange risk management instruments by the market, and allows for some independence in the determination of the country's monetary policy.

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION167

Strong prudential regulations, supervision,and monitoring is important. This also includes greater transparencyand disclosure requirements on the banks and other financial institutions. This is important either under fixed or flexible exchange rate regimes. This is critical asthe country deepensits financial linkages with the restof the world. Much of that strengtheningof the prudential environment would involve moving towardsinternational bestpractice in banking, regulations,and monitoring approaches. Improvement in corporate governance.This involvesnot only financial institutions but also of borrower firms. As the country deepens its linkages with the restof the world, it is likely that more and more Philippine firms would seekout foreign funds directly rather than through banks. Thus, unless the foreign funds are well utilized by the firms, the country could be exposed to greater risk. Improvements in corporate governancecanbe expectedto be a long process that may involve changes in societal relations. Nonetheless, well performing banksand stock market, acting asoutside monitors on borrower firms, canprovide the impetusfor improvementsin corporate governance.The government can also provide some pressure for improvements in corporate governance.This can be done, for example, by requiring firms that want to borrow abroad directly to meet some quality criteria, suchasa minimum rating aswasthe rule in Chile in the 1990s. Chile's rule that firms or financial institutions borrowing abroad should meet a minimum required rating by two rating agenciesis primarily an external debt management measure. There is some merit to it. Chile's imposition of credit rating requirements before domestic firms and bankscould borrow abroad contributed to the improved debt profile of the country. This is in contrast to the aggressiveforeign borrowing of Indonesian firms and banks before the East Asian crisis, which complicated the country's external debt management and restructuring. To a large extent, the East Asian crisiswasan external debt managementproblem disguisedas capitalinflows problem. The point is, there are systemicrisksto a lot of firms borrowing abroad. As in the Indonesian case,where the recent economic crisis wasaggravatedby a large number of externally indebted firms whoseexternal debtwasnot even known by the monetary authorities. This recommendation is particularly important during periods of "investmenteuphoria" asduring a bubble or

168 FINANCIALLIBERALIZATION, MANAGING RISKSANOOPPORTUNITIES

fastacceleratingeconomicgrowth. The importance of maintaining prudent fiscal and monetary policies.This is easiersaid than done especiallybecausean economyis buffeted by internal and external shocksand passesthrough businesscycles.This callsfor a biastowardsa more conservativestanceto the fiscal deficit. Clearly,this involvesconstantmonitoring and good analysisof the domestic economyand world markets. There is merit in putting some "sand in the wheels" on short-term foreign borrowing by domesticfirms and banksand greaterliberalization on longer-termborrowing and flows. Where there is a significant surge in capital flows,there is somemerit to look into the institution with an unremunerated reserverequirement on short-term capital inflows if necessary.Malaysiaand Chile have bias for longterm flows and investments.Malaysiafurther liberalized foreign equity restrictions in certain critical industries while at the sametime imposing selective capital controls in 1998-1999.This is because long-term flows impart greater stability and foreign direct investments can alsohave technology transfer,market development,and human skill benefits to recipient countries. This recommendation is only relevant during periods of large capital inflows. Thus, even Chile loweredto zerothe unremuneratedreserverequirement when there wasa turn around in capitalflows to emerging markets in the aftermath of the EastAsiancrisis. Finally, the quality of macroeconomic outcomes is dependent on the quality and capabilityof the institutions,both private (e.g.,banks, rating firms) and public (e.g., central bank, finance), in managing the challenges offinancial integration and the economy.Thus, it is important to continue investmentsin human resource and institutional development both governmentand private institutions.

FINANCIAL LIBERALIZATION ANOINTEGRATION IN THEAPECREGION169

Appendix Model Specificationsand Frameworks: A Reviewof Banking and Currency Crisis Models Jitendra RafaelS. Mojica Abstract Three years since the East Asian incident, economists are still searching for an adequate answer to the questions why it aU happenedand, why thecrisis meant incumnga huge cost for those economies that were affected" While there have been many attempts to fill this void in the literature, the general sentiment among economists continues to be that the frameworks invoked to explain the phenomenon, fall short of giving a complete picture of the entire quagmire. This paper summarizes the different crisis models in the literature to give a better picture of policy dilemmas faced by pundits during times of crisis.

Introduction The particular irregul4rities of the EastAsianCrisishaveled someto suggest the development of a third-generation classof models for currency crises. It wasapparent at the onsetof the Asian financial turmoil that first and second generation type models were inadequate in giving correct policy prescriptions. However,this sentiment circling in the academeremained an assertion without the benefit of comparing thesemodels. What are thesemodelsabout? How are they inadequate? What are their strengthsand weaknesses?These are the things, questionsand qualifications,neededto bring forward a clearer understanding of crisesliterature. The evolutions of currency and financial crisesmodels haveso far been limited to rational experience and policy implications. This paper discussed the details of thesecrisesframeworks,i.e., mathematical specificationsfound throughout the literature. First the discussionwill be on the early development of first and second generation crisesmodels. After which some of the finer points of third generation type models are then presented. F~t generationmodel: Krogman, flood and Garber (KFG) The classicapproach to a balance of payment crisesis to perceive currency crisesasthe inconsistencybetweena fIXedexchangerate rule and the pursuit of domestic policies such as monetizing large fiscal deficits. These models draw whatappearsto be a suddenspeculativeattackon currencies,yetis quite rational. Rajan (2000)noted that Within a monetary framework, rational for-

170 FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

ward looking agents causeda breakdown of a fixed exchange rate regime once there wasa general perception of an unsustainableexchangerate peg. Especially since the regime has been made unsustainable because of policymakers'persistenceto monetize itsfiscal deficit (Rajan2000;ERR1999). Once speculatorsperceive that an attackis inevitable,eachtries to buy foreign currencies from the central bank before the reservesare depleted, which simply a run on reserves. Drawing from Rajan (2000),the KFG model wasdiscussedlike this: Assumptions: .Small open economywith perfect capital mobility and a single trade able good .Agents hold three assets .Domestic money .Foreign bonds .Domestic bonds Model: .a1a2 > 0 m, -p, =ao -ali, +a2y, (1) m, = g, + c, (2) ..'

I, =1, +e,+rp, p, = p; + e,

(3)

de/, = c, = ~ > 0

(5)

(4)

Where: m, = Nominal domestic money (high powered) supply y, = Real output/income (whichis assumedconstantfor simplicity) P, = Domestic price level P; = Foreign price level C,= Domestic assets(in nominal terms) i, = Domestic real interest rates i; = Foreign real interest rates ~, = Exchange rate (in foreign currency terms) e, = Expected rate of depreciation de/,= Fiscal deficit *All the variableswith adot (.) over them refer to rates of change; and are a,o,a,\,a,2' f.lnonnegativeparameters. * All variables other than those in ratesand rp, are in natural log *All variables other than those in ratesand are in natural log

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION171

Equation (1) is the real money demand function. Equation (2) expressesmoney supply (monetary base)as equal to domestic assetsplus foreign assets. Equation (3) is the international assetmarket arbitrage condition, i.e., uncovered interest parity theorem plusa country/currency risk premium (rp), the latter taken to be exogenousand constant. Equation (4) is the PPPcondition. Equation (5) states that the fiscal deficit is monetized at a constant rate J.!. This is the rate of credit growth. Assuming that i;, p; and rpl are constant,substituting equations (1) and (3) into (4) derives:

Where:

(6)

et = mt +a\ et-Y Y = (ao + P; -a\rpt

+a2y,)

Under a fixed exchange rate regime (e.i. e,= 0), using equation (2) and totally differentiating the resulting equation:

g,=-c=-m

(7)

Where: g, = foreign assetsI reserves Equation (7) statesthat the combination of a fixed exchange rate regime and an open capital account simultaneouslymust imply the lossof monetary autonomy (i.e., the "impossible" or " inconsistent" trilogy principle). The fiscal deficit generatesdomestic credit in the form of money creation, and under a fixed exchange rate regime, has to be absorbed asa decline in international reserves. Agentsare assumedto have perfect foresight and understand that the peg is unsustainable in light of the prevailing fiscal stance. Hence, they expect reservesto eventuallyfall to some minimum leveland the currency to consequentlydepreciate. The argumentcontinues by looking at the international interest rate parity condition, which producesa rise in domestic interest rates. Furthermore, equation (1) suggeststhat real money demand decreases.Indicating that domesticprices are held by world prices through the Purchasing Parity Power (PPP)condition, by equation (3), a wayto calibrate the systemwould be through a discontinuous upward jump in the actual exchangerate. Since domestic credit growscontinuously, this decline in the nominal monetary base must be fully accounted for by a fall in foreign reserves. In

172

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

other words, the presenceof farsighted agentsimplies that foreign reserves will decline to their minimum level at the earliest possible time of an expected currency depreciation (Rajan2000). Second generationmodels: Obstfeld's FscapeClause The second generation models to some extent are similar to their first generation counterpart insofar as to identifying inconsistent government policies as the causeof currency crises (Flood and Marion 1996). The secondgeneration modelsfocus on the dynamicinteractions of market expectations, particularly investors' expectation and conflicting objectivesof the government, which is essentiallythe actual policy outcomes and show how thiscan lead to a self-fulfilling run on the domesticcurrency (Pesenti2000). Flood and Marion (1996)relied on Obstfeld's presentation of a devaluation model: Purchasing power parity holds so that e,= p,. Domestic output,y" follows:

y,=a(e,-w)-u,

(1)

Where: Logs

e =

p, = p = W, =

u, =

Exchangerate quoted asthe domestic Currency price of foreign levelnormalized to zero Domestic prize level Constantforeign price level normalized to zero (log) wage Seriallyindependentmean-zeroshock

* Wages for period t are set at the end of period t -1 so that expected real wages stay constant W, = EI_le,

(2)

The policymaker hasone tool in this set-up-the exchangerate and it is choseneachperiod after seeingthe wagefor the period. The policymaker, at the beginning, does not incur any direct costfrom using discretionarypolicy. Decisionsare entirely purposeful and reduce the weighted averageofinflation and businesscycle considerations. Lt =.:J)(Pt

-Pt-I)+.5(Yt

_yO)2

(3)

FINANCIALLIBERALIZATION AND INTEGRATION IN THE APECREGION 113

Where: y' = Policymaker's output target e = Relativeweight attachedto deviationsof inflation from a target of 0 The structure and resultsof this model are well known. Aslong asy* is unrealistically high (>0 presently) and wagesare setbefore policy, workers must anticipate that the policymaker exercising discretion will inflate the attempt to reach y*. With that expectation built into wage negotiations, it becomesoptimal for the policymakerto validate the expectations. Therefore, the model predicts an inflationary equilibrium eventhough no one is made betteroff by anticipatedinflation. The modelalsopredictsthat the policymaker will stabilise the resultsof shocksbut at the costof higher than ideal average inflation. In contrast, decisionmakersmaytakeinto accountreplacing discretion with a rule. If today, the rule is to hold the exchangerate fixed for all time then it means that the inflation is held to zero. In effect, the rule circumvents the discretion'sinflationary tendenciesbut at the costof higher output volatility since no policy response now puts output shocks in place (Flood and Marion 1996). Essentially,the guiding principal behind escapeclause models is the combination of the both rules and discretions. The idea is to follow a rule until suchrule is affected by someexternal condition that forces it to rely on discretionary action. A caveatto this is the fact that it can be twisted and abused. Policymaker may deem all situations as affected by some external condition. Thus, to ensure that discretionaryactionsare only taken in special casesis to impose a cost on the policymaker everytime they break the rule. This hasbeen deemed in the literature to be the superior arrangement over following pure rules or pure discretion strategies(Flood and Marion 1996). LD +C<

Condition Where:

LD = Period loss under discretion LR = Period loss underrule

Condition for indifference: j.,1/2(a.O(u) + u+ yO) = (2C)1/2

(4)

174 FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

Where: A=a2/(9+a2),~is a critical value of the output disturbance such that the two policies produce equal valuesof the loss function and 5 (~)is a quadratic function of that represents the market's depreciation expectations. Third

generation

models

The main distinction attributed to thesemodels is its bank-centered view on currency crisis (Krugman 1999). Generalizing all of models astaking a bankcentered approach or to outrightly dismissingthe first- and second-generation models as nonfinancial is erroneous. Calvo's portfolio-equity based model focuseson returns to investment,or Krugman, Flood, and Garber (KFG-type) model straightforwardlyinclude the role of banksin its analysis(Rajan2000). This third-generation type models included in this survey is that of Chang and Velasco's(1998). As mentioned, it revolvesaround the conceptof international illiquidity, particularly the mismatch of assetsand liabilities in the financial systemof a country. The bank panic model Drawing from Rajan (2000), Changand Velasco'sstylized model waswritten like this: First assumea small open economy with ex -ante identical agentswith three periods of interest: Planning period (t = 0) A short-run (t= 1) The long-run (t = 2)

To assumea composite consumption good whoseprice in the world market is fixed over time and normalized to one "dollar". Furthem1ore,assumethat eachdomestic agenthas: An endownment e> 0 of consumption in (t = 0) The agentis indifferent betweenwhether sheconsumesin either shortor long-run. In addition to their endowment,domestic residentshaveaccess to international capital marketsand are able to borrow at most dunits. There existsa technology in the planning period, which yields:

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION175

R units of consumption in the long-run r units of consumption if liquidated in the short-run Where 0 < r< 1 < R

Howeverdue to indivisibilities,agentsare unable to accessthe technology if acting individually, only being able to do so if they pool their resources(i.e., if theycoalesceand form a bank). Ifagents do form a bank, the relationship/ contract between each bank and the domestic resident / owner is asfollows. She surrenders her: Endowmente Capacityto borrow d to the bank In exchange, she can withdraw either the initial deposit e in the shortrun or an amount y in the long-run. Both deposits and loans are assumed to be short term, needing to be renewed at t = 1. The banks operate in a perfectly competitive environment such that long-run profits are zero,and they distribute all their remaining value to the depositors/owners at t = 2. Banks are faced with a reserve requirement of b per depositor. These reserves are held in liquid form (i.e., world asset). Given these assumptions, at t = 2, investment by each bank: (k) = e+ d-b > 0 per depositor Consequently, y = R(e+ d- b) -d+ b = Re+ (d- b) (R-l) Since R> 1, and as long as b is "small" (compared to d ), Y > e, thus providing the incentive for the depositor to form / invest in banks

Assume that there is some trigger such that depositors and creditors "panic" and attempt to withdraw funds from the banksat t= 1. To be precise, creditors will recall d units while depositors will attempt to withdraw their initial endowment of eunits. The bank however has only b units of liquid assetsand receivesjustrfrom "premature" liquidation of the project. Since T<l Andk=e+d-b>O

The potential capitaloutflowsfrom obligationsof the bank (e+ d)exceeds the resourcesavailable (b+rk). In other words, the bank is internationally "illiquid." Thus banks,in this model, aresocialwelfaremaximizersthat channel

FINANCIAL LIBERALIZATION ANDINTEGRATION IN THEAPECREGION177

MaxEU(X)

= [(1-9)&

+ P] -v

/2[90"0)2

/ (J -1)

+ (1-

9)2 O"~], v> 0

The promotion of fund devoted to country kobtains: (1- 9) = [Y+E/ v]/Y+cr~]

(3)

(4)

Where:

y=~/(J-l) However,the absenceof information on the returns in country k (i.e., country his identical to all other countries emnte), from equation(4), the shareof portfolio allocated to the country is 1/], aswould be expecteda priori. Accordingly, in the absenceof news,the portfolio allocatedto country k tends to become unimportant, asJgets arbitrarily bigger (i.e., plenty of alternatives for investmentdiversification). Yetassoonasnewscomesin, the change in the portfolio compositionto countryk becomesextermelysensitiveto the expected mean return differential (E) and variance in country kas] ~ CX) Specifically: 8(1-9)/& 8(1-9

= [v/[y )/&

+0'\2]-1

~ 1/(vO' 12)asJ ~

8(1-9)/80'\2

=-[y

+E/v]/[y

8(1-9)/80'\2

~-E/(vO':)asJ~oo

00 +0'\2]2

The idea here is to differentiate speculativetendenciesof agents. Ifanagent takesa laid back approach to speculation, then it would be best for the agent to gather relevant information upon which to basetheirinvesttnentdecisions. To the extent that their actions are based on best available information, speculation cannot be considered arbitrary. The incentive for investors to gather information maybe explored within thisportfolio diversificationmodel. Let there be an unspecifiedfixed costinvolved in learning about country k. Assumethat the learning costsallow the agentto obtain infonnation about returns in the <:ountrywith certainty (i.e., 0": = 0). From equation (4): (I-9)=O+E/(vy)1

(4)

FINANCIALLIBERALIZATION AND INTEGRATION IN THE APEC REGION 179

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Kaminsky, G. and C. Reinhart. 1999. The twin crises: the causes of banking and balance of payments problem. AmericanEconomicReview89: 473500. Kawai M. 1999. The resolution of the East Asian crisis: financial and corporate sector restructuring. Paper presented at the conference on Reforms and Recovery in East Asia: The Role of the State and the Economic Enterprise. 21-22 September, Australian National University, Canberra, Australia Khatkhate D. 1998. Moneyand finance: il'SUe5, institutions and policies.New Delhi: Sameeksha Trust Publication. Krugman P. 1998. Bubble, boom, crash; theoretical notes on Asia's crises. Mimeograph. University of Princeton. Lamberte M., M. Milo and V. Pontines. 2001. NO to 짜E$? Enhancing integration in East Asia through closer monetary cooperation. Asia Pacifzc Social ScienceReview 3(1) :52-105. Laurens, B. and]. Cardoso. 1998. Managing capital flows: lessons from the experience of Chile. Working Paper No. WP/198/68. Washington, D.C.: International Monetary Fund. Le Fort, G. and C. Budnevich. 1997. Capital account regulations and macroeconomic policy: two Latin American experiences. International Mon~ etary and Financial Issuesfor the 1990s 8: 37-58. Leung, Suiwah. 1998. Capital flows, monetary policy and exchange rates in the Asian Region. In Financial deregulation,caPitalflows and macroeconomic managementin theAsia Pacijic. EDAP Joint Policy Studies No.5. Seoul, Korea: Korea Development Institute. Lopez-Mejia,A.1999. Large capital flows: a surveyof the causes,consequences, and policy Responses. Working Paper No. 99/17. Washington, D.C.: International Monetary Fund. Masera, R. 1994. Single market, exchange rates and monetary unification. World Development,17(3): 249-79. Melitz,]. 1994. French monetary policy and recent speculative attacks on the Franc, In CobhamEurope's monetaryupheaval5,edited by David Cobham. Manchester: University Press. Micossi, S. and P.C. Padoan. 1994. Italy in the EMS: Mter crisis, salvation? In The monetaryeconomics ofEurope: causes ofthe EMS crisil' edited by C. Johnson and S. Collignon. London: Pinter Publishers. Montiel, P. 1994. Capital mobility in developi~g countries: some measurement issues and empirical estimates. World Bank Economic Review, 8(3): 311-50.

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Montiel, P., N. Haque, and K. Lahiri. 1994. Estimation ofa macroeconomic model with rational expectations and capital controls for developing countries.foumal ofDevetopment&onomics42 (1). Nadal-De Simone, F. and P. Sorsa. 1999. A review of capital account restrictions in Chile in the 1990s. Working Paper No. WP /99/52. Washington, D.C.: International Monetary Fund. Nagayasu,J.2000. Currency crisis and contagion: evidence from exchange rates and sectoral indices of the Philippines and Thailand. Working Paper No. 80/39 Washington, D.C.: International Monetary Fund. Nasution, A. 1999. Recent issues in the management of macroeconomic policies in Indonesia. In Rising to the challengein Asia: a study offinancial markets,edited by Asian Development Bank. Mandaluyong, Philippines: Asian Development Bank. Park, YC. and c.Y Song. 1997. Managingforeign caPitalflows: theexperiencesof Korea, Thailand, Malaysia and Indonesia. Geneva: UNCTAD. Pesenti, P. and C. Tille. 2000. The economics of currency crises and contagion: An introduction. FederalReserveBank ofNew YorkEconomicPolicy Review6(3):3-16. Piei, M. H. and T. Tan. 1999. An insight into macroeconomic policy management and development in Malaysia.In Rising to the challenge in Asia: a study of financial markets, edited by the Asian Development Bank. Manila: Asian Development Bank. Radelete, S. and J. Sachs. 1998. The onset of the East Asian financial crisis.Cambridge: Harvard Institute for International Development Rajan, R.S. 2000a. (IR) Relevance of currency crisis theory to the devaluation of the Thai Baht. Policy Discussion Paper No. 0030. Australia: Center for International Economic Studies University of Adelaide. Rajan, R.S. and R. Siregar. 2000b. Private capital flows in East Asia: boom, bust, and beyond. Policy Discussion Paper No. 0039. Australia: Center for International Economic Studies, University of Adelaide. Reisen, H. 2000. Policies for crisis prevention. In Achievingfinancial stability in Asia, edited by R. Adhikari and U. Hiemenz. Paris: Organization for Economic Cooperation and Development. Schadler, S. 1998. Capital movements and surveillance. In Frameworksfor monetary stability, edited byT. Balino and C. Cottarelli. Washington, D.C.: International Monetary Fund. Shigehara, K. 1999. Causes and implications of East Asian financial crisis. In Financial liberalizationin Asia: analysisand prospects, edited by D. Brooks

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and M. Queisser. Paris: Organization for Economic Cooperation and Development. Schneider, B. 2000. Issues in capital account convertibility in developing countries. DevelopmentPolicy Review19(1):31-84. Sharma, S. 1999. The challenge of predicting crises. Finance and Development june:40-42 Werner, R, 1999. Macroeconomic management in Thailand: the policy-induced crisis. In Rising to the challengein Asia: a study offinancial markets. Vol. 11: Thailand, edited by the Asian Development Bank. Mandaluyong, Philippines: ADB Yoshitomi, M. 1999. The Asian Capital Account Crisis. In Financialliberalization in Asia: Analysis and Prospects, edited by D. Brooks and M. Queisser. Paris: Organization for Economic Cooperation and Development. Yamazawa, I. and S. Okuda, S. 1994. Basic trade statisticsfor theAPDC project on changing comparativeadvantage patterns and intraregional trade expansion in Asian and the Pacific. Tokyo: Institute of Developing Economies.

CIIAPTER

III

Human Resource Requirements of the Financial Sector Under a Liberalized Regime Leila Y: Calderon,Cheryl Villanuevaand TeresoS. Tullaojr.

Abstract

his study looked at the human resource requirements of the financial sector under a liberalized regime within the General Agreement on Trade in Services (GATS) framework. The studycovered the personnel requirements of the banking, stockbrokerage,and insurancesubsectors.Using industry sources,the studyidentified the human resource requirements of the finance subsectorsin terms of educational attainment, technical skills and competencies, work experience, and personal characteristics. In addition, it reviewedthe finance curriculum of variousundergraduate and graduate programs in selectedacademicinstitutions aswell asspecialtraining programs offered by various financial organizations.The identification of gaps between the finance curriculum and the requirementsof the finance service industry formed part of the evaluation. Introduction The financial sectoris one the major sectorsof the economy that hasundergone extensive liberalization and deregulation in recent years.The country hasopened up the sector to international playerson variousmodes of supply subjectto certain limitations on market accessand national treatment. When the Philippines accededto the GATSunder the World Trade Organization (WTO), it committed to open up banking operations, servicesoffered by nonbank financial institutions, and insurance by allowing fore~gnplayersto establishand expand various financial operations. An essentialelement of successin any liberalization processis the readinessof parties to compete. Readinesscanbe viewed in terms of the capability of the domestic firms to face foreign competition and the capacityof the host

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economyto provide the necessaryinfrastructure to reap the benefits ofliberalization. The studyfocuseson the analysisof a major componentof the softinfrastructure of the economythe availability and quality of human resources.It explores the capability of the country's financial sectorto compete in a liberalized setting from a human resourceperspective.In particular, it examines whether the country has sufficient supplyof professionalsthat are capableof meeting the human resource requirementsof domesticand foreign financial corporations as the financial sector becomesmore integrated in the world market. Aside from the number of professionals,the studyidentifies the variousskills and competencies that are needed in a liberalized financial sector. In addition, it examines the current statusof variousforms of human capital formation, and how theseare linked with the human resourcesrequirements of a liberalized financial sector. Lastly,it reviewsthe programs and plans of academic institutions, finance corporations, and professional organizations in preparing our local talents to continually update themselvesand prepare for global competition. Objectivesofthestudy .Review the changesin the financial servicesbrought about by the liberalization of the sector .Outline the anticipated changesin the Philippines' commitments in the financial servicesunder the GATS .Identify the skills,competencies,and human resourcerequirements needed to answerthesechangesin the financial servicessector .Review curriculum offerings of degreecoursesof selectedbusiness schoolsand the nondegree programs of other institutions in light of the requirements a liberalized setting in the financial sector .Design a demand-supplyanalysisof the skills requirements under a new financial environment .Identify the role and possible contributions of various academic, finance-related organizations in preparing and upgrading the needed professionalsin the financial service sector Significance of the study Several studies have been made on the adjustment mechanisms and readiness of domestic firms with the entry of foreign competitors under a liberalized setting. What is overlooked in these studies is the other component of readiness the availability and quality of infrastructure that will provide the

HUMANRESOURCE REQUIREMENTS OF THE FINANCIALSECTORUNDERA LIBERALIZEDREGIME 187

appropriate environment for a liberalization processto prosper. The human wealth of an economy,which enablesa country to reap the benefitsof liberalization and deregulation, is a major component of this socialinfrastructure. A systematiclisting and analysisof the needed skills, competencies,and professional manpower needs will be a beneficial input to educational institutions in updating and revising their curriculum to meet human resource requirementsof the financial sector.In addition, the studymayserveasa basis for formulating a continuing education program that financial institutions and appropriate professional organizations mayconsider.More importantly, the studycan starta collaborativeeffort on the part of educational institutions, financial corporations, and professionalorganization in mapping out human resource development plan for the financial sector. Reviewofrelatedliterature The link betweeneducation and trade canbe traced indirectly to the StolperSarnulesontheorem within the Hecksher-Ohlin trade analysisframework. As an economyadoptsa more open trade environment in commodities,the beneficial impact of trade will accrueto the ownersof the abundant factorsof the country that are used intensively in the production of export commodities. According to this view,laborers in a labor-abundant country will be favorably rewarded under a more liberalized trade regime with enhanced employment and higher wages. Similarly, the country that specializesin the production of commodities that use skilled manpower intensively will experience higher demand for education and training as the demand for skilled professionals increases under a liberalized trading environment. According to Stokey (1988), since trade alters relative prices and wagesin the smalleconomy,it will also change the returns on invesunentsin human capital.This maystrengthen or weaken the incentives for human capital accumulation. Thus, if a small country is backward in terms of skilled manpower relative to the rest of the world, free trade will lower the relative prices of goods produced by highly skilled labor and hence, will reduce the return to invesunent in that skill. However,with the liberalization of trade in services,including manykey factor inputs, the incentive to demand education becomessignificant again even if the country does not havea comparativeadvantagein the production of commodities using highly skilled manpower.With a freer flow of trade in services,the host country to these inflows of serviceswill have to invest in human capital to prepare domestic playersfor competition with foreign entrants. In addition, greater flows into the host country, together with the ac-

FINANCIALLIBERALIZATION, MANAGING RISKSANO OPPORTUNITIES

companyingbenefits, will only be fully realized if foreign serviceprovidersare able to recruit competent and skilled manpowerdomestically. Mallea (1997) identified professional preparation, professional competency,continuing education, and quality assuranceas the key issuesthat may affect the direction of trade in professionalservices.These sameissues are likely to surface in the liberalization of financial servicessince part of the supply mode being liberalized is the movement of human persons. For example, professional preparation can take the various forms of investment in human capital. A specific question that economistsand educatorsoften askis the optimal form and mix of investment in human capital that an economy should adopt towards an efficient preparation of skilled and competent professionals. In formal education, which is an essentialingredient in the processof professional preparation, there is a basicquestion and an ongoing debate on the orientation of higher education. One school of thought believes and emphasizesthe role of liberal artsand generaleducation. On the other hand, the pragmatistsfrom the manpowerplanning school of thought put greater value in technical and professional training to ensure minimal mismatch between the needsof industry and graduatesof educational institutions. A strong general education is preferable to someeducators for several reasons.General education is adaptable to changing technologies and prepares the individual for lifelong learning. Together with on-the-job training programs and continuing education programs, it makesfor an optimal mix that can enhance labor productivity. This view was echoed in a study by Rumberger and Levin (1989) which showed that a highly specializedformal education can become obsolete in a few years,and graduatesare not able to upgrade due to their limited skills in learning new things, which is often acquired in general education. Related to this issueisa relevantstudyofNadurata (1998) on the importance of general education. According to the study,gradesin general education of accounting graduatesare significant predictors of competence and performance in auditing firms. On the other hand, gradesin accounting and auditing subjectsare significant predictors of students' performance in Certified Public Accountant (CPA)board exams. Beyond general education and professional skills training, the more basic question being askedby economistsis the link between education and productivity of workers. The human capital theorists (Shultz 1961,Denison 1962,and Becker 1975) have argued and verified empirically the positive relationship between investment in education and training with the produc-

HUMAN RESOURCE REQUIREMENTS OF THEFINANCIALSECTORUNDERA LIBERALIZEDREGIME 189

tivity of workers. However, the link has been questioned on theoretical and empirical levels.The impact of ability and socioeconomic statusof workers, for example, has been cited as a significant factor that can reduce the estimated ratesof return to education and the unexplained residualsto growth. On a theoretical ground, the asymmetric information between individuals and employers can give rise to a different perspective on education that is disconnected from productivity. According to this view, individuals invest in education to enhance their employability and not necessarilybecause it can increase their productivity. An individual's level of education sendssignalsto employers that he/she has the ability and the potential to be more productive. Since productivity enhancementis companyspecificaswell asbasedon individual ability, the levelof education informs the employer that an educatedindividual is trainable and possesses the qualities of a potentially productive worker. Thus, education, through itsscreeningprocess,sortsindividuals at the schoollevelwho can be productive in the workplace.The investment in education, in effect, expands the limited information available to future employersabout future employees. Giventhis view,the role of education in directly enhancing productivity is severed.The previous question on what type of education efficiently prepares studentsfor the workplace becomeswhich type of education increases the information to the employers on the individual's ability and potential productivity. Although there are argumentsfor viewing education asa screen and as an information-enhancing activity, empirical studies do not support suchview or at leastthe strong versionof it, and still maintain a partial preference to the human capital approach (Groot and Hartog 1975). Related to this debate on education and productivity is the issueon the impact of technological progresson the skills requirementsof jobs in various sectorsof the economy.One school of thought considers the impact of technological progress on upgrading skills (Rumberger 1984). Technological innovations including the useof computers are upgrading the skills requirements of existingjobs in many occupations.The alternative perspective,on the other hand, is the deskilling trend in capitalist economies to lower cost and maintain control over the workforce (Braverman1975,Zimbalist 1979). The middle ground view considerstechnology ashaving an impact on skills and educational requirements of jobs, but its effect is not uniform across industries. In some industries, there is positive upgrading while in other industries, there is deskilling. Flynn (1988)basedhis prediction on the impact of technology on skills requirements on what he termed asskill-training life cycle. In the earlystage

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of the technology, the impact is the upgrading of skills. Over time, there is a mixed effect. Once the technology is learned, segmented,and standardized, training shifts to vocational and educational institutions, and there is skills downgrading. In addition, Rumberger (1984)posited that the impact of technology on skills requirements is conditioned by severalfactorsincluding market forces,managerialstrategies,and selectedorganizationalfactors. The GATS and financial liberalization in the Philippines Anoveroiewofthe

(GA1S)l

The GATSis a multilateral agreementthat coverslegallyenforceable rights to trade internationally in all services except in the exercise of government authority. The agreementalsoservesasan avenueof economic growth for all trading countries in addition to putting in placea setof transparentrules and regulations limiting the intervention of governmentsand other institutions in the flow of trade in services. Previoustrade negotiations did not coverservicesmainly due to problems arising from the nontradability of mostservices.Difficulties in transport and storageaswell as the need for physicalproximity between consumersand suppliers did not lend servicesto international trade. In addition, government regulation has prevented the global transactionsof services.Thus, to protect consumers,maintain public safety,and provide national securityin an environment of asymmetricinformation betweenserviceproviders and consumers,government has to regulate the provision of a service. The developments in information technology,rapid improvements in telecommunications, expansionof foreign direct investments,and the rise in the global flow of human resourcesexerted pressuresfor substantialgrowth in international trade in services.Domestically,the contributions of the servicessectorin terms of value addedand employmenthave grown significantly. For these reasons,the negotiatorsof the lastglobal trade negotiations felt the need to draft an international agreementon services. There are severalobligations and disciplines that member countries agreeto follow. But among thesegeneralobligations,three major obligations stand out: mostfavored nation treatment,national treatment, and market access.The most favored nation (MFN) treatment refers to the nondiscrimination in the treatment among foreign serviceproviders. In particular,Article II Section2 of the agreementstatesthat Eachmember shallaccord immediately

1This section is taken from Tullao 1999.

HUMAN RESOURCE REQUIREMENTS OF THEFINANCIALSECTORUNDERA LIBERALIZEDREGIME 191

and unconditionally to servicesand servicesuppliers of any other Member treatment no lessfavorable than that it accords to like servicesand service suppliersof any other country. However,the MFN treatment doesnot prohibit a group of countries from extending among themselvespreferential concessions to enhance trade in services(Tullao 1999). National treatment, on the other hand, refers to nondiscrimination in the treatment of domestic and nonlocal serviceproviders. Article XVII Section 1 specifically provides that each member shall accord to servicesand service suppliers of any other Member, in respectof all measuresaffecting supply of services,treatment no lessfavorable than that it accords to its own like servicesand serviceproviders. Market accessrefers to the lifting of variousforms of limitations on the number of serviceproviders,valueof servicetransactions,number of persons employed by serviceproviders,value of foreign capital,and the restriction or requirement on a specific type of legal entity in establishing a supply provider. Member countries with market accesscommitments are prohibited by Article XVI Section 2 to maintain theselimitations and restrictions (Tullao

1999). Upon accession,member countries are required to make commitments along the four modes of supplyand identify their limitations on market access,national treatment, and additional commitments. The four modes of supply (that is,crossborder, consumption abroad,commercial presence,and presence of natural persons) describe the alternative manner trade in services can take its form asdefined in Article I of the agreement. Crossborder refers to the supply of servicefrom one territory into another territory. Consumption abroad is the purchaseby foreigners of servicesin the territory of another country. In the caseof commercial presence,the serviceprovidersare present in the territory in which they supplythe servicethrough the establishment of offices, branches,agencies,joint ventures and other forms of equity participation. Presenceof natural persons,on the other hand, refers to the entrance and temporary stayof the individuals into the territory of another country to supply services(Tullao 1999). Giventhese modes of supply,the member countries identify their horizontal and specific commitments by scheduling their limitations on market accessand national treatment. Horizontal commitments are limitations on market accessand national treatmentby modesof supplyacrossall committed sectorsof the country. On the other hand, the list of limitations on market accessand national treatment by modesof supplyby specific sectorsis a specific commitment of the country.

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Initial commitments of the Philippines under GATS On horizontal commitments, the Philippines setslimitations on the market accessin all sectors under the supplymode of commercial presence. In particular, it statesthat participation of foreign investorsin the governing body of any corporation engaged in activities expresslyreserved to citizens of the Philippines by law shall be limited to the proportionate shareof foreign capital of suchentities. In addition, there is alsoa limitation in the acquisition of land: Foreign investors mayleaseonly private owned lands. An important limitation in market accessthat was scheduled in the supply mode of presence of natural persons is the labor market test: Non resident aliens maybe admitted to the Philippines for the supplyof a service after a determination of the non availabilityofa personin the Philippines who is competent, able and willing, at the time of application, to perform the servicesfor which the alien is desired.This labor market testmustbe reviewed within two yearsasrequired by GATS (Tullao 1999). For sector-,specificcommitments, the Philippines has committed the transport servicesincluding the subsectorson maritime transport, air transport, road transport, and rail transport, the communications servicesincluding courier and telecommunications services,financial servicesincluding banking and insurance,and the tourism sector.The country has not made any commitment in businessservicesincluding professionalservices. In transport services,a limitation on market accessin the supplymode of presenceof natural personswaslisted. Specifically,only aliens qualified to hold technical positions maybe employed within the first five yearsof operation of the enterprise. Their stayshould not exceedfive years.Eachemployed alien should have at leasttwo Filipino understudies.The samelimitation was scheduled in insurance under financial services.In maritime transport services,foreign workers are allowed assupernumeraries in specializedvessels for only sixmonths. In tourism, variouslimitations on the temporary stayof foreign professionals and workers were scheduled. A maximum of four managerial positions was set for hotel and resort establishments.Moreover, foreign workers are allowed during the preoperation stageand initial stageof operations of new hotels and resorts up to three months and renewable for another three months. There are also limitations on the number of aliens that can be hired in specialtyrestaurants. For travel agencies,it is specified that managersand executivesmust be resident Filipino citizens.

HUMAN RESOURCE REQUIREMENTS OFTHEFINANCIALSECTORUNDERA LIBERALIZEDREGIME 193

SPecific commitments in thefinancial sector The financial sectoris one the major sectorsof the economy that hasundergone extensive liberalization and deregulation in recent years.The country hasopened up the sectorto international playerson various modes of supply subjectto certain limitations on market accessand national treatment. When the Philippines acceded to the GATS under the World Trade Organization {WTO) ,itcommitteditself to open up banking operations, servicesoffered by nonbank financial institutions and insuranceby allowing foreign playersto establishand expand various financial operations. For all subsectors,we havedeclared a general limitation on market accessin the supplymode of commercialpresence.In particular, "authorization to establish commercial presence or expand existing operations in banking and other financial services(excluding insurance) shallbe subjectto a determination by the concerned regulatory authorities whether public interest and economic conditions justify the issuanceof suchauthorization." Limitations listed in the horizontal section of the Philippine commitmentsto GATS shall also apply in commercial presenceand presenceof natural persons. In commercial banking, we have committed the liberalization of the acceptanceof depositsand other repayablefunds from the public, all typesof lending including consumer credit, mortgage credit, and financing commercial transactions,all paymentand money transmissionservicesincluding credit, charge and debit cards,travelerschequesand bankers draft, guaranteesand commitments,trading for own accountor for accountof customersof money market instruments, foreign exchange,derivative products including futures and options, exchangerate and interest instruments including products such asswaps,forward rate agreementsand other allowable negotiable instruments and financial assets,participation in issuesof all kinds of securities including underwriting and placementas agentand provision of services related to such issues,assetmanagement,suchas cashor portfolio management, all forms of collective investment management, custodial, depository and trust services. The country hasalsoidentified certainlimitations in commercial banking. For example, cross-bordersupplyrequires commercial presence.rn addition, there are certain limitations on commercial presence including 30 percent maximum (40 percent if approved by the President of the Philippines) in the voting stock of foreign equity in existing and new domestic commercial banks. Deposit taking is only extended to domestic commercial banksand to the four grandfathered foreign bank branches.Foreign participation in the board of directors is limited to one-third of the board total

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membership. There is a ceiling imposed on equity ownership (20 percent for individuals and 30 percent for corporations). Acceptance of deposit substitutes,guarantees,and commitmentsrequire prior authorization. Commercial bankswith expandedcommercialbanking authority mayconductperformance of trust, investment management and other fiduciary business,and underwriting. In financial advisory serviceswe have committed the liberalization of underwriting, guaranteesand commitments, credit reference and analysis, investment, and portfolio researchand advice.We have also made commitments in the other subsectorsof the financial sectorincluding factoring, financialleasing, money broking and foreign exchange broking, credit card services,promotion and provisionof information about the services/products offered by a foreign bank, sale of contracts for the payment of benefits or performance of future servicessuch as life, education, pension and internment plans, securities dealership/brokerage of equities and its derivative products (warrantsand options) and in transferablesecurities. There are certain limitations on market accesspertaining to commercial presence in the country's commitments in financial advisory services. Serviceproviders should be organized asa commercial bank or a nonbank financial intermediary. Foreign equity is limited to 40 percent for nonbank financial intermediaries. In addition, there is a limitation on national treatment for the presence of natural persons. Foreign service suppliers shall perform technical functions only with Filipino understudies. For factoring and financial leasing,commercial presenceis required in crossborder supply. For commercial presence,only financing companiesorganized as a corporation or a general partnership can perform the service. The usual 40 percent foreign equity participation and one-third membership of foreigners in the board of directorsalsohold. There is alsoa prohibition for foreign managing partners in the caseof general partnership. For limitation in national treatment, a Filipino understudyshould be trained if the foreign service provider shall perform technical functions. For moneybroking and foreign exchangebroking, credit card services, commercial presence is required and must be performed by a commercial bank or a nonbank financial intermediary. The usual foreign equity limitations hold. There is alsoa requirement for a Filipino understudy for a foreign service provider in money broking and foreign exchangebroking. However, this is not required in credit card services. Only commercialpresenceis required for the promotion and provision of information about the servicesoffered by foreign banks. But in the caseof

HUMANRESOURCE REQUIREMENTS OFTHEFINANCIALSECTORUNDERA LIBERALIZEDREGIME 195

securities dealership/brokerage, asidefrom the requirement of commercial presence,the company must alsobe organized asa securitiesbroker/dealer corporation or partnership. The corporation mustbe a member of the stock exchange.Underwriting is allowed only on a best-effortbasis. For the performance of the functions of stock transfer agent, commercial presence is required and the seIViceprovider must be organized as a corporation or partnership with at leastone CPA. In insurance,we havecommitted to liberalizethe life insurancesubsector covering ordinary, group, individual, industrial, health and accident,and annuities; the general nonlife subsectorincluding fire and allied risks, earthquakes,shock,typhoon, floods, and tidal waves;marine subsectorincluding oceanmarine, inland marine, marine hull, and aviation; casualtymotor car; health and accident; burglary; engineering; suretyship fidelity/surety and bonds; insurance auxiliary seIVicessuchas actuarial consultanciesand averageadjustors;and reinsurance/retrocession. Limitations on market accessincludes the approval of the Insurance Commission on the establishmentof newinsurance companies. Only aliens qualified to hold technical positions may be employed within the first five years of operation of the enterprise, and their stayshould not exceed five yearsupon entry. For life and general nonlife insurance, for cross-bordersupply, risks located in the Philippil1es should be insured with the companiesauthorized to transactbusinessin the Philippines. For reinsurance/retrocession, limitations on cross-bordersupplyinclude the priority cessionsto authorized insurance/reinsurance companies,foreign unauthorized insurers should be represented by resident agentsregistered with the Insurance Commission,and 10 percent of total insurance cessionsto foreign unauthorized reinsurers should be ceded to the National ReinsuranceCorporation of the Philippines. Financial liberalization ofthePhilippines In the 1980sand 1990s,the Philippines' financial systemwassubjected to a number of reform programs aimed at promoting a liberalized environment. These financial reforms proceeded along the following categories: Interestrateliberalization To encourage more savingsin banks,improve domestic resource allocation, and deepen financial markets,the then Central Bank of the Philippines deregulated all bank interest rates in 1981 except for short-term lending rates. The following year, interest rates ceilings on depositswere lifted followed by

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the removal of those covering medium- and long-term lending rates. The deregulation processwascompleted by the end of 1982with the removal of the remaining ceiling on short-term lending rates (Suleik 1992). Rationalization ofthereserverequirement

With the issuanceof Circular No. 1209 on September1, 1989.and Circular No. 1269 on December28,1990, the reserverequirements acrossall banks and types of deposits were gradually unified. The unification processwas intended to reducebanks' intermediation costand promote financial efficiency. In the 1990s,the thruslof reforms wasdirected at lowering the reserve requirement in order to reduce banks' intermediation cost and, eventually, lending rates. From a reserverequirement againstdepositand deposit substitute liabilities of banksand nonbankswasgraduallyreduced from 25 percent in December 1992to 9 percent legalreserveand 3 percent liquidity reserveas of year 2000 (PDCP1996). Rationalization oithe CB rediscountwindow The Central Bank Rediscount Window was rationalized and simplified in November 1982. The rationalization included, among others, the removal of fixed spreads and the adoption of a unitary market-based rediscount rate across all types of papers and applied to all types of eligible banks. These changes were instituted to encourage efficiency in the allocation and utilization of funds as well as the promotion of market-oriented interest rates (Suleik

1992). Establishment ofnew banksand branches

The liberalization of the banking sectorwasundertaken in 1993to enhance competition, reduce interest rates,promote innovations in financial services, and improve financial intermediation especiallywith the country's trading partners. The liberalization covered three areas:the entry of foreign banks, the liberalization of bank licensing, and bank branching (PDCP1996). The liberalization of bank licensing is meant to relax the rules for licensing; thus, enabling more applicantsto q~alify. Relaxing branching rules, meanwhile,allowsexisting commercial banksto put up branchesanywherein the country except in overbranched areas.Removing the tedious auction processin the awarding of bank branches,banksare now more free to establish branches aslong aJthe branches fulfill prudential requirements suchas liquidity, capital requirements, capital adequacyratio, profitability, and other financial ratios (PDCP Industry Digest1996).

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Entry offoreign banks

In May 1994,Republic Act (RA) 7721 provided for the entry of foreign banks to foster greater market competition, reduce intermediation costs,and increaseforeign capital inflows. Under the new law,foreign bankswere allowed to enter under any of the three prescribedmodes.Foreign bank entrantswere to be chosenamong the top 150international banksor top five banksin their domestic markets (PDCP1996). Directlendingprogram In 1994, alternative investments for the 15 percent agricultural credit requirement for bankswere expended to include financing educational institutions, cooperatives,hospitals and other medical services,socialized housing and lending to local government units without government guarantee. Financial restructuring ofthe Central Bank

In 1993,RA 7653 created an independent central monetary authority. the Bangko Sentral ng Pilipinas (BSP),replacing the old Central Bank. Certain assetsand liabilities of the old CBwere transferred to the BSPto give the latter an initial net worth of P10 billion. Most of the external liabilities and nonperforming assetswere retained with the old CB. Mter the transfer, the National Government issued P220 billion worth of government securities partly to reimburse the BSPadvancesmade during the transition and allow the BSPgreater flexibility in its open market operations. Broadening thesecuritydealershiPoftreasurybills

Policy reforms were made in the securitiesdealershipof treasurybills to level the playing field in interest rate determination. An "open application policy" for accreditation of government securities dealerswasadopted starting August 1991. On April 22, 1994, the Monetary Board further liberalized the accreditation guidelines by expanding the coverageof the dealership network. GeneralBanking Law of 2000

The General Banking Act is an act regulating banksand banking institutions and for other purposes asamended in RA 337enacted on July 24,1948. Despite severalamendmentsintroduced to RA No. 337, there remains a pressing necessityfor a new generalbanking law that would meet the challengesposed by globalization,provide additional safeguardsfor new risksand challengesin the banking system,align said act with the provision of recently

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passedlawssuchasRANos. 7653,7906,7721,and 7353,and take into consideration current practices,innovations,and technology. On May 24, 2000,the GeneralBanking Lawof 2000wassigned into law by then President Estrada.The law introduced major reforms that aimed to strengthen the banking systemthrough the adoption of measuresthat would ensure safe and sound practices in Philippine banking. Said law mandates the BSPto enforce prompt corrective actions on banksfound to be conducting businessin an unsafe and unsound manner. Measuresagainstviolations of the rule on Directors, Officers, Stockholdersand other Related Interests borrowings nave also been tightened. The new law also relaxes certain bank ownership ceilings and entry offoreign banks. Securitiesregulation code At present, Batas Pambansa BIg. 178, otherwise known as the Revised Securities Act, serves to regulate the securities market. However, with the changes occurring globally, there is a need to align our securities market with these new developments. Senate Bill No.1220 titled The Securities Act of 1998 in consolidation with House Bill No. 8015 titled The Securities Act of 2000 has been enacted and shall be known as "The Securities Regulation Code. The Securities Regulation Code seeks to institution~lize two core reforms of full disclosure and self regulation. It also seeks to respond to the need for consistency on our part with the practices of practically all exchanges around the world in providing market liquidity. The securities market would cease to be a ready and efficient mover of funds from one sector to another if broker-dealer functions are made into separate legal entities. Highlights of the Securities Regulation Code include the following: .Insures the independence of the Securities and Exchange Commission (SEC) from any government body, particularly the Office of the President. .Clarifies the role of the stock exchange and other self-regulatory organizations to act in the interest of investors and the public. .Provides a more transparent securities market through full disclosure of material information about public companies to investors. .Clarifies prohibited market practices and raises the amount of type of penalties meted out for violations of the securities laws and their rules for public interest and the protection of investors. .Imposes higher standards for market participants consistent with international best practices.

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Increasesthe protection availableto minority shareholdersof public companies. Under the Securities Regulation Code, the capital market would move to full disclosure regulation from a systemof merit regulation. Under the new regulation, investorswill be betterinformed in order for them to assess whether an investmentin a particular offering is suitable or not. In addition, consistent with international standards,the proposed bill institutionalizes the concept of self-regulatoryorganizations by the market playersthemselvessuchasthe Philippine Stock Exchange (PSE) and other associationsas they are in a better position to assesstheir needs than the SEC. The PSE plans to have its demutualization by August 2001. Demutualization is the processof opening up the ownership of the stock exchange to the public, just like a company undertaking an initial public offering (IPO). At present, the PSEis owned by 170member-brokers. With demutualization, the ownership of the bourse will be broadened although some member-brokers will likely object to this move since this would mean giving up complete control of the exchange. liberalization of insurance markets On October 24,1994, the insurance market wasliberalized when a presidential order issued on June 22, 1994cancelled Negative List C in the Foreign InvesbnentsActof1991, which limited foreign invesbnentsin certain areasof business,including insurance,to a maximum of 40 percentequity. Asa consequence, the insurance serviceindustry wasdeemed open to foreign investors. However,there wasa provision that Negative list C would be reviewed after a period of two years. To implement this new development,the Deparbnentof Finance,upon the recommendation of the Insurance Commission,issued Deparbnent OrderNo.100-94datedOctober24, 1994containing the guidelines on entry of foreign insurance or reinsurance companies or intermediaries in the Philippines. The guidelines included the mode of entry, basis of selection, and capital requirements depending on the equity percentage of foreign investmentsincluding qualification of applicantfirms. Furthermore, the number of entrants during a two-yearperiod would be limited to five eachof insurance, life and nonlife, reinsurance,and intermediaries but maybe increasedto 10 each with approval of the Presidentof the Philippines and upon the recommendation ofth~ Secretaryof Finance.

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The approval of Republic Act No. 8170dated March 28, 1996,further liberalized the entry offoreign investmentsin the insuranceindustries asthis legislation measure completely deleted Negative List C in the Foreign Investments Act of 1991.Nevertheless,newinvestorswill still be governed by the Insurance Code of the Philippines and will have to satisfystandards on financial capability and reputability as well as comply with the licensing requirements setby the Insurance Commission. Impact of legislationsand reforms on the removalof country's limitations on market accessand national treatment Nondiscrimination in the treatment of countries that have accededwith the GATSis one of the major obligations of the multilateral trading agreement. Section72 of the GeneralBanking Lawof 2000statesthat "the entry of foreign banks in the Philippines through the establishment of branches shall be governed by the provisions of the Foreign LiberalizationAct." The conduct of offshore banking businessin the Philippines shall be governed by the provision of the Offshore Banking SystemDecree of the Presidential Decree No.

1034. Changesin the General Banking Law of 2000have certain implications on future committnents with the GATS,The GATSencouragesrecognition of standards,educational levels,and qualifications,Relatedto the improvement of human talents in the financial sector,the country has stated,asone of the limitations of its committnents with the GATS,the provision that a non-Filipino citizen employed asan officer or assignedto do technical functions shall havetwo Filipino understudies,With this training and transferof knowledge, it is expected that the standardsand qualifications of Filipino officers will be uplifted, Section 16 of the GeneralBanking Law of 2000provides the fit and proper rule. The Monetary Board "shall prescribe,passupon and review the qualifications and disqualification of individuals elected or appointed bank directors or officers and disqualify those found unfit," Although the GATS allows for domestic regulation, and the intention of the lawis to professionalize the managementof the financial sector,this provision maybe interpreted as a restriction in the national treattnent of the foreign officers of financial institutions operating in the country. Likewise, for the Securities Regulation Code, it imposes higher standards for market participants consistent with international best practices. Chapter 8 of the code discussesthe regulation of securities market professionals. In this chapter, Section 31 looks at the development of securities market professionals.

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"The Commission,in joint undertaking with self-regulatoryorganizations, organizations and associationsof finance professionalsas well as private educational and research institutions, shall undertake or facilitate/ organize continuing training, conferences,seminars,updating programs, research and development as well as technology transfer at the latest and advanced trends in issuanceand trading of securities, derivatives,commodity tradesand other financial instruments,as well as securities markets of other countries."

The Philippine commiunents with GATSalsoidentified requiring commercial presence in crossbordersupplyof commercial banking services.Section 73 of General Banking Law authorizes the Monetary Board to allow a foreign bank to acquire up to one hundred percentof the voting stockof only one bank organized under the Republic of the Philippines. Within the sameperiod, the Monetary Board mayauthorize any foreign bank, which, prior to the effectivityof this Act, hasavaileditself of the privilege to acquire up to sixty percent of the voting stockof a bank under the Foreign Banks Liberalization Act and the Thrift Bank Act, to further acquire voting sharesof suchbank to the extent necessaryfor it to own one hundred percent of the voting stockthereof. This provisionis more liberal than the limitations on foreign equity stated in the country's current commitments with GATS. The General Banking Lawof 2000alsoallows ownership of bank holding corporations in all typesof banks,instead of only thrift banksand rural banks.The change provides more freedom for the accessof foreign banksto the Philippines in casesof future investment opportunities and future market accesslimitation commitments with the GATS. The new banking lawincludes universal banksasan additional classification for bankscompared to the old sectionin the GeneralBanking Act that limits the most complex classificationof banksto commercial banks. Section 23provides that a universalbank shall have the authority to exercise,in addition to the powersauthorized for a commercialbank in Section 29, the powers of an investmenthouse asprovided in existing lawsand the power to investin nonallied enterprisesasprovided in this act.Sincea universal bank is deemed to provide a wide array of financial services,its reclassification will support local banksto go global and provide a healthy competition with its more advanced foreign counterparts. Section 59provides that the BSPshallhavefull authority to regulate the use of electronic devices,such as computers, and processesfor recording, storing, and transmitting information or datain connection the operations of the bank, quasibank trust entity, including the delivery of servicesand prod-

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ucts to customersby suchentity. The GATSprovides market accessthrough free transfer and processing of information. Section 57 may have set some limitations on our commitment with GATS. Chapter II of the General Banking Lawof2000 focusesentirely on the provisions for the Authority and supervisorypowersof the BSP.This enumeratesits authorities in governingfinancial institutions ascompared to the GBA, which does not have a chapter devoted to the authorities of the BSP. Under the GATS,appropriate regulatory authority in the Philippines is allowed, which shall determine whether public interest and economic conditions justify authorization for the establishmentof commercial presence or expansionof existing operations in banking and other financial services.For foreign financial institutions with internationally recognized standing, such determination shall include a demonstrated capacityto contribute to the attainment of Philippine development objectives,particularly in the promotion of trade, investments,and appropriate technology transfer.Whether the financial institution's country of incorporation hasstrategictrade and investment relations with the Philippines will also come into play. Demand for professionals in the financial sector Economic contributions ofthefinancial sector The finance industry, which consists of banks, nonbanks and insurance companies, contributed to the economy an estimated gross value added of Php 130.3 million in 1998. This amount is approximately 5 percent of the gross domestic product and 9 percent of the gross value added of the services sector. The bulk of income (72 percent) of the industry came from the banking sector. The industry exhibited very rapid expansion in the 90s as shown by the average annual growth rate of8.8percentfortheperiod 1993to 1998.The surge in financial services during the period was triggered by the liberalization of the entry of foreign banks with the passageofRA 7721 in 1994and the seriesof policy reforms undertaken by the BSP. These reforms helped expand the resources and operating network of the banking system, especially commercial banks, which accounted for more than 90 percent of the expansion. Deposits during the period grew substantially from Php 639 billion in 1993 to Php 1,630.9 billion in 1997, or by 155 percent, reflecting the degree of network expansion, the improvement in banking services, and the competitive yields on deposits. The industry employs some 695,000 workers that constitute around 2.4 percent of the total labor force. Although it takes in only a small portion of the labor force, the capacity of the industry to absorb additional employment has been growing rapidly as shown by an average employment growth of7percent

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RESOURCE REQUIREMENTS OF THEFINANCIALSECTORUNDERA LIBERALIZEDREGIME 203

annually. This employment growth has been attributed to the expansion of the industry due to the liberalization measuresimplemented in the 1990s. Human resourcerequirementsin thefinancial sector Competence refers to the basic skills of reading, writing, and math. But there is a difference. Not only must the worker of tomorrow know how to read a simple book, article, or set of instructions, he/she must also know how to read and interpret graphs, charts, and diagrams. He/she must be able to scan information quickly and pick out relevant information. So much information will be available that it will not be enough for a worker just to be able to struggle through written information a word or phrase at a time. Speed reading and comprehension, particularly the latter, will be critical. Employers want workers who can quickly digest complex material and then be able to use the information they acquire to solve problems. In writing, it will not be enough for a worker to simply be able to put together a grammatically correct sentence. Workers will need a level of writing skill that will enable them to communicate quickly and effectively. Workers will need the skill to prepare business documents that are clear, concise, accurate, specific, logical, and easyfor readers to understand and use. Finally, the required numeracy skills will be more conceptual than computational. It will be less important that workers know how to add a long series of complex numbers manually than to be able to scan computer-generated results and understand the computational routines used to arrive at these results. Since these computational routines are likely to be highly sophisticated, workers will require more than just the ability to add, subtract, multiply, and divide. At least some knowledge of higher -order mathematics, including a knowledge of business statistics, will be essential (Boyett and Conn 1991). Quinn (1992) argued that the firm must focus on developing and managing intangibles through three core knowledge competencies: culture (knowingwhy), know-how, and networks (knowing who). Arthur et al (1995) believe these competencies are relevant also to individuals planning an intelligent career. Know-how relates to important skills and abilities and knowing who relates to the networks to which an individual belongs. In combination, these three competencies distinguish the individual career. It is therefore important for the individual to examine these competencies. Old competencies

The nature of skills in banks and insurance institutions pointed out in the book by Dicken (1998) areasfollow~:

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Common emergingcompetencies include the ability to operate in a well-defined and stable environment, the capacity to deal with repetitive, straightforward, and concrete work processes, the ability to operate in a supervised work environment as well as cope with isolated work, and the ability to operate within narrow geographical and time horizons. For upper-tier workers, generalist competenciesinclude broad, largely unspecialized knowledge and a focus on operating managerial skills, while administrative competencies include the usual leadership skills, routine administration, top-dOwn, carrot-and-stick personnel management approach, and the ability to carry out orders from senior management. Proceduralcompetencies for middle-tierworkersinclude specialized skills that involve applying established clerical procedural techniques. This requires a capacity to receive and execute orders. SpecializedskillS'for lower-tierworkÂŁrsinclude data entry and data processing. Newcompetencie5

Common emerging competencies include the ability to operate in ill-defined and ever changing environments, the capacityto deal with nonroutine and abstractwork processes,the ability to handle decisions and responsibilities, group/interactive work, system-wideunderstanding, and the ability to operate with expanding geographical and time horizons. Professionalsin the financial sectorhaveto acquire the emerging competenciesto be able to cope with the intricacies and complexities of products as well as manage the risks in the global market environment. In addition, flexibility and adaptation are essential,and specializedjobs must be integrated into a functioning whole. The new expertise required for upper-tier workers includes high-level specializedknowledge in well-defined areasneeded to develop and distribute complex products. The new entrepreneurship for upper:.tier workers requires the capacityto manageand setstrategic goals,to share information with subordinatesand listen to them, and motivateindividuals to develop new businessopportunities. Informants attestto the truthfulness of theseviewsconsidering that the financial sector is now experiencing competition in terms of professional qualifications and expertise with the global environment. More and more foreign companies are establishing financial institutions, so new concepts and technology are being introduced. They saythat this createsnewjobs for highly skilled people. Higher-ups do better when they get feedbackfrom subordinates,and motivating them is

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thekey. Also,job opportunities are in fact offered. A feedbacksystemis crucial to determine people's ideas and reactions to situations. That there must be communication with subordinatesthat would eventuallymotivate them. They also believe that two brains are better than one, with more people sharing ideas,they will be more productive. Middle-tierworkers

Middle-tier worker includes customer assistanceand sales competencies. Broader and less-specializedfocused on assistingcustomersand selling, and the capacityto define and solveproblems.The key informants agree that they are indeed experiencing this situation considering the fact that more and more customersare awareof customerservicedeliveryby computer. In addition, they pointed out that salesand marketing people must know the needsand wantsof customersto better serveand satisfythem. Therefore, salesand customer servicepeople must know their products and what they can offer. With this, it is important that there must be a room for these professionals to go up the corporate ladder. However,one respondent believes that specializationis still important and inevitable in this competitive world. Lower-tier warker:s

Lower-tier workers involve disappearanceof low-skilljobs. The respondents are indeed being disregarded and as a consequence,the disappearanceof low-skilljobs is worsening the unemployment problem since highly skilled individuals are not alwaysreadily availablein the labor market. Dicken (1998)observesthat technological and organizational developmentsare drastically changing the nature of work at alileveisredefining skills and increasing flexibility. There have been substantial changes in the demand for particular typesassociatedwith: .Technological change in both processesand products (including, for example, the growth of direct telephone and computer provisions of banking insurance and other services) .Organizational changesin how new and existing service products are produced There has been a widespread tendency for a dramatic decline in the volume of clerical processing work performed, until recently it is manually done by lower-tier personnel with someassistanceof mainframe counters for data crunching. This remarkable contraction in old-fashioned clerical processingwork is the result not only of automation but also of the transformation

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of work done by personnel in the middle and upper-rungsof a firm's occupational structure. Parallel to this transformation in data processingand data handling, increasing competition is generating new demands for both sales and assistancepersonnel. Likewise, specialistsare able to identify new markets, conceive new products, develop new systemsand sell the new, often complex services(swaps,futures, etc.). The outcome of this profound processof skill transformation is the emergenceof a new matrix of competencies that may be viewed in terms of new skills that are being substituted progressivelyfor older ones. Some of these new competenciesare common to both middle- and upper-levelworkers; others are specific to various groups within the occupational hierarchy (Bertrand and Noyelle 1988). All the major banksand financial servicecompanieshave undertaken major rationalization and restructuring programswhich haveresulted in substantial job losses.Some of these have gone hand in hand with large-scale acquisitions and mergers. For example,following the mergers of two Unites Statesbanks, Chemical Bank and Manufacturers Hanover in 1991,the number of European staff wasreduced from 3,400 to 2,000. The more recent merger between Chaseand Chemical will certainly result in job lossesbecauseone of the motivations for the merger is to increaseefficiency. The loss of financial jobs is especiallymarked in the retail banking sectorwhere the number of retail branchesis falling dramaticallyas the banks concentrate their servicesin a smallernumber of centersand provide more of their servicesonline. For example, in the United Kingdom, the National Westminster Bank shed around 8,000jobs between 1994and 1996and announced plans to reduce its workforce by a further 10,000jobs by the end of the decade in the United Statesand Europe, it is being predicted that there could be labor reductions in die financial servicesindustries of up to 50 percent by the year 2005 (The FinancialTimes 1996). More employment reductions may well result from the continued deregulation of financial markets.The regulatoryprotection of national markets hasallowed "inefficient" practicesto exist. As the regulatory walls come tumbling down from one country to another,and asthe full impact of the internationalization of the industry takes hold, changesalmost certainly signal the continuation of 'joblessgrowth" in the financial serviceindustries,even though there may well be localized exceptions. The rapid pace of global change has created demand for people with specializedtechnical and managerialskills. It might be said that people with these skills have a comparative advantageover others. Many global leaders believe that technical skills in combination with people skills represent an

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important knowledge set,but there maybe greateremphasison the ability to learn than on current knowledge. Firms increasinglyexpectnations to invest in education sufficient for employment (Parker 1998) Desiredskills for thefuture According to Boyett and Conn (1991), employers wanted and expressed a desperate need were for workers who had a solid basic education, relationship skills and skills in self management. Reviewing the results, American Society for Training and Development lumped the most desired skills of workers in the future into seven categories: learning to learn, competence (reading, writing, and computation), communication, personal management, adaptability, group effectiveness, and influence. Each of these had a specific meaning for prospective employers. .Learning to learn. Each person should acquire the self-knowledge concerning when and how he/she learned best. The workplace should be one of constant change, and to retain their competency, workers must continuously learn new skills. .Communication. This refers to verbal and listening skills. Workers will be members of teams. Much of the value of teams stems from the increased communication between team members sharing information and ideas. Workers of the future must be good communicators. They must have the skill to express their ideas and convey information to others quickly and effectively. They must also be good active listeners, since much of the information required to perform their jobs, solve problems, and work effectively with others will come from verbal interaction rather than written sources. Written sources are deemed too slow. .Personal management.Refers to the individual's self-esteem and self motivation. Intrinsic motivation or internal drive to succeed on a job has much to do with how successful a person is in finding the right match between what he/ she enjoys doing and what he/she does for a living, workers will need skills in setting personal and career goals, and planning and managing their career in concert with these goals. .Adaptability. Refers primarily to creative thinking and problem-solving skills. There will be increased responsibility on employees for decision-making and problem-solving. Workers of tomorrow need the skills to break mental sets, think creatively, analyze problems, and find innovative approaches to problem resolution. Since most of this problem solving activity will occur in team or group settings,

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employees need skills and experience in group problem-solving activities. Groupeffectiveness. Refersto interpersonal and team skills. Employeesneed skills to work effectively in groups. They need to understand how their individual behaviorimpactsothers.They need skills to negotiate, resolve conflict, handle stress,and deal with undesirable behavior in others, share in task accomplishment, and build positive working relationships with others in a group setting. Influence.Refersto skills in organizational effectivenessand leadership. Employeesneed an understanding of what organizations are, how they work, why they exist,whatmakesorganizationseffective or ineffective, and how external and internal forces affect organizational accomplishment. On the leadership side, employeesneed an understanding of what makesleaders effective or ineffective, how the leader influences membersof the group, the rise of formal and informal leaders,the importance of a "vision,"ethical standards, etc. Human resourceneedsin thefinancial sectorin thePhilippines The Bankers Associationof the Philippines (BAP) surveyedits members on the minimum competencies of tertiary education graduatesas required by the banking industry. The oral and written communication skills were the primary requirement of banks for entry level positions. In addition, knowledge in the following banking courseelectives: .treasury, .foreign exchange, .investment banking, .financial institutions .trust, .finance math, .international banking, and .accounts management To date, there has not been anyPhilippine studymade on the resource requirements of banksin the financial sectorto find out whether the country is indeed readyto compete in the global arena.The usual studieswould only include issuesthat are related to banking and non bank operations and are usuallycommissioned by the private financial institutions for their ownuse. Financial servicesinclude: banking services,other credit services,services

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related to administration of financial markets,servicesrelated to securities markets(brokerage and portfolio management),and other financial services (suchas foreign exchange and financial consultancy). At present the entry/staff job levels in the Banks,Insurance and Non bank Financial Institutions are: .authorized signer, .teller, .trainee, .new account personnel, .accounting assistants, .marketing officer, .programmer, .legal and collection, .loans coordinator, .accounts coordinator, .financial assistant/analyst, .nsk management staff, .risk managementanalyst, .sales traders, .dealers, .research analystsand assistants, .backroom office staff (accounting or settlement), .office clerks,and .management trainee (salesresearch). Professional/managerial levels are: .Accounts Officer, .Finance Manager/Director, .Business Development Officer, .Risk Management Officer, .Assistant Vice President, and .Vice President.

Another wayof identifying the human resource needs of the financial sectoris to look into the limitations of national treatment on the presenceof natural personslisted in our commitmentswith GATS.Basedon our commitments in the GATS, we have cited a limitation on the presence of foreign service suppliers in the performance of technical functions. We require a Filipino understudy in financial advisoryservicessuchasunderwriting, guar-

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anteesand commitments, credit reference and analysis,investment and advice. A Filipino understudyis alsorequired in trading of money market instruments, foreign exchange,derivative products suchasfutures and swaps,exchange rate and interest rate instruments including swapsand forward rate agreements.In addition, a Filipino understudyis also required for a foreignservice provider in factoring, financial leasing, money broking and foreign exchange broking. A requirement of a Filipino understudy in these very specific financial servicesimplies that we still lack the necessaryhuman resourcesin these services. It should also be mentioned that a Filipino understudy is not required in the some commercial banking activities like acceptanceof deposits, all typesof lending, all fornls of paymentand money transmissionservices.Moreover, in credit card services,trading in securities,and all type of insurance services,the requirement of a Filipino understudyis not listed asa limitation in the presence of foreign provider in these specific services.This implies that we have enough local talents who can perfornl these servicesand can match the capabilities of foreign serviceproviders. Summary olke)' informantY In today's highly competitive and expanding global financial markets, expertise in every product is very vital and, in a global market environment, one must be familiar with market conditions, practices, customs as they vary from country to country. Therefore, it is very important to assessthe readiness of the our nation's human capital as it slowly opens its doors to the rest of the world. The resource requirements of banks can be divided in terms of educational attainment, technical skills/ competencies, work experience, and personal characteristics:

Educationalattainment A college degree specifically a Bachelor of Science degree in the courses related to Commerce, Accounting, Computer Science,Banking and Finance and Economics,is a very important requirement in entering financial institutions. Graduating with honors and specialawardsare alsogiven priority. Age does matter howevcrin the insuranceindustry, in the sensethat the respondentsfavor applicantswhoseagesrange between30and above.Suchis the casebecauseit would be easierto believe somebodyin his/her thirties than a fresh college graduate.

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Skills/competencies For theBankingIndustry Requirements include excellence in oral and written skills and proficiency in numbers or forecasting,good analytical skills,attentivenessto details,and orderliness. Knowledge in computer applications like MS DOS, Microsoft Office and other computer applications.They mustalsohavea background in accounting and finance. For theInsuranceIndustry

The specific skills required of an applicant are almostsimilar to the banking and stock brokerage professions.They include: excellence in written and oral communication, selling and servicing,and computer literacy. For Stock BrokeragefiTm5

No specific course or age is required, as long ashe/she passesthe Certified SecuritiesRepresentativeexaminationgivenby the SecuritiesExchangeCommission. For the order taker, he/she is required to take the MAKTRADE Examination, before he/she can get a license. He/she must also have an adequateknowledge of the national aswell asinternational stockmarkets. Worltexperience

For entry level positions, work experience is not strictly required but 2 to 3 yearsof experience in banking (credit, treasuryand operations) is preferred. Whereasfor managerial positions,extensivework experienceis required and professionalswith a degree in Master in BusinessAdministration (MBA), as well asexposure to international banking operations, remittance, trade (imports and exports) and treasuryoperationsasidefrom branch banking operations would serveasa great advantage. Personalcharacteristics

Ethical integrity and honestytop the list. Followedby being hardworking, selfdisciplined, assertiveand confident. Also,being accommodating,aggressive, tenacious and with initiative, displaying a high emotional quotient such as being respectful of people, open to challengesand to new ideas,persevering, creative,dynamic, quick thinker, having a passionfor learning, and an ability to easilyadapt to various situations are a plus. In addition to those above,having excellenthuman relations and motivational skills have been chosenas the most important requirements for the workers in the financial servicesholding both staff and managerial positions.

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In termsof the adequacyor inadequacyof the number of graduatesthat can meet the financial sector'srequirements,a key informant mentioned that there are more than enough graduates with finance degrees to fill in the availablepositions but too little graduateswho meet the standardssetby the finance industry. Only graduates from the top Philippine universities can meet the industry's criteria. For example, a key informant mentioned that graduatesfrom other schoolsare unable to expressthemselveswith clarity in both the oral and written form and only a few are familiar with the term "e-commerce." The importance of the human resourcesfunction in the servicesarena have strongly been stressedin a book titled Managing Services (Lovelock 1988). It states: "For top management it is a crucial strategic issue. It is ha;d to conceive of a successfulservicebusinessmanagermuch lessan entrepreneuror innovatorwho is uninterested in personnel matters. Even minor questions rel~ted to personnel policy are usually vital to the service business,and the waythey are treated and the location of responsibility for human resources managementin the organization should reflect its importance..."

Human resourcesissuesconfronting the financial sector Training and development Many feel that training programs need to be updated and upgraded. A refocusing geared towardsworld financial trends and practicesand self-development is called for aswell. One key informant pointed out that further training in terms of active involvement in international conferenceswheneveropportunities arisewould definitely be of great help to updating the finance professional'sknowledge in the latest approaches in doing and managing transactions in the global market. A finance professional should be upd~ted on the following: International Rules on Documentary Credits UCP 500, Bank to Bank ReimbursementsURR525; Uniform rules for CollectionsURC 522;International Standby Letter of Credit ISP 98; Swift Operations; Euro One Currency System,FED Wire and Chips PaymentOrder System. Another key informant feels that there is not enough training seminars given. Stating that the training that theseprofessionalsget are not commensurate to the degree of responsibility that they aregiven.

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Hence, in view of globalization, the rapid pace of global change has createda demand for people with specializedtechnical and managerial skills, and people with these skills might be said to have a comparative advantage overothers. Many global leadersbelieve that technical skills, in combination with people skills, represent an important knowledge set, but there may be greater emphasis on the ability to learn than on current knowledge. Firms increasingly expectnations to investin education sufficient for employment. Leadersbelieve that the knowledged worker should be more than a repository of technical knowledge. He/she must be able to accessthat knowledge and transfer it to other people. In terms of compensation, a career in the financial servicesgives the following benefits package as one advancesin his/her career: high paying salary,bonuses,opportunities to travel,paid holidays,car plan and employee recognition awards.In spite of all thesebenefits,almostall the informants feel that finance professionals/workers receive low compensation as compared with those working in multinational banks. In terms of recruitment and selection,one key informant mentioned that the ability to fit in the culture of the bank is very important if one is to make a career in banking. Also, the studentswho graduated from the top three schools in the Philippines are still highly preferred. It is also noteworthy to look into the consequencesof continuousconsolidations/mergers and reengineering ventures of finance institutions, trends that have been going on for the past three to four years that have resulted to an excesssupply of bankers due to retrenchment. In addition, in viewof liberalization, the country mayexperience a shortageof highly qualified professionalsto work locally becausethey now haveopportunities to be hired abroad. A key informant also mentioned that a number of lower level and a few of the higher level finance workers feel a senseof boredom with their work sincesomeof their tasksare monotonous. In addition there is alsoa belief that one will never reach a very high position since foreigners are usually preferred over local professionalsto occupy top management positions, especially in multinational companies. Labor relations A key informant observesthat labor relations in this sectorhas generallybeen harmonious and peaceful given the fact that this sector belongs to the category of having the most number of collective bargaining agreementsin the Philippines which comprises33.1 percent (Edralin 1999). It is interesting to

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note that adversarial relationship between the labor unions and management is nonexistent. Worldwide demand for skilled workers is creating new awareness among nations of the need to educate beyond basic skills, many nations have targeted education as a primary means of labor force improvements. In the industrialized world where skilled and knowledgeable workers are concentrated, the average worker has completed 11 years of education compared with 5 to 11 years in the developing countries (Parker 1998). Mismatch in relation to the competency level of graduates with that of the demands of the industry is not a new issue in the financial sector. "The educational systemmust continually be reexamined and renewed to be relevant to the society in which it is embedded. This is where evaluation and research can playa central role. It is not enough that evaluation and researchfindings are disseminated to potential users. The translation of thesefmdings into action addressedto the improvement of the policy and practices must be a major concern. The bottom line is the institution of an effective transmission-transformationsystem which will ensurethat researcheffectivelyserveseducationaldevelopment." Since all efforts will involve all people, actions of the education system must be directed to making all sectors like media, clubs, associations, and other government and nongovernment agencies complement rather than compete in the task of developing education so that it can contribute to the rebuilding of our nation. Such efforts must constitute actions calculated to contribute to the improvement of teachers to deliver quality education, a constitutional mandate which may be immediately addressed. Those who think so cite the high incidence of high unemployment among college graduates to prove their point. Forthwith, they advocate education planning, which involves the projection of needed skills, and accordingly, an identification of the courses and programs that schools should offer. The pitfalls from this type of education planning are many. To be able to determine which skills are going to be a great demand in the future, a great deal of information is required. And it is not clear at all that the government possess an advantage over the private sector in producing the information. The problems are similar to those posed by industrial policy, where the government identifies the industries to promote and direct scarce resources towards industries that make it to the priority list. The issue of matching is considered as a macro problem. Key informants feel that this is due to the lack of effective school curriculum supervision wherein schools tend to commercialize the curriculum with the sole

RESOURCEREQUIREMENTS OF THE FINANCIALSECTORUNDERA LIBERALIZEDREGIME 21 S

intention of attracting more studentsto take up the finance coursesand not really making sure that the curriculum is in congruence with meeting the needsand demands of the industry, nonmonitoring of student's career after graduation and nonexistence of a body or committee to evaluatethe curriculum from both the government and the private sectors. Recommendations ofthe key infonnantt

According to the key informants, the following strategiesshould be considered in developing tertiary education in the Philippines: .Reviewing the program curriculum and making sure that all shortfalls are addressed,offering specializedcoursesin banking (that is, Risk Management,International Banking, etc.), inclusion of more sophisticated subjectscovering the various fields in Finance and Investments(for example,units in Mergersand Acquisitions,Hedge Funds, Mutual Funds etc.), getting practitioners in the field offinancial servicesasfacultyto the variouscourses,and hiring teachers with a mastersdegree; .Making sure that schoolfacilities are complete; .Schools should be able to include in their curriculum not only standard computer skills but also specific computer applications such as tellering, accounting, etc; .Assuring quality in on-thejob training immersion to know what's happening outside the four walls of the classroomand adequate training in the workplace; .Continuous education through seminarsand workshopsto be conducted by experts in the field to continuously update studentsand finance workers on variousfinancial productsand trends in the field. .Sending graduatesabroad specifically through the initiative of privatecorporations; .Conducting examinations to use as entry qualification before one canjoin the banking services;and .Sponsoring more quiz competitionsby the schools,the BAPand the Financial ExecutivesAssociationof the Philippines (FINEX). One key infonnant also mentioned that being open to the idea of the emerging trend of liberalization in itself through transferof technologywould greatly help in bridging the gap between industry needs and expectations with that of improving the quality and level of skills/ competencies of our professionalsin the financial sector.

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According to one key informant, shefeels that the financial sectorhas yet to determine the proper matching strategies,this is due to the fact that at present, mergers and consolidations result to an overflow of qualified and experienced professionals,that new graduatesare abundant but have been displaced. Until the trend has gained grounds, only then can we determine the proper matching strategies. Manyenthusiasticproponentsof the globalizationthesisargue that businesssurvivalis increasinglyaboutperform~ce in the world market. Domestic markets are no longer the focus of economic activity and competition. It is competing to world classstandardsthat counts. However,there are a handful of key informantswho feel that our country is not ready to compete in th,eglobal financial market and their reasonsfor this are the following: first, there is lack of discipline. When opportunities for quick, substantial profit at the expense of market integrity present themselves,many brokers go aheadand take advantage.Second,in terms of technology and advancementof facilities ascomparedwith the first world's capacities, a few key informants feel that the country is five years behind in this aspect. Nevertheless,almost all of the key informants agree that the country's professionalsare indeed readyfor globalization. But the challengeremains to continuously upgrade, refine and polish our country's intellectual capital to be able to harnessour nations greatestasset,that is, the Filipino worker,ashe opens himself up to the rest of the world. Supply of professionals in the rmancial sector Review offinance-related coursesin higher educational institutions According to the Commission on Higher Education (CHED), there are very few schools offering a degree in banking and finance in the country. The practice in many schools, however, is to incorporate finance as a major course in business management, accountancy, business administration, economics, and other commerce programs. In fact, there are only two schools, San Sebastian College-Recoletos and the Polyte,hnic University of the Philippines offering a baccalaureate degree in banking and finance. In terms of enrollment, more than a third of the over two million students in tertiary level are taking courses in business and related programs. Although there were 775,355 students in business courses enrolled in 199697 allover the country, we do not have the exact number of students enrolled in finance programs. At De La Salle University (DLSU), for example, the number of Management of Financial Institutions students was estimated at

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403 approximately in 2000-2001,which is 15 percent of the total enrollment of the College of Businessand Economicsand 4 percentof the total university student population. If we use this as a grossindicator, the estimated enrollmentin finance programs can range from 88,000to 116,000studentsallover the country. Undergraduate accountancy programs

The accounting program leading to a Bachelor of Science in Accountancy prepares students for careers in public accounting and related fields. The curriculum coversgeneral education, businessprofessional coursesand accounting subjects.The accounting subjectsinclade basic accounting, financial accounting, managementaccounting, costaccounting, managementservices,accounting problems, auditing theory and practice, and management information systems. There is a prestigeattachedto a CPA,and becauseof this many students in businessprograms are attracted to the accountancyprograms asa preparation for the professionallicensure examination. Becauseof the strict requirements brought about by low passingrate in the CPAlicensure examinations, accounting programs in manyschoolshavea very low retention rates.Manyof the students of these programs shift to related fields including more often the finance programs. This is not unusual, at DLSU, the freshmen students in the finance program constitute not more than 6 percent of the entering freshmen in the College of Businessand Economics.But becauseof shifting students,the share of finance students goes up to 15 percent of the college enrollment. These transfereesare mostlystudentscoming from the accountancyprogram. Although the accountancyprogram in manyschoolsare gearedtowards the training of CPAsand auditors through the passingof the CPAlicensure examinations, many accounting graduatesaswell asa large number of CPAs are attracted to finance-related occupationsandjobs. The quality of accountancyprogramsdiffersacrossthe country although they follow similar curriculum prescribed by the CHED and the Board of Accountancy. The quality is indicated by the percentage of passing in the licensure examinations. There are schools that have consistentlyscoredway above the national averageof17 percentestimatedfrom 1994-1998.However, 82 percent of 265schoolsoffering accountancyprogramshavescored overall passingrate below the national average.In addition, half of the schoolsoffering accountancyprograms havescoredzero overallpercentagepassingin the 1999and 2000 licensure examinations (Board of Accountancy 2000). The

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consistent top performing schoolsinclude the University of the Philippines in Diliman (UP-Diliman), DLSU-Manila, University of Santo Tomas (UST), Silliman University, San Beda College. UP-Visayas, and St. Louis University, Baguio City. Undergraduate finance programs

Like any other major businessprogram, the finance curriculum is composed of three broad categoriesof courses:general education,businessprofessional coursesand core professional courses.In a comparative examination of the course offerings of five schools in Metro Manila offering coursesin finance conducted by the Philippi~ Associationof Collegiate Schools of Business (PA~B) two schoolsoffered Bachelorof Sciencein BusinessAdministration and Accounting, one offered Finance aad Banking and the rest offered Financial Management. The report showedthe CHED's minimum required units in gener.a}education distributed asfollowed: English (6), Filipino (6), Philosophyand Humanities, SocialScience(12), Rizal (3), Science (6), Math (6), and Information Technology(3). For BusinessProfessional Courses,the CHED minimum units are as follows: Economics (3), Statistics(3), Operations Research(3), BusinessSoftware Applications (3), Accounting (12), BusinessManagement (6), Marketing (3), Finance (3), BusinessLaw (6), Taxation(3). For the core professional subjectsor finance major subjects,CHED minililum requirement is 21 units. Most of the schools included in the examination had more than the required minimum units for generaleducation,businessprofessionalcourses and the core professionalsubjects.Since the CHED curriculum setsonly the minimum requirement, schoolshave the option of offering more coursesto enhance their programs.For example,one schooloffers an additional subject in accounting, accounting for financial institutions, beyond the 12 units requirement of CHED. Another school has only 6 units of core professional subjectsin finance, Controllership and International Finance,Trade Payments and Development. Another schoolhasno finance major courSesbut hasnine units of finance in its businessprofessionalcourses.One school that offers a Finance and Banking program has 39 units finance major courses.It is the only school among the schools examined that offers subjectsin Credit and Collection, Public Finance,Central Banking and MonetaryPolicies,Financial Institutions. Another school has 33 units in its Financial Management major program. Basedon the five schools,it is the only one offering the following finance major courses:Financial Intermediation, TreasuryManagement,Financial Strategy,Electronic Banking Seminar,and Quantitative Methods in

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Finance. It is also the only one offering a seminarcourse.The fifth schoolalso offers a major program in Financial Managementwith 36 units of coursesin finance. Of the five schools examined, it is the only one offering Corporate Financial Planning and Strategy I and II. Three schools offer practicum/ office internship and thesiswriting. Although there are minor differences in course offerings and in the number of coursesoffered in the professionalbusiness courses,all schools examined meet and even go beyond the minimum academic units required by CRED. Since there are similar coursesoffered in various schools the question of quality will come into play in determining the better schoolsoffering the finance programs. The quality of academic program is influenced to a great extent by a single factor, the quality of teachers.The qualifications of teachersin the program will determine the type of subject offerings, the content of the course, selection of instructional materials and the delivery of instructional activity. One thing going for Philippine schoolsis the use of the English languageasthe medium of instruction. Given this, many schools,particularly the better ones, can adapt the latest textbooks in finance used in American collegesand universities. With information technology,manyschoolshave patterned their course offerings with some the leading finance schools in the United States. However,the problem does not lie in the contentsof the syllabusnor in the availability of textbooks but the manner in which the syllabusis implemented and the textbooks utilized. For many schools in the Philippines, a large proportion of their facultydoesnot havethe necessarygraduatedegrees to teach finance, accountancy,businessand economics.At the national level, only 7 percent of the facultyhasPh.D. degrees,26 percent has masterdegrees in all fields at more 1,300 higher educational institutions. We do not have a statisticsfor facultymembersin businessprograms.However,at DI.SU-Manila, 84 percent of fulltime faculty has at leasta master degree in the College of Businessand Economics.This figure, however,does not reflect the national norm on faculty qualifications. If many of the faculty members in finance programs are only baccalaureatedegreeholders, the presenceof highly technical textbooksbecomesuselesssincetheywere not exposedto the analytical sophistication of these textbooks taken in graduate coursesin finance and economics. Related to faculty qualification is the load of faculty members teaching in the tertiary level. In many schools,theyhire teacherswith no professional background in finance, and faculty members usuallycarry between 24 to 36

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units per semester. Given this load, there is hardly any time for research, innovative classroomprograms, outside classroomactivitiesand limited student-teacherinteraction. The useof the lecture method and the repetition of lectures are very common practices since the teacher has to teach several hours a day. One of the positive developmentsin the teaching of finance coursesin many schools is the hiring of parttime faculty who are practitioners in the field. In many schools,this is a small proportion of their faculty. However,at DLSU-Manila,in the finance department, closeto 74 percent offaculty members are parttime usually connected with banksand other financial institutions. Thus, the runtime faculty members,carrying 12 units load, havetime for student consultations,research,curriculum improvement, program development and committee work. The parttime teachers,on the other hand, are professionals in the field with managerial positions in banks, investment houses and other financial institutions carrying an averageof 6 units per trimester. Graduate program.5

Master in BusinessAdministration There are severalcollegesand universitiesallover the country offering graduate programs in business.The most prestigiousis the AsianInstitute of Management (AIM). It a full time program and hasattracted and graduated more than 2,800professionals in the Asia Pacific region and hasbeen cited asone of the top businessschoolsin the region. The program usesthe casemethod extensivelyand allows studentsto do hands-onactivities including company internship and consultation and the preparation of management action report. I t is a two-yearprogram covering generalmanagement,finance and economics, human behavior in organizations, marketing, information technology,and operations management. In the field of finance and economics,the elective coursesoffered are the following: Asian equities,bank credit analysis,capital budgeting and longterm finance, corporate financial management,corporate valuation,financial engineering and risk management, financial policy and strategy,financial restructuring and rehabilitation, fixed income market analysisand strategies, fundamentals of stock market and technical analysis,integrated risk management, international economics,international financial institutions, investment banking, macroeconomics,managementbanking, micro-finance and special lending institutions,portfolio management,projectfinanceand venturecapital.

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Other universities offering MBA programs are DLSU-Manila, UPDiliman, Ateneo de Manila University (ADMU), UST and almost all universities cited by CHED ascenters of development in businessand management education. Although these institutions offer specializedcoursesin business including finance, many of the MBA programs in the country are geared towards the formation of a generalmanager. The MBA program at DLSU "aims to develop capable and socially responsible managers for modern Philippine enterprises. It addressesprincipally the professional development need of working studentspursuing their studies on a partial academic load basis" (DLSU Brochure). The program consistsof sevenpre-MBAcoursesand 36unitsof core, electiveand integrating courses.There isone coursein financial managementaspart of the corecourses. Although the program is not developed along functional specialization in management,a student can take three electivesincluding finance courses. However, the MBA programs at the UST have four typesof specializations: general management,information and communication management, international business,and newventures and entrepreneurship. Graduate programs in finance The UP offers the 30-unit Masterof Sciencein Finance program designed to be completed in one year (that is, three trimesters). Studentsare required to take nine core courses.Thesecoursesaim to provide the student with a strong foundation and in-depth coverageof key concepts, techniques, and topics that are crucial to a deeper understanding of the field offinance. Aside from the nine core courses,the student is required to take six electives(12 units) to exposehim/her to variousareasfor a careerin finance: corporate finance, banking, investment managementand government regulatory work. The core coursesare macroeconomicsand the financial system, financial analysisand reporting, quantitative methods,financial institutions and markets, corporate finance, investment management,financial derivativesand industry competitive analysisand strategicplanning. The DLSU Graduate School of Business,on the other hand, offers a program towards a degree in Masterof Sciencein Computational Finance. The aim of the program is "to provide educating students,investmentprofessionalsand financial advisersto integrate mathematicaland statisticalmodels and techniques with financial theory and computer technology" (DLSU brochure). Core coursesinclude mathematics of investment, financial management, managementscience,multivariate analysis,investmentanalysis,portfolio management,trading softwareand programming, and securitiesresearch.

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At the UST, a program in Master of Science in Commerce major in Banking and Finance is offered. Coursesinclude financial management,economics of money and banking, securitiesand financial markets, credit management, monetary theory and policy, managerial accounting, investment managementand managerial economics. The scopeof finance coursesoffered in graduateprograms by the leading academic institutions reveals certain thrusts and market niches. Although the AIM does not offer a graduate program in finance, the list of electivesin finance in their MBA program is quite extensiveand relevant to the specific n~edsof a financial sectoropening up to the global environment. The UP program is more focused than the AIM list of electivesby directing studentsto four fields: corporate finance, banking, investment management, and government regulation. The DLSU program is tools-oriented and bias towardscorporate finance and investmentmanagement.The UST program, on the other hand, mirrors the coursesoffered in undergraduateprograms in banking and finance. One weaknessof theseprograms is the inadequate foundation in economics. In many graduate coursesin finance abroad, a solid foundation in advancedmicroeconomics and advancedmacroeconomicstogether with the tools of advancedstatisticsand econometricsis required among the students. Financial economicsand advancedcoursesin finance are bestunderstood by theories in microeconomics and macroeconomics. Graduateprograms in accountancy DLSU- Manila offers a graduate program towardsa degree in Master of Science in Accountancy. The program is a professional graduate accounting program intended to meet the needsof the profession for individual with a broad and extensivetraining in researchand high quality professionalpreparation for teaching at the graduate level. It is a 42-unit program designed to develop in CPAsa high theoretical knowledgeand a sound understanding of advanced accounting and researchprinciples and techniques in their pursuit of a researchand teaching-oriented career.Course offered include current development in accounting researchand financial accounting, current developments in auditing and auditing research, current development in managerial accounting, managementplanning and control, advancedauditing techniques, law and taxation and advanced accounting research. (http://www.dlsu.edu.ph) At the UST,a Master of Science in Commerce major in Accounting is offered. Someof the major coursesinclude estateplanning, practical control-

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lership, operations audit, current issuesin accounting and taxation, managerial accounting, investment management,managerial economics. While the DLSU program is intended for the continuing professional education of CPAsin auditing practice and collegiate instruction, the program at UST has some relevance to finance practitioners since many of the coursesoffered relate to finance. Doctorateprograms In Metro Manila, there are very few institutions offering doctoral studies in business.The Doctor in BusinessAdministration (DBA) program is offered at DLSU-Manila, UP-Diliman and Polytechnic University of the Philippines. The UST, on the other hand, offers a Ph.D. in Commerce. The DLSU program is designed to train and develop businessmanagers and the businessfaculty on the framework and strategic implications of businessmanagementconcepts.Coursesinclude advancestatistics,organization theory, businesseconomics,advancedmanagementscience,marketing, finance, production and operations,and human resource development. At the UST,a courseleading to a degree in Doctor of Philosophy major in Commerce is offered. The program consistsof completing 66 academic units. Some of the major coursesoffered are the following: corporate planning, government and business,executivemanagement,organization development, risk management, labor and sociallegislation, cooperative management, performance management,managementinformation system,international economics,managementof corporate culture, public finance and fiscal policy, international business,and project management. At the UP, the program consistof 45 units consisting of 18 units taken from the MBA program from amongthe coursesincluding economic analysis, basicquantitative methods, managerial accounting and control, fundamentalsof organizational behavior,fundamentalsof marketing management,fundamentals of production and operations management,fundamentals of financial management,managinginnovation, managinginformation technology,and general management. At the second and third years, 27 units are taken in businesseconomics,managementscience,organization theory and five coursesin the major field of specialization The programsat UP and DLSU are lean and more focusedcompared to the heavyand diffused course requirements at UST.

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Nondegreetraining programs ofprofessionalsin finance

Ateneo-BankersAssociationof the Philippines-Institute of Banking Every quarter, the Institute of Banking of the ADMU-GraduateSchoolof Business (ADMU-GSB) BAP consortium has been offering certificate training programs in finance. Two coursesoffered at the time of the researchare nondegree coursesin Corporate Finance and Financial Analysis. In course entitled Fundamentalsof Corporate Finance the course description statesthe following: "The finance playsa crucial role in ensuring the continuing viability of a firm particularly during periods of uncertainty. This course provides an integrated view of the finance function in the corporate setting, its scope of responsibilities and authorities, and linkages with other segmentof the organization. Emphasisis placed on the discipline asfunction of management, upon the routine problems encountered by the financial manager, his/her methods of solution, and the rationale for his/her deci-

sions." The course, which employslectures,interactive discussions,caseanalyses,and practical application exercises,coversthe following areas: .The Financial Function: An Overviewand Introduction, .The Mathematicsof Financeand Investment, .Basic Financial Planning and Control, .Working Capital Management, .Capital Budgeting, .Short-, Medium-, and Long-term Financial Methods,and .Special Topics, sucha -Business Combinations, -Business Restructuring and Reorganization,and -Bankruptcy. The course on Techniquesof Financial Analysis,on the other hand, has the following course description: "This courseprovides the participants with the basic conceptsand tools used in analyzingand interpreting financial data. Specifically, the course is meant to assistthose involved in making credit decisions evaluate the creditworthiness of credit applicants using financial statementsand other relevant financial information. Specificanalytical tools and the related financial conceptsare likewisediscussedfrom the investment decisionmaking standpoint." The course,which employslectures,interactive discussions,caseanalyses,and practical application exercises,coversthe following areas (AteneoBAPInstitute of Banking):

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Reviewof accounting fundamentalsand generallyacceptedaccounting principles Diagnostic evaluationof financial statements:contents, the interrelationships among numbers,and keyareasof concern to readers, Techniques of financial analysis, Cashflow analysis, Time value of money,and Operating and financial leverage. AIMR Chartered Financial Analyst (CFA) examination The Associationfor Investment Managementand Research(AIMR) offers a Chartered Financial Analyst (CFA) curriculum that is solidly grounded in the practice of the investment profession.The program is a globally recognized standard of measuring the competence and integrity of financial analysts. The CFAexam is administered annually is severalcountries. In our country, this program is offered by the AIMRin cooperation with the AIM. There are three levelsin the studyprogram. Levell studyprogram emphasizestools and inputs and includes an introduction to assetvaluation and portfolio management techniques. Level II study program emphasizesassetvaluation and includes applications of the tools and inputs (including economics,accounting, and quantitative techniques) in assetvaluation. LevelIII studyprogram emphasizesportfolio managementand includes strategiesportfolio managementand includesstrategiesfor applyingthe tools and inputs in managing equity and fixed-income securi.ties (http:/ / www.aimr.org). Finex examination The FINEX felt the need to professionalize the practice of finance in the country. To this end the organization developed the Financial Management and AnalysisTest (FMAT). The examination aims primarily to assistfirms in determining the entry-levelknowledge of applicants to finance positions in the basic conceptsand foundations of financial management.The FMAT also helps firms in identifying the training and development requirements of finance people already in their employ.The testprovides corporations with a standardizedand objective basisof assessing presentand prospective employees (FMATPrimer). The FMAT has three modules: 1) financial and managementaccounting, 2) corporate finance 1, and 3) corporate finance 2.

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Under Module 1: Financial and managementaccounting. Financial accounting will test the examinee's knowledge of basic accounting concepts and methods, and financial statements.While, in management accounting the examinee'sknowledgeof the methods,tools,and techniquesavailablefor managerial planning and control will be assessed. Module 2 or Corporate Finance1 will testthe examinee'sknowledge on the following topics: understanding financial statements,financial planning and forecasting,sourcesof short-term funds,working capital policy, management of cash,marketable securities,accountsreceivablesand inventories. Module 3 or Corporate Finance 2 will test examinee's knowledge on economics, both macro, and micro. It will test examinees in terms of their understanding of basic theories and principles, of corporate investment, financing and dividend decisions,and long-term financial managementin the Philippines (FMAT Primer). Training programs of banks Most banks offer training programs for its employees.Those with management potential from the rank and file are recommended to management training program. The topics include: branch operations, treasury management, trust operations,accountmanagement,international finance. Mter the training program, the traineestake written and oral examinations.Then, they are fielded in the various bank units asjunior officers. Those in supervisory level, middle management also attend seminarsto up-date themselveswith changesin finance. Training programs at the insurance commision There are many continuing professionalprograms that the Insurance Commission offers and training seminarsis one of them. The Insurance Institute for Asiaand the Pacific (IIAP) aims"to support the insuranceindustry through education, training and research."Also,the llAP aimsto train insurance officers in the different fields of insuranceand management.This is to make sure that insurance companies here in the Philippines are at par with rest of the

region. The lIAP has specific objectivesand theseare asfollows: .To impart knowledgeand skills in insuranceand other related fields in the Philippines as well as in the other countries of Asia and the Pacific, .to develop a core of trained and qualifies trainers in the various subjectsinvolved in the insurance industry,

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to develop the competenceof professionalmanagersoccupyingthe lower, middle and upper managementpositions in the industry, to undertake researchand studies, conduct inquiries and obtain data on the laws,practicesand operationsof insurance in the Philippines,Asia and the Pacific for the purpose of improving and developing industry practices,management techniques,skills and technological efficiency,and To develop and promote courseson insurance and businessmanagement, theoretical aswell asapplied. The IIAP also conducts quarterly seminarsto further broaden the perspective of those who are interested in Insurance or are already in similar fields. An example of the coursesoffered comes the list of the third quarter seminarsare the following: .109111 BasicNon-Life Insurance Course, .Reinsurance Accounting, .Introduction to Lost Adjustment, .Budgetary, .110111 BasicNon-Life Insurance Course, .Engineering Insurance, .Business Interruption, .Advanced Reinsurance, .Fire Surveyingand LossControl, and Training programs of SEC and PSE

The primary purpose of the Philippine-SECInstitute Foundation, Incorporated (Phil-SEC)is to establishand provide an institutional medium that will initiate, sponsor,promote, develop,assist,or conduct seminars,programsand projects geared towards researchand development in the variousdisciplines of securitiesdevelopmentand regulationand other related fields of endeavor. The Phil-SECengagesin activitiesinvolving any or all of, but not limited to the following: .Organize training programsto enhancethe skills and qualifications for the Phil-SECstaffregarding the SEC'sadministrative, regulatory and supervisoryfunctions. .Develop professionalstandardsamongsecuritiesmarket participants and organize training sessionsin preparation for certification exams on various aspectsof the Philippines securitiesindustry. And

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Enhance the working knowledgeof the Phil-SECstaffand practitioners in the Philippines securities markets on key aspectsof financial markets in the Philippines and their regional and global linkages(PSEFact Book 1997). Another training center is the Capital Market Development Center, Inc. This center is a nonstock, nonprofit institution that servesasa coordinating organization for institutions involved in training and research for the development of the Philippine capital market. Comparative analysisbetweendegreeand nondegree programs Becausefinance is highly specialized and differentiated field, the degree coursesboth in the undergraduate and graduateprograms are not sufficient to fulfill the needs of an ever changing financial sector in a global setting. With our financial sector being integrated in the global market and the impact of information technology, new products and servicesas well as skill requirements are emerging. The current degreeprograms offered by educational institutions cannot fulfill all the human resourceneeds of this dynamic sector. One school of thought views the role of educational institutions as providing the training for basicskills and competencies.Another perspective is the need for schools to train individuals with the specific skills needed by the industry. The first viewemphasizesbasiceducationand foundation courses.They should be trained in communication skills,reading and writing and critical analysisand people skills.On foundation courses,finance practitionersshould be well-grounded in economics,mathematical analysis,statisticsand account-

ing. If the graduatesof finance programs are well grounded in these foundation courses, then professional organizations as well as financial institutions can play an important and relevant role in providing non-degree continuing professional education. They can complement what academic programs conducted by educational institutions by offering training and nondegree programs meant to upgrade finance professionalsin the current developments in the field. The training programs will be specific and intended for practitioners in financial services. There are some sectors in the finance industry calling for licensure examinations in the name of professionalizing the finance practitioners. Although, this has some merit in terms of limiting the number as well as for quality control, there are also disadvantages.For one, the accountancypro-

HUMAN RESOURCE REQUIREMENTS OF THEFINANCIALSECTORUNDERA LIBERALIZEDREGIME 229

gramsof our businessschoolsare geared primarily towards the passingof the CPAlicensure examination. Becauseof this orientation, a number of someof the more important issuesin finance,economicsand statisticsthat CPAsshould also understand, particularly those who will be finance professionals,are not offered in their academiccurriculum. This is becausethese coursesare not covered in questions asked in the licensure examinations. A licensure examination in finance similar to the CPAlicensure examination mayfall into the same pitfalls. It may also limit the flexibility and dynamism in finance education. If any licensure examination be given, it should be to practitioners in the field and for specific servicesin the finance sector. In addition, it should be given by a professional organization. The key is continuing professional education and upgrading of professional competence similar to the ones practiced by medical doctors and actuaries.One problem with licensure examination is that once you passit, you maypossessthe licenseforever. But in a professionlike finance, new developmentsare quick and the servicesoffered are everincreasing that there is a need for periodic reviewand evaluation of competence of its professionals. Initially, the nondegree programs complement the degree programs. It bridges the gap between the needs of industry and what the academe has taught. Apparently, new graduatesare still inadequate with technical skills and come in raw. As for the FMAT,it giveswould-be employers,an assessment of the applicant's grasp on the concepts in financial and management accounting, corporate finance and economics.These areasare covered in all the programs offered by the five schoolssurveyedby CHED. Those who are serious in pursuing a banking career can look at the course offerings of the ATENEO-BAPInstitute of Banking since these specialized coursesand the professional'sexperience can prepare him/her for executive positions. Also, another wayof preparing for higher management levelsis through MBA and managementtraining programs of banks. On the other hand, thosewho want to pursue careersin the stockbrokeragecan take the test conducted byPhil-SEC to be a licensed trader. Those who want to be CFA, can take the three levelsof program study. The five schools surveyed cover most of the topics included in the review. However,the coveragemay not be an in-depth asthe one required by the CFA test. Someschools in their coursesmayuse the recommended materials but not all of them is required. Most of the training programs abroad focus on the preparation for the CFAexaminations. Severalreviewprograms are given for the examinations.

230

FINANCIAL lIBERALIZATIOtl MANAGINGRISKS AND OPPORTUNITIES

Other training programs include financial planning, insurance, and securities licensing. Demand and supply analysis ofmanpowerrequirements

For the analysisof demand for labor in the financial sectorunder a globalized setting,we based our estimateson the trend of the employed laborers in the sector from 1988to 1998 taken from the annual Labor Force Surveyof the National StatisticalOffice. The period coveredin the analysisis quite relevant becausethis coincides with the liberalization of the sectorand its opening to the global market. In 1998,there were 260,915workersemployed in variousinstitutions of the financial sector where banks accounted for 55 percent of the workers. Nonbanks and insurance firms, on the other hand accounted for 22 percent each of the estimated employed workers. The estimated employment figure for the sectoraccountsfor only0.88percentof the total laborforce of thecountry. Although the sectorabsorbsonly a very small portion of the economy's labor force, it is one of the fastestgrowing sector in terms of employment. While the national labor force hasincreasedby 32.42percent over the period coveredin the analysis,the financial sectorhasincreasedby 60 percent for the sameperiod. In 1988,the sectorhasemployed an estimated 163,032workers with banksabsorbing 58 percent followed by insurance with 32 percent, and nonbanks10 percent of the total. The nonbanksregisteredthe highest groWth rate in the past 10 with an estimated growth rate of 275 percent followed by bankswith 51 percent while insurancehasremained almoststagnantregistering a very low 11 percent growth rate. This trend implies that financial liberalization in the country brought about tremendous growth in employment in non-banksfinancial institutions. In terms of educational qualifications,70 percentof the employedworkers in 1998are college graduatesand 17percent are college undergraduates. Banksregistered the highest proportion of workers with college degrees (76 percent) while non-bankshas the lowestwith 56 percent. One-fourth of the employed workers in non-banksinstitutions are college undergraduates. Since the datapresentedin Table1 representthe stockof manpowerper yearin the sector,the employmentflow or the changesin the stockof employed workers for the demand analysisis needed.To do this,we havesubtracted the previousyear employment stock from the current year employment stock to get the incremental required manpower per year. The computed changes represent annual demand for manpower in the financial sector.This computation wasdone only for workerswho are college graduatesTable 2.

IUMAN

RESOURCE REQUIREMENTS OF THEFINANCIALSECTORUNDERA LIBERALIZEDREGIME 231

Table 1. Employed

workers

in financial

sector

by educational

attainment

(1988-1998) Year

Banks

Nonbanks

Finance divisions Total Year Banks Nonbanks Insurance Elementary undergraduate

Insura'1ce

No grade

Total

1988

455

1989

1,150

1990

1,707

2,065

693

4,465

1991

989

323

1,312

1992

1,479

689

2,169

1993

342

1,468

1,810

1994

1995

1,078

1996

1,454

1997

683

195

152

1,029

1998

962

Elementary graduate

Highschool undergraduate

1988

2,573

392

2,090

5,055

1988

386

1989

2,044

493

1,353

3,891

1989

1,089

1,010

638

2,736

1990

1,858

1,163

1,286

4,307

1990

2,384

486

615

3,485

1991

349

886

420

1,655

1991

2,848

1,239

614

4,701

1992

1,046

1992

773

647

471

1,890

1993

1,456

1,946

3,403

1993

1,021

2,286

899

4,206

1994

1,253

995

289

2,537

1994

1,169

2,571

1,179

4,919

1995

1,238

855

1,428

3,521

1995

3,391

1,701

759

5,852

1996

1,259

1,579

2,236

5,074

1996

1,795

2,142

2,093

6,031

1997

531

1,766

1,863

4,160

1997

2,609

2,718

1,404

6,731

1998

261

1,185

151

1,597

1998

2,751

3,231

1,035

7,017

Highschool graduate

College graduate

1988

6,998

1,212

5,194

13,405

10,646

4,480

19,028

34,155

1989

10,998

2,615

5,838

19,450

8,726

4,762

14,878

28,366

1990

12,846

1,343

5,209

19,398

15,763

2,863

10,883

29,509

1991

7,393

3,129

4,793

15,314

9,837

2,978

12,215

25,030

1992

10,890

2,198

5,160

18,249

10,032

7,578

11,797

29,407

1993

11,839

5,702

2,688

20,228

10,798

8,814

11,178

30,790

1994

14,374

7,201

4,313

25,888

14,554

6,990

14,870

36,414

1995

13,155

6,834

5,666

25,654

16,593

13,365

12,266

42,224

1996

15,610

8,480

3,754

27,844

17,647

18,116

14,986

50,749

1997

17,509

7,199

5,004

29,713

16,800

17,267

11,485

45,552

1998

13,329

5,785

4,369

23,482

17,997

14,704

11,805

44,506

College graduate

All levels

1988

74,693

9,483

25,400

109,576

95,297

15,567

52,168

163,032

1989

82,601

15,642

24,558

122,801

105,457

25,671

47,265

178,393

1990

91,081

13,986

30,393

135,460

125,639

21,905

49,079

196,623

1991

81,491

14,762

32,034

128,287

102,906

22,995

50,399

176,300

1992

84,894

18,692

28,292

131,878

109,115

29,804

45,720

184,639

1993

80,300

20,323

35,219

135,842

105,756

40,539

49,983

196,278

1994

87,577

18,678

33,178

139,433

118,927

36,436

53,828

209,191

1995

100,652

24,442

24,379

149,473

135,029

48,275

44,498

227,802

1996

110,964

31,293

40,957

183,214

148,729

61,610

64,027

274,366

1997

108,169

35,145

32,656

175,970

146,301

64,290

52,564

263,155

32,661

40,751 183,265

144,275

58,528

58,112 260,915~

1998 109,853

232

FINANCIAL LIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

Table 2. Demand and supply of manpower

Year

College graduates

All levels

Demand for college graduates

Supply of commerce graduates

Supplydemand 1

Number of CPA examinees 17,185

Supplydemand 2

1988

109,576

163,032

1989

122,801

178,393

13,225

81,575

68,350

12,410

3,960 -249

1990

135,460

196,623

12,659

89,731

77,072

10,495

17,668

1991

128,287

176,300

-7,173

69,211

76,384

8,984

5,393

1992

131,878

184,639

3,591

61,068

57,477

9,790

5,826

1993

135,842

196,278

3,964

69,045

65,081

9,689

6,098

1994

139,433

209,191

3,591

84,592

81,001

7,654

-2,386

1995

149,473

227,802

10,040

87,131

77,091

7,928

-25,813

1996

183,214

274,366

33,741

96,665

62,924

9,554

16,798

1997

175,970

263,155

-7,244

79.297

7,323

11,955

4,660

1998

183,265

260,915

Source:

7,295

Labor Force Survey, Commission on Higher Education, Professional Regulation Commission

From Table 2,we obselVefluctuations in demand for manpoweroverthe years.The highest annual demand wasregistered in 1997with 33,741 while negativeincreaseswere noted in 1991and 1997of over 7,000each.The 1997 negative employment increment can be attributed to the regional financial crisis that took its toll on the ability of the sectorto absorbadditional workers. The 1991 experience can be due to the stagnant growth of the national economy. For supply, we have used two indicators in the absenceof data on the number of studentsas well asgraduatesof finance programs in our colleges and universities. The first indicator utilized is the number of graduates in commerce and managementwhile recognizing that only a small portion of the commerce graduate are finance students.This data wastaken from the CHED. The secondindicator that is probablynearerto the number of finance graduatesand the graduates going to the financial sectoris the number of CPAexaminees.This number is based on the annual passingaverageof the CPAlicensure examination taken from ProfessionalRegulation Commission (PRC). However,we recognize the limitation of this number asit understates the number of accounting graduatessince manyaccounting graduatesdo not take the licensure examination. Basedon the first supply indicator which is number commerce graduates,we would expect a substantial excesssupply of graduates to fill in the annual manpower requirements of the financial sector.The highest excess wasregistered in 1994with 81,001 and the lowest in 1997with 7,323 excess manpower.However,ifwe usethe number of CPAexaminees,there are years

HUMAN RESOURCE REQUIREMENTS DFTHE FINANCIALSECTORUNDERA LIBERALIZEDREGIME 233

with shortagesand yearsof excesses.The annual demand was higher than supply in 1990 (-249), 1995 (-2,386)and 1996(-25,813). However, the negative increments in supply in 1991 and 1997due to the economic crisesgave rise to huge surplusesamounting to 17,668in 1991and 16,798 in 1997.Based on these estimates,we find that the manpower requirements of the financial sector has been met by the graduatesof commerce programs and even the accountancyprograms. Issuesand concerns Adequacy of existing training programs in finance

There are somepositive featurescontributing to the relevanceand potential strength of the undergraduate finance education in some selectschools in the Philippines. The fact that we use English as a medium of instruction, manyof our coursesin finance can availof someof the latesttextbookswritten in the English language,and used extensivelyin manyuniversitiesabroad. In addition, the course syllabi often follow the contentsof booksand patterned after standards set in many American universities. Another feature in many private higher educational institutions in the Philippines is the hiring of a substantial number of parttime faculty members. In some selectinstitutions, theseparttime teachersare practitioners in the finance industry, mostly senior officersof banksand other financial institutions.A good number of thesesenior officers, who are teaching on a parttime basis, have earned their graduate degreesin businesseither here and abroad. Thus,we havequalified practitionerswho can teachand utilize someof the best textbooksavailablein finance. .However,the problem ascited in a previous sectionof this report is the manner in which the syllabusis carried out and academic curriculum implemented. Given the limited academicqualifications of majority of teachersin many schools,the heavyacademicload theycarry everysemester,and the lack of professional practice, they may not be able to appreciate the technical sophisticationand the dynamic changesin the field of finance, particularly, in a global financial environment. Becauseof the inadequacyof teachers,some finance teachersuse locally written textbooks that are usuallysurveysof the various components of the discipline. Another problem faced by educationalinstitutions is the limited number of schools that are able to hire financial executivesas part-time faculty. Evenin big cities outside Metro Manila, the most that they can get are branch bank managersin the region. Since manyof the key financial institutions are in Metro Manila, it is difficult for thesenon-Metro Manila schoolsto get highly specialized individuals in finance.

234

FINANCIAL LIBERALIZATION:MANAGINGRISKS ANO OPPORTUNITIES

Aside from the qualityand other academicconstraints,the undergraduate programs in finance seemto be inadequate to meet the demands of a rapidly growing field brought aboutby globalizationand information technology. This deficiency is supposedto be answeredby the various graduate programs in finance and related fields. The graduate programs in finance at DLBU, UP and UST,and in accountancyat DLBU and UST havewell-defined and specific curriculum intended to answerseveralniches and differentiated manpower needs in the financial market. However,in spite of the growth in the financial sector,studentsin theseprogramsare very few compared to the students in the MBA programs in theseuniversities. In fact, graduate education in the country is composedmainly of studentsin business(mostly MBA) and students in education. One interpretation for this strong demand for MBA programs is the preference of business students for the general management thrust the program provides. It can also imply that for specialized training, like financial services,practitioners opt not to enroll in graduate programs but prefer specializednondegree training programs. This trend in graduate education in finance has certain implications on the role of degree-grantinginstitutions in the formation of human resources in the financial sector.It seemsthat the emergingrole of schoolsis not primarily the training of human talentswith highly specializedskills in finance. As mentioned in previous literature and studies,what the financial sectorneeds are individuals with good communication skills and analytical skills or highly trainable and adaptable individuals. If this is the case,our undergraduate programs in finance should be well-grounded in the foundation coursesthat stressesthe training of studentsin communication skills,critical analysisand human relations skills. Asmentioned in Chapter 3, in the the BAPsurvey,that is, of stockmarket brokers and insurance industry showed the required skills at the entry level include: .For the Banking Industry: Excellencein oral and written skills,proficiency in numbers or forecasting,good analytical skills, attentiveness to details, and orderliness are required. Knowledge in computer applications like MS DOS, Microsoft Office and other computer applications is alsoa must. In addition, participants must have some background in accounting and finance. .For the Insurance Industry: The specific skills required of an applicant are almost similar to the banking and stockbrokerage professions. These include: excellence in written and oral communication, selling and servicing,and computer literacy.

HUMAN RESOURCE REQUIREMENTS OFTHEFINANCIALSECTORUNDERA LIBERALIZEDREGIME 235

For StockBrokeragefimls: No specific course or ageis required, as long as he/she passesthe Certified Securities Representative examination given by the SecuritiesExchange Commission. For the order taker, he/she is required to take the MAKTRADE Examination, before one getsa license.He/she must alsohave an adequate knowledge of the stock market here and abroad. The above resultsare not mere adherence to CHED requirements but this somehowfacilitates training of graduatesjoining said industries. Probablywhat is needed is familiarization with products offered in the global market. As for the banking and stock market industry, the trend is to go more online banking and trading. We have a few banksand brokerage firms who have dealt with online banking. Also, derivativeand option products are being developed in the banking area. However, our curriculum touches this topic at a minimum level becausethe argument of faculty is it is difficult to teachsomething that does not yet exist or perhapsisjust being introduced in the Philippines. Also, for the stock exchangesand insurance, crosslisting of products and familiarity with them is necessaryto be abreastwith developments in a globalized environment. The relevant and appropriate training programs for financial specialists, therefore, are the nondegree continuing professional education programs conducted by severalprofessionalorganizations.These programs are task-specific,skills-oriented and tailor-made to suit the needs of financial professionals in a rapidly changing financial sector. In complementing the degree programs, theybridge the gap betweenthe needsof the industry and what the academehas taught the students.For example, the proposed FMAT of FINEX can assessthe applicant's graspof the basic concepts in financial and management accounting, corporate finance and economics. For those pursuing a career in banking, the comprehensive course offerings of the ATENEO-BAP Institute of Banking can prepare individuals for executive positions.Thosewho want to be CFA,the CFAprogram and testconducted by the Associationof Investment Managementand Researchis a must. The varioustraining programsof the Insurance Commission,the PSEand the SECare highly organized to suitvaried needsof the sectorsthe finance industry. Given the breath of coverageof finance, the differentiated specializationand the innovative changesin the sector,no graduate program in business,accountancyand finance in this country can matchthe scopeand breath of specialization given by these training programs.

236

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

Granted that academicprogramsare rather incomplete in meeting the training needsof the financial sectorand since the relevantfinance training programs are taken in post-baccalaureatenondegree programs provided by professional organizations,what then is the role of an academicundergraduate finance and finance-related programs?Aside from the formation of the crucial skillsand competencies,undergraduateprogramsmayseIVeasa screening device in selecting graduates that the industry will hire. The screening devicesor information-enhancing indicators mayinclude, among others, the type of schoolsand academicprograms attended by thejob applicants. Although finance is a very specialized field, graduates of commerce, accounting, computer science,banking and finance and economics,are being hired in severalfinancial institutions. However, it is perceived that accounting graduatesor CPAswould be more productive employeescompared with finance graduates, other things being equal. Graduating with honors and with specialawardsas well as the type of schoolwhere applicants graduated are also given priority asthey enhance the information given to the employer on the ability and potential productivity of the employee. Schoolsof recognized quality are perceived by the industry asleading institutions that provide quality educationand produce good graduates.Many companies hire graduates from these schoolsas they match the manpower needs of industry. Since studentsare also informed of this industry perception, they in turn demand the servicesand programsof theseacademicinstitutions as part of their information-enhancing activityrather than for increasing their productivity through the acquisition of skills. If schools are consistent in maintaining the quality of their programs and graduatesover time, they areable to createan image or a charterof quality institution. As perceived by the studentsand the industry, maintenance of this image or charter maylead to a sustaineddemand for their graduatesas well asthe continued competition among studentsfor limited spotsin these academicprograms. Schools,in turn, are able to get the best students among several applicants given limited slots available due to resource constraints particularly qualified teachers,classroomsand other educational inputs. The role of college education, therefore, from this perspectiveis to ~creenstudentswith high mental and emotional abilities from those with low abilities so that firms will be able to train them with easeand at lower costs. Quality ofgraduates Based on the BAP study, there is a perception among banking executives on the inadequacy of graduates of enuy-level positions on skills required in bank-

HUMAN RESOURCE REQUIREMENTS OF THEFINANCIALSECTORUNDERA LIBERALIZEDREGIME 237

ing institutions. Although many of the newlyhired employeesof the banksare coming from other non-finance academicprograms, the very fewgraduatesof finance programs are going into the more lucrative sectors in the financial sector. Many finance graduates can end up as financial analystor dealers in the stock market and securitiesmarket. Evenin the banking sector,there are positions that are more competitive than bank tellers. Moreover, there is a perception among applicants on the ranking of banks based on their compensation packageaswell asprograms for professionalgrowth. These factors together with numerous professionaloptions in the industry can limit many banksto hire non-finance and sometimesnon-businessgraduates. In many schools,finance studentsare perceivedassecondclasscitizens compared with accounting students. Even in the labor market, this perception continues asmanyfirms hire accounting graduateswith special premium for CPAsfor finance-relatedjob. Is this a manifestationof screeningprocessin the job market?Doesa CPAapplicant possessa packageof good information on his ability to perform his job adequately? Becauseof the high failure rates in the CPA licensure examination averaging83 percent in the lastfive years,some unsuccessfulexamineesare attracted tojobs related to finance. In addition, it is estimated that more than half of the CPAsin this country are not in public accounting or auditing professionsasindicated by the low percentage of taking continuing professional education and renewal of license (Tullao 1999). It is possible that these professionals are in accounting-related fields including finance. It is not unusualto seethat manyof the treasurers,vice-presidentsfor finance, and key officials in the treasuryare mostly CPAsbut theyare not practicing public accounting or auditing. The orientation of accountancyprograms in almost all schools in the country is towards the passing of the CPAlicensure examinations. In addition, many of the studentswho take the accountancy program and passthe CPAexaminations are usually the top studentsin the hierarchy of business programs. Since this is the caseand asargued earlier, it is possible that many of our keyfinance officerspossessgood academiccredentialsand intellectual ability but they did not specialize in finance in their undergraduate programs. But then, where did they learn their specializedknowledge in finance? It is highly probable that on-thejob and specializedtraining programs were taken by them financed by the company or the individual. Since these individuals possesshigh intellectual ability, they are able to absorb new knowledge and easilytrained in new skills that become the determining factors of their successfulprofessional careersin finance.

238

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

If this casecontinues in the labor market for financial services,companies will continue to hire CPAs,and MBAsfirst before considering those with finance degrees.Since the market is relatively segmented,firms offering attractive compensationpackageand perceived to haveaffirmative action programstowardsprofessional growth will be filled in by CPAsand MBAs.Graduate finance undergraduate may end up in the second tier of jobs and firms. However, finance being part of the service industry, it will require jobs of servicefrontliners who maybe recruited from nonfinance and evennonbusinessprograms. The limited knowledge of basic finance of these employees cansometimesincrease the internal training programs of banks. Becauseof this perception of being second only to CPAs,manyfinance executivesand practitioners are planning to initiate an examination for financial analystasone move towardsthe professionalizationof finance specialist and give the CPAsa stiff competition in the labor market in an emerging financial market. Matching industry needs with educational capacity

Based on our initial demand-supplyanalysisof manpower requirements in the financial sector,we have concluded that the manpower demands of this dynamic sectoras shownby itsrapid growth in employmentcan be matchedby the graduatesin commerce programs aswell asgraduatesin accounting programs.There is a view in the industry that there is more than enough finance graduates to fill in the available positions but too little graduates who can meet the standards set by the finance industry. Only graduatesfrom the top Philippine universities can meet the industry's criteria. Aside from poor communication skillsand lack of computer literacy,the inappropriatenessof their knowledge of finance with the requirements of a globalized financial sector are often cited asproblems in hiring newgraduates.Mismatch in relation to the competency level of graduateswith that of the demandsof the industry is not a new issuein the financial sectorand the educational sector. The complaint of the industry on the mismatchof graduatesand industry need is a legitimate concern. However,if we compare the industry requirements with the curricular requirements of the CHED (Table 3), we note that the major skills and competency requirements of the industry are being met at least in terms of offering of academic coursesrelated with appropriate skills. On educational qualifications, commerce,accountancy,finance, computer science and economics,academicprograms where the industry draw their manpower,are offered in mostof the collegesand universities throughout the country. The only caveatis the quality of academicprograms offered.

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Quality varies in numerous educational institutions acrossthe country. As mentioned in previous section, the quality of teachersand other educational inputs determine the quality of instruction. On skills requirements, the key respondents cited communication skills, analytical skills, computer literacy, background in accounting and finance, including selling and servicing for the insurance industry as the relevantskills needed in the industry. Basedon the minimum CHED curricular requirements, we have noted that these skills and competenciesare being addressed,albeit limited, by the number of academic credit units required. Communication skills are tackled in English, Filipino, philosophy and humanities. Analytical skills are taken up in mathematics,statistics,operations research, economics,social science,scienceand businesslaw. Computer literacyis covered in information technology courses.There are some courses, however, such as the course on Rizal, that do not suit any of the skills and competencies required. Since the schools are given leewayin increasing the requirements beyond the CHED minimum standards,the value of these coursesmaybe indicated by the amount academic units are augmented in severalschools. For example, a school in Metro Manila requires up to 18 units of English when CHED requirement is only six units becauseit recognizesthe importance of communication skills in English for businessstudents. But for Filipino, most schools follow the mandated six units. Many schools follow the minimum CHED requirement for science,socialscience,information technology,and the humanities. On the other hand, mathematics,economics,businessmanagement, businesslaw are given additional credit units in many schools reflecting their value for developing analytical skills among finance students. On personal characteristics,there is a very wide gap between what is required by the industry and the curriculum setby CHED. Understandably, thesequalities are formed in other socializinginstitutions including the family, church and to some extent basiceducation. We have,however,identified courses in humanities, business management and social science that may have indirect bearing on the developmentof personalcharacteristicsparticularly their people skills. The additional recommendation of the key informants on the offering of specializedcoursesin banking, finance and investment can be addressed by the 21 units required for major professionalcourses.There are schoolsthat require up to 39 units of major professionalcoursesand the specializedcourses may be integrated in this category. For coursesin information technology,

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what is ideal is not to increasethe number of units but to integrate information technology in business,finance and other relevant courses. One conclusion in this gap analysisis not to increase the number of academic credit units that will address the various skills and competencies required by the industry. Although there is value in reallocating academic units to reflect the needsof the industry, even this alternative may not be the most efficient avenue in addressingthe mismatchissue.One important recommendation is the need to integrate all the skills and competencies required in all courses. Information technology for example should not be relegated to computer coursesbut to all courses.Similarly, analytical skills should not be given only to mathematics and the sciencesbut all courses should develop the analytical skills of students. Likewise, communication skills should be integrated in economics, finance, accountancy and mathematics and should not be relegated solely to the teaching of English and Filipino. Once we haveadopted this philosophy of education, the new developments in the industry will not be addressedby increasing the number of units or reducing or removing irrelevant courses.Aswe havereviewedearlier, even the courses under general education in businessare relevant in the formation of communication skills, analytical skills as well as in enhancing somepositive personalcharacteristics.All coursescanbe relevantdepending on how they are conducted and how theyaddressor answerthe skills requirements of the industry. But the key in implementing this integrative approach to instruction is the quality of teaching force. The problem of mismatch is not due to the outdated curriculum nor the number of irrelevant general education courses nor the inadequate units of businesscoursesbut more so on how this curriculum is implemented at the school and even classroomlevel. The efficient implementation of the curriculum is centered on the quality of teachers.No amount of juggling and horse trading of academicunits can fully addressthe inadequaciesof our businessschoolsif the faculty membersare not academicallyprepared to teachand do research.Thus, the more pressingissuein our businessschoolsis not the introduction of newcoursesnor the revisionof the curriculum to reflect the new skills in the market, although they are important, but the need to upgrade the academic qualifications of our teachers. Following Flynn's (1988) view on skills training life cycle, educational and training institutions will alwaysbe lagging behind in terms of training of new skills.Schoolsare effective institutions in the training of standardized or fully developed technologies. This can explain the phenomenon of mismatch between graduates and the needs of the industry. The mismatch is more

HUMANRESOURCE REQUIREMENTS OF THE FINANCIALSECTORUNDERA LIBERALIZEDREGIME 243

pronounced if the indusuy is characterizedby newtechnologieswhile educational institutions are still giving training programs for standard technologies. If such phenomenon occurs, the industry will conduct its own training programs to train new entrants in the indusuy incorporating the technological innovations in the indusuy. An implication for this view is that in the life cycle of skills training programs,the locations of training programswill depend on the stageor level of technological innovation and adaptation. Schools cannot be ahead of industries in the introduction of skills training for new technologies. Since innovative technologies are company specific, then some form of specific training should be conducted and financed by innovating companies. As thesebecome developed,standardizedand adopted by the entire indusuy, it is then that schoolsstartoffering ttaining programsof standardizedtechnologies. Another reasonfor the lag in technological innovations in educational and training institutions is the asymmetric information available to schools and the indusuy. Although it can be argued that universities and research institutions are the source of innovative technologies,training institutions do not know which new technologies are going to be adopted by firms. Because there are uncertainties on what innovative technologies will be adopted and huge costsinvolved in designing training programs, schools cannot decide before hand or second-guessthe needsof indusuy. In addition, even if they know the needs of the indusuy, they may not have the human resourcesto conduct the training programs for skilled manpower required by the industries. But once the technology hasreachedwidespreadapplication, it is easier for the schoolsto offer training programs in thesetechnologies. At that time, there will be a number of takers,teaching personnelwho will be available,and the marketability of the program. Applying this view in the financial sector,the Philippines cannot be considered asa trailblazer in financial innovations given the stateof technological developmentsin finance in the global context. The most that we do is implement standard technologies through transfer of technology. As earlier discussed,the level and type of training that will be undertaken by schools, companiesand professional organizationswill be determined by the stageof development of skills training program and the specific skills needed by the financial sector. Human resourcesissuesconfronting thefinancial sector In terms of recruitment and selection,a person with a degree in commerce, accounting, finance, economics and even computer science is usually hired for

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FINANCIALLIBERALIZATION:MANAGINGRISKS ANO OPPORTUNITIES

entry positions in the financial sector. Although there are no professional license requirements, somedegree of screeningis observedin manybanking institutions with preference shownon graduatesfrom top three schoolsin the Philippines. Invariably, communication skills,numeracy skills and computer literacy are considered important in banking and insurancecompanies.However,for brokerage firms, knowledge of the stock market and passingexamination for certified securities representation and the market trade examination are required. For personal skills ethical integrity and honestytop the list. In addition, excellent human relations and motivation skills are important requirements for the workers in the financial servicesholding both staff and managerial positions. It should be noted that there are human resource implications of the continuous consolidations/mergers and reengineering ventures of finance institutions on the supply of bankers due to retrenchment. On the other hand, in viewof liberalization, the country mayexperiencea shortageof highly qualified professionalsto work locallybecausethey now haveopportunities to be hired abroad. With the entry of foreign banks,a dual internal labor market can also emerge with differences in compensationbetweenforeign and local professionals. In terms of training and development, there is a need for updating and upgrading existing programs. The focus should be towards the development and requirement of an integrated financial market. For example,attendance in international conferences for updates on international rules in banking will become necessaryas the banking sectorbecomesmore integrated globally. The attraction of a careerin the financial sectoris influenced to a great extent by a package benefits given to the employees.With a more globalized finanGial sector, this package will have to be upgraded. There are several factors that contribute to the compensationupgrading. One is the competition coming from foreign playersthat mayhire local professionalstaken from domestic firms. Related to this is the impact of brain drain. As the financial markets in the region become integrated, the free flow of professional services mayentice Filipino financial expertsto seekemployment overseas.Another factor is the upgrading of skills in a highly dynamic sector.Acquisition of skills through training programs will only be attractive if the future monetary returns are enhanced. Such upgrading of compensation package can also create a segmented intemallabor market asdomestic financial institutions hire foreign professionals.

HUMAN RESOURCE REQUIREMENTS OFTHEFINANCIALSECTORUNDERA LIBERALIZEDREGIME 245

Improvingundergraduateeducationin finance Although we believe that an undergraduate education in finance should not be too specializedand be considered asthe sole training ground for skills in financial services,there are various waysof improving the program. Aside from the emphasison the foundation courses,specializedcoursesin banking should be offered or at leastintroduced including risk management,international banking, mergers and acquisitions,hedge funds, mutual funds, interestrates and foreign exchange options, swapsand others. Although there is value in improving the undergraduate curriculum in terms of focus, contentsand relevanceto the needsof the financial sector,the keyis the improveIIient in the quality of teachers.With this, it canimprove the curriculum, enhance the quality of instruction, and possibly start up academic research. There should be a balance mix of full time faculty and parttime teachers.A full time faculty should have at leasta master'sdegree in finance and related fields including accountancyand financial economics. With these degrees,finance teacherscan appreciate the theoretical foundations aswell asfollow the current developmentsin the field. Aside from giving an overall framework to the practitioner's treattnent of finance, these qualified full time teachers in finance can also initiate researchactivities that will further enhance the quality of instruction. There are severalgraduate programs offered in some of the leading universities in Metro Manila. These programs are more relevant than the MBA program that many teachers in finance take currently. In addition, they are more discipline specific than the graduate programs in business education that focuses on the teaching of business courses. Although these graduate programs in finance are quite differentiated from the MBA and MBE programs, they should be improved and gearedtowardsthe formation of teachersin the undergraduatewith strong foundations in accounting, economics,finance and statisticaltools. Given the tremendous impact of the digital revolution in facilitating the integration of financial markets,graduateof finance programs should be computer literate. The useof computer softwareprograms in understanding the various financial servicesand tools of analysisshould be integrated in the teaching of finance courses.In many textbooks thesesoftwareprograms are standard components accompanyingthe books.To implement this program, there should be improvement in facilities and the allocation of financial resourcesin purchasing computers,softwareand textbooks. Finance as it emerges now is one of areas in applied economics, or financial economics. But manyteachersin finance are grounded in accounting more than in economics.One wayof improving the program is to empha-

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FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

size the role of financial economicsin the finance curriculum. Aside from the leading universities in Metro Manila, the lack of well-trained economic professorsis one single factor that mayhinder the developmentof finance education in the country. Asmentioned earlier, the graduate programs in finance with a solid foundation in microeconomics,macroeconomicsand econometrics can address the weak economic foundations of both teachers and the curriculum. Another avenue of addressingthis issueis to refocus the accountancy program awayfrom public accounting bydevelopinga program towardsfinancial accounting or management accounting. There is a proposal being discussedcurrently with PACSB,PICPAand CHED and PRCon establishingtwo tracts in our accountancy program. One track is geared towards public accounting or auditing and the other is towardsmanagementaccounting. This is meant to minimize the failure rate in the CPAlicensure examinations and also to expose bright accounting students to the fertile field of corporate finance and managementaccounting. Internationalcooperation With the liberalization of professionalservices,and in particular the financial servicesand the fact that financial servicesis integrated globally, there is a likelihood that foreign professionalsmaybe hired to accompanythe entry of foreign finance serviceproviders. Although foreigners are not yet a threat as manyof our Filipino professionalsand banking managersare the ones being sent abroad, possibility existsgiven the weaknessesin educational institutions and the neglect in continuing professionaleducation. Filipino professionalsmaybe displacedby foreign professionalsparticularly in the fields and areaswhere technological innovations in banking and financial sectoris very

pronounced. On a positive light, it is also possible that with the liberalization of the financial sector,training programs on the innovations in the field developed by foreign financial institutions may also accompanythese foreign service providers. Thus,we should welcome the entry of foreign financial institutions since they serveas conduit in upgrading the skills and competenciesof Filipino professionals in the field offinance. Becausethe need for highly-trained professionsin finance is not only a requirement in the Philippines but also in other countries in the region, it maybe wisefor professionalorganizations,in banking,finance and insurance, to establisha consortium arrangement with the key universities in the region for the conduct of specialized training programs in finance. The ASEAN

HUMAN RESOURCE REQUIREMENTS OF THEFINANCIALSECTORUNDERA LIBERALIZEDREGIME 247

University Network together with the parallel professional and government groups in finance can provide a venue for a consortium arrangementin graduate studies in finance, economicsand accountancy. The financial sector is a dynamic industry which needs constant improvement and monitoring by its playersand participants. Asmentioned earlier, the entry level positions focused on the following skills computer and oral and written communications. Integrity and honestymattered most becauseof the sensitivenature of work in the finance industry. However,there is a continuing need to educate these entry level holders since in the future they would be holding key positions in variousfinance companies. It is not enough that they are trained with skills alone, there must be a continuing preparation for good governance of companies. It must be emphasized to thosewho are moving to middle or top management,the role that they playfor the stakeholders of the company. These people must also be ethically and morally grounded to be able to carry out good governance and avoid the pitfalls of insider trading scams.Probably,those entry level holders with the potential of becoming managerssomedaycanbe under the tutelage already of present managers. Perhaps the coaching method, aside from getting a masteraldegree, will help prepare thesewould-be managersfor the greater tasksahead of them. Policyrecommendations There is a need to continually reviewand upgrade the curriculum in finance to reflect the dynamic changes in the financial sector under a liberalized regime. The CHED with the assistanceof the Technical Panel on Business Education can conduct periodic dialogue with the academeand the industry leaders on how to make businesseducation particularly finance education more relevant in contemporary setting. There is a need to upgrade the quality of teachers in business and finance through graduate educationand continuing professionaleducation. The existing graduate programs in finance and accountancyshould not only be geared towardspractitioners but also the developmentof college teachers and academicresearchersin the field of finance. Undergraduate programsin finance should be well-groundedin courses that train studentsin communication skills,critical thinking and human relations skills. It seems that the emerging role of schools is not primarily the training of human talents with highly specialized skills in finance but the development of individuals with good communication and analytical skills who are highly trainable and adaptableindividuals. Ideally all coursesshould

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FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

integrate communication skills, analytical skills, computer literacy and the formation of positivepersonalcharacteristics.The training of specializedskills in finance, on the other hand, can be done through nonacademic training programs conducted by professionalorganizations. There is a need to professionalizefinance specialiststhrough an examination for financial analysts. Aside from professionalizing the finance practioners, it can give the CPAsa stiff competition in the labor market in an emerging financial market. Aside from upgrading the skills of finance specialistto meet international competition, there should be an upgrading of the compensationpackageto arrest anyegressof professionals.As the financial marketsin the region become integrated, the free flow of professionalservicesmayentice Filipino financial experts to seekemployment overseas. The improvementof academiccurriculum and qualityof teachersshould be complemented by a balance mix of fulltime faculty and parttime teachers. A fulltime faculty should have at leasta master'sdegree in finance and related fields including accountancyand financial economicswhile parttime faculty should be drawn from the managementpool of financial institutions. One wayof improving the finance program is to emphasizethe role of financial economics in the finance curriculum. Finance as it emergesnow is one of the areasin applied economics.But manyof the teachersin finance a!e grounded in accounting more than in economics. There is a need to refocus the accountancyprogram awayfrom public accounting by developing a program towardsfinancial accounting or management accounting. This is meant to minimize the failure rate in the CPAlicensure examinations and also to exposebright accounting studentsto the fertile field of corporate finance and managementaccounting. Becausethe need for highly-trained professionsin finance is not only a requirement in the Philippines but also in other countries in the region, it maybe wisefor professionalorganizationsin banking, finance and insurance to establisha consortium arrangement with key universities in the region for the conduct of specializedtraining programs in finance.

HUMANRESOURCE REQUIREMENTS DFTHE FINANCIALSECTORUNDERA LIBERALIZEDREGIME 249

Bibliography Abueva, J. 1998. The book ofthefuture: thePhilippines into the21s1century.Quezon City: UP Press. ATENEO-BAP Institute of Banking. Non-degree training programs of professionals in finance. Quezon City: Ateneo Press. Becker, G.S. 1975. Human capital: a theoretical and empirical analysis with special reference to education. 2ndEdition. New York: National Bureau of Economic Research. Bertrand O. And T. Noyelle. 1988. Human resources and corporatestrategy.Paris: OECD. Boyett,J. and H. Conn.1991. WorkPlace2000: therevolution shaPing American business.USA: Penguin Group. Braverman, H. 1975. Labor and monopolycaPital: The degradation ofwork in the 2a" century. New York: Monthly Review Press. Clarke, T. and S. Clegg. 1998. Changing paradigms the transformation of management knowledge for the 21" century. New York: Harper Collins Business. Denison, E. 1962. The sources of economic growth in the United States and the alternatives before the U.S. New York: Committee of Economic Developmen t. Dicken, P. 1998. Global shift. transforming theworld economy.3rd Edition. New York:The Guilford Press. Flynn, P.M. 1988. Facilitating technological change: the human resource challenge. Cambridge, Massachusetts: Ballinger. Groot, W. and Hartog. 1975. Screening models and education. In International encyclopediaofeconomicsofeducation. Edited by M. Carney. 2nd Edition. Oxford: Pergamon Press. Lovelock, C. 1988. Managing servicesmarketing, operationsand human resources. UK: Prentice Hall International. Mallea,J. 1997. International trade in professional and educational services: implications for the professions and higher education. Paris: OECD. Nadurata, T. 1998. BSA students: academic achievements vs. audit competence. DLSU Businessand EconomicReview.10 (2) Parker, B. 1998. Globalization and business practice managing across boundaries. London: Sage Publications Ltd. PDCP Bank Industry Digest. 1996. Banking industry: liberalization fuels growth Part II. Manila: Private Development Corporation of the Philippines.

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Rumberger,R W. 1984. High technology andjob loss. Technology in Society. 6: 263-84. Rumberger,R W. and H. M. Levin. 1989. Schoolingfor the modem workplace. In Investing in people: a strategy for addressingAmerica's workforce crisis. Background Papers Vol. 1. Washington,DC: US Department of Labor. Shutlz,T.1961. Investmentin human capital. ArnericanEconomicReuiew. 51 (1): 1-17. Stokey,L. 1988. Learning by doing and the introduction newgoods.journal of PoliticalEconomy 96(4): 701-17. Suleik, M. 1992. Banking and Financial Reforms in the Philippines Part 2. GBReview January. Tullao, T.S. 1999. Professionalaccreditation in the liberalization of trade in services. CBE Working Paper Series1999-06. De La Salle UniversityManila. Zimbalist, A. 1979. Casestudiesin thelaborprocess. NewYork: Monthly Review Press.

CHAPTER IV Foreign Bank Entry, Bank Spreads and the Macroeconomic Policy Stance GeorgeN. Manzanoand Emilio S. Neri,Jr. Abstract he Philippine banking industry wasopened to limited foreign entry in 1994.The liberalization measurewasjustified on the basisof enhanced competition. While it wasobserved that foreign-bank entry brought about a slight deconcentration in the banking industry, there appearsto be no systematic reduction of bank spreads.On the contrary,bank spreads(using alternative measures)were observedto haveincreasedfrom 1994to 1997,indicating that the relative profitability of bankshaveimproved amid foreign-bankentry. This paper offersan alternativeexplanationto the 'puzzle' of widening spreads. The high interest rate policy (due to sterilization) kept lending rates high. On the other hand, banks had little incentive to compete for deposits by increasing interest ratesas cheaperfunds were easilyaccessiblefrom cheaper funds overseasowing to policies of promoting pegged exchange rates. Toward the late 1990s,a narrowing of spreadswasobserved,accompanied by a reversal of the macroeconomic policy stance in the 1994-1997period. The paper thus argues that the prevailing macroeconomic incentives matter in the determining outcomes of liberalization measures.

Introduction Increasingly, the mantra of liberalization, deregulation and free markets is beginning to reverberate worldwide. This trend has not been lost on Philippine policymakers. Starting with the Aquino administration, and continued by the subsequentadministrations, sweepingeconomic reforms in the areas of investments,telecommunications,trade, and infrastructure provision have been initiated. The banking sector,long thought to be "different" due to the role it played in ensuring the smooth functioning of the payments systems, hasalsobeen subjectto the liberalization drive.

252

FINANCIAL LIBERALIZATION: MANAGING RISKSANDOPPORTUNITIES

In May 1994,a lawwaspassedliberalizing the entry and scopeof operations of foreign banks in the Philippines. This law allowed foreign banks (a maximum of 10 new banks) expanded market accessand accorded them national treatment though branching limitations continued to be enforced. The foreign bank community received the new charter positively. To illustrate, shortly after the passageof the newcharter,10foreign banksentered the market Did the entry of foreign banksin 1994bring out the desiredoutcome of more competition in the domestic banking sector? We begin the discussionwith a brief reviewof the merits and demeritsof liberalizing the sector to foreign banks.This paper attemptsto contribute to the debate over the effectivenessof the banking liberalization in developing economies by highlighting the effect of the macroeconomic policy stanceon the degree of competition within the sector. Specifically,it seeksto distuss the query: What are the necessaryand sufficient conditions, on the macroeconomic policy plane, for the entry of foreign banksto heighten the competition in the banking system?We draw attention to the puzzleof persistentbank spreadsin the two yearsafter 1994and the tapering off of the spreadstowards 1999. We then explain the aforementioned observation by discussing the interaction between macroeconomic incentives and bank-pricing behavior. To conclude this part, we highlight the necessarymacroeconomic conditions to effect competition in the processofliberalization. The pros and cons of foreign banks' presencein developing markets The theoretical casein favor of opening marketsto foreign banksrestson the traditional argumentsof competition and thosemore specific to finance such as diversification benefits. The effect of foreign banks' entry on competition in the domestic banking sectorfocuseson the expectedimprovements on the technical, allocative,and dynamic efficiencies that competitive pressure can bring to bear on the local banking industry. The entry of foreign banks is expected to ameliorate the technical inefficiencies associatedwith protection and draw out the benefits of lower lending rates,improvements in services,and more attractive deposit rates in the domestic banking industry. In addition, crossborderentry of foreign bankscan help dilute collusive domestic equilibrium as many national banking marketshavelong been characterized by tacit or even explicit collusiveagreementsby national banks (Hoschka 1993). It is also recognized that the entry of foreign banksproduced benefits beyond the standard efficiency-enhancing effectsof increased competition.

FOREIGNBANKENTRY.BANK SPREADSAND THE MACROECONOMIC POLICYSTANCE 253

One such benefit is the contribution of foreign banks in developing more robust and efficient domestic financial systems.For instance, competition from foreign pressure the institutional infrastructure to improve regulation and supervision (Claessensand Glassner1997),corporate governance practices, disclosure rules, and other international practicesand standards.This development can be very important since banks,due to the nature of their maturity-transforming operations, are "special" and easily subject to bouts of instability. In a similar vein, foreign bankscanbring to the local market the financial strength of their parent institutions and "import" the regulatoryand supervisoryservicesof their home-countrygovernments,including the lenderof-last-resortand deposit insurance functions (Gavinand Hausmann 1996). Dynamic benefits, on the other hand, are expected to come from the speedier diffusion of technical improvementsand innovations il:l the delivery of financial servicesfrom abroad to the local industry that otherwise would have taken longer in the absenceof foreign serviceproviders. Such innovations include credit card facilities, derivatives,fund management,etc. Anecdotal evidence suggestthat foreign financial servicesproviders do introduce new financial products, enhance the quality of existing servicesand spur improvements in the quality of the institutional framework (Claessensand Glassner1997). Goldberg et al. (2000) state that foreign banks' presencecan boost the amount of funding available to domestic projects by facilitating capital inflows. To the extent that foreign bankshave better accessto cheaper funds from their home base or from the global capital markets, they can provide financing at a lower cost. Furthermore, the presence of foreign banks also help diversify the capital and funding sourcesfor local credit and help stabilize available credit especiallyduring crises. Arguments againstthe entry of foreign banksmostlyhinge on the assertion that banks are "special." The concept of "overcompetition" underlies many of these arguments. For instance, it is feared that a massiveinflux of foreign bankscould result in overaggressive competition or overfragmentation of the financial system.Becauseit is expected that asforeign banks tend to select the most lucrative segmentsor clients, the domestic banks are left to service the more risky segments(Goldberg et al. 2000). Such competitive pressures pull down the future earning capacities of domestic incumbent banks, thus diminishing their "franchise values."Consequently, the difficulties could raise the incentive for bank managers to engage in more risky behavior to recoup losses,that is, gambling for redemption.

254

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

Other reasonsinclude infant-industry arguments on the grounds that the banking industry can be regarded asa strategic industry best left in the hands of nationals. For instance,directed lending by local banks have been employed as an instrument of industrial policy in a number of developing countries. A number of empirical studies generally support the arguments for foreign bank's entryinto thedomesticbankingindustry.For instance,Claessens et al. (1998) examine the effectsof foreign entry on the domestic banking marketsusing a cross-sectionanalysisof 80countries. They provide empirical evidence that the entry of foreign banksimprove the functioning of national banking markets,with positivewelfareimplications to the domestic economy. Country casesstudies are reported in Abola (1998) for the Philippines; Jayaratneand,Strahan (1997) for the US caseof interstate banking liberalization; APEC (1998a) for the experience of Peru and APEC (1998b) for the related experience of Australia and Taipei. Denizer (1997)statesthat liberalizing the entry of banksforeign and domestic alikehad significant effects on lowering lending ratesin the Turkish banking industryin the 1980s.Goldberg, et al. (2000) find that, in the Argentine and Mexican experiences,foreign banks generally have had higher loan growth rates than domestic bankswith lower proportionate volatility of lending contributing to lower overallvolatility of credit. Impactof foreign bank's entryinto thePhilippines:concentration,bank spreads and macroeconomic policies There are at least three approaches to analyzing the determinants of bank interest margins and other measuresof spreads(Saundersand Schumacher 2000). First, margins can be related to the market structure of the banking industry. Under this approach, high spreads can be said to be a result of banks' monopolistic behavior. Secondly,changesin regulations such as reserve requirements or taxes,can affect the spread.Thirdly, issuesrelated to risk premia, such as the interest-rate volatility, could contribute to higher interest rate margins to provide some cover or insulation from unexpected risks. Using stylized facts,this sectiondiscussesthe spread behavior of Philippine banks shortly after the period of the surge of foreign banks' entry. It offers an explanation that relates the persistenceof relatively high spreads during the specific period to the macroeconomicpolicy stancerather than to the market structure nor to intermediation costs.The analysispresented, of course,is not mutually exclusiveof the other approachesbut offers another

FOREIGNBANKENTRY.BANKSPREADSAND THE MACROECONOMIC POLICYSTANCE 255

"window" in viewing the behavior of banks, especiallyduring the period of market liberalization. Stylizedfact of spread behavioramid the entry of foreign banks:the structureconduct-performance (SCP)approach A fairly standard way of assessingthe impact of liberalization is by using the structure-conduct-performance (SCP)approach. The rationale is that the market structure affects the firm's conduct, which, in turn, has a direct bearing on performance. Market structure is often measured by the extent of market concentration in the industry. Applying this to the banking sector, market structure is usuallymeasuredby the share of the largest banks in the total industry assets,loans or deposits. Conduct, on the other hand, dictates the degree of rivalry in the industry, which is usually reflected in the bank spread (the difference between the lending rate and the costof funds). Performance refers to the rates of return of the banking industry compared to other industries or ratesof return in other countries. Often, high levels of market concentrations are associatedwith larger bank spreads and above-averagereturns. Recall that the case for allowing foreign banks' entry restson its impact on market deconcentration. Following standard industrial analysis,the entry of more players deconcentrates the, banking industry, making it more competitive. With more competition, bank spreadsare expected to narrow and profitability to fall to what are considered "normal" levels.Thus, under this paradigm,to achievecompetitive outcomes, it is important that foreign bankshavethe incentive and ability to compete for the market share alreadyheld by the dominant playersof the industry. In applying the SCPanalysisto the impact of foreign banks in the Philippines, it would be useful review the history of foreign banks' operations in the Philippines. Prior to 1994,only four foreign bankswere allowed to operate in the Philippines. These bankswere subject to more restrictive regulations: they could neither operate as universal banks; engage in trust operations nor open newbranches. It is interesting to note that there remain to be only nine branchesof the four "old" foreign banks,the samenumber they had since 1948. In 1994,Republic Act No. 7721,which allowed the entry of a maximum of 10 new foreign banks,waspassed.While restricting branching privileges, this wasmore generous in permitting the foreign banks to open branches than previous laws.To prevent foreign banks from dominating the local industry, the law required that domestic majority-ownedFilipino banksto hold 70 percent of total resourcesof the entire banking system. It is important to

256

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

distinguish the 10 new foreign banks from the original four in assessingthe impact of the liberalization measureof 1994. The responseof the foreign banksto the new charterwasquite positive, asmentioned earlier. In 1995,10 foreign banksentered the Philippine banking industry. The most common form of entry in 1995wasestablishing full branches (Table 1). To date, 21 foreign banksoperate in the Philippines, a sizeableincrease from the original four. Previousstudieshaveused the SCPapproach in analyzingthe degree of competition in the commercial banking. For instance,Garcia (1992and 1993) analyzed the structure, pricing and performance indicators of the industry from 198291. He associatedthe widening spread between lending and deposit rates and the very high rates of return on equity of the sector with the increase in market concentration ratio. Basedon these findings, he recommended that the Philippines open the banking sector to foreign. Using a similar framework, Abola (1998) analyzedthe impact of the entry of the foreign banksby constructing severalmeasuresof concentration, indicators of bank spreadsand calculationsof ratesof return from 1991 to 1997. Stylizedfact: There wasa slight deconcentration in the structure of the Philippine banking industry but there wasno systematicreduction in bank

spreads The structure of the banking industry, asgleaned from the changesin concentration ratios in assets,loansand deposits,did not appear to be significantly altered by the entry of new foreign banksfrom 1994to just before the financial crisis in Asia. As shown on Table 2, the share of the top five banks to total banking assets(all domestic commercial banks) hovered between 43 percent and 47 percent from 199194, the period prior to the actual entry of new foreign banks. In 1995,the concentration ratio in the total banking assetsof the top five banksdid not changesignificantly.The newforeign banks,accounting for less than 2 percent in 1995, slightly increased their share in total assetsto close to 3 percent in 1996. It was only in 1997 that the share of the top five banks in total assetsdecreasedby 7.63 percent. The share of foreign banks (old and new alike) actually expanded from around 13 percent in 1996 to close to 20 percent in 1997.By 1999,however,the share of foreign banks in assetsdeclined to less than 15percent. The movements in the concentration ratios in loans mirror that of the corresponding ratios in assets.Prior to the liberalization, the top five banks accounted for 4048percent of all loans.No significantchangesin the concentration ratios of loanswere noted when the additional foreign bankswent into

FOREIGNBANKENTRY.BANK SPREAOSANO THE MACROECONOMIC POLICYSTANCE 257

Table 1. List of foreign bank's branches (As of 31 December 2000) Date of 1st entry into

the

and subsidiaries

Bank Classification (Universal, commercial,

Foreign Bank Branch! Subsidiary

Philippines

Mode of Entry

Number of

Branches

Capital (P Million)'

etc.) 6/28/45 7/23/45 8/6/45 4/15/47 4/3/95

5 5 4 0 0 0 0 2

2,567

c c c c

0 0 0

1,238 760 266 223

Commercial

2,616

Commercial Commercial

c b

Commercial Commercial Commercial

b a a

Thrift

Commercial Thrift

a a

0 0 13 59 20 24 96 14

250 2,505 2,495 1,895 2,244 857 2,184 671

Citibank, N.A. Standard Chartered Bank Hongkong & Shanghai Banking Corp Bank of America NT & SA The Bank of Tokyo-Mitubishi Ltd.

Commercial Commercial Commercial Commercial Commercial

6/1/95

Korea Exchange

Commercial

6/30/95 7/4/95

The Fuji Bank Ltd. The International Commercial

Commercial Commercial

c c

7/10/95 7/14/95 8/11/95 9/26/95

Bank of China ING Barings, Manila Branch Deutsche Bank AG Bangkok Public Company Ltd. The Chase Manhattan Bank

Universal Commercial Commercial Commercial

9/26/95

(foremerly Chemical Bank) Chinatrust (Phils) Commercial

10/2/95 1/8/96

Bank Corp. ANZ Banking Group, lid Banco Santander Philippines,

1/29/96 11/6/97 9/1/98

Dao Heng Bank, Inc. Maybank Philippines, Inc. DBS Bank Philippines, Inc'

9/7/99

ABN-AMRO

11/26/99 12/29/00

United Overseas Bank Philippines HSBC Savings Bank Phils. Inc.

1 Mode of entry classified a) by b) by under c) by 2 As of

Bank

Inc.

Savings Bank Corp.

Original Original Original Original c

4 4 4 4

900

1,350 423 720 257 602 389

as follows:

acquiring, purchasing or owning up to 60 percent of the voting stock of an existing bank; investing in yp to 60 percent of the voting stock of a new banking subsidiary incorporated Philippine laws; and establishing branches with full branching authority December 2000, exclusive of main branches of foreign banks and head offices of foreign

bank subsidiaries , Based on published

statements

as of September 27, 2000 for universal/commercial

banks and as of

June 26, 2000 for thrift banks .Foremerly Bank pf Southeast Asia, a locally incorporated bank that was acquired by Development Bank of Singapore (DBS) Accordingly, DBS gave up its full bank branching authority originally granted on 28 November 1995 Source

Bangko Sentral ng Pilipinas

operation. In fact, the shareof the new foreign bankswasless than 4 percent before the crisis. This modest expansion in loans came from these banks' capitalbase. Similarly, the top five local banksaccountfor closeto half of total deposits from 1991 to 1996.The entry of foreign banksdid not appear to make a dent in the concentration ratios for depositsduring the pre-crisis era. The

258

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

Table 2. Concentration Ratios (assert, deposit, and loan concentration ratios 1991 -2000) 1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

ASSETS ShareofTop5 Shareof'Old' FBs Shareof New10 FBs ShareofTotalFB's DEPOSITS ShareofTop5 Shareof'Old' FBs Shareof New10 FBs ShareofTotalFB's LOANS ShareofTop5 Shareof'Old' FBs ShareofNew10 FBs

43.55 4434 44.1 46.96 4571 44.04 13.75 11.56 12.09 10.01 9.03 9.8 1.81 2.96 10.83 1277

48.44 782

4794 803

48.68 7.74

49.99 758

49.1 5.61 0.53 6.14

44.52 44.92 39.96 10.81 10.11 10.5

4755 866

ShareofTotalFB's

Source:

"fA]

36.43 37.95 42.69 49.58 1292 8.72 9.44 10.38 6.44 6.56 5.24 3.38 19.36 15.37 14.68 15.8

49.74 44.11 5.12 655 0.77 2.49 5.89 9.04

44.28 7.08 279 988

51.8 5362 8.12 9.63 3.03 323 11.15 12.86

47.25 73 1.31

46.39 677 3.7

3286 566 4.81

38.73 43.08 6.24 9.53 5.31 4.48

49.38 7.39 5.3

8.61

10.47

11.55

12.69

14.01

Bangko Sentral ng Pilipinas

share of the new foreign banks, tellingly, is less than one percent of total depositsin 1996. Only in 1997did their sharerise significantly.The low share of foreign banksin total depositswasa natural consequenceof restrictions in branching (Table 3). If foreign banks put competitive pressureon local banks, their entry in 1994should havenarrowed bank spreadsin subsequentyears.However,bank spreads cannot simply be captured by the difference of the lending and deposit ratesowing to severalimplicit costs(Sorsa1997;Claessensand Glaessner 1997). Thus, Abola (1998) usedthe difference betweenthe nominal lending rate and the intermediation cost (which is a catch-allvariable for all other opportunity costsassociatedwith depositssuchasreserverequirements, deposit insurance, taxes,etc.) as the bank spread.To scalethe bank spreadswith the general movements in interest rates,he constructed a ratio of the bank spread to nominal lending rate! (Box 1 discussesthe alternative measuresof spreads). , A test to determine

difference

in the means of the spreads

in pre-liberalization

period

(199194) from the post-liberation period was carried out (1995-99). The spread was computed according to the accounting method (see Box 1). The test showed that there was no significant difference between the spreads in the two periods. A similar for the variable, accounting spread as a proportion of lending rate, showed that the mean increased in the post-liberalization period at a 5 percent degree of significance.

FOREIGNBANK ENTRY,BANK SPREAOSANO THE MACROECONOMIC POLICYSTANCE 259

Table 3. Performance indicators of banking sector (in percentage) Netlnterest Margin I Total Years

Hong Kong Indonesia South Korea Malaysia

Philippines Singapore Thailand India Comparators Germany Japan

U.S.

1990-1995 1988-1995 1991-1995 1988-1995 1988-1995 1991-1995 1988-1995 1992-1995 1992-1995 1989-1995 1988-1995

Overhead! Total Assets

Total Assets

Assets

1.9 3.5 1.7

2.4 4.2

Net

Profitt

1.5 2.9

2.1 1.6 4.4 1.3

1.7 0.9 0.4

0.9 2

1.4

1.1 1.1 2.3

1.9 1.4

2.1 1.1

0.4 0.2

3.1

3.2

0.5

1.9 3.1 3.3

Note:

Data presented are weighted averages of figures from all reporting banks, domestic and foreign.

Source:

Demirque-Kunt and Hizinga 1997 as cited in Claessens and Glaessner 1997.

As Figure 1 shows,intennediation costssteadilydeclined from 1991 to 1997.The post liberalization analysisof the impact of foreign banks' entry in 1995and 1996,showed only slightlydeconcentrated and reduced profit rates in commercial. Barring major structural changes,bank spreadsshould have narrowed after the adventof foreign banks. Surprisingly,bank spreadsstarted to climb in 1994-1997,indicating that relative profitability improved. Abola's (1998) general analysisof using the SCPindicated that while the entry of foreign banks intensified competition in commercial banking, this wasnot enough to reduce bank spreadsto belowthe pre-liberalizationperiod. In fact, spreadsonly began narrowing substantiallyin 1999,a time when concentration ratios sawa significant rise. This observationappearsto be a puzzle. The effects of macroeconomicpolicies on bank spreads It can be argued that high bank spreadspersistdespite the entry of new banks becausethe effects of competition were not felt immediately. It can also be argued that the liberalization measuresofRA 7721 were too anemic to make a mark. While these theories partially explain the persistence of relatively high bank spreads,we suggestthat macroeconomicpolicies played an important role in determining bank spreads.

260

FINANCIAL LIBERALIZATION,MANAGINGRISKS ANO OPPORTUNITIES

Box 1. Alternative

measurements

of intermediation

spreads

Most of the arguments made in this paper are based on a particular methodo!ogy accounting method of computing for intermediation spreads. This specific definition varies from the more popular method found in most of the earlier work (e.g Abola 1999) done to explain the behavior of bank spreads mentioned in the literature revies. Unfortunately, due to the rapid growth of foreign currency intermediation and the ever-widening range of services provided by commercial banks, the lending and deposit rates data series published by the Bangko Sentral has become less relevant. Among its many weakness is the fact taht the data only covers peso-denominated loans and deposits A through discussion on the need to have a wider definition of bank intermediation spreads can be found in Brock and Suarez (2000) where the authors provided six different definitions Of these definitions, this paper provides only two defined below as 1) Average Spreads Method and 2) Accounting Spreads

1. Average spreads cost of funds")

method ("average

yield on earning

assets"

minus

"average

Formula

AS=

(EA1 + EA2)

(Iel, + fBL,)

AS = [YEA -CF]

where AS EA IBL YEA iEA i'Bl

= average spread = earning assets or interest bearing assets = interest bearing liabilities = yield on earning assets = interest yield on earning assets = interest cost on interest bearing liabilities

To compute for the average spread, one simply has to get the difference between 1) the average interest yield that all commercial banks make from their interest earning assets and 2) the average interest cost of all their interest bearing liabilities. Like most 'macro" level indicators, it fails to capture the various implications of, for example, changes in the maturity structure of the various components of banking sector's balance sheet. Limitations (Data limitations make it difficult to compute for yield-on-earning assets (YEA) across a broader definition For instance, if the income report of the BSP had separated the different balance sheet and income statement items, it would have been much easier to measure the yield of banks in all earning assets Data limitations only allowed us to measure interest as a proportion to bank loans and investments, making our figures slightly overstated To compute

for the average

spread,

one simply

has to get the difference

between

1) the

average interest yield that all commercial banks make from their interest earning assests and 2) the average interest cost of all their interest bearing liabilities. Like most "macro' level indicators, it fails to capture the various implications of, for example, changes in the maturity struture of the various components of banking sector's balance sheet

/."""""

FOREIGNBANK ENTRY,BANK SPREADSAND THE MACROECONOMIC POLICYSTANCE 261

Often, in considering the effectsof liberalization to an industry, macroeconomic issuesare set aside,and policy issuesrevolve around "fair" pricing and providing "level playing fields" to all industry participants by removing barriers to entry. Thus, departing from the standard "microeconomic" analysis,that is, the SCP approach, emphasisis given on the interaction between the macroeconomic environment and the pricing behaviorof banksascentral to the understanding of the puzzle of the persistent bank spread two years after limited banking liberalization wasimplimented and the subsequent drop of spreadsin 1999. Admittedly, the spread,after controlling for intennediation costs,still contains the risk premium. Riskpremium is linked with the degree ofuncertainty in the system.Becausehighly volatile interest rates inject uncertainty, the variance of the interest rate is usuallymade an indicator of risk premium (Saunders and Schumacher 2000). The connection between the entry of foreign banks and the degree of volatility of interest rates is not very clear, however.2Thus, it may be difficult to establisha systematicrelationship between liberalization and risk premium as understood in a macroeconomic senseasvolatility of interest rates. It is true that higher risk premium calls for higher spreads.However, bank spreadscould not go lower than the difference between the Treasury

2 Saunders systems

and Schumacher

in developed

(2000) showed that spreads for a cross section

of banking

countries vary with the volatility of interest rates (an indicator risk).

262

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

bill rates3and the cost of funds (which are largelydetermined by the savings interest rate plus the intermediation costs).Thus, the difference betweenthe (risk-free) Treasurybill ratesand the costof funds is effectively the minimum spread. The presence of risk premia could causethe spreadsto widen. The fact that the difference between the Treasurybill ratesand costof funds widened during the liberalization implies that the minimum spread also widened (Figure 2). Macroeconomic policies and deposit rates What macroeconomic policies were in place during the liberalization which allowed banks to maintain high spreads?Judging by the obseIVed movements in the peso-dollar exchange rate under its newly decontrolled foreign exchange market it is quite evident that, between 1994 to mid-1997 monetary authorities deliberately kept the movement of the peso-dollar exchange within a very narrow band (Figures 3 and 4).1 During the net foreign currency inflow episode of this period, the policy was generally of sterilized foreign exchange inteIVention to meet both the BSP's tight monetary and foreign exchange targets (Box 2). Maintenance of both an IMF-sponsored monetary aggregate targeting program and an exchange rate peg, however, often requires maintaining relatively high interest rates, similar to the effects that sterilized foreign exchange inteIVention would have on interest rates under a fixed exchange rate regime (World Bank 1996). However, the crisis in mid-1997 led to the collapse of the de facto peg of the peso to the dollar. In 1998, the macro policy mix had to be adjusted. While the peso-dollar rate was allowed to move within a wider band, interest rates were kept high by the BSP to stabilize capital outflows. Monetary aggregate targeting was therefore abandoned in favor of defending the peso through tight monetary policy. By 1999,the more stabilized currency marketsin Asiaallowed the localmonetaryauthorities to shift to a different policy mix. With the easing of capital outflows and effects of contagious currency volatility virtually disappearing, the local monetary authorities were able to adopt a more flexible exchange rate regime and revert to the previous monetary policy regime of monetary aggregate targeting.

3 While indicators

a such as the PHIBOR can seve as an alternative

benchmark

rates, the authors chose the 91-day T -bill rate given its longer time series. 4 Hernandez, Montiel (2001) and Calvo, and Reinhart (2001) provided empirical

to lending evidence

that during the pre-crisis period (1994 to 1997) the exchange rate regime of the Philippines was not a managed float, as declared by the Philippines to the IMF, but was more of a 'soft peg' to a fear of floating.

FOREIGNBANK ENTRY, BANK SPREADS AND THE MACROECONOMIC POLICYSTANCE 263

Figure 1. Intermediation cost and bank spreads

Source of Basic Data: Bangko Sentral ng Pilipinas

Figure 2. Difference between risk-free T -bill rate and cost of funds (deposit rates plus other intermediation costs): "Risk-free" spreads fall to narrow

Source:

Bangko Sentral ng Pilipinas

264

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

Figure 3. Open capital account policy was mixed with virtual currency peg

Source:

Bangko Sentral ng Pilipinas

Figure 4. Peg did not hold for long

Source: Bangko Sentral ng Pilipinas SDEV (Right Scale) = standard deviation

of the first difference

rate AVG (Left Scale) = average monthly spot rate f P/$ rate

of the monthly average spot

FOREIGNBANK ENTRY,BANK SPREADSANO THE MACROECONOMIC POLICYSTANCE 265

Box 2. A policy bias for tightening:

the BSP-IMF financial

programming

framework

.?"...

While the Philippines was under an 1994 to 1997, the monetary and exchange rate po}ICY mJX.put;lnp1af~~a~jan agreed framework between the BSP and the IMF. It IstheObJecl!veofth!ยง~ctlon to demonstrate how the BSP-IMF financial programm!ng framewo!k.is biased for tight monetary policy (or high Interest ra.te~). To unders.tandth!s, we need to expound on how .the reserve money-targeting iramewo!kwOrkS: ;

After the BSP submits its GDP growth target to theiMF; the IMF asks for an income elasticity of demand for money figure from the BSP.Th.is.f\gure will yield a money supply growth target figure; BasedontheJMF'Sflnancia!programmirg framework, meeting thjs target will facilitatemanageabjlity of the coun\ry's baJanceofpaYQ1ents ..' C"'C/C cC C to keep the country's inflation rate at very manag:eabJec!eyei.s. Thechosenc intermediate target for the or domestic liquidity, bulk of which.ispeso-denolllinateddeposit liabilities of commercial banks. However, because M3 data comes too infrequently, a proxy or operating target takes its pJace in the near1erm and an agreed growth target by the Philippjne monetary authorities is the growth of..reservemoney (RM) And since the programming framework assumes a steady moneymultipl.ier for RM and M3, RM becomes the operating target. c c Take note, however, that with a highly mobile capital acCQum,anopera\ingta.rget such as RM is biased toward a tightening of the domesticcurrenoycmoneysupply, whether there is a net inflow of capital or a net outflow of capital,Ouringcapitat inflow episodes, a sharp increase in NFAwiil requlreanequallysharpreduotionc in ND~ If the RM target commitment to the IMF is tobem~lFort.nst~nce,!f theRM target IS 15 percent and NFA grows by 25percenl meetlrgthecRMc\arget means NDA will have to be reduced by 10percenl This,moreoftenth:ancnot,leads to higher interest rates on the home currency Underihisframework, if the policy bias of the .BSP is to ~.eep the peso very stabi.e,capit.~.r inflQweplS~$s~f: usually accompanied by stenllzedforelgn exchange Intervention FIgure 8 cleanYII!Ustrates how this was practiced between 1994 to 1997 c Unfortunately during an outflow episode, the BSP could not do the reverse. Whenever there is a decline in NFA, the only way to meet the RM target is to expand NDA For example, if the RMgrowth target is 15 percent and say, NFA declines ., by 10 percent, then NDA must .'be expanded byZ5 percent...Ihls IseaSlef said than done. The fact is, it is very difficult to, expand N9Aqlirin9c acapit.~J outflow ep1sode (Bruno 1993) as an expanS10n .lnNDAreduC~$theY.l~ldson c c home

currency

(or

peso-denominated)

assets

and

could

exaggerate

outflow Under this framework, if the po!icy biasoftheBSPis)o~e:ep very stable, capital outflow episodes are foreign exchange intervention

the

capital

the peso Cc

The fact that the policy bias during a capital inflow episode is toward sterilized intervention and the policy bias during a capitatoutflow episode is toward unsterilized intervention means that the policyb!as of the BSP during a pegged exchange rate regime is toward high domestic interest rates,

266

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

How does this macroeconomic policy mix (sterilization) affect the pricing decisionsof local banks on both lending and deposit rates?Recall that a bank spreadis basicallythe differencebetweenthe lending rate and the costof loanable funds, of which ratespaid on depositsare an important component. Combined effects on spreads To assessthe effectsof the chosenpolicy mix, we considerfirst their effectson deposit rates. For banks,a consistenteffort of the monetary authorities to fix the level of the exchange rate fuels expectations that the exchange rate will remain stable. It also signalsvery little risk in funding bank loans through foreign currencies, that is, low foreign exchangerisk. And since the interest rates on foreign debt instrumentsasdepicted by the annual peso equivalent of the three-month LIBOR5were typically lower than the marginal cost of raising peso deposits,bankswere encouragedto fund a growing shareof their assetsthrough foreign currency denominated liabilities. The differentials were, in fact, evenmore pronounced during the liberalization period (Figure 5). In addition, the regulatorystructure favored dollar rather than peso in termediation (Lim and WoodrufI1998). Thus,6it is no surprise that in 1995and 1996, the dollar-denominated deposit liabilities of commercial banks expanded dramatically (Figure 6). This incentive to engage in more d9llar intermediation had implications on the deposit rates and indirectly on bank spreads.This policy and regulatory regime tends to put lesspressure on banks to compete for peso deposits.This is especiallytrue when we consider the relatively higher costof time deposits,7which canbe taken to be the marginal costof generating funds for banks,compared to dollar deposits.The switchto the more attractive dol-

5This is derived by simply adding the yield on the LlBOR and the rate of depreciation

of the

peso against the U.S. dollar. This, in effect, is the peso cost of generating foreign- or dollardenominated funds. 6Another factor in foreign-currency intermediation is the fact that banks are able to claim tax savings of 35 percent on deposit interest expenses from Foreign Currency Deposit Units (FCDU) deposits while they only incur a 10 percent tax liability for foreign currency loans to residents (IMF 1998). Another source of incentive for raising funds through more dollardeposit liabilities is the fact that there is no reserve requirements on foreign currency deposits while the reserve requirement for peso deposits continued to be one of the highest in the region. 7Take not that some of these foreign currency deposits were in fact US dollar Floating Rates Certificate of Deposits (FRCDs) brought in from offshore. Savings and demand deposits alone grew sluggishly. Special savings deposits, however, rather than regular savings deposits, provided a good portion of the growth. Although classified on the balance sheet as saving deposits,

special savings deposits earn rates only slightly lower than time deposits

FOREIGNBANK ENTRY,BANK SPREADSAND THE MACROECONOMIC POLICYSTANCE 267

Figure 5. Incentive to fund loans from abroad

Source:

Bangko Sentral ng Pilipinas

Figure 6. Peso's float erased foreign borrowing

Source:

Bangko Sentral ng Pilipinas

268

FINANCIAL LIBERALIZATION,MANAGINGRISKS ANO OPPORTUNITIES

lar intermediation implies that there would be little motivation to bid up the deposit rates to generate more deposits. In effect, the substitution of pesos with dollars assourcesof bank funds tends to lower the costof funds and lead to wider bank spreads. Of course, the bidding up of deposit rates as the number of players (foreign and local banks alike) increasescould be stymied by restrictions on establishing branches or by specific strategiespursued by the foreign banks. Since the granting of full licensesto operate in 1994,the new foreign banks did not embark on an aggressivebranching strategy. This behavior implies that foreign banks prefer to concentrate on the loans market and using sourcesother than depositsasloanable funds. Notwithstanding this behavior,the macroeconomicincentives,which affectdepositsof both domesticand foreign, are not conduciveto increasingdepositrates. As expected, banks lost appetite for funding bank lending through dollar liabilities when the crisis struck in mid-1997 and the narrow pesodollar rate band could no longer be maintained. This can be seen in the decline in foreign currency borrowing and deposit-taking during the precrisis surge of foreign capital (seeFigure 7). In fact, there wasstill very little interest among banksto borrow during the peso'sappreciation in 1999. Macroeconomic policies and lending rates Looking now at the other side of the coin the lending sidewe argue that the same policy mix chosen by the monetary authorities were also key to keeping interest rates relatively high, which, in turn kept intermediation spreads high. How did the aforementioned macroeconomic policy-mix affect lending rates? The answer obviously depends on the rate-setting mechanism of local banks. It is very much affected by the 91-dayTreasury bill rate. Since the latter is generally considered the least risky debt instrument in the country, its movements affect lending rate behavior in two important ways. First, it serves as a benchmarks for bank loans. And since interest on these instruments typically amount to the opportunity cost of bank lending to riskier private entities, its rate often preempts movements in the average lending rate. 8 Some observes raised the issue about the true benchmark

of bank lending rates. While the

91 -day T -bill rate is generally recognized as the benchmark yield, it is often pointed out that the Philippine Interbank offered rate (PHIBOR) was sometimes a better basis for bank lending rates, particularly from 1998 and 1999. However, the fact that yields for the PHIBOR was often higher than the 91 -day T-bills, the argument that bank spreads did not decline due to the failure of benchmark rates to fall becomes even stronger.

FOREIGNBANK ENTRY,BANK SPREADSAND THE MACROECONOMIC POLICYSTANCE 269

Figure 7.

Changing liability structure of KBs+ 40

Local and Foreign Funding Cost in Pesos

30 25

,"':

.. . '

.6.

15'

' ,

..6. .

f-&

, -~\~-.~':'~--~~..~~~-~(~~~<:

' '

..."

'".'

'A --A

0 y--~~:

-1~---A--

-5

-10 0

ffi .Source:

8i ,,- ffi $

ffi

ffi .-

Banko Sentral n9 Pilipinas

Figure 8. Macro policy mix and financial market imperfections led to persistent arbitrage 30 25 20 15

10 5 0 0 m m ~

0> .-

N m

m ...

CO)

OJ .-

$ Return on 91TBR

". m m

It)

OJ OJ

-.e- LlBOR

10 0) 0) ..-

270

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

It is not difficult to show that lending rat~s or the return on any pesodenominated debt instrument, forthat matter,yielded very attractive returns. Since the dollar returns on 91-dayT-bills consistentlyexceeded the returns on the LIBOR (ranging from 490to more than 1,100basispoints), implicitly, lending rates in the Philippines remained quite high (Figure 8). The gap betweenthe high Treasurybill ratesand the low interest ratesoverseasduring the mid-1990srepresentsprofitable arbitrage opportunities. Therefore, given functioning capital markets,this gapis expectedto disappearquite quickly unlessa large premium is required to motivate investorsto hold onto Philippine financial assets.However,while structural or institutional factors are often suspectedfor the failure to remove the price differential, macroeconomic factorsmay explainthe failure to eliminatesucharbitrageopportunities (Box3). Summaryand conclusions The combined effectsof the chosenmacro policy mix on depositand lending rates are not inconsistent with the patterns of bank spreads. Bank spreads, given the macroeconomic incentive outlined earlier, remained high during the pre-{;risisliberalization period simplybecausethe reference rate of lending rates did not decline substantiallywith the entry of foreign banks. Also, since foreign currencies were much easierand much cheaper to tap, banks found no urgency in bidding up the deposit rates to generate peso-denominated deposits.Macroeconomicforces,thus,werecritical in determining bank spreadsduring the capital inflow period. During the capital outflow episode, the change in the policy mix did not immediately narrow spreads.Again, while the pesowasallowed to move within a much wider band (which kept banksfrom aggressively sourcing their loanable funds from offshore channels,like they did before the inflow episode), spreads remained high mainly as a result of higher lending rates. However,when the currency volatility in Asia diminished in 1999,lending rates fell along with key policy interest rate. As a result spreads declined remarkably in 1999. In the final analysis,did the entry of foreign banksintensify competition in the local banking sector? The fact that variations in intemlediation spreadswere explained by the government's chosenmacroeconomicpolicy regime suggeststhat macroeconomic policies may maskthe intended effectsof foreign banks' entry on competition in the local banking market.The macroeconomicincentive structure adopted during 1994-1998servedto maintain relativelywide bank spreads than local banks would otherwise enjoy in the face of competition from

FOREIGNBANK ENTRY,BANK SPREADSAND THE MACROECONOMIC POLICYSTANCE 271

Box 3. How did arbitrage opportunities persist?

11 Sterilized

foreign

exchange

intervention

during

inflow episodes

is done to meet both

foreign exchange and money supply targets and automatically implies tightening. Foreign exchange intervention during capital outflow episodes, however, is not sterilized and leads to interest rate differentials. See Bruno (1993) to show how base money targeting has a natural bias for tight monetary policy.

272

FINANCIAL LIBERALIZATION: MANAGING RISKSANOOPPORTUNITIES

foreign banks. A chance to fully implement a different exchange rate regime in 1999sharplynarrowed spreads,despitea slight reversalof concentration ratios. It is interesting to note that banking sectorspreadsnarrowed substantiallyat a time when the Treasurybill rates In other words, controlling for the effectsof the sterilization policies adopted in 1995-97,we would expect more, rather than less,competition in the commercial banking systemasa result of foreign-bankentry. Admittedly, such an assertion is not easyto prove. Nevertheless,it does highlight the important lessonthat to havea "successful"liberalizationprogram, the nece&sarycondition of having the appropriate macroeconomicenvironment should be met. In the Philippine experience, the impact of the chosenmacro policy regime on spreadsmaskedthe competitive pressurethat foreign bankswould otherwise exert on the local banking system.

FOREIGNBANK ENTRY,BANK SPREAOSANO THE MACROECONOMIC POLICYSTANCE 273

Appendix The Role of Foreign Banksin Times of Crisis Arguments for and againstforeign banksduring crises Do foreign banks have a role in the financial marketsduring times of crisis? There are concerns that the internationalization of the finance sectorcould lead to more volatile capital flows,which will threaten the stabilityof domestic bank credit. It is also feared that, in the event of a crisis, the presence of foreign banks may provide an additional channel for capital flight. Furthermore, it is plausible that a foreign bank may abruptly withdraw from the market, exacerbating the disturbance. On the other hand, the arguments for foreign banks during times of crises simply mirror the arguments againstthem. For one, becauseforeign banks have diverse sourcesof capital, their credit behavior will be less affected by the presence of crisescompared with domestic banks. Moreover, becauseforeign banksare usuallycharacterizedby more solid financial positions arising from larger basesof capital, they can continue to extend loans. To the extent that they can divert resourcesthat otherwisewould have flown the local markets (capital flight), the foreign bankscould have a stabilizing function. Lastly,foreign banksare expected to adopt risk managementmeasuresaccording to standardsof their home country. Again, to the extent that foreign banks possesssuperior risk management practices than domestic banks,they maybe better. Goldberg at el. (2000) found that in Argentina, foreign-owned banks provided greater loan growth than domestic-ownedbanks, while reducing the volatility of loan growth for the financial system.They also observed that foreign banksshowednotable loan growth during the crisis,suggestingthat foreign banks maybe important stabilizersof credit during suchperiods. In the Mexican case,the aforementioned authors found that domestic banks had more volatile lending patterns with respect to GDP. As in the case of Argentina, foreign banks in Mexico, which have low nonperforming loans, were more responsiveto market forcesand were important providersof credit during the crisis.These resultsindicated that foreign banks in Mexico had a stabilizing impact on the domesticfinancial systemcredit. Profile of foreign bank loan portfolio With the benefit of hindsight, the one sectorthat clearlysuffered through the asset-pricebubble burst during the Asiancrisiswasreal estate.Now,one-anda-half years after the crisis, the portfolio of foreign banks in the Philippines

274

FINANCIALLIBERALIZATION, MANAGING RISKSANOOPPORTUNITIES

are leastskewedtoward the real sector.Domesticcommercialbanksexpanded and non-expanded alikehaveexposuresto the real estatesectorof around 15 percent and 20 percent respectively.Although there wasno publicly available information on the sectoraldistribution of the outstanding loans of commercial banks prior to the crisis, it is not difficult to expect that the share of real estateloans to total loans among domestic bankswould be very high. The low exposure to the real estate sector by the foreign banks indicates that their credit risk assessments, ex post,were more accurate. Compared to domestic banks, foreign banks in the Philippines, as a group fared relatively well during the crisis. At the end of 1999, the non performing (NPL) loans of the foreign banksstood at a little over 4 percentof total loans.Domesticexpandedand non-expandedcommercial banks, on the other hand, had NPL ratios of between 13 percent and 16 percent respectively.A more striking statisticis the percentageof pastdue real estate loans to total real estateloans.Closeto four percent of the real estateloans of foreign banks in the Philippines are past due while the corresponding figures for expanded and non-expanded domestic commercial bankswere between 17 percent and 19 percent. Finally, foreign banks tended to be more conservativein providing for loan loss reserves.As Table 4 reports, the percentageof loan lossreservesto NPLs for foreign bankswasdefinitely higher at is close to 70 percent. A summary surveyof the relatively low NPLs of the foreign bankscompared to the rest of the domestic commercial banks' figures, the sectoral distribution of their loans and their loan lossprovisioning practicesindicate that they,asa group, mayhave superior loan screeningand risk management systems.Bythis measure,it can be said that foreign bankscould havea role in stabilizing the economyduring crises. The lending behavior of foreign banksis considereda keyissueduring a crisis. Of course, since demand for loans is linked c1.osely to the general Table 4. Total loan loss provisioning as of Dec 31,1999

Domestic Foreign Banks

Expanded Commercial

NPL Loan Real Past Past

to Total loans Loss rEserves to NPLs Estate Loans to Total Loans Due RE Loans to Re Loans Due RE Loans to Total Loans

Source:

Bangko Sentral ng Pilipinas

4.12 68.13 2.73 3.68

12.98 40.54 12.45 16.84

0.1

2.1

Non Expanded Commercial 16.44 19.63 14.53 19.05 2.77

FOREIGNBANKENTRY.BANK SPREADSAND THE MACROECONOMIC POLICYSTANCE 275

macroeconomic conditions, it is expected that general lending would be curtailed during the crisis. The influence of different bank classes(stateowned, private or foreign) could be evaluated on the basisof the relative degreeof loan cutbacksduring timesof adversity.Table 5 details the quarterly loan growth rates for the different bank 1995-97classes.The findings indicate that before the crisis (second quarter), foreign banksexhibited the highest loan growth rates becauseof their low bases.In contrast, state-ownedbanks showed the lowest (even negative) real loan growth rates from 1995to the onset of the Asianfinancial crisis. More interestingly, during the crisis (from the third quarter of 1997to the end of 1998) the foreign banks,among all classesof banks, cut back the least in lending in both weighted and unweighted real loan growth rates. Among the foreign banks, the "old" institutions reduced their lending to a Table 5. Quarterly loan growth rates (Philippine commercial bank system) Panel A: Average Across individual Banks (unweighted) Time Period

All

State-Owned

Banks

Private Domestic Commercial

Banks Per-Crisis 1989Q1-1997Q2 Crisis 1997Q3-1998Q4

-4.59

5.64

Private Foreign

Banks 29.18

-10.24

-4.32

-1.03

-11.74

-1.17

-1.82

Post-Crisis 1999Q1-2000Q1 Panel B: Weighted Lending Growth Across Banks Per-Crisis 1989Q1-1997Q2

-0.6

0.06

0.15

1997Q3-1998Q4 Post-Crisis 1999Q1-2000Q1 Note:

-1.72

0.14

-0.028

For missing observations, loan growth was first computed by getting the average of the prior period growth rate adn the following period growth rate. The weight used is the loan of an individual bank as a percentag to the total of the class of banks (state-owned, private local and foreign banks).

Source of basic data: Published Financial Statement Reports of Commercial Banks, Bangko Sentral ng Pilipinas

276

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

larger extent than the "new" foreign banks. However immediately after the crisis, while the overall volume of lending was still negative (in terms of unweighted bank real loan growth rates), private domestic banks exhibited the leastloan curtailment. In the weighted reaIloan growth rates,the private domestic banks showed the first loan growth rate recovery,with the foreign banksclosebehind. Lending behavior,asproxied by the loan growthrates,are crude indicators of the stabilizing influence of different classesof banksduring crises.In the Philippines during the Asian financial crisis,foreign banksreduced loans the least,a trend similar to that in Argentina (Goldberg et aI. 2000). Flight to quality The affected economies of EastAsia suffered a massivereversal in capital flows at the height of the financial crisisof 1998.This reversalis a stark contrast to very strong capital inflows into the sameregion in the "Asianmiracle" yearsprior to the crisis.To some observers(Sachsand Wing 1999),the abrupt swingin capital flows,causedbasicallyby panickyinternational investorswhich severelystrained the financial systemsin the affected economies. The Philippines' assetmarketswere not sparedby the regional disturbance, though not in the samedegreeasThailand or Indonesia. Like the rest of the region, the peso underwent a major devaluationand the stock market index plunged. Official records show that US$7.4billion fled the country in the second half of 1997and the whole of 1999.At the heart of capital flight is the lack of confidence in the economyin general, and particularly the financial system.An interesting issueis whether the foreign banks could have a beneficial or harmful role in a crisis situation when a massivecapital flight

occurs. In this context, foreign bankscanbe said to havea stabilizing influence in that they encourage depositors to keep their holdings within the country, helping prop confidence in the domestic financial system.The reassurance comes from their perceived more solid capital bases,more sophisticated risk managementsystems,ability to diversifytheir risks. An indicator of the "flight to quality" phenomenonwould be the changes in the deposit growth rates among different typesof banks.In times of crisis,it is expected that a migration of depositswill flow from domestic to foreign banks. Of course, there are differences in the degree of financial standing amongdomesticbanks.Table 6 reportsthe averagereal deposit growth rates among state-owned,private commercial, and foreign banks in the pre-crisis, and post-crisisperiods. Foreign bankswere further

.41

FOREIGNBANK ENTRY,BANKSPREADSAND THE MACROECONOMIC POLICYSTANCE 277

Table 6. Average real deposit growth rate (in percentage)

State-Owned Banks

Crisis 1997 Q3-1998 Q4 Post-Crisis

Private

Old

New

-7.73

2.34

60.07

8.19

77.37

.0.03

-1.49

0.13

4.74

199901-2000 02 Source:

Published Statement Reports of banks, Bangko Sentral ng Pilipinas.

Notes:

Old Foreign Banks Bank of America, Citibank, HSBC and Standard Chartered New Foreign Banks -all others

For missing observations of deposits, deposit growth was first computed by getting the average of the prior period growth rate and the following period growth rate. Computed growth rates were used to get the corresponding values of deposits.

The data show that private foreign banksenjoyed relatively higher deposit growth rates than both state-ownedand domestic banks. However,the new banks account for much of the growth of the deposits.Considering that the new foreign banks started from a low deposit base,the very high growth rates in deposits registered prior to the crisis. What is more striking is the comparisonof the growth rates depositsbetweenforeign and domesticbanks. The foreign banksold and newalikeexhibited higher growth rates in deposits than local private commercial banks. Becausethe growth rates of deposit in the new foreign banksmaybe influenced by their low starting base,the more important finding is that the old foreign banks experienced considerably higher growth in deposits,indicating "flight to quality" from the state-owned

banks. An analysisof the comparative growth rates of depositsduring the crisis period showsthat some form of "flight to quality" ensuedprimarily from stateowned banks to the private foreign banks. Whether the volume of deposit migration wassignificant enough to exert a calming influence on the domes-

278

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

tic banking systemis not easyto resolve.Nevertheless,the facts showthat the relation between "flight to quality" and the presenceof foreign banksis consistentwith the stability argument.

FOREIGNBANKENTRY.BANK SPREADSAND THE MACROECONOMIC POLICYSTANCE 279

Bibliography Abola, V. 1998. Bank liberalization Since 1994: boon or bane. Economic Policy Paper 6, Manila: Center for Research and Communication Foundation. APEC. 1998. Financial services sector in Peru. The impact of liberalization: communicating with APEC communities. Singapore: APEC Secretariat. APEC. 1998. The financial services industry: the impact of investment liberalization in APEC. Policy Reviews and Case Studies. Singapore: APEC Secretariat Brock, Rojas-Suarez. 2000. Understanding the behaviour of bank spreads in Latin America. journal ofDevelopmentEconomics 63 (1) 113-134 Bruno M. 1993. Policy making in the open economy.United Kingdom: Oxford University Press Calvo, G., L. Leiderman, and C. Reinhart. 1992. Capital inflows and real exchange rate apreciation in Latin America. International Monetary Fund Working (IMF) Paper 92/62. Washingon: International Monetary Fund. Calvo, G., L. Leiderman, and C. Reinhart. 1992. Capital inflows to Latin America: the 1970s and 1990s. IMF Working Paper 92/85. Washingon: International Monetary Fund. Calvo, G., and C.A. Vegh. 1991. Exchange Rate Based Stabilization Under Imperfect Credibility. IMF Working Paper 91/77. Washington: International Monetary Fund. Calvo, G. and Reinhart, Carmen. 2000. Fear of Floating. NBER Working Paper 7993. Cambridge, Massachusetts National Bureau of Economic Research, Corbo, V., and L. Hernandez. September 1993. Macroeconomic adjustment to capital inflows: rationale and some recent experiences. Washington: World Bank. Claessens, S. and T. Glaessner. 1997. Internationalization of financial services in Asia. Paper presented at the conference Investment liberalization and financial reform in the Asia-Pacific Region, August 29-31, Sydney, Australia. Claessens, S., A. Dermiguc-Kunt, and H. Huizinga. 1998. How does foreign entry affect the Domestic Banking Market? Policy Research Working Paper, 1918, Washington: World Bank. Denizer C. 1997. The effectsoffinancial liberalization and new bank entryon market structure and competition in Turkey: macroeconomics and growth development researchgroup. Washington: World Bank

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FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

Dooley, M., E. Fernandez-Arias, and K Kletzer.July 1994. Recent private capital inflows to developing countries: is the debt crisis history? NBER Working Paper 4792. Cambridge, Massachusetts: National Bureau of Economic Research. Frankel,J. A, December 1994. Sterilization of money inflows: Difficult (Calvo) or easy (Reisen)? International Monetary Fund Working Paper 94/159. Garcia, PJ. 1992. Do we need to liberalize the entry of foreign banks? Masteral Thesis, Center for Research and Communication, Manila. Garcia, PJ. 1993. Banking on reform: the liberalized entry of foreign banks. Economic Policy Paper 2. Manila: Center for Research and Communication Foundation Garcia, PJ. and R Abis. 1994. Why are bank intermediation costs high? Economic Policy Paper 2. Manila: Center for Research and Communication Foundation. Gavin, M. and R Hausmann. 1996. Make or buy? A case for deep financial integration. Washington D.C.: Inter-American Development Bank. Gavin, M. and R Hausmann .1998. The roots of banking crises: the macroeconomic context. Washington D.C.: Inter-American Development Bank. Goldberg, L., B. Dages and D. Kinney .2000. Foreign and domestic bank participation in emerging markets: lessons from Mexico and Argentina. EconomicPolil)' Review6(3) 17-36. Gochoco, M. 1988. Financing the budget deficit in a small open economy: the case of the Philippines. Working Paper 88-10. Makati: Philippine Institute of Development Studies. Gulane, E. and C. Grino .1996. Commercial banking in the Philippines: need we open the door wider? Economic Policy Paper 5. Manila: Center for Research and Communication Foundation. Hernandez Land P. Montiel. 2001. Post-crisis exchange rate policy in five Asian countries: filling in the .hollow middle? IMF Working Paper No. 170. New York: International Monetary Fund. Hoschka, T. 1993. Cross-border entry in Europeanretailfinancial services.London: St. Martin's Press. Houben, Aerdt C.FJ. 1997. Exchange rate policy and monetary strategy for stability and sustainability, IMF Paper on Analysis and Assessment. New York: International Monetary Fund. Isard, P. 1995. Exchangerate economics:London: Cambridge University Press Jayaratne,J. and P. Strahan. 1997. Entry restrictions, industry evolution, and dynamic efficiency: evidence from commercial banking. StafIReports, 22, New York: Federal Reserve Bank of New York.

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Leonor, P.2000. Empirical study on government securities. MS Thesis,University of Asia and the Pacific Lim, C.H. and C. Woodruff (1998) ManagingCorporate Distressin the Philippines: Some Policy Recommendations,Working Paper 98/138, International Monetary Fund. Manzano, G.. 1997. A Note on the Agreement on Financial Services.Philippine Initiativesin Vancouver:SustainingAPECProgress. University of Asia and the Pacific, Manila. Mathieson, D. and L.A Rojas-Suarez.March 1993.Liberalization of the Capital Account: Experience and Issues,IMF OccasionalPaperNo. 103. Milo, M. 2000. AnalysisOf the Stateof Competition and Market Structure of the Banking and Insurance Sectors' PASCN,unpublished monograph Oyson,M. 1997.Philippine banks: clearlya presentdanger.Deutche Morgan Grenfell, Philippine Research. Riesen,H. 1992.The 'Impossible Trinity' in South-EastAsia. Mimeo. Ravalo,J..1996.Re-assessing a SecondRound of Foreign-BankEntry. Bankers Association of the Philippines, processed. Saunders,A. and L. Schumacher.2000. The Determinants of Bank Interest Rate Margins: an International Study.Journal ofInternationalMoneyand Finance,19,pp. 813-832. Sorsa,P.1997.The GATS Agreement on Financial Services-A Modest Start to Multilateral Liberalization. IMFWorking Paper,97/55, IMF. Valdehuesa, C. 1996. Role of Government Securities in the Philippine Economy.PhilippinePanorama,Manila Bulletinpp.13-15. World Bank. 1996. Development In Practice:ManagingCapital Flowsin East Asia. Oxford.

II. Interviews Bautista, Cannelo, Presidentand CEO:ABN-AMRO Bank, Philippines. September 2000,Makati City Sinio, Gertie, Vice Presidentand Head of Investor Relations Group, Bank of the Philippine Islands, December 1999,Makati City Salak,Manuel, Presidentand CEO: International Nederlanden Grup (ING) Bank, September2000, Makati City

CIIAPTER

Reaction to the Entry of Foreign Banks in the Philippines: A Critical Study of Local Selected Banks ReneB. Hapitan

Abstract

n this paper, various reactions to the entry of foreign banksare obtained from a surveyof 10local commercial banks.While there is increasedcompetition from the foreign banks,there is little evidenceto support that their entry has increased the variety of financial services,brought incremental intermediation activities,and brought in newtechnologiesand processes.This canbe attributed to relativelyhigh returns on equityand substantialpotential revenue lossesfrom the local banks. To meet the increasedcompetition, the most preferred reaction of the local banksis through core marketing strategies as foreign banksare seenmore of a "marketing problem" rather than a "banking problem." This paper hopes to reinforce macroeconomic studies made in the entry of foreign banks. Introduction Ten foreign banks were allowed to establish branches under the Foreign Bank Liberalization Act (Republic Act (RA) No. 7721) of 1994. It was envisioned that the entry of these foreign banks will create a "dynamic banking and financial system that will stimulate economic growth, attract foreign investments, provide a wider variety of financial services to Philippine enterprises, households and individuals, strengthen linkages with global financial centers, enhance the country's competitiveness in the international market, and serve as a channel for the flow of funds and investments into the economy to promote industrialization" (Section 1, RA 7721). With this law, "the Philippine banking and financial system is hereby liberalized to create a more competitive environment and encourage greater foreign participation"

(Section

284

FINANCIAL LIBERALIZATION: MANAGING RISKSANO OPPORTUNITIES

1, RA 7721). Itis the clear intention of this law to liberalize the banking and financial sectors by allowing wider foreign ownership. In other countries the entry of foreign banks had been evaluated and results showed some varying reactions among the respondents. In the 1980s whenjapanese banks obtained a sizeable presence in the United States, local bankers felt the competitive pressure and expressed concern over the increased foreign presence. This prompted the United States Government to convince the Japanese and other foreign countries to allow similar treatment for US banks present in their countries (Grosse and Goldberg 1991). Meantime, perceptions that foreign bank entry to Australia was a failure resulted into a government inquiry that deregulated foreign access into that country (Williams 1998). In Mexico, further relaxation of barriers to foreign entry into the their financial services came with the ratification of the North American Free Trade Agreement (NAFTA). But the Mexican Finance Ministry, seeking to limit the impact ofuS bank competition, drove a hard bargain. Even though the Mexican banks' operating efficiency was steadily improving, new private sector owners of Mexico 's largest commercial banks were not anxious to face foreign competition (Moriaux etal. 1997). In the book Banking in Asia: the end of entitlement,Casserley and Gibb (1999) described the banking activity in Asia prior to the crisis as follows: In the 1980sand most of 1 990s,immense fortunes were made as commercial and investmentbanksfunded "the Asian miracle". In mostAsian markets then, a banking or securities license gaveaccessto easyprofits. So, even though the Asian marketsoutsideJapan were very small when compared to those of Asia and Europe, manyinternational bankers felt they had to be part of banking in Asia. But the 1997-1998crisis brought those of making easymoney in Asia to an abrupt end. What the crisisdid wasto quicken the regulatory and competitive changes,compressing what most in the financial industry thought would take as long as 10 years into just two or three.

Recent studies from the Asian DevelopmentBank, cited severalarguments on foreign bank participation in domesticeconomies. Among theseare the following: .Domestic branchesof foreign bankshave their own private lenders of lastresortthe foreign head office and the monetaryauthorities of their home countries. This lowers to some extent the liquidity support of the domestic central bank.

REACTIONS TOTHE ENTRYOF FOREIGN BANKSIN THEPHILIPPINES:A CRITICALSTUDYOF LOCALSELECTED BANKS 285

A country could import competent managersfrom foreign banks, likewise,internationalized domestic bankscould become more sensitive to international regulations and standards. Domesticbranchesof foreign banksare likely to possesa more internationally diversified assetbase,thereby lowering the vulnerability of their assetsto the boom-bustcycle. Foreign banks' presencemayincreasethe amount of funding available to programs by facilitating capital inflows. Foreign bank participation wasgenerally associatedwith a lower incidence of local banking crisesduring 1988-1995for a large number of countries (Yoshitomiand Shirai 2000). Foreign bank presenceis likely to decreasethe stabilityof aggregate domestic bank credit, by providing additional avenuesfor capital flight, or by more rapidly withdrawing from local marketsin the face of crises. Foreign bankspick the mostlucrative marketsor customers,leaving lesscompetitive domesticfinancial institutions to serveother more risky customersand increasing the risk borne by domestic financial institutions. Foreign bank participation may deteriorate financial supervision owing to the multiple challengesto supervisionraised by complex financial institutions, especiallyin the presenceof asymmetriesin information betweenhome and host country supervisors(Yoshitomi and Shirai 2000). In analyzing the reactions of selectedlocal banks,valuable insights are to be obtained on whether these banks have changed their strategies as a result of the entry offoreign banks. Specifically,this studyaimed to: .Identify general reactions to the entry of foreign banks. .Determine if thesechangesresulted in someform of reorganization or creation of new departments specificallydesigned to meet competition from foreign banks. .Evaluate the overall successor failure of the changeswhenever applicable. To accomplish this, a preliminary surveyof selected local banks was made to provide the initial input. Subsequentinterviews of selected bank personnelwere made to validate the responses.Secondarydata from various

286

FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

sources,including previous empirical studieswere used to support the survey and interview results. The study was further expanded to include the experience of three commercial banksin terms of reorganization. The reorganization casesinvolved the entire bank or part of its operations. Reviewof related literature Adamos (1992) acknowledged that the successof financial integration depends on proper sequencing and speed especiallyon countries with shallow and oligopolistic financial markets. Slow transformation mayhave causeda drag in the economyand a hastytransition can contribute to financial disruptions and evenfinancial crisis. Countries undertaking financial reforms have dealt with the initial shockssquarelyand decisivelyand fast so that financial liberalization will not merely end up an economic aberration. In the 1970sand 1980s,financial liberalization wasa byword, a key economic policy. The processhas become associatedprimarily with a reduction of government intervention, deregulationof in terestrates,and elimination of credit controls. Later, in order to acceleratethe paceof liberalization, several radical policies were introducedthe entryof foreign banksbeing one of them. However,as the 1980sclosed,economiesthat experimented on several of these radical policy shifts to acceleratefinancial liberalization soon began to experience a slowdown in growth and productivity. The latter half of the 1990sexposed the weaknessesof thesepolicy shifts with adverseresults. A comparison of the financial liberalization efforts of Korea, Malaysia, Sri Lanka, Indonesia, and Thailand revealed that before foreign bankswere allowed to enter, various interest rate controls were imposed, relaxed, and in some cases,reimposed (Aguirre etal.1999). This allowed some form of protection to local banks, but at the sametime created an environment for the entry of foreign banks. A comprehensive reviewof the entry of foreign banksisprovided in the World Bank studyof Claessensetal. (1998). Using bank level datasuch as net interest margins, overhead,taxespaid, and profitability of foreign and dome&tic banksof80 countries,the authorsfound that foreign banksachievedhigher (and conversely lower) profits than domestic banks in developing (developed) countries. The study further suggestedthan an increase in the share offoreign banksled to lower profitability of domesticbanks. Denizer (2000) investigating the entry of foreign banksin Turkeyfound that despitea smaller scaleof operations, foreign banksincreasedcompetition and that their entry reduced the overheadexpensesof domestic commercialbanks,which in turn increased their profits.

REACTIONS TOTHE ENTRYOF FOREIGN BANKSIN THEPHILIPPINES, A CRITICALSTUDYOF LOCALSELECTED BANKS 287

In the Philippines, Tolentino (1998) identified Philippine financial liberalization reforms in four components: .The gradual abolition of legal ceiling on interest rates. .The reduction of specializationamong banks .The further increase in minimum capitalization. .The move towards the closure of allocative low interest rediscount windowsof the Central Bank. The country's experience in liberalization during the early 1980swas hampered by severeliquidity crisis with the government taking over several banks in order to restore confidence in the banking system. This environment eventuallyallowed the entry offoreign banksinto the local banking industry, culminating the passageofRA 7721, or An Act Liberalizing the Entry and Scope of Operations of Foreign Banks in the Philippines. Under this law,a foreign bank can enter into a country via any,but only one of the following modes by acquiring, purchasing, or owning up to 60 percent of the voting stockof an existing bank; by investing up to 60 percent of the voting stock of a new banking subsidiary,incorporated under Philippine laws; or by establishingbranches with full banking authority. The 1990srevealeda further weaknessin the country's efforts to liberalize with the onsetof the AsianFinancialCrisisamid this newliberalization law. Delhaise's (1998) study recounted the Philippine experience during this period: Mter theJuly 1997devaluation, interest ratesjumped and liquidity melted down, ultimately constricting interest income. The Philippines wasthe first Asian country to really open its doors to foreign banks, after years of isolation. Initially, someselected bankswere permitted to open 100 percent foreign owned branches,although networkswere limited in size. Subsequently,PresidentRamoscame out with the surprising offer for foreign investors to acquire up to 60 percent of local banks, with almost no restriction. Foreign bankshad just begun to take advantage of the new liberalization when the crisis erupted. started. Their presence wasbound to have a further negative impact on bank margins.

The currency crisis and the general slowdown of the economy have affected the Philippine banks in a much smallerway than they are affecting the banking systemsin other countries of the region. The cashflow generated over the yearshas allowed the banksto achieve severalobjectives. The need for loan loss provision has been met immediately out of recurrent prof-

288

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

its. This has permitted the banksto enter the crisis with almost a clean slate. The bankshavebeen able to improve their capitaladequacyratios well above international guidelines, to the point that many of them are capitalized at more than twice the norm. The late growth in lending, witnessedoverthe last fewyearsonly, wassupported with adequateadjustmentsto equity funds,something the averagebank in the restof SoutheastAsia wasnot achieve. ByJuly 1999,nine foreign bankscontinued to operate in the Philippine banking industry. Initially, ten foreign bankswere granted licenses,but the Development Bank of Singapore decided to acquire the Bank of Southeast Asia already established under existing Philippine laws. Consequently, in a prono~ncement by Governor RafaelBuenaventuralast August 1999,there is no haste for the Central Bank to fill the vacantslot to allow more bank mergers.! Becausethe presence of these bankshasbeen relativelynew,empirical studies on the entry of foreign banks into the country waslimited. Fisher (1997) in his paper "Financial liberalization to bank failure: starting on the wrong foot?" revealed that extensivereorganizationsof financial institutions have costgreat sumsto societythat taxpayersended up shouldering the entire burden causedby the institutional failures induced by government's ploy to shift to a liberalized regime. It is from this paper that the focus of this study will be made. Is the Philippines starting on the "wrong foot" in terms of financial liberalization through the entry of foreign banks? Data presentationand analysis Industryoverview Tables la and 1 b show the list of commercial banks in the Philippines both privately owned and government-ownedasof December2000.The information wasbased on the data from the Central Bank and the Bankers' Association of the Philippines: For purposes of this study, the following banks were classified as foreign, since their licenses to operate were approved under RA 7721: .ANZ

Banking Group

.Bangkok

Bank

, Fo)lowing Persident Estrada's visit to China last May, 2000, the Bank of China (BOC) was granted a license to operate in the country. BOC will take over the slot vacated by the Development Bank of Singapore, which gave up its foreign license when it acquired 60% of the Bank of Southeast Asia in September 1998.

290

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

Table 1 b. Philippine commercial banking industry foreign banking sector Foreign Ban~[s ANZ Banking Group Banco Santander Phils. Inc.

Bangkok Bank Public Co.. Ltd. Bank of America, NT & SA Bank of Tokyo, Ltd. Chase Manhattan Bank Citibank. NA Deutsche Bank AG Fuji Bank, Ltd. Hongkong and Shanghai Banking Corporation (HSBC) Inti Coml. Bank of China ING Bank Korea Exchange Bank Standard Chartered Bank

Offshore Banks

Representative and Regional Offices

ABNAMRO American Express Bank Ltd. Bank of Nova Scotia

Banco Espanol de Credito Bank of Hawaii

Bankers Trust Company Banque Indosuez Banque National de Paris Credit Lyonnais First National Bank of Boston Inti. Bank of Singapore Overseas Chinese Bank

Banque Pari bas Continental Bank, NA Export-Import Bank of Japan Mitsui Taiyo Kobe Bank Ltd. Morgan Guarantee Trust of New York Philadelphia National Bank State Bank of India

PT Lippa Bank

Summa International Bank

Bank of New York

Stanchart Australia

The shareof foreign banksin terms of total assetsto the banking industry wasreflective of the economic performance from 1995 to 2000. Mter peaking in 1996, a severedrop wasexperienced in 1997and 1998due to the Asian financial crisis. The drop continued in 1999and a modest growth was seen in 2000. Much of the assetgrowth of foreign bankswasmade at the expense of government banks except in 1999. This wasattributed to the increasedactivity of the Land Bank of the Philippines and Philippine National Bank. Furthermore, the share of government banks in terms of assetshas been on a steadydecline since 1995. The performance of the local banksdeteriorated much faster than the foreign banks,despite the seriesof mergersand acquisitionsmade in 1998to 2000. The drop in shareof assetscould be attributed to the closure of several banks, suchasthe Urban Bank. Since the behavior of depositsmore or lessfollowed the behavior of loans, the samedramatic trend in terms of loan portfolio share wasevident. Severelyaffected by the crisis,lending activities by the domestic and government bankslikewisesloweddown, except for a slight decline in 1998;foreign banksseemedunaffected by the crisis in terms of loan activities.

REACTIONS TO THEENTRYOF FOREIGN BANKSIN THEPHILIPPINES, A CRITICALSTUOY OF LOCALSELECTEO BANKS 291

Table 2a. Philippine commercial banking industry market share summary: total assets, for the year ending December 2000 Domestic

GovernmentBanks

Foreign Banks

Banks

Amount

%to

Amount

%to

Amount

%to

(Php

total

(Php

total

(Php

total

817,134

63.7

120,472

9.4

million) 344,362

26.9

1,273,803

67.5

217,701

11.5

396,518

21.0

1,647,388

63.8

433,474

16.8

500,248

19.4

1,642,982

65.1

394,802

15.7

484,256

19.2

1,784,962

65.0

411,053

15.0

548,815

20.0

1,911,325

64.6

466,692

15.8

578,463

19.6

million)

Notes:

Source:

million)

1. Foreign banks include the fifteen (15) banks listed in Table 2b. 2. Data from Chemical Bank is until 1996 only. 4. Govemment banks include AI-Amanah (Islamic) Bank, DBP, Landbank and PNB. 5. Figures may not add due to rounding. Central Bank Factbook, various years

Table 2b. Philippine commercial banking industry market share summary: total deposits, for the year ending December

Domestic Banks

1995

Amount (Php million) 513,879

1996

839,782

1997 1998

%to total

Forei9n_~~n~~

Government Banks

Amount

%to

Amount

(Php

total

(Php million) 178,314

million)

%to total

67.7

67,187

71.0

114,658

8.8 9.7

1,009,404

67.5

182,398

12.1

304,465

20.4

980,023

68.1

170,610

11.9

289,040

20.0

1999

968,310

67.2

194,127

13.5

279,103

19.3

2000

973,000

65.9

222,041

15.0

281,601

19.1

228,557

23.5 19.3

Notes: 1. Total deposits include demand, savings, time, and special deposit accounts. 2. Foreign banks include the fifteen (15) banks listed in Table 2b. 3. Data from Chemical Bank is until 1996 only. 4. Government banks include AI-Amanah (Islamic) Bank, DBP, Landbank and PNB. 5. Figures may not add due to rounding. Source: Central Bank Factbook, various years

292

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

The preliminary dataseemedto suggestthat foreign bankshaveindeed slowlytaken some market share from the domestic and government banks, especiallyon the deposit side.2 Presentation ofsurveyresult\"

Table 3 showsthe profile of the 10 banks that responded to the survey;one bank declined to answer.The respondent bankscomprised about 54 of total assets,65 percent of total deposits,and 62 percentof total capital of the banking industry as of December2000. Getting the description of the overallcompetitiveenvironment, answers revealeda significant changeof "verycompetitive"and "competitive" environment before the entry of foreign banksto "highly competitive" and "very competitive" environment after the entry of foreign banks (Table 4). Although one bank said that the entry of foreign banks did not have a competitive impact on its operations,majority of the responsesrecognizedthe presenceof foreign banksindeedhavedrawnattentionto competitionamongthe localbanks. Most local banksobserved that it wasin wholesalebanking where competition in area of operations (Table 5) wasmost significant. Likewise,it was the product perceivedto havereduced market shareand revenues(Table 6). This was expected becauseforeign banks initially catered to clients of the larger and presumablyhigher margin accounts. Deposits and money market placementswere the banking products that majority of the respondentsrecognized asbeing "significantly" affected by the entry of foreign banks. By rank, foreign exchange wasfirst in terms of significance, followed by lending/loans, investment banking, and deposits. Rounding up to the lower levels of significance were money market placements, trust services,and investment in fixed assets. Becauseforeign banks initially catered to their own nationals, it was expected that foreign exchange transactionswould rank very high. Lending/loans and investment banking would also rank high aslocal bankswere significantly affected in the wholesale banking business,which could partly account for the findings in Table 2b. On the other hand, investment in fixed assetswould be on the low side becauseof the limited number of branches allowed under RA 7721. Trust serviceswere also expected to be low becausenone of the foreign banks under RA 7721 have been granted licensesto undertake these operations. 2 Note that Tables 2a and 2c include other foreign banks which were operational implementation

of RA 7721.

before the

REACTIONS TO THEENTRYOF FOREIGN BANKSIN THEPHILIPPINES, A CRITICALSTUDYOFLOCALSELECTED BANKS 293

Table 3. Profile of respondents

banks

Typeof Bank

Number

Universal/Commercial Government Specialized Savingsfrhrift TOTAL

6 2 2 10

Note:

% To Total Banking Industry As of June 2000 Assets Deposits Capital 40.4 49.7 49.8 13.6 15.1 11.9 n.a. n.a. n.a. 54.0 64.8 61.7

Fourty five banks comprise the banking industry sample that excludes the savings/thrift banks. Preliminary data is sourced from the Central Bank

Table 4. Description of the overall competitive environment

Before the Entryof ForeignBanks Response

No. of

%to

After the Entry of Foreign Banks Response

responses total Highly competitive Very competitive Competitive Little competitive effect No corn petitive effect total

1 4 3 0

11.1 44.4 33.3 0.0

1.1

100.0

No. of

%to

responses total Highly competitive Very competitive Competitive Little competitive effect No corn petitive effect total

4 3 1 0

44.4 33.3 11.1 0.0

11.1

100.0

There were certain requirements needed in order for these licenses to be granted. Among the other qualitative factors, local banks' depositshave been mostaffectedby the entry of foreign banks.Hiring of employees(Table 7) was also influenced. Three of the local banksinterviewed admitted that during the first few months of foreign bank's operation, they experienced a few personnel problems like hiring and retaining productive employees. This problem wasaddressedin Calderon et al. (2001) study which revealed that "there were human resourceimplications of the continuous consolidations/mergers and reengineering ventures of finance institutions on the supply of bankers (i.e., retrenchment). On the other hand, in view of liberalization, the country mayexperiencea shortageof highly qualified professionalsto work locally becausethey now have opportunities to be hired abroad. With the entry of foreign banks,a dual intemallaoor market canalso emerge with differences in compensation betweenforeign and local profes-

294

FINANCIALLIBERALIZATION, MANAGING RISKSANO OPPORTUNITIES

Table5. Area of operations where competition was most significant ~re! ~f Operations

No. of Responses

Wholesale Banking Retail Banking

7 1

Development Banking N~ competitive impact Others Foreign currency transactions Deposit-taking (high end market) Corporate banking (triple A borrowers) Treasury products

0 1

Note:

Multiple

answers

1 1 1 1

possible

Table 6. Products or services which have been significantly terms of reduction of market share or revenues)

-General

Classification-

affected

No. of Responses

Retail Wholesale

3 8

Development Others Lending to MNCs and top 100 domestic firms Deposit-taking (high end market) Corporate banking (triple A borrowers) Treasury products

Note:

Multiple

1 1 1 1

answers possible. Based on the eight banks which experienced

significant competitive

(in

impact from the entry of foreign banks.

Table7. Other significant factors affected -.O~her Significant Factors Branch network Fund sourcing Obtaining new clients Hiring of employees Changes in information technology/computerization Increase in capital Other Retaining existing clients

No. of Responses 2 7 3 7 4 3

sionals." The study further discussedthe various supply-side1 the labor

ematives

issue.

Specific products or serviceswhich havebeen significantly affected are shown in Table 8.

REACTIONS TO THEENTRYOF FOREIGN BANKSIN THEPHILIPPINES, A CRITICALSTUDYOFLOCALSELECTED BANKS 295

Table8. Specific products or services which have been significantly affected (in terms of reduction of market share of revenues) Specific

Product/Service

Highly

Very

Significant

Significant Significant

Fairly

Not

Significant Significant

Lendin!Jl1oans Deposits Foreignexchange Trustservices Investment banking Moneymarket

2 1 4 1 3 2

2 1 1 0 2 0

4 6 2 3 2 5

1 1 2 3 1 1

1 1 1 3 2 2

plCK:ements Investmentin fixed

assets Others

Owing to the highly secretivenature of the industry, only six bankswere open of their losses(Table9). Surprisingly,closeto a half a billion pesoswere potentially lost by these local banks to their foreign counterparts, a direct result of the competition on the wholesalebanking activities. Follow-upinterviewsfrom those banks which have experienced potential revenue lossesof over Php 100million admitted that the lost revenuesforced them to look into other market niches in order to offset the losses. However, the banksinterviewed downplayed theselossesand said that more competition wasfelt from the other local banks rather than theseforeign banks. Table9. Potential business revenues lost (current year) Business Revenue Lost Below Php 1.0 million Php 1.0 million to below Php 25.0 million Php 25.0 million to below Php 50.0 million Php 50.0 million to below Php 100.0 million Above Php 100.0 million

No. of Responses 0 2 1 1 3

In order to meet the competition from the entry of foreign banks,local bankshave resorted to a variety of strategies(Table 10). In terms of "strong" responses,we can further re-classifythe strategiesasfollows: 1. Strategies immediately being implemented .Move to other markets/market niches .Review pricing to meet competition .Re-engineer all or some processes 2. Strategiesalreadybeing addressed: .Invest in new technology

REACTIONS TOTHEENTRYOF FOREIGN BANKSIN THE PHILIPPINES, A CRITICALSTUDYOF LOCALSELECTED BANKS 297

The core marketing strategiessuchasmoving to other markets or market niches, review pricing, introduction of new products, and increase in advertisingand promotion activitieswere often a preferred choice in an environment of increasingcompetition. Interviewsconfirmed that majority of the local banksviewedthe entry of foreign banksasa marketing challenge;hence, there is a need to prepare. This explained why re-engineering wasranked high. Banksviewed their marketing strategiesaspart of an on-going re-engineering effort, but only in terms of the core strategiesmentioned above. Respondentsexplained that re-engineeringis only to a portion of the organization (i.e., marketing department or its equivalent). Significantly,the entry of foreign banksdid not move the local banksto re-engineertheir entire organi-

zation. Investing in newtechnology appearsto be the more preferred response of the local banks.The potential transferof technologyof the foreign banksto their domestic branches could havea significant impact on the industry. Foreign banks were perceived to have a more superior or advance technology than the local banks. This reality drives the local banks to consider investments in new technologyasthe new frontier, providing at leasta level playing field. Jumping into the e-<:ommercebandwagonis now common among local banks.They were looking beyond the additional investmentin the number of automated teller machines asa response. Primarily due to time and costconsiderations,mergersand acquisitions were generally the least preferred. Since most of the banks have already complied with the CentralBankrequirementson capitalization,a future merger or acquisition is not an immediate need. Another leastpreferred options to meet competition were the "costly" ISO certification and the hiring of consultants.One bank wasevenskeptical about the benefits of an ISO certification (i.e., a certain bank that wasISO certified consequently experienced troubles in its ope.rations). On the other hand, one bank viewed the entry of foreign banksashaving no significant impact to its operations. Primarily becausethis bank felt that their productsand servicesaccommodatea different market niche (Table 11). In preparation for the eventual competition, the said bank introduced new products, increased its network, and formed strategic alliances with foreign banks (Table 12). In the process,it is also engaged in possible investments to new technology,reviewing pricing, re-engineering, and increasing advertising and promotion activities. What would change the said bank in its position would be an increasein the number of foreign banksand its branches,and an increasein the top-tier banks, whether local or foreign (Table 13).

REACTIONS TO THE ENTRYOF FOREIGN BANKSIN THE PHILIPPINES, A CRITICALSTUDYOFLOCALSELECTED BANKS 299

Table13. Whatwould change the bank's position on the present "no competitive impact" perception of "No Competitive Increase in Nature the number of foreign banks

Impact" -.

No. of Response

Increase in the number of branches the foreign banks will be allowed to establish Increase in the number of foreign banks and the number of branches for each foreign bank Increase in capitalization requirements Others Increase in the number of too-tier banks

Table 14. General assessment of foreign banks and financial liberalization Were ten foreignbanks satisfactory in liberalizing the banking sector? Response .,

Yes, No. More than is required, but there should be a limit. No. There should be no limit to the number of foreign banks.

No. of Response 6 2 1

% Total 66.7 22.2 11.1

Were ten foreign banks satisfactory in liberalizing the economy in general? Response

No. of Response

% Total

Yes,

-6

66.7

9 9

33.3 100.0

Total

What changes would make the entry of foreign banks more desirable? Response Increase the number of banks Decrease the number of Increase thenumber of branches per bank Increase the capitalization requiements Allow the entry of local banks in the country of origin of These foreign banks (complementary/reciprocity) Others "Note: mutiple answers allowed: Would you favor legislaton of foreign banks?

No Total

tha will further increase the competitive

Response

..Yes

No. of 2 2 3 2

environment

No. of Response 6

% Total

9 9

33.3 100.0

66.7

300

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

Table 14 (cont'd) Would you favor a merger with a foreign bank? Response

No. of

Response

Yes

Yes. but not at this time. No Depends on the strategy.

% Total

-2

22.2

3 3 1

33.3 33-3 11.1

Competition wason the wholesalebanking operations, particularly on foreign exchange transactions,lending/loans, and investment banking. Leastaffected were investmentsin fixed assets,and trust services. Other qualitative effectsof the entry of foreign bankswere on fund sourcing and hiring of employees. The potential revenue lossesfrom the entry of foreign bankswere estimated to be Php 500million. Preferred responsesof the local banksto meet competition include mostly marketing strategies. Re-engineeringwas made on some bank processesonly and not on the entire organization. Local banks generally agreed that the entry of foreign bankswere satisfactory in liberalizing the economy and the banking sector. However,there wasa mixed reaction asto whether the local banks would favor a merger with a foreign bank. Analysisof results There is an acknowledgedincreasein the competitive environment, particularly in the wholesalebanking side. Central Bank data support this finding: In Table 2aand 2b, foreign bankshaveobtained a sizeablemarket share from the other domestic banks and the government banks. Even if the 10 banks under RA 7721 were isolated,substantial growth can still be obtained. Thus,while it can be argued that the growth canbe attributed to the increased activities of the establishedforeign bankssuchas Citibank, HSBC,and Standard Chartered, the other foreign bankswere not far behind. Table 15 showsthat over the lastfive years,total loans of selectedforeign banks have grown by almost four times; total depositsby almost ten times. While accounting for a small portion of the industry asof December 1999, the growth figures were quite substantial.This supported the findings on the increased competitive environment where foreign bankshave grown much fasterthan the industrv.

REACTIONS TO THEENTRYOF FOREIGN BANKSIN THEPHILIPPINES, A CRITICALSTUDYOF LOCALSELECTED BANKS 301

Table 15. Summary of total loans and deposits December 1995 to December 1999

Bank

ANZBank

Bank of Tokyo Bangkok Bank Chemical Bank DBS Bank Deutsche Bank Fuji Bank INGBank Int. Coml. Bank of China Korea Exchange Bank Total (foreign banks) Total (industry) Foreign banks to total industry

of selected

foreign

banks,

Total Loan Portfolio (Php Million) Dec Dec %

Total Deposits (Php Million) Dec Dec

1995

583

4,051 976 182 n.a. 1,302 977 170 239

1999 2,910

growth -339.1

10,496 1,302 n.a. 9,104 10,750 6,403 10,152 5,305

159.1 33.4 n.a. n.a. 725.6 555.3 5,871.8 2,119.7

3,690 1,977 12,170 58,336 759,380 1,441,524

-46.4 379.3 89.8

1.6%

4.0%

162

2,055 155 n.a. n.a. 295 415 21 142

1999 2,534

-1,464.2

10,985 434.6 543 250.3 n.a. n.a. 4,525 n.a. 9,783 3,216.2 2,400 478.3 5,91028,042 1,645 1,058.4

493 1,539 3,740 39,685 830,073 1,767,892 0.4%

growth

212.2 961.1 112.9

2.2%

Notes: 1.

Total loans portfolio include interbank receivables, net loans and discounts, and customers liabilities. 1. Total deposits includes demand, savings, time, and special/other deposits. 2. Figures may not add up due to rounding. 3. No other figures were made available for Chemical Bank except for 1995 loans. 4. Yearly financial figures from DBS were made available for 1996. Source: Central Bank Factbook, 1995 and 1999

Individual foreign bank performance also highlighted increased competition with lNG, DBS, ANZ, and Deutsche Bank taking the lead. These bankshave posted very high percentage growths indicating a rather aggressivestrategyin terms of loans and deposits. Only one bank registered a negative growth in its deposit base. The growth in depositswasindicative of the strategy that these foreign banksconcentrated on wholesaledeposits(whichwere normally highly competitive, but veryvolatile and sensitive to cost) asopposedto retail. This was quite expected as the entry barriers to retail banking can be very high for a foreign bank asopposed to its local counterparts. Since mostof the clientsof the foreign bankswere their own nationals,it wasexpected that they would be the first source of newbusiness. However,ascompetenciesand economiesof scaledevelop,these banks moved into other markets, including domestic clients. This could create a "crowding out" in the wholesalebanking side,something that could force the

302

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

local banks to move to the more lucrative,but at the same,costlier (i.e., due to the number of accounts) middle market or even retail banking. We did not discount, however,that asa preventive strategylocal banks would match the competition on the wholesaleside (another finding that is supported by the survey). With the relaxed branching rules under the New Banking Act of 2000,foreign banks,will "leapfrog" and move to the middle market or to retail banking. This wasevident when HSBC acquired PCI Savings Bank or Equitable-PCIlast November2000. However,somebank managersinterviewed did not seethis happening for the establishedforeign banks. Nonetheless,this will open the possibilityof local banks being more aggressive in strategically reaching out to the middle market or to retail banking somethingto watchfor in the universal/commercialbanks.A favorite strategy wasthrough mall advertisementsand "appliancesales"for credit card companies affiliated with the local banks. Casserleyand Gibb (1999) supported this when they mentioned that "locals will be naturally advantagedin the middle market and small business segments;regional alliances canbuild attractive trade finance business. Big multinational bankswill havea natural advantagein the large corporate segments,where their sizablelending limits, sophisticatedproducts, and highly skilled staff will win most of the business." The interplay of strategieswould only result in a more vibrant banking system,wherein more marketscould be reached in a fasterpace. In terms of loans, foreign bankshavekept pacewith the industry lNG, DBS,and Bank of Tokyo accounting for the bulk. A Central Bank report released in the middle of this year disclosed that outstanding loan exposures of foreign banks concentrated in three (3) sectors:financial institutions and businessservices(32.5 percent); manufacturing (26 percent); and community, social,and personal services(15.2 percent) (Gatdula2000). This indicated that foreign banksstill concentratedon the wholesalebanking sector. Basedon this study,revenue loss wassubstantial. Admittedly, margins could suffer whenever there wastransfer of wholesale banking activity from the local to the foreign banks. Table 16's return on equity figures explains how foreign bankshave benefited from their operations in the country over the pastfive years. By increasing their activity,especiallyon the deposit and loan side,foreign banks have maintained a satisfactoryreturn on equity. Increased loans and deposits,limited capital infusion meant eventually profits. Hence, the rest of the listed foreign banks (exceptfor International Commercial Bank of China and Bangkok Bank) were in the top 30 performing banks in the coun-

REACTIONS TO THEENTRYOF FOREIGN BANKSIN THEPHILIPPINES, A CRITICALSTUOY OF LOCALSELECTEO BANKS 303

Table 16. Return on equity of selected

foreign banks, as of December

Bank ANZ Bank Bank of Tokyo Fuji Bank DBS Bank ING Bank Korea Exchange Bank International Commercial Bangkok Bank Notes: Source:

2000

Return on Equity

Bank of China

22.1% 10.0% 5.6% 4.8% 2.9% 2.0% -5.8% -10.0%

No data available for Deutsche and Chemical Banks Central Bank

try. Most of the saidforeign bankshave kept their capital growth at leasttwice (Table 17). Since foreign bankswere not included in the capital requirements imposed by the Central Bank on their local counterparts,they could enjoy relatively high returns. Another factor contributing to this performance is the relatively low non performing loans (NPL). Becausemost their loans they have extended are current, this did not severelyaffect their profitability. Table 18enumerates the non-performing loan ratios of selectedforeign banks. Becauseforeign banksenjoyed relatively high returns on their equity, there waslittle evidence to support that their entry had increased the variety of financial services,brought incremental intermediation activities, and the adoption of new technologiesand processes.Surveyresultsrevealed contradictory findings on the matter. While the local banks have acknowledged that the foreign bankshaveliberalized the economyand the banking sector, partly through investing in new technologies, responsesshowed that there has been little innovation in terms of developing new "foreign" technologies and processes. For example, most of the product developments (either in terms of new products and services)being made in market are indigenous and is mostly made to compete with the local banks. As foreign banks go to the "traditional" products and servicesthat are locally available,domestic bankshave takenthe lead in terms of e-<:ommerce. One domestic bank evenclaimed to be the first e-bankin the country hence, its name. It wasonly when this local bank capitalized on this claim that the other banksfollowed. However,none of the foreign banksmentioned, except for DBS and ING. have been "visible" in terms of media advertisements.

304

FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

Table 17. Total capital accounts of selected foreign banks, December 1995 to December 1999 Bank

December 1995 (Php million)

December 1999 (Php million)

DBS Bank

203

ING Bank Bank of Tokyo Fuji Bank Deutsche Bank International Commercial Bank of China Bankok Bank Korea Exchange Bank ANZ Bank

250 200 201 210 205

-2,804

1,144 720 602 625 293

255 283

265 257 250

n.8.

% growth

.926.6

357.6 250.0 199.5 197.6 42.9

3.9 -9.2n.8.

Table 18. Nonperforming loans of selected foreign banks Ys. Industry, as of December 2000

Bank

Bangkok Bank DBS Bank Deutsche Bank Inti. Commercial of China Korea Exchange Bank ANZ Banking Group, Ltd. ING Bank Fuji Bank Bank of Tokyo Total foreign banks Total Industry % to industry

Non-perfOnTling loans (Php-million)

Non-performing loans to Total Loan Portfolio

418 1,732 1,016 1,145

21.4 15.7 15.0 11.0

150

7.5 5.2 3.8 1.00 0.29

173 396 63 34 5,127 245,800

15.1

2.0

Sauce:

whether in print or media (DBS has since been absorbed by BPI.) This is traced to the fact that foreign bankshave high returns on their equity. A similar finding could be found in De Youngand Hasan's study on De Novo US banks. Profit efficiencyimproved rapidly at the typical De novo bank during the first three years of operations. But on the average,it took about

REACTIONS TO THE ENTRYOF FOREIGNBANKSIN THEPHILIPPINES, A CRITICALSTUOYOFlOCAL SELECTED BANKS 305

nine yearsto establishbank leveloperations. Excessbranch capacity,reliance of large deposits,and affiliation with a multibank holding companywere associated with low profit efficiency at De Novo banks(DeYoung and Hasan1998). Finally, as earlier mentioned Yoshitomi and Shirai (2000) pointed to foreign banks picking on the most lucrative domestic markets or customers. This is an increasing risk borne by domesticinstitutions as they take on more riskycustomersasone argument againstthe participation offoreign banks. The most common responseof the local banksto meet the challengesof the presenceof foreign bankswasthrough enhancing core marketing strategies. Foreign banksare perceived to be a "marketing problem" rather than a "banking problem." Becauseof the limited foreign bank branch network essentialin obtaining more markets,local banksdid not perceive the entry of foreign banksasa threat to their operations. Under existing provisions in RA 7721,foreign banks that were granted licensesare allowed to put not more than sixbranches. Of thesesix branches, the Bangko Sentral should identify the locations of three branches;the other three should be strategicallylocated. However,this could be changed with the GeneralBanking Act of 2000that could now allow asmanyas 100percent of the number of existing local bank branches. As of the first quarterof2001, HSBC hasannounced an aggressivebranching strategyby acquiring PCI Savings Banksfrom Equitable-PCI. As competition increased, the move toward middle markets or retail banking would need investments in advertising and promotions. As mentioned earlier, mall advertisements among local banks were quite commonCitibank, HSBC,and StandardChartered. Boot and Thakor (2000) sawa mixed trend in terms of competition vis-a.-vis in developing loan portfolios. According to them, as intet:"bankcompetition increased, bankswould make more relationship loans. But eachhad a lower value added for borrowers. Capital market competition had reduced relationship lending but each relationship loan had greater added value for borrowers. In both cases,welfare increased for borrowers but not necessarilyfor all. Re-engineering was undertaken for its own sake, not becauseof the entry of foreign banks. Probably,the most surprising result of the surveywas that the banks embarked on re-engineering as a self-improvement strategy rather than an entry barrier for the foreign hanks. This could be seenfrom the different approachesand objectivesmade by the samplebanks. Appendices A, B, and C showsan illustration of how three bankshaveused re-engineering to this end.

306

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

Conclusion

As the operations of foreign banksincreased in scopeand reach in the coming years, it was seen that the local banks will eventually move to the middlemarket and retail side of the banking business,while maintaining presencein the wholesaleside. The resultwould be a more liberalized banking sector,where the public could seeimproved products and services.Thus, achieving one of the major goalsof allowing the entry of foreign banks. With branching rules slowlybeing relaxed, we could seemore and more domestic branches of these foreign banksin the near future. Policy recommendations While thc approach made in this studywasmicro in nature, there were three policy implications supported by the results. .To acceleratethe liberalization processis to increase the number of branches allowed for eachforeign bank. .With reciprocity and complementaryarrangements,local banksmay be allowed to enter the country of origin of any foreign bank. Incentivescan be set-upto encourage suchan arrangement. .Increasing capitalization requirements for foreign banks will encourage mergers that can further boost the liberalization process. While the General Banking Act of 2001hasaddressedsome of these,it would be interesting to develop further research that will determine the changesin the reactions of the local banksfollowing this newlaw.

REACTIONS TO THEENTRYOF FOREIGN BANKSIN THEPHILIPPINES:A CRITICALSTUDYOFLOCALSELECTED BANKS 307

Bibliography Abola, V.A. 1998. Bank liberalization since 1994: boon or bane? Economic Policy Paper 6. Manila: Center for Communication and Research

Foundation. Adamos, T.D. 1992. Financial fiberalization in selected Asian countries. Central Bank Review. Manila :Central Bank of the Philippines Aguirre, R, C. Bella, C. Cruz, and C. Salud. 1999. An empirical investigation on the effects of foreign bank entry on private domestic commercial banks' performance and financial deepening (1990-1997). Unpublished thesis. De La Salle University Manila. Benston,GJ.1994. Universal banking. journal ofEconomicPerspectives 8(2):121143. Boot, A. W.A. and A. V. Thakor. 2000. Can relationship banking survive competition? journal ofFinance (1 )55:679-713. Calderon, L., C. Villanueva, C., and T. Tullao, Jr. 2001. Human resource requirements of the financial sector under a liberalized regime. PASCN Discussion Paper, DP 2001-10. Makati City: Philippine Institute for Development Studies. Casserley,D. andG. Gibb.1999. Banking in Asia: theendofentitlement.Singapore: Saik Wah Press Pte Ltd. Claessens, S., A. Demirguc-Kunt, and H. Huizinga. 1998. How does foreign entry affect the domestic banking market? World Bank Policy Working Paper No. 1911.Washington: World Bank. Delhaise, P. 1998. Asia in crisis, theimplosion of the banking and finance systems. Singapore: John Wiley & Sons (Asia) Pte Ltd. Denizer, C. 2000. Foreign entry in Turkey's banking sector,1980-1997. In Internationalization of financial services:issues and lessons for developing countries, edited by S. Claessensand M. Jansen. Boston: Kluwer Academic Press. De Young, R and I. Hasan. 1998. The performance of De Novo commercial banks: a profit efficiency approach. journal of Banking and Finance22: 565-587. Fisher, KP. 1997. Financial liberalization: starting on the wrong foot? Centrede rechercheen economieetfinance aPliquees. Gatdula, D.A. 2000. Report notes foreign banks' deteriorating performance in RP. Philippine Star, 19June. Kaminsky, G.L. and C.M. Reinhart. 1998. Financial crises in Asia and Latin America: then and now. AmericanEconomicReview.88(2): 444-448.

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Grosse,Rand L.G. Goldberg. 1991. Foreign bank activity in the United States:an analysisby country of origin. journal ofBankingand Finance 15: 1093-1112. Lamberte, M.B. and G.M. Uanto. 1995.A Studyof Financial SectorPolicies: The Philippine Case,p. 235-301. In Financial SectorDevelopment in Asiaedited by S. Zahid. Manila: Asian Development Bank. Moriaux, M., M. WoocCummings,KE. Calder,S. Maxfield, and S.Perez.1997. Capital ungoverned: liberalizing finance in interventionist states. London: Cornell University Press. Tolentino, BJ. 1998. Political economy of credit availability and financial liberalization: notes on the Philippine experience. PillS Staff Paper. Makati: Philippine Institute for Development Studies. Wetmore,J.L. andJ.R. Brick. 1994. Commercial bank risk: market, interest rate, and foreign exchange.journal ofFinancial Research 17(4): 535-

596. Williams, B. 1998. Factorsaffecting the performance offoreign-owned banks in Australia: a cross-sectionalstudy. journal ofBanking and Finance, 22: 197-219. Yamori, N. 1998. A note on the location choice of multinational banks: the caseof Japanesefinancial institutions. journal ofBankingandFinance, 22: 109-120. Yoshitomi, M. and S. Shirai. 2000. Policy recommendations for preventing another capital account crisis. Technical Background Paper. New York: Asian Development Bank

CllAPTER

The Impact of Liberalization of Foreign Bank Entry on the Philippine Domestic Banking Market Angelo A. Unite and Michael J. Sullivan Abstract T his pape~ uses accounting da~ fro~ Philippine commerc~al banks fr~m the penod 1990 to 1998 to InvestIgate how the relaxatIon of foreIgn

enuy regulations affectsdomesticbanks. Aspart of this analysis,we controlled for features of ownership structure that are common in many developing economies; namely,group affiliation and ownershipconcentration. There is evidencethat foreign bank enuy is associatedwith a reduction in interest rate spreadsand bank profits, but only for thosedomestic banks that are affiliated with a family businessgroup. Generally,foreign entry improves operating efficienciesbut causesa deterioration of loan portfolios. Meanwhile,increases in the percentage of foreign ownership of domestic banks reduce these improvements in operating efficiencies and result in lessemphasisgiven to earning income from nontraditional banking sources. Overall,we conclude that foreign competition compels domestic banksto be more efficient, to focus operations due to increased risk, and to become less dependent on relationship-basedbanking practices.Weproposefurther policy reformsaimed at fully realizing the benefits and reducing the social costsassociatedwith increased foreign bank presence in the Philippine domestic commercial banking sector. Introduction In recent years, the Philippines has embarked on a number of economic policy refonns aimed at liberalizing and internationalizing its domestic financial markets. In general, theserefonns involve the relaxation or removal of barriers to international investmentsand the easing of barriers to international capital flows. An important subsetof these refonns is centered on liberalizing restrictions on the involvement of foreign interestsin the domes-

310

FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

tic banking market This liberalization is of two generalforms: regulations that allow the entry of foreign-controlled banks,and regulations that provide incentivesfor foreign ownership of the common stockof domestic banks. The most consequential of theseregulations is RA No. 7721,which waspassedin May1994.RA7721 allows the entry of additional foreign banksto operate in the Philippines and permits a foreign bank to acquire up to a 60 percent interest in an existing domestic bank. The intent of this particular actwasto change the competitive landscapeof the Philippine banking sector through an influx of foreign competition and wasbased on the premise that greater foreign competition will prompt sounder banking practices. Furthermore, there were additional incentives aimed at encouraging foreign ownership of the common stock of Philippine companies,including that of banks, that occurred over the years1992to 1998asthe Ramosadministration focused on economic liberalization. It has been conjectured that increasesin foreign bank entry increase competition and, therefore, compel domestic banks to operate more efficiently (Terrel 1986; Bhattacharaya 1993; McFadden 1994; Levine 1996; Kroszner 1998; Claessensand Jansen 2000; Claessenset al. 2001). For example, Kroszner (1998) argued that greater foreign bank penetration in an emerging market economyimproves banking practicessince foreign banks tend to be less politically connected and are less likely to exert self-promotional influence upon regulatoryauthorities. Levine (1996)summarizedthe purported benefits of allowing foreign bank entry as follows: (1) improvement in the quality and availability of financial servicesand the adoption of modem banking skills and technology; (2) stimulation of the developmentof the bank supervisoryand legalframework;and (3) enhancementof a country's accessto international capital. Specifically,it hasbeen assertedthat greater foreign penetration causesdomestic bank interest rate spreadsto narrow and profitability to decline as new competitors reduce the market price of funds in an attempt to build market share. However, direct empirical evidence demonstrating that foreign bank penetration affectsinterest rate spreadsand bank efficiency is limited. Recent liberalization of foreign bank entry in the Philippines provides us the unique opportunity to undertake a comprehensivestudyof theseissueswithin a natural laboratorysetting due to four distinct advantages. First, foreign bank entry is confined to a single year where a significant number of foreign bankswere granted rights to establishoperations. This allows us to better isolate the effects of foreign entry. Second, confounding effects, suchas restrictions on capital accounts,are largely absent in the Philippines as generaleconomic liberalization took place prior to

THE IMPACTOF LIBERALIZATIONOF FOREIGNBANK ENTRYON THEPHILIPPINE DOMESTICBANKINGMARKET 311

the liberalization of foreign bank entry. Third, the study of a single country allowsa more direct testof the effectof foreign competition within a uniform environment. Finally,unlike manydeveloping countries, the Philippine government plays only a minimal role in the ownershipof banks. A large degree of state ownership may create a cartel-like environment that could distort results (Cetorelli and Gambera2001). Besidesconsidering the impact of foreign bankentry, we alsoexamined how changesin the levelof foreign ownershipaffectdomesticbanks. Foreign ownership of domestic bank common stock may help alleviatetwo perceived problems in the Philippine banking market; namely,a lack of effective monitoring and the preponderanceof relational bankingpractices(Ii 2000). These problems occur in the Philippines, and commonly in other emerging market economies, due to a corporate governance systemthat is typified by high ownership concentration. In the Philippine case,this ownership concentration is centered around family corporategroups that control a large portion of corporate assetsand, likewise,have significant ownershipin the nation's large commercial banks. For example, we find that 10 of the 16 large domestic Philippine commercial banks are subject to significant group ownership. Additionally, when affiliation is more broadly defined to encompassrelated parties, including group companies,affiliated companies, and managerial insiders,we find all large commercial banksare effectivelycontrolled by these related parties. As a consequence,bank managers are often related or appointed by the dominant ownership group and, therefore, owe someallegiance for their position (Riveraand Koike 1995). The resulting systemof relationship-basedbanking may hinder economic growth, since these banks may not fulfill an in termediary role by acting aseffective corporate monitors (Ii 2000). Consequently,a decline of group influence may act to diminish the presence of relationship-basedbanking and, in turn, may enable large commercial banksto better monitor corporate activities. Within this framework, we investigated how foreign bank entry and changesin foreign ownership affect the operation and structure of domestic banks in the Philippines. We conducted this analysisusing bank-level accounting data and generalmacroeconomic datafor the time period covering 1990to 1998. We found evidence that an increase in foreign bank entry acts to reduce interest rate spreadsand operating expenses.This evidence supports our conjecture and the evidence of related studies (Denizer 1999; Claessenset al. 2001). However,the narrowing of interest rate spreadsare concentrated only in banks with higher levels of group-affiliate ownership, while gains in efficiency are lower for domestic bankssubjectto rising foreign

312

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

ownership of their shares. We also uncovered evidence that foreign bank entry brings about an increasein loan lossprovisionssimilar to the findings of Barajasetal. (1999b),while changesin the percentageof foreign ownership of domestic banksis inverselyrelated to the amount of income earned from nontraditional banking sources. Related literature There are only a handful of empirical studies that directly examine the impact of liberalizing foreign bank entry on domestic banking markets. The most comprehensive of theseis by Claessenset at. (2001). Using bank-level data for 80developedand developingcountries over the 1988to 1995period, they examined the impact that foreign bank entry had on domestic bank net interest margins, profitability, noninterest income, overhead expenses,and loan lossprovisions. They found that an increasein foreign bank presenceis associatedwith a reduction in profitability, noninterest income, and overall operating expensesof domestic-ownedbanks. These resultsare interpreted asevidence that foreign bank entry improves the efficiency of national banking marketsand providespositivewelfareimplications for a domesticeconomy. Studiesinvestigatingthe effect of bank liberalization for particular countries include Terrel (1986), Bhattacharaya(1993), McFadden (1994); Clarke etal. (1999), Denizer (1999) and Barajasetal. (1999a)and Salazar(1999b). Terrel (1986) studied aggregateaccounting data for the banking marketsof 14developed countries and found that countries where foreign bank entry is allowed tend to have relatively lower grossinterest margins, lower before-tax profits, and lower operating costs.In Bhattacharaya's(1993) investigation of the national banking marketsof Pakistan,Turkey,and Korea he discovered that entry by foreign banksincreasedthe amount of foreign capitalavailableto fund domestic projects. Through an examination of the Australian banking sector, McFadden (1994) uncovered evidence that foreign bank entry improved domestic bank operations. In a study of Argentinian banks, data from Clarke et at. (1999) supported the contention that greater foreign bank presence instills competition in some areas for domestic banks. However,they believe this effect is somewhatmitigated sinceforeign banksprimarily specializein areasthat are not in direct competition with domesticbanks. In addition, their work looked primarily at indirect forms of foreign entry. Most of the rise in foreign presence is in Argentina wasderived from the foreign acquisition of troubled domestic banksand an increase in the sizeof foreign banks. Denizer (1999) examined the effect of foreign entry on Turkish banksand found that foreign

THE IMPACTOF LIBERALIZATIONOF FOREIGNBANK ENTRYON THEPHILIPPINE OOMESTICBANKINGMARKET 313

entry reduced domestic bank profitability and overhead expenses.He interpreted this asevidence that foreign entry increasedefficiency. However,he alsosurmised that the effect of foreign en try would havebeen greater if capital accounthad been opened earlier. Turkeyallowedforeign entry starting in 1980,whereas capital accountswere not opened until 1989. Barajaset al. (1999b)investigatedhow the liberalization of foreign participation affected the Colombian financial sector. They found some confirmation that liberalization reduced intermediation spreadsand loan quality, but also that liberalization increased administration costs. However, when considering specific relationships based on the number of foreign banks entering Colombia they found that intermediation spreadswere not affected by entry. It is difficult to evaluatethe effectof foreign bank entry using Colombian data for the following reasons.First,the governmentowneda substantial portion (55 percent) of bank assetsin 1991 when liberalization began. Conversion of much of these assetsto private banks throughout the decade may have overwhelmed any effect attributed to foreign bank entry. Second, an increase in foreign bank participation apparently took yearsto occur in any significant sense. While the percentageof domestic banks with foreign participation wasat 7.6 percent in 1991,it increasedto only 9. 7 percent by 1996 before accelerating to 31.4 percent in 1998. These studies are subject to some limitations based on their structure and the countries studied. First, studiesinvestigatingeffectsacrosscountries are inherently confronted with the problem of separatingthe effectsassociated with foreign bank entry from the effectsattributed to contrasting economic and regulatory factors. Second,any effect derived from increasedforeign penetration depends on whether other financial reforms have taken place, suchasdomestic financial deregulation, strengthening the regulatory and supervisoryframework, capital accountliberalization, and privatization of bank assets(Claessensand Jansen2000). In the aforementioned studies, these other financial reforms took place either simultaneouslyor subsequent to the deregulation of foreign penetration. Finally, in previous studies,deregulation of foreign entry occurred over long periods of time such that it becamemore difficult to isolateassociatedeffects. There is also a body of related research that highlights the importance of an effective banking regulatory system. Demirgu~-Kunt and Detragiache (1998)havedemonstrated that countries with weakinstitutional environments, characterized by ineffective legal enforcement, inefficient bureaucracies,and corruption, are faced with greater prospectsof instability in their banking sector within the time period immediately following finan-

314

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

cialliberalization. LaPorta et al. (1998) investigated how certain legal and political features evolve and demonstrated that a country's legal system is determined primarily by its culture and history. Rajanand Zingales (2000) expanded on this work and demonstrated a link betweenpolitical considerations and the institutional impediments to financial development. Overall, thesestudiesreported that many countries do not develop efficient financial and legal systemsevenwhen it is generallyagreed to be economically beneficial becausepoliticians fear a redistribution of economic wealth and the loss of political control. However,Rajanand Zingales (2000)believe globalization and technological changemaybe important catalyststo overcomeentrenched political interests and act as an impetus for financial development. Variable description and predicted relationships Asa meansof investigating the effect of liberalization that has taken place in the Philippines, we analyzed how greater foreign presence in the domestic banking sectoraffected domestic bank operations. Changesin foreign presence are defined asadditional foreign bank entry and the change in ownership in domestic bank common stock by foreign investors. Our sample included all 16 domestic expanded commercial banks (ECBs). We feel this sampleforms an accurate representationof the Philippine domestic banking market. These 16 ECBsconstitute,on average,roughly 70 percent of the total assetsof the entire commercial banking sectorover the period of study, 1990 to 1998 (Appendix 1). They are publicly traded on the Philippine Stock Exchange (PSE)and all rank asone of the largest 1,000corporations in the Philippines. Using theselarge ECBsalsoallowed for a direct investigation of the effect of foreign bank entry since the markets served and the services provided by new foreign banksare comparable to those provided by the domestic ECBs. The authors believe that the smaller domestic banks not included in our analysisserveunique market segmentsthat are less likely affected by a change in foreign presence. Other factorswere also considered that mayaffect bank operations,specifically,measuresof ownership structure, bank-level variables,and general economic variables. The variablesused in this study are defined in Table 1. One way to measure the change in foreign presence is to use a measure of foreign bank entry. For this variable, that author looked at the proportion of foreign banksto the total number of large commercial banks (FOR#). With this variable, it is conjectured that domestic banks react at the time of foreign bank entry in an effort to effectivelycompete against these new market entrants. The authors posited that foreign banksare moti-

THE IMPACTOF LIBERALIZATION OF FOREIGNBANK ENTRYON THEPHILIPPINE OOMESTICBANKINGMARKET 315

Table1. Description of dependentand independentvariables Variable

Description Dependent Variables

Interest rate spreads (IRS)

the difference between the ratio of interest income loans to total loans and the ratio of interest expenses total deposits to total deposits

Operating performance Accounting profitability (AP) Noninterest income (Nil) Operating expenses (OE) Risk (RSK)

ratio ratio ratio ratio

of of of of

on on

before-tax profits to tatal assets non interest income to tal assets total overhead expenses to total assets loan loss provisions or reserves to total assests

Independent Variables Foreign presence Entry number (FOR#) Foreign ownership (FOR%)

the number of foreign banks as a percentage commercial banks the percentage of foreign ownership

of all

Ownership Structure Group affiliation (GRP) Ownership concentration (OWN) Group ownership (GROUP)

affiliation with a domestic family corporate group, a dummy variable equal 1 if bank is affiliated and 0 otherwise the percentage of insider, group, and related party ownership of the top twenty owners the percentage of group ownership of the top twenty owners

Bank-level factors Noninterest earning assets (NIA)

Funding (FND) Operating expenses (OE) Relative bank size (R5Z)

ratio of cash, non interest earning deposits at and other noninterest earning assets to total ratio of all short-term and long-term depostis nondeposit short-term funding to total assets ratio of overhead expenses to total assets the total assets of the bank as a percentage mercial banks' total assets

other banks assets plus other

of all com-

General economic factors nflation (INFL) Capital scarcity (RINT) Reserve requirement (RR)

percentage change in the consumer price index the real interest rate, calculated as the nominal interest rate on short-term government securities minus the inflation rate set by Bangko Sentral ng Pilipinas the year-to-year percentage change in real gross domestic

316

FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

vated by profit and market penetration and that domestic banksare forced to adopt more efficient bank practicesto maintain marketshare. Other measure of foreign presence is the percentage foreign ownership of domestic bank common stock. The levelof stockownershipby foreign investorsmayprovide an indication of the opennessand efficiency of that market. A rise in foreign , "7Dershipis thought to increase outside monitoring activity and result in improvemeJ1tsin bank practices. This variable may be important because foreign OwnL ship of domesticECBsincreasedmarkedly from 8.69 percent of the total in 1992 to 14.81 percent in 1998. To evaluate how changesin foreign presenceaffect bank operations, the effectsof foreign entry on interest rate spreads,various measuresof operating performance, and risk are analyzed. Similar to Terrel (1986), Barajas et al. (1999b)and Claessensetal. (2001),the authorsexpectedinterest rate spreads to decline with greater foreign presence. This narrowing of interest rate spreadsmay occur due to either a decreasein interest income or an increase in interest expenses. Interest income maydecline ifloan ratesare reduced as a bank attemptsto fend off declinesin the sizeof their loan portfolio. likewise, interest expensesmayincreasewith rising deposit interest rates asthe ability to attract new depositsbecomesincreasinglycompetitive. Interestrate spreads are defined as the averageinterest rate receivedby banksfrom their lending activitieslessthe averageinterest rate paid by banksto their depositors (IRS). HI: An increase in foreign presence is expected to result in a decline in interest

ratespreads. A bank's operating performance is measuredthrough three fator: accounting profitability, noninterest income, and operating expenses.Accounting profitability consistsof profits from all sourcesincluding interest rate spreadsas well as any profits derived from nonIending sources. Here, we attempted to include the possibility that domestic banksmayrespond to increasing competition by seeking alternative sourcesof businessto replace the traditional bank businessthat waslost. However,the realizationof any nonlending profits may occur gradually"clfherefore,in the time period immediately following an increasein foreign bank presence,accounting profits are expectedto decline. H2: An increasein foreignpresenceis expectedtoresultin a decrease in accountingprofitv. Many commercial banksin the Philippines engagein nontraditional banking activities,including investmentbanking and brokerage~eIVices.In addition,

THE IMPACTOF LIBERALIZATION OF FOREIGNBANK ENTRYON THEPHILIPPINE DOMESTICBANKINGMARKET 317

the importance of these activities may increase as competition erodes the market share of domestic banks in these traditional banking areas.The authors used noninterest income asproxy for a bank's levelof nonlending activities. ill: An increasein foreignpresenceis expected toresultin an increasein nonlendingactivities. Changesin foreign presenceaffectsoperating expensessinceany associated improvements in managerial efficiency and organizational structure are expected to result in a decline in operating expensesClaessenset al. (2001). Similarly, Berger and Hannan (1998) discussedthe possibility that with an increasein foreign bankentry, domesticbank managersmaybe forced to give up their sheltered 'quiet life' and exert greater focus on cost efficiency. In this study, operating expenseswere proxied by overhead expenses. These are expensesassociatedwith a bank's lending and nonlending operations, including employee and managerial compensation,fringe benefits, depreciation charges,overhead,and equipment-related expenses. H4: An increasein foreign presenceis expectedto result in a decreasein operating expenses. Claessens et al. (2001) argued that an increase in foreign bank presence may induce domestic banks to take on relatively less creditworthy customers, thereby increasing bank risk. For example, domestic banks may give greater focus to retail lending as foreign competition takes away safer wholesale business. Therefore, the immediate impact of an increase in foreign presence is to increase the risk of domestic banks as competition decreases profit margins, induces profit volatility, and encourages the underwriting of riskier loans [see Shaffer (1998) for a discussion of adverse borrower selection]. However, in the long run, an opposing effect may occur if competition encourages improved bank managemen t, including underwriting procedures and greater bank disclosure. In this study, bank risk is by total loan loss provisions. The loan loss provisions are a reflection of the quality of a bank's loan portfolio. H5: An increasein foreign presenceis expectedto increasebank risk in the short term. Ownership structure variables include group affiliation and ownership concentration. Group affiliation is a dichotomous variable describing whether a bank is considered affiliated with a domestic family corporate group. A domestic bank's response to a change in foreign presence may be affected by whether the bank is affiliated with a group. Close ties to a corporate group

318

FINANCIALLIBERALIZATION, MANAGING RISKSANO OPPORTUNITIES

may equate to close relational banking ties that are largely immune to the effectsof foreign bank entry. Or conversely,foreign bank entry may have a more forceful effect on group-affiliated firms if this entry helps reduce relationalbanking ties. Similar to Rajan and Zingales (2000), we used ownership concentration asour proxy of political obstaclesand the levelof transparency.Because many emerging economiesare subjectto high ownership concentration, we were interested in first determining if this wasthe casewith Philippine commercial banks,and if so,determining the effectthis ownership concentration had on bank operations. Ownership concentration is calculated as the percentage ownership of the five largest stockholders. We surmised greater ownership concentration is an indication of the presenceof political obstacles and a resulting diminished transparency (Kroszner 1998). Therefore, we expected relativelyhigher ownership concentration to lessenany effectsfrom foreign bank entry. To control for bank-specific effects,we included four bank-levelvariables: noninterest earning assets,funding, operating expenses,and relative bank size. Thesevariableswere included sincethey maybe directly related to bank profitability and are consistent with previous research including the general model of Claessenset al. (2001). The measure of noninterest earning assetscontrols for the level of assetsthat do not directly generate interest income and wasused to proxy for bank efficiency. Funding includes those bank liabilities that generate an interest expense. Therefore, the level of funding directly affects interest rate spreads,operating performance, and bank risk. Operating expenseswere usedasan independent variable in cases where we expected operating efficiency to be an important factor. The relative size of the bank wasincluded to capture any scaleefficiency effects that maybe present We hypothesized that a domesticbank's responseto foreign bank entry maybe related to the domestic bank's size,which proxies for the extent of its relationships and reputation. Having more concrete relationships and an enhanced reputation were expected to be positively correlated with the relative size of the bank. We also included a set of general economic variables that may affect interest rate spreads,operating performance, and bank risk. These variables included the yearly inflation rate, a measure of capital scarcity,reserve requirements, and economic growth. The level of inflation controls for the expected direct relationship between inflation with interest rate spreadsand profits. Greater capital scarcityallows banks to increase their spreadsand profits but may have an adverseimpact on loan losses.The legal reservere-

THE IMPACTOF LIBERALIZATIONOF FOREIGNBANKENTRYON THE PHILIPPINE OOMESTICBANKINGMARKET 319

quirement ratio wasusedbecausechangesin this ratio will affect bank performance.A measureof generaleconomic growth wasincluded to control for any effect that generalincreasesin economic activitymayhave on bank operations and profits. Data for the Philippine banking industry Accounting-basedmeasuresare used for interest rate spreads,operating performance, and risk to circumvent problems associatedwith differences in market liquidity of commercial banks in our sample since trading activity in the Philippine stockmarket.\islimited. Besidesinvestigating how a change in foreign presence affectsbarik operations,we alsoincluded variables to control for the possibleinfluence of ownership structure, bank-levelfactors,and general economic factors asDemirgli<;-KuntandHuizinga (1998)found such variablesimportant. We gathered specific accounting-basedbank data from bank annual reports, the Philippine StockExchange (PSE)ResearchDepartment, and the Securitiesand ExchangeCommission(SEC). Macroeconomic dataand datausedto measureforeign bank entrywere obtained from the BSP StatisticalCenter. Ownership datawasobtained from the PSEResearchDepartment and the SEC. Descriptive statisticsfor the entire Philippine commercial bankingsector for the period 1990to 1998are presentedin Table 2. These data highlight the dramatic jump in the number of foreign-owned commercial banksstarting in 1995,corresponding to regulation passedin 1994. The number of foreign-Qwned commercial banksincreasedfrom 4in 1994to 14 in 1995, or on a percentage basis went from 12.1 percent to 31.1 percent of the total number of commercialbanks. Similarly,a rise in the amount of total assetsand liabilities began in 1995,but instead of an immediatejump, the increase was gradual. For example, the averagesizeof a foreign-owned commercial bank declined from Php 21,630.5million in 1994to Php 8,247.6 million in 1995. However,by 1998the averagesizeof foreign commercial bankssurpassedthe 1994 level reaching Php 29,825.7million. In addition, the averagesize of domestic commercial banks appeared to have increased in reaction to the entry of foreign commercial banks. While the averagesize of domestic commercial banksincreasedsteadilyfrom 1990to 1993from Php 17,176.5million to Php 24,879.6million, this trend acceleratedin 1994,perhapsdue to anticipation of the regulation liberalizing foreign bankentry. By 1998,the average sizeof domestic commercial bankshad increasedto Php 50,975.9million. Our statisticsvary from the summarystatisticsreported by Claessenset al. (2001) and Cetorelli and Gambera (2001) for the Philippines. For ex-

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THE IMPACTOF LIBERALIZATION OF FOREIGNBANK ENTRYON THEPHILIPPINE DOMESTICBANKINGMARKET 321

ample, Claessenset al. (2001),using data from BankScopefor the years 1988 to 1995, gathered a sample of 17 banks of which the 46 percent that was foreign had 57 percent of bank assets.In contrast, based on a sample that included all domestic commercial banksand all foreign banks,we found, for the year 1995,that the 31 percent of banksthat were foreign had 9.1 percent of bank assets. Over the period 1990 to 1998,we found that, on average, foreign banksmade up 21.2 percent of all banksand possessed12.8 percent of bank assets.In addition, Claessenset al. (2001)and Cetorelli and Gambera (2001)reported that the three largestbankshad a 40 percent market shareof total assets,while we found that the market share of the three largest banks averaged32.0 percent. These differences in summarystatisticsare probably due to using different sourcesfor data. Where theseprevious studies relied on a limited number of banksreported by BankScope,we collected data on all Philippine commercial banks and we cross-checkedour data through multiple sources. Table 3 presentsstatisticsfor interest rate spreads,accounting profits, noninterest income, operating expenses,risk, and relative size for the 16 domestic ECBs in operation from 1990to 1998. Interest rate spreadswere shownto varywidely betweenbanks. Datafor operatingperformance (AP,NIl, and DE) corroborate this finding highlighting that some commercial banks perform substantiallybetter than others. These dataalso highlight responses to the structural changes in the Philippine banking sector. Interest rate spreads,profits, and noninterest income appeared to decline throughout this period. Whether those declineswere associatedwith changesin foreign presence is investigated further in the next section. Overall, our resultsare consistent with Claessenset al. (2001), except in the caseof interest rate spreads.Where they found an averagespreadof 3.5 percent over the 1988to 1995period, we found an averagespreadof 6.4 percent over the 1990to 1998 period. These differences maybe due to sample construction asreferred to previously, or due to the fact that our sample excluded two economically troubled years, 1988and 1989. Ownership data, reported in Table 4, revealsthat ECBsare closelycontrolled. Comparing ownership data for the pre-liberalization year of 1992to that of the post-liberalizationyearof 1998,we found that averageinsider ownership declined from 55.34percent to 43.25percent. It is interesting to note how insiders were split between direct insiders and group-affiliated companies,where direct insidersare defined asdirectors, officers, and related interests(DOSRI). In 1992,the total insider ownership portion of55.34 percent wascomposed of 17.77 percent DOSRI and 37.57 percent group-affiliated

322

FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

Table 3. Descriptive statistic on selected variables for 16 publicly traded. domestic Expanded Commercial Banks (ECBs),1990-1998.* 1~

1001 1002 1003 1~

1997 1!m Average

6.17 1.75 2.56 8.89

InterestRate~~

Spread(IRS) Average StdDev Minimum Maximum

7.34 9.21 8.00 5.51 8.40 4.52 1.35 2.27 4.00 22.19 39.16 23.10

6.44 3.09 3.63 17.26

6.85 1.70 4.34 10.29

5.60 1.76 2.48 9.92

5.59 1.86 2.43 9.46

6.87 2.34 1.88 9.82

6.00 1.17 5.59 9.21

2.87 2.70 2.65 2.33 0.94 1.00 0.00 0.66 1.35 0.39 0.48 0.83 4.77 4.60 4.13 3.26

2.32 0.64 1.38 3.98

2.24 0.43 1.42 3.02

2.44 1.97 1.17 2.30

Accx>unting Profit (AP) Average Std Dev Minimum Maximum

Noninleresl income (Nil) 3.83 Average Sid Dev 0.98 Minimum 2.35 Maximum 6.28 O~ng expenses (OE) Average Sid Dev Minimum Maximum

3.95 0.70 2.98 5.25

2.70 3.56 0.86 1.91 0.78 2.18 4.37 10.29

2.00 0.56 2.18 3.78

2.44 2.81 0.65 2.60 1.65 1.63 4.43 12.42

4.32 4.20 4.02 0.60 0.99 0.83 0.80 3.08 3.05 2.99 3.04 5.81 6.66 6.10 5.97 4.13

Relative Size(RSl) Median 4.46 4.68 StdDev 2.69 2.68 Minimum 0.4314.31 0.46 Maximum 16.49

3.70 0.70 2.83 5.37

0.48 0.64 1.68 0.50 1.86 0.67 -4.09 1.17 3.52 3.05 3.41 2.87

2.24 1.03 0.66 4.49

2.08 2.23 2.76 0.79 0.64 0.61 0.99 1.49 2.08

3.44 0.53 2.60 4.51

3.19 0.52 2.44 4.26

3.92 3.62 3.83

3.66 3.85 0.60 0.38 2.62

3.19

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Source: Philippine Stock Exchange (1997b), individual banks' annual reports, and individual banks' audited financial statements submitted to the SEC and the PSE.

* For the annual figures, the statistics are reported as percentages

and computed based on

individual bank data for the each year. Relative size is calculated as the ratio of the banks's total assets to tatal assets of all commercial banks. All other variables are defined in Table 1.

THE IMPACTOF LIBERALIZATION OF FOREIGNBANK ENTRYON THEPHILIPPINE OOMESTICBANKINGMARKET 323

Table 4. Descriptive statistic domestic Expanded

on ownership variables for 15 publicly Commercial Banks (ECBs)*

traded,

Ownership Category Foreign Insiders DOSRI Group Government Other Top One Top Five Top Twenty

Owenership from 1992 Average Minimum Maximum

8.69 55. 34 17. 77 37. 57 2. 26 33. 73 18. 17 50. 36 73. 94

Sources: Philippine vidual banks' audited are different, figures financial statements

0.00 0.00 0.00 0.00 0.00 10.90 2.24 7.93 15.55

39.97 89.07 60.74 87.01 19.54 99.01 39.97 81.77 99.99

Owenership from 1998 Average Minimum Maximum 14. 43. 2573 23. 19. 52 5. 32 36. 63

25. 12 61. 22 81. 29

40. 00 68. 31 58. 02 48. 92 48. 90 69. 80 48. 52 93. 67 99. 54

Stock Exchange (1997b), individual banks' annual erports, and indifinancial statements submitted to the SEC and PSE. Although sources reported in these various sources are all based on the banks' audited as of the end of each year.

.Ownership variables are based on data for year-end 1992 and 1998, adnd descriptive statistics are computed based on individual bank data for the respective year. Ownership figures are based on the percentage ownership by category of the top 20 shareholders. Insiders are defined as directors, officers, related interest, and group-affiliated companies. DOSRI ownership is defined as directors, officers, related interest. One bank is excluded from the original sample due to lact of cwnership data for 1992 or any of the years between

1990 and 1993.

companies. However,by 1998,DOSRI ownershipincreasedto 23.73 percent while group-affiliated ownership declined to 19.52percent. This suggestsa movementby group affiliates awayfrom investing in ECBsand maybe seenas a response to banking and financial market liberalization. Perhaps groupaffiliated companies tapped other alternativesfor obtaining funds. Another possibleexplanation is that the ability of group-affiliated companiesto extract wealth through bank ownership declined. According to the private interest theory developed by Kroszner (1998),well-organizedgroups are able to use coercive power over the stateto capture rents for thesegroups at the expense of other dispersedinterests. As the influence of thesegroups declined after the fall of the Marcos presidency in 1986and the subsequenteconomic reforms, the ability of groups to extract rents mayhavealso declined. Further evidence of the concentration of commercial bank control is provided with data for average ownership of the top one, five, and twenty shareholders, also reported in Table 4. It is interesting to note that these

324

FINANCIAL LIBERALIZATION, MANAGING RISKSANOOPPORTUNITIES

measuresof ownership concentrationincreasedfrom 1992to 1998. However, these statisticsmust be viewed with caution for the following reasons. First, ownership data for Philippine companiesis difficult to decipher. Someowners mask their identities using front companies or investors. This was probablymore common in the early1990sasmanyex-Marcoscronies hid assetsto avoid govemmentscrutiny. For example,for the Philippine National Bank in 1992, the top one, five, and twenty ownership stakeswere 2.2 percent, 7.9 percent, and 15.6 percent, respectively.By 1998,as the government sequestered sharesdeemed to be illegally obtained by the cronies of ex-President Marcos,the Philippine National Bank's ownershipstakesof the top one, five, and twenty categorieshad risen to 45.6 percent, 84.1 percent, and 86.6 percent, respectively. As evidence,government ownership increased from less than 1.0 percent in 1992 to 45.9 percent in 1998. Second,there have been problems associatedwith the reporting of ownershipdataby regulators. Lack of regulators' enforcement powers and severeunderstaffing problems resulted in significant inaccuracies in the filing and recording of mandatory ownership data. Analysisof foreign presence To investigate how a change in foreign ownership affects the operation of domestic banks,we employed a random effectsmodel to analyzeour sample of cross-sectionaltime-seriespanel data that consistof data for 16ECBsovera nine-year period. In Table 5, we present resultsof three separatemodels for each of the five dependent variables,including interest rate spreads (IRS), profits (AP), noninterest income (Nil), operating expenses (OE), and risk (RSK). In the first model, we present measuresof foreign presence that capture both the number of newforeign banksentering the market (FOR#) and the change in the percentage ownership by foreign investors (FOR%). The second model usesthesemeasuresof foreign presenceinteracted with a dummy variable that designateswhether the ECBis affiliated with a domestic family group (GRP). The third model againusesthesemeasuresof foreign presence but theseare instead interacted with the percentage of group ownership in the ECB (GROUP). We included theseinteraction terms becausea large proportion of productive assetsis controlled by domestic family corporate groups and the degree of group ownership may affect the relationship between foreign entry and a domesticbank's operations [for a discussion,see Unite and Sullivan (2000)]. For example, LaPorta et al. (1998)found that in many developing countries, the actionsof firm managersare oftentimes controlled by the founding families. The control position taken by thesefound-

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ing families help reduce anysevereagencyproblems that are present in countries with undeveloped corporate governancesystems(Shleifer and Vishny

1997). We found that foreign bank entry (FOR#) is inverselyrelated to both interest rate spreadsand profits, but only in caseswhere group affiliation is important. For example, interest rate spreadsand profits significantly declined in responseto the competitive pressuresinduced by foreign entry only when those domestic banks were affiliated with a domestic family business group. Therefore, it is only when the ECBis affiliated with a domestic group that our findings for the Philippines support those of Terrel (1986), Bhattacharaya (1993), McFadden (1994), and Claessenset al. (2001). We surmise that a decline in group ownership, and, therefore, the relational banking ties thesegroups havewith certain affiliated domestic banks,creates an environment in which these affiliated banksare significantly affected by competition from the newly entered foreign banks. Overall, it appears that group-affiliated banksare affectedmore by foreign entry becausegroup-affiliated bankshave relativelyhigher pre-liberalizationspreads.We take this to be evidence of a decline in the influence of relationship-basedbanking. In addition, we found that as the relative size of the bank (RSZ) increased, the greater wasthe associateddecline in interest rate spreadsand profits. Becausewe alsofound evidence that the smaller banks are subject to greater decreasesin interest rate spreads,we conclude that.the smaller ECBsresponded to foreign competition by increasing their sizemore quickly than larger ECBs. We surmise that group-affiliated banksand smaller ECBs are often better politically connected and have more established relationships.Therefore, liberalization, which deregulated foreign bank entry, had a more profound affect on the earnings and profits of these politically connected banks. It may be that these politically connected banks lost political influence during this period. These findings support the contention ofRajan and ZingaIes (2000) that politically powerful groups will not give up economic power easily.In the Philippines, banking liberalization took place during a period following a dramatic change in government when the ex-cronies of the former PresidentMarcos lost much of their political influence. Politically,this type of deregulationwasnot possibleprior to the pro-market administration of PresidentRamosthat started in 1992and extended through 1998 (Unite and Sullivan 2000). Asopposed to group-affiliated banks,the relativelyfaster growing ECBs appeared to become more efficient, asindicated by the inverse relationship betweenoperating expensesand relative size. We conclude that the intent of

THE IMPACTOF LIBERALIZATION OF FOREIGNBANKENTRYON THE PHILIPPINEDOMESTICBANKINGMARKET 327

banking liberalization, which is to make domestic banks more competitive and efficient, worked effectively in the caseof this setof fast-growingECBs. Group-affiliated banks, although adverselyaffected in terms of revenuesand profits, did not become more efficient Perhapsthesegroup-affiliated banks provided benefits to other group corporations that precluded them from markedly reducing operating expenses. We also found that the entry of foreign banks wasdirectly related to a decline in operating expensesand an increase in bank risk. The decline in operating expensesis consistentwith finding ofClaessenset al. (2001),which suggeststhat banking liberalization allowing foreign entry results in greater efficiency. The increase in loan lossprovisions associatedwith foreign bank entry supports the contention of Claessenset al. (2001) that domestic banks are forced to take on lesscreditworthy customersdue to the increasedcompetition brought by the entry of foreign banks. Liberalization pertaining to foreign ownership of domestic banks did not appear to have an important influence. We found that increasesin the percentage ownership by foreign investorsin domestic banks (FOR%) caused an increase in operating expensesand a decrease in noninterest income. While operating expenseswere shownto decline with foreign bank entry as expected, operating expenses increased as the percentage of ownership in domestic banks by foreigners increased.This finding may be comparable to Barajaset al. (1999b), who found that there is a component of liberalization unrelated to entry that causesthe administrative costsof domestic banks to rise. Perhaps this is related to an increase in intermediation costsresulting from stricter provisioning and reporting requirements that accompanied liberalization. There may alsobe an increase in costsas banks ready themselvesliberalization took place during a period following a dramatic change in government when the ex-croniesof the former PresidentMarcos lost much of their political influence. Politically,this type of deregulation wasnot possibleprior to the pro-market administration of President Ramos that started in 1992 and extended through 1998 (Unite and Sullivan 2000). Asopposed to group-affiliated banks,the relativelyfaster growing ECBs appeared to become more efficient, asindicated by the inverse relationship betweenoperating expensesand relative size.We conclude that the intent of banking liberalization, which is to make domestic banks more competitive and efficient, worked effectively in the caseof this set of fast-growingECBs. Group-affiliated banks,although adverselyaffected in terms of revenuesand profits, did not become more efficient Perhapsthesegroup-affiliated banks

328

FINANCIALLIBERALIZATION, MANAGING RISKSANO OPPORTUNITIES

provided benefits to other group corporations that precluded them from markedly reducing operating expenses. We also found that the entry of foreign bankswasdirectly related to a decline in operating expensesand an increase in bank risk. The decline in operating expensesis consistentwith findingofClaessens etal. (2001),which suggeststhat banking liberalization allowing foreign entry results in greater efficiency. The increase in loan lossprovisions associatedwith foreign bank entry supports the contention of Claessenset al. (2001) that domestic banks are forced to take on lesscreditworthy customersdue to the increasedcompetition brought by the entry of foreign banks. Liberalization pertaining to foreign ownership of domestic banks did not appear to have an important influence. We found that increasesin the percentage ownership by foreign investors in domestic banks (FOR%) caused an increase in operating expensesand a decrease in noninterest income. While operating expenseswere shownto decline with foreign bank entry asexpected,operating expensesincreasedas the percentage of ownership in domestic banks by foreigners increased. This finding may be comparable to Barajaset al. (1999b), who found that there is a component of liberalization unrelated to entry that causesthe administrative costsof domestic banks to rise. Perhapsthis is related to an increase in intermediation costsresulting from stricter provisioning and reporting requirements that accompanied liberalization. There may also be an increase in costs as banks ready themselvesfor competition, specificallycostsrelated to activities such as the hiring of higher skilled employees,training current employees, and the acquisition or upgrading of equipment. This suggeststhat increases in foreign ownership provide managersthe impetus to modernize their operations. The decline in noninterest income associatedwith greater foreign ownership supports a view that, with greater levels of foreign monitoring, domestic bankscan reduce their dependence on nonbanking areas of business. Although we do not find that foreign ownershiplevelsare significantly associatedwith spreads or profits, there is presumablya corresponding increasein revenues from traditional banking sourcesassociatedwith foreign ownership that makesup for this decline in noninterest income and increase in operating expenses. Besideseffectsrelated to foreign presence,the bank:'leveland general economic factors we employed as control variableswere found to be significant in manycases.Profit wasfound to be negativelyassociatedwith noninterest earning assets(NIA), the level of funding (FND), and operating expenses (OE). The negative relationship between noninterest earning assetsand

THE IMPACTOF LIBERALIZATIONOF FOREIGNBANK ENTRYONTHE PHILIPPINE OOMESTICBANKINGMARKET 329

profits suggeststhat banks that focus on noninterest earning assetssuffer relatively greater profit erosion. This supports a view that banks are more profitable when they focus on traditional banking services.The inverse relationship between profits and funding highlights an agencyproblem present when banks rely more on deposit and nondeposit funding than as capital sources equity. Berger (1995) discussedhow profits should be positively related to equity levels since this will encouragemore prudent lending and, therefore, better performance. The inverse relationship we found between funding and profitability is therefore expectedsincethe level of depositsand nondeposit funding are inverselyrelated to the level of equity. The negative relationship betweenoperating expensesand profits correspond to resultsof Denizer (1999) and Claessenset al. (2001). Our results imply that Philippine banksare unable to passhigher operating expenseson to customers. With noninterest income (Nil) as our dependent variable, we found evidence of a positive relationship with operating expenses.This supports the view of Claessenset al. (2001) that banks incur greater operating expenses in order to generate more income from alternative sources. Bank risk (RSK) was shown to be significantly affected by two bank-level variables,noninterest earning assetsand the level of funding. The inverse relationship between risk and noninterest earning assetsmay be a consequenceof banksdiversifyingtheir cashflowsstreamsby relying on other sources of business rather than confining themselvesto loans. We also found that deposit and nondepositfunding increasedin conjunction with loan lossprovisions. This points to a general increase in risk in the banking sector since banksare relying lesson equitysourcesfor funding at the sametime that bank assetquality appearsto be deteriorating. Of the general economic variables,the level of GDP and reserve requirements were positivelyrelated to profits but not to interest rate spreads. The effect of GDP growth makessensefrom the aspectthat when the spread between interest revenuesand expensesis constant, profits will increase as the amount of businessincreaseswith economic activity. These findings correspond with findings of Demirg\i<;-Kuntand Detragiache (1998). The direct relationship we found between profits and reserverequirements is contrary to what we expected since higher reserverequirements reduce the level offunds availableto earn interest Perhapsthis is related more to the timing of changes in reserve requirement by the BSP,where the BSPincreasesreserve requirements when bank profits are increasing and cuts reserve requirements when bank profits are declining.

330

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

Our finding that noninterest income is positivelyrelated to the level of real interest ratesis contrary to findings of Claessenset al. (2001). Our results suggestthat Philippine banksturn to nontraditional sourcesof revenuesduring periods when real interest rates are high. Operating expensesare inverselyrelated to GDP,correspondingto thefindings of Claessenset al. (2001), but opposite to that found by Denizer (1999). This indicates that Philippine bankersdo not reactquicklyto economicdeclinesby cutting operatingexpenses. The levelof loan lossreserveswasfound to be positivelyrelated to the levelof real interest rates (similar to Barajasetal. [1999b]) and negativelyrelated to GDP (similar to Claessensetal. [2001]), but contrary to findings of Barajaset al. [1999b]). Loan quality of Philippine banksappearedto strengthen asreal interest rates rose,but deteriorated asexpectedwhen the economysuffered. Conclusion

Recentreforms undertaken in the Philippines that liberalized restrictions on the involvement of foreign interests in the domestic banking market appear to have had favorable results. Overall, we found evidence that interest rate spreads narrow and operating expensesdecline with greater foreign bank entry. This supports the hypothesesthat foreign competition reducesinterestrate spreadsasboth domesticand foreign banksvie for the samebusiness, and that foreign competition forces domestic banks to be more efficient. However,the narrowing of interest rate~preadsisconcentrated in bankswith higher levelsof group-affiliate ownership,while efficiencygainsare lower for domestic banks subject to rising foreign ownership of their shares. We conclude that the intent of banking liberalization, which is to make domestic banks more competitive and efficient, has worked effectively in the caseof larger Philippine banks. Group-affiliated banks,although adverselyaffected in terms of revenues and profits, did not gain in efficiency. Perhaps these group-affiliated banksprovided benefitsto other group corporations that precluded them from markedly reducing operating expenses. We also found that the entry of foreign banksis directly related to increasesin risk. The increase in loan lossprovisions associatedwith foreign bank entry supports the contention of Claessenset al. (2001) that domestic banks are forced to take on less creditworthy customers due to increased competition brought by the entry of foreign banks. The increase in the percentageownershipby foreign investorsin domestic banksis shownto result in an increase in operating expensesand a decreasein noninterest income. This relationship may capture an increase in intermediation costsassuming increasesin foreign ownership are related to providing managersthe impe-

THE IMPACTOF LIBERALIZATION OF FOREIGNBANKENTRYONTHE PHILIPPINE DOMESTICBANKINGMARKET 331

tusto modernize their operations. The decline in noninterest income associated with greater foreign ownership supportsa view that with greaterlevelsof foreign monitoring, domesticbanksreduce their dependenceon nonbanking areasof business. Overall, we conclude that foreign competition induces domestic banks to be more efficient. Asa result of thesecompetitive pressuresand increased monitoring, we expected a general weakeningof relationship-style banking. Our findings support this view as we found that banks that are likely to be more politically connected suffered greater declines in spreadsand profits, and were able to reduce operating expensesto a greater extent. Therefore, overall, we expect banks to become more independent and to lose much of their political influence. In general, this should lead to better lending practiceswhere the allocation of funds dependsmore on merit Asa consequence, we believe liberalization of foreign presence will have a positive effect on economic growth and will enhance the ability of the economy to overcome negative external shocks. Policy recommendations While RA No. 7721 liberalized foreign entry, this act still restricts 100percent foreign ownershipto a maximum of 14bankswith restrictions on the number of branches that suchfully foreign-<>wned bankscan have. In general,foreign ownershipof banksis currently limited to 60percent. Our resultssuggestthat a policy of further opening up the domestic commercial banking market to foreign participation may be beneficial in terms of increased efficiency of domestic banks, although we are not certain asto the exact amount of extra benefit this will bring. Specifically,increased foreign competition should be allowed by allowing more fully foreign-<>wnedbanks to enter the domestic market; increasing the number of branches that fully foreign-owned banks mayhave;and permitting greaterforeign ownershipparticipation in domestic banks. Claessensand Glaessner(1998) found evidence to suggestthat limited opennessto foreign financial servicesproviders translatesto slowerinstitutional development, greater fragility, and higher costsof financial services. However,in order to mitigatethe adjustmentcostsaccompanyinggreater market opennessand the moral hazardproblems associatedwith group-affiliated banks,further liberalization offoreign bank entryand participation should be done in conjunction with built-in safeguardsin the form of credibly enforced government supervisionand regulation aswell as greater reliance on the market mechanism in monitoring the banking system.The rationale for the accompanyingsafeguardsis asfollows.

332

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

Prudential regulations and oversightby a governmental agencyare an essentialmeansof certifying somesenseof economic propriety by corporate groups and can temper the negativeaspectsof the relationship-basedsystem of bank governance in the Philippines. However,while it is true that the BSP has implemented measuresto further strengthen the banking system,improve transparency in the banking system,and promote market discipline in recent years,a weak Philippine bureaucracyhas historically proved to be unable to ensure enforcement (Gonzalez1999;Unite and Sullivan2000). The screening of the entry of new foreign banksshould alsobe made transparent and based on objective criterion in order to ensure that regulatory capture is lesslikely. In addition, the government should rely less on explicit and implicit guaranteesvia deposit insurance schemesto reduce the moral hazard problems associatedwith such safety net and in order to put pressure on domestic banksto improve productivity and serviceprovision. A policy of greater reliance on the market mechanismis premised on the potential that a more competitive banking market that results after the opening up of the market can better discipline bank managersby tempering their nonvalue-maximizing behavior (suchasexcessiverisk-taking in the face of greater competition) which, in turn, further improves bank performance (see,e.g.,jayaratneandStrahan 1996). In addition, ownershipof banksby the economicallydominant family corporategroups createsan obviousconflict of interest for these banksto actascorporate monitors. This is becausethe managersof these banks maybe related or appointed by the corporate group or are, in some sense,subservientto thesegroups.A casein point is the failure of Orient Bank, which was controlled by the Go family during the 1997 East Asian financial crisis. This bank's failure wasattributed to excessivelending to its DOSRI accountswhose investmentswere mainly in real estatedevelopment. Therefore, greater reliance on the market mechanism in disciplining banksrequires better information and greaterinformation disclosureby banks. These can be achievedvia legal or regulatorymeans. Increased level of transparency and information disclosure would necessitatethe following policies in addition to those alreadymandated by the BSP.Ownership information should be required of banks and must be detailed enough for regulators to discern preciselywho owns significant interest in the bankssince ownershipequatesto influence over bank activities, especiallyloans. Such information will assist regulators in determining parties who qualify asbeing in the DOSRI category.Ownership data, in addition to borrower data, mustbe provided in an accurateform to regulatorsand should be made public, especiallyin casesof larger ownership positions, for

THE IMPACTOF LIBERALIZATION OF FOREIGNBANK ENTRYON THEPHILIPPINE DOMESTICBANKINGMARKET 333

both private and publicly traded corporations. Current regulation regarding ownership disclosure requires that owners of 10 percent or more of a corporation's equity must disclosethis information to the SEC.Such ownership includes the beneficial owner, relatives,and associates.However,these curren t regulations are not adequatelyenforced and the accuracyof this ownership disclosure is questionable for two reasons.First, blind accounts allow investors to purchase common stock without disclosure through numbered accountswhenever these accountscomprise less than 10 percent of ownership. Unite and Sullivan (2000) found that, based on the ownership disclosure information reported to the SEC,this is a common occurrence in publicly listed companies in the Philippines. A problem occurs if these blind accountsare controlled by a single party and the total ownership interest of these accountsis greater than 10 percent. Second, the wide use of foreign holding companiesenablesstockownersto hide holdings under the umbrella of undisclosedforeign ownership. Therefore, lowering the mandatory ownership disclosure requirement to 5 percent or more, asin the United States,and applying this to both private and publicly listed companies may result to a higher degree of enforcement and accuracyof ownershipinformation. Transparencyof information on loan quality is also important not only for regulators but also for the public at large.While currently, BSPregulations require that all banks must publicly discloseinformation about their DOSRI loansand the amount of the DOSRIloansand advancesthat havebecome past due, suchinformation should be detailed enough to disclosethe identities of the parties involved. The messageis that in the presence of credibly imposed prudential regulations and supervisionand effective monitoring via the market mechanism, group affiliation can be useful in extracting the benefits from a high degreeof banking market opennessto foreign banks.Eventually,ashigh level of transparencyand disclosurebecome an integral part of domestic banking practices,the current banking corporategovernancesystemwill be transformed from that characterized by relational or social influence to that with more formal controls. Finally, in order to reduce the near monopoly ofECB lending to large domestic family corporations or corporate groups, the government should ensure that the programs of the SmallBusinessGuaranteeand Finance Corporation are fully utilized.

THE IMPACTOF LIBERALIZATION OF FOREIGNBANK ENTRYON THE PHILIPPINE DOMESTICBANKINGMARKET 335

Bibliography Bangko Sentral ng Pilipinas (BSP).1996, 1997a,1998a. Supervisory reports and studies office: The Philippine financial systemfact book. .1997b, 1998b. Supervisory reports and studies office: Executive highlights, the Philippine banking system. .1997c,1999. Selected Philippine economic indicators. Barajas,A, R. Steiner and N. Salazar.1999a. Interest spreadsin banking in Colombia, 1974-96,International Monetary Fund, IMF StafIPapers 46(2). .1999b. Foreign investment in Columbia's financial sector,Working Paperof the International Monetary Fund, No. 99/150. Berger, A. and T. Hannan. 1998.The efficiency costof market power in the banking industry: A test of the 'quiet life' and related hypotheses, Reviewof Economics and Statistics80. Berger,A. 1995. The relationship between capital and earnings in banking, Journal ofMoney,Creditand Banking27:432-456. Bhattacharaya,j. 1993. The role of foreign banksin developing countries: A surveyof evidence,Unpublished Manuscript. Cornell University. Cetorelli, N. and M. Gambera. 2001. Banking market structure, financial dependence,and growth: International evidencefrom industry data. Journal ofFinance56(2): 617-648. Claessens,S., A. Demirglif;-Kunt and H. Huizinga. 2001. How does foreign entry affect the domestic banking market?Journal ofBanking and Finance25: 891-911. Claessens,S. and M.jansen. 2000. Theinternationalizationofftnancialservices: issues and lessons for developing countries. Boston: Kluwer Law Claessens, S.and T. Glaessner.1998. Internationalization of financial services in Asia, Working Paper.Washington: The World Bank. Clarke, G., R Cull, L. D' Amato and A. Molinari. 1999.The effect of foreign entry on Argentina's domestic banking sector,working paper, The World Bank. Demirglif;-Kunt, A. and E. Detragiache,1998. Financial liberalization and financial fragility, working paper, International Monetary Fund. Demirglif;-Kunt, A. and H. Huizinga. 1998.Determinantsof commercial bank interest margins and profitability: Some international evidence. Unpublished Manuscript. Washington: The World Bank. Denizer, C. 1999..Foreign entry in Turkey's banking sector,1980-1997,IFC/ World Bank. Unpublished Manuscript. Wahington: World Bank.

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Gonzalez, E. 1999. The crisis of governance in Asia: The long road for the Phili ppin es. In ReconsideringtheEastAsian Economicnwdel: what's ahead for thePhilippines? Edited byE. Gonzalez. Pasig City: Development Academy of the Philippines, Hutchcroft, P. 1998. Bootycapitalism: the politics of banking in the Philippines. Manila: Ateneo de Manila University Press. jayaratne,J. and Strahan, P. 1996. Entry restrictions, industry evolution and dynamic efficiency: Evidence from commercial banking. Mimeograph. New York: Federal Reserve Bank of New York. Kroszner, R 1998. On the political economy of banking and financial regulatory reform in emerging markets. Unpublished Manuscript. University of Chicago. Krugman, P. 1998. What happened to Asia? Unpublished Manuscript. University of Chicago and National Bureau of Economic Research (NBER) LaPorta R, F. Lopez-de-Silanes, A. Shleifer and R Vishny. 1998. Law and finance, journal of Political Economy 106: 1113-1155. Levine, R 1996. Foreign banks, financial development, and economic growth. In International financial markets,edited by C. Barfied. Washington, DC.: AEI Press, Li, j.S. 2000. The benefits and costs of relation-based governance: An explanation of the East Asian miracle and crisis. Working Paper, Hongkong: City University of Hong Kong. McFadden, C. 1994. Foreign banks in Australia. Unpublished Manuscript. Washington D.C.: The World Bank. Philippine Stock Exchange, 1997a, Corporate Review, Issues 1-19. .1997b, Investments Guide. Rajan, RG. and L. Zingales. 2000. The great reversals: The politics of financial development in the 20mcentury. Working Paper. Chicago: University of Chicago and NBER Rivera, T. and Koike, K. 1995. The Chinese-Filipino business families under Ramos government. joint Research Program Series No. 114.japan: Institute of Developing Economies Shaffer, S. 1998. The winner's curse in banking. Journal of Financial Intermediation 7: 359-392. Shleifer, A. and R W. Vishny. 1997. A survey of corporate governance. Journal ofFinance 52: 737-783.

THE IMPACTOF LIBERALIZATION OF FOREIGNBANK ENTRYON THE PHILIPPINE DOMESTICBANKINGMARKET 337

Terrel, H. 1986. The role of foreign banks in domestic banking markets. In Financial policy and reformin Pacific-Rim countriesedited by H. Cheng. Lanham Maryland: Lexington Books Unite, A. and M. Sullivan. 2000. Reform and the corporate environment in the Philippines. In Reformand recovery in East Asia edited by P. Drysdale. London: Routledge. White, H. 1980. A heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity. Econometrica48: 817-838.

CIIAPTER

VII

The Role of the GATS-FSA in the Financial Liberalization Efforts of APEC Economies Victor c. Pontines

AbstraÂŁt

he study evaluated the commiunents made by a major sample of AsiaPacific Economic Cooperation (APEC)member countries in the Financial ServicesAgreement (FSA)negotiated under the General Agreement on Trade in Services(GATS). The studyalso distinctly analyzedthe actual practices in the financial servicessector acrossthe same major sample of APEC member countries placing emphasison the level and extent of foreign participation in the domesticfinancial servicessector.The evaluationof the commiunents and the actual practices involved the estimation of a frequencybased index as an indicative measure of the extent of market openness in actual practices and binding commiunents. Drawing on crucial issuespertaining to the deregulation and progressiveliberalization of financial services trade, the studylisted possible areasof negotiation strategiesand proposals which Philippine negotiators canpursue in the next round of servicesnegotiations, particularly in the financial servicessector. Introduction When negotiations on serviceswere included in the Uruguay Round of trade negotiations, negotiators had finally recognized the growing importance of trade in servicesin the growth and development of the world economy, in particular financial servicestrade. The resultof the separatetrack of negotiations on servicesin the Uruguay Round gavebirth to the General Agreement on Trade in Services,or simply GATS. Although GATS covers all trade in services,the negotiations could not be completed in four areasby becember 1993.These areasinclude: maritime services,basictelecommunications services,movementsof natural persons,and financial services.

340

FINANCIALLIBERALIZATION, MANAGING RISKSANO OPPORTUNITIES

For financial services, the member countries decided to hold the next round of negotiations during the first half of 1995. The conclusion of the negotiations in July 1995 was only an 'interim' agreement, because the United States, taking the lead role in the negotiations decided that the interim agreement was unsatisfactory. Negotiations officially resumed again in April 1997, and finally concluded on December 1997. The conclusion of the 1997 financial services negotiations is now known as the Financial Services Agreemen t of 1997, and individual country commitments were attached to the Fifth Protocol to the GeneralAgreementon Tradein Services.A total of 70 World Trade Organization (WTO) members made commitments in the Fifth Protocol, in which 15 of the 70 member countries are full-fledged APEC members.! The sole general objective of the paper is to determine the role of the Financial Services Agreement (FSA) , negotiated under the GATS in helping shape future liberalization among APEC member economies through improving and relaxing restrictions on financial services. The paper is divided as follows: the following section (Section II) presents a brief discussion of the framework agreement, and highlights the perceived shortcomings of the agreement. Section III presents initial trends and data on financial services across a sample of countries, in particular Asian countries. Section IV analyzes the commitments made by APEC member countries by estimating a numerical equivalent of the commitments as well as numerical estimates of the actual practices of APEC economies based on a certain frequency index. Section V discusses some crucial policy issues relevant to the liberalization of financial services trade. Section VI presents a discussion of actual practices in the treatment of foreign service providers in the Philippine financial services market and suggests possible areas of negotiation strategies and options for Philippine negotiators in the next round of financial services negotiations. Section VII concludes the paper.

Fmancialservicestrade liberalization under the GATS The significance of the conclusion of the FSAon December 1997under the GATS should be viewed as providing the opportunity of consolidating and complementing unilateral opening of domesticfinancial servicesmarkets in a binding and comprehensivemultilateral framework. Ratherthan represent-

1The fifteen APEC member countries are: Australia, Canada, Chile, Hong Kong, Indonesia, Japan, South Korea, Malaysia, Mexico, Thailand, and the United States.

New Zealand,

Peru, the Philippines,

Singapore,

THE ROLEOF THE GATS-FSA 341

ing a liberalization agreement in itself,2 the GATSand henceforth the FSA, provides only a framework for liberalization of financial servicestrade.3According to the wIO, the agreementcoversmore than 95 percent of financial servicestrade. The agreement consistsof the following framework: first, the general conceptsand provisions covering all sectors,including financial services;second, the annexes, which establishesthe rules and provisions focusing on specific sectors,suchas the Understanding on Financial Services,4 and lastly,the schedule of specific commitments on market accessand national treatment. According to GATS,trade in servicesincluding trade in financial services,can be delivered through any of the following four modes: Mode1 (Cross-border supply)a servicecrossesa national frontier, but not requiring the physical movement of consumersor suppliers. Mode2 (Consumptionabroad)the movement of consumersto the territory of the suppliers. Mode3 (Commercial presence) establishmentof the serviceprovider in the territory of the consumer. Mode4 (Movementofnatural persons)the supply of servicesthrough the presenceof natural personsfrom one territory to another. Much has alreadybeen written about the perceived shortcomings and weaknessesof GATS.These will be highlighted below.The rules of GATSare patterned and based on the same general principles of trade in goods as in General Agreement on Trade and Tariffs (GATT), the Most-FavouredNation (MFN) Treatment and Transparency,for example.However,unlike in GATT, national treatment is not an automatic but a negotiable right. Member countries may inscribe limitations on national treatment in their schedules with respectto each of the four modes of supplyasdescribed above. The GATSdoes not define market accesseither, but stipulates six measures that limit it, specificallyrestrictions on: .the number of servicesuppliers, .the total number of servicetransactionsor assets,

2 Most observers contend that the agreement contains little new liberalization

since member

countries offered few new access to their markets, particularly for most emerging markets. 3Cornelius (2000); WTO (1998). The activities covered by the GATS in financial services include two broad categories of services: insurance and insurance-related services and banking and other financial services. 4Refer to Appendixes I and II for the Annex on Financial Services and the Understanding on Financial

Services.

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FINANCIAL LIBERALIZATION,MANAGINGRISKS ANO OPPORTUNITIES

the total number of serviceoperations or the total quantity of service output, the total number of natural personsthat maybe employed in a particular sector, the types of legal entity through which a service can be supplied, and foreign equity participation in servicesuppliers. The existence of any of these limitations has to be indicated in the scheduled sectors with respect to the four modes of supply. According to Warren and Findlay (2000): "". The lack of clarity in GATS regarding national treatment and market accessmakes it broader in scope than the national treatment and market accessprovisions of GATT,The GATSprovision on national treatment embracesall policies that might discriminate betweendomestic and foreign suppliers, In contrast, national treatment in GATT extends to matters ofintemal taxation and regulation only, More importantly, the GATS article on market accessextends beyond traditional concems of accessfor foreign servicesuppliersto encompassall policies which restrict accessto a market,"

This 'structural weakness'of GATSof rendering national treatment and market accessas 'specific commitments' rather than general obligations has made it specificallydifficult to categorizeactual policies of member countries into market accessor national treatment.5 If national treatment and market accesswere considered as general obligations, the framework agreementwould be using a negative list or 'topdown' approach to scheduling commitments. The consequence of this approach is that all market accessand national treatment would apply to all sectorsunless specificallylisted otherwise in the country's negative list schedule of commitments. Severalobservershaveexpressedand argued strongly in favor of this scheduling strategy,citing primarily the fostering of greater transparency. This is because the approach immediately makes it obvious those

5 However,

according

to Mattoo,

the main reason

why negotiators

avoided

the GATT

approach of making national treatment as a general obligation is because granting market access with full national treatment would have been the equivalent of free trade. Whereas, governments wanted the option of proceeding slowly and gradually towards opening up their

markets.

THE ROLEOFTHE GATS-FSA 343

sectorsthat are excluded from the coverageand brings them to light. The approach forces member countries to 'come clean', which permits them to better assessthe contestability of their markets. In addition, the emergence and development of newactivitiesor sectorswould be automaticallyincluded to establishedframework or discipline. However,during the actual Uruguay negotiations, countries remained opposed to a negative list of scheduling commitments, and settled with a hybrid approach as a compromise.6The reasonsraisedfor the compromisewere:first, the advantageof fostering greater transparency can also be addressedby directly coming up with clear provisions on transparencyin the framework agreement.Second,evenif member countries are willing to adopt a negativelist approach,becauseof the unwillingnessof member countries to make newmarket opening measures,governments may find themselveswith a long list of negative exclusions that they consider as sensitive,and this will take out the essenceof the scheduling commitments.Insteadof attempting to proposewhat amountsasa major structural changeof the agreement,a schedulingproposal wasput forward by Low and Mattoo (2000) that emphasisshould be made on the schedulesor entries that are "unbound" (that is, no bindings), and widening the scope of the coverageof the sectors} Recognizing that countries should take measuresfor prudential reasonsin order to protect depositors,investors,and the integrity and stabilityof the financial system,the agreement asprovided in the Annex on Financial Servicesallows member countries the option of not listing in their schedule of specific commitments measuresthat are considered for prudential purposes.This is known as the 'prudential carve-out.'The' carve-out'is basedon the premise that the measuresare not used as a way to circumvent commitments or obligations. However,it is alleged that, asargued by Mattoo (2000), regulators would seemto have considerablediscretion in their choice of prudential measuressince no definition or definite list of suchmeasuresis provided in the Annex. Thus, according to Sorsa (1997), the broad prudential carve-outcan imply very broad departures from the basic principles of the agreement. For example, on the basisof capitaladequacyratios or discretion in granting of banking licensesmaygo againstt he MFN treatment principle or national treatment by permitting discrimination among countries.8 6This hybrid approach

is a combination

of positive and negative

list approach.

approach, meanwhile, identify sectors or activities on which commitments than those on which they are not. 7Das (1998). 8Cornelius (2000).

A positive

are made rather

344

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

Initial trends in financial services trade The nontradable nature of services, including financial services trade makes official gathering and availability of data difficult and cumbersome. In addition, the presence of inconsistencies and conceptual problems in the definition of what constitutes financial services trade can be a source of confusion with regards to the value and size of financial services trade. To illustrate this point, for instance, according to Das (1998), the GATS definition of trade in services goes beyond the products crossing geographical boundaries, or to transactions between residents and non-residents. The definition of trade in services includes local salesby foreign entities that would be considered 'resident' by conventional statistical criteria and for whose activities relevant statistics are not available. The only statistics available follow the Balance of Payments (BOP) Yearbook classification of the IMF. However, BOp9 statistics, reflect only cross-border trade and thus understate trade in financial services. Thus, when services are traded through foreign affiliates with the status of residents in the country where the services are supplied, such transactions are not covered by the BOP. The challenge in achieving a realistic estimate of trade in financial services is to come up with measures of activities of foreign affiliates.lo Barring this limitation, according to IMF-BOP data for 1999 on crossborder trade in banking and securities, the United States ranks as the number one exporter of banking and securities (Table 1). Its exports were US$13,930 million, or 23.87 percent of the total world exports in this category. Aside from the United States, four other APEC economies are included in the top 20 exporters of cross-border banking and securities. japan accounted for US$2,004 million, or 3.43 percent of the total world exports, and the Seventh top exporter. Canada accounted for US$966 million, or 1.66 percent and the eleventh top exporter. South Korea accounted for US$478 million, or 0.82 percent, and the fifteenth top exporter. And, Australia which approximately accounted for US$478 million, or 0.81 percent, and the sixteenth top exporter position. These five APEC member economies mentioned (i.e., the United States,japan, Canada, South Korea, and Australia) accounted approximately towards a combined 30.54 percent share of the total cross-border trade in banking and securities in 1999. Meanwhile, the United States,japan, Canada, Australia, Philippines and Mexico were listed as the top 20 importers of cross-

9 Tamirisa

et al. (2000)

'OThe United States is the only WTO member country, which officially releases and publishes a comprehensive data on financial services, including activities of foreign affiliates.

THE ROLEOF THE GATS-F$A 345

Table 1. Top 20 exporters and importers of banking and other financial services 1999 (US dollar million)

Exporters

Value

United States

13,930 11,310 7,969 5,815 3,990 2,261 2,004 1,662 1,440 1,347 966 942 607 492 478 472 347 305 265 227

U.K. Switzerland Belgium-Lux. Germany Italy Japan Ireland France Spain Canada Austria Netherlands Sweden Korea Australia Turkey Brazil Portugal Czech Rep.

Share of total (%) 23.87% 19.38 13.66 9.97 6.84 3.87 3.43 2.85 2.47 2.31 1.66 1.61 1.04 0.84 0.82 0.81 0.59 0.52 0.45 0.39

Importers Belgium-Lux. United States Italy Germany Japan France Canada spain Ireland Austria Netherlands Brazil Switzerland Turkey Sweden Czech. Rep. U.K. Australia Philippines Mexico

Value 4,714 3,570 3,099 2,850 2,720 1,400 1,337 1,318 1,259 835 738 573 562 491 430 354 330 321 317 250

Share of total (%) 15.90% 12.04 10.45 9.61 9.17 4.72 4.51 4.45 4.25 2.82 2.49 1.93 1.90 1.66 1.45 1.19 1.11 1.08 1.07 0.84

Source of raw data: International Monetary Fund, 2000 Balance of Payments Statistics Yearbook;

border trade in banking and securities.These six countries combined accounted approximately 28.71 percent of total trade in this category. Statisticson cross-bordertrade in insuranceseIvicesshowthat five APEC member economies were listed in the top 20 of leading exporters of insurance services(Table 2). Canadaaccounted for US$2,627million, or 9.2 percent of the total exports in this category.The United Statesaccounted for US$2,300million, or 8.06percentof the totalworld exports.Mexico accounted for US$l ,072 million, or 3.75 percentof total exports.Australia accounted for US$563million, or 1.97percent of total exports. And, Singapore accounted for US$486million, or 1.70percent of total exports.Thesefive APEC member economies combined accounted approximately 24.68 percent share of the total cross-border trade in insurance seIvicesexports in 1999. Meanwhile, eight APEC member economieswere listed in the top 20 importers of insurance seIvices.Mexico, United States,Canada,japan,China, Singapore,Thailand, and Australia combined approximately accounted 50.57 percent share

346

FINANCIAL LIBERALIZATION,MANAGINGRISKS ANO OPPORTUNITIES

Table 2. Top 20 exporters and importers of insurance services. 1999 (US dollar million)

Exporters U.K. Canada Germany USA Switzerland Italy Mexico Ireland

France Belgium-Lux Austria Spain Poland Australia South Africa Singapore

Sweden Norway India Netherlands Source

Value

6,650 2,627 2,550 2,300 1,882

Share of

total (%) 23.29 9.2 8.93 8.06 6.59

1,299

4.55

1,072 990 970 914 838 809 570 563

3.75 3.47 3.4 3.2 2.94 2.8. 2.0 1.97

Importers

Share of

total(%) Mexico

U.S.A. Canada Japan Germany China

Italy Ireland France Austria Spain

U.K.

502

1.76

Singapore Belgium-Lux. Poland

486 466 454 242 224

1.70 1.63 1.59 0.85 0.78

Norway Thailand India Australia Netherlands

Monetary

Fund, 2000 Balance

of raw data: International

Value

5,235 4,080 3,412 2,330 2,120 1,932 1,818 1,416 1,008 943 936 920 803 751 741 717 654 614 599 566

13.90 10.83 9.06 6.19 5.63 5.13 4.83 3.76 2.68 2.50 2.49 2.44 2.3 1.99 1.97 1.90 1.74 1.63 1.59 1.50

of Payments

Statistics

"Include both life and non-life insurance, as well as reinsurance and retrocession, intermediation, and services auxiliary to insurance.

insurance

Yearbook;

of the total cross-bordertrade in insuranceservicesimports in 1999.Basedon information presented in Tables1 and 2, the internationalization of crossborder financial servicestrade obviouslyindicates that developed countries largely dominate this type of trade. Meanwhile,Table 3 showsexportsand imP9rtsof financial servicestrade exclusively among selectedAsianeconomiesfor the period 1988-1999based on data from the IMF Balanceof PaymentsStatisticalYearbook.Hong Kong ranksasthe consistenttop cross-borderexporter of financial servicesfollowed by China, Korea, and Singapore, respectivelyin that order over the sameperiod. In terms of imports of cross-borderfinancial services,Hong Kong also consistentlyranksasa top importer of cross-borderfinancial servicesfollowed by China, Singapore, Thailand, and Korea, respectivelyin that order (Table 4). Notice that India is also gradually becoming a substantial exporter and importer of cross-borderfinancial servicestrade in Asia.

THE ROLEOFTHE GATS-FSA 347

Table 3. Exports of financial services for selected Asian economies, 1988-99 (US dollar million) 1988 1989 1990 1991 1992 1993 1994 1995 1&

~ HongKong Korea Singapore Taiwan

~ Indonesia Malaysia

Philippines ThailClld

1997 1998 1999

819 006 953 1177 1493 ~ 2794 2637 ])18 276 283 332 445 ~ fÂŁ7 595 8ffi 0C6 98 00 88 114 168 262 3I> 421 489 n.a. n.8. n.3. n.3. n.3. n.3. n.3. n.3. n.3. n.a. n.a. 2 3 13 17 6 7

n.a. n.8. 3 14 10

n.8.

Z3 44

n.a. n.8. 6 21 ffi

6 10 ffi

n.8.

7 62 00

n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a

n.a

n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 2B

111

SOUTHASIA India 71 110 123 107 1&J 141 145 170 210 Pakistan 4 17 11 6 5 lJ lJ 15 40 China 345 332 'l27 342 400 452 1700 1852 123

24 71

24 51

1292))

118 ffi 242

41 n.a. n,a. 201 411 370

Source of raw data: Das (1998); 2000 IMF Balance of Payments Statistics Yearbook.

Table 4. Imports of financial services for selected Asian economies, 1988-99 (US dollar million) 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Source of raw data: Das (1998); 2000 IMF Balance of Payments

Statistics Yearbook.

Tamirisa et al. (2000) argued that in the absenceof comprehensive country statisticson trade of foreign affiliates,the share of foreign bank assets in total bank assetscould be usedas an alternative indicator of suchtrade. In addition, Claessenset aI. (2001) not only viewedmeasuressuch asthe share

348

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

of foreign bank assetsto total bank assetsaswell asthe share of banks that is foreign-owned, asproviding the extent of foreign assetpenetration and foreign bank penetration in the domesticbanking system,respectively. As shown in Table 5 we see that for mostAPEC member countries, (for f) out of 19 countries), the foreign penetration measure exceedsthe asset 1- ~trationmeasure(this applyto the casesof Australia,Canada,Chile, China, Indonesia,Par'1laNewGuinea,Peru, Taiwan,Thailand and the United States). This indicate~ hat foreign banks tend to be smaller than domestic banks.11 Only two APECmember countries,Hong Kongand New Zealand,havea large foreign bank presence with both foreign penetration measuresof at least 50 percent. It is surprising to note that the United States,contraryto what maybe expected,appearsto havea relativelyinsulated banking market, with foreign penetration measuresbelow 10 percent.12 With regard to the insurance sector,Table 6 showsthe importance of the insurance sectorfor member countriesofAPEC asmeasuredby an indicator of insurance penetration-insurance premiums asa shareof grossdomestic product (GDP). There is a clear discernible pattern in the distribution of importance of the insurance sector for APEC member economies. Higher income member countries (i.e., Australia,Canada,Hong Kong,japan, Korea, New Zealand, Singapore, Taiwan,and the United States)attach greater importance to their insurance sectors,with total insurancepremiums averaging at eight percent of GDP. However, the fact that the lower income member countries of APEC spend only two percent of their GDP on insurance suggeststhe great growth potential of this sectorasthesecountries prosper.15m addition, available data on eighteen member economies of APEC show that these economies accord a slightly greater importance to life insurance than non-life. Insurance premiums in the life sectoraverageat around 3.07 percentofGDP in 1998,while in the non-life sector it is about 2 percentofGDP. Table 7 presents the level of foreign participation in the insurance sector for selected Asian insurance markets in 1997. Foreign insurers are activevia establishing domesticallyregistered companies,joint ventures,and foreign branches. Foreign insurers are mostactive in Indonesia, Philippines, Singapore and Thailand both in the life and non-life sector. In these four 11Claessens

et al. (2001).

12Claessens et al. (2001); However, DeYoung and Noelle (1996) reported contrary evidence of a foreign bank penetration ratio of almost 50 percent for the United States. Although, this study define a bank as foreign if it has more than 10 percent foreign ownership. 13Kono et al. (1996).

THE ROLEOF THE GATS-F$A 349

Table 5. Share of foreign

banks in domestic

banking systems:

No. of foreign banks in total .Australia 0.37 Canada 0.64 Chile 0.32 China 0.13 Hong Kong 0.60 Indonesia 0.35 Japan 0.09 Korea 0.23 Malaysia 0.09 Mexico 0.04 New Zealand 0.85 Papua New Guinea 0.50 Peru 0.43 Philippines 0.49 Russia 0.08 Singapore 0.29 Taiwan 0.14 Thailand 0.08 United States 0.25

1988-1995

Foreign banks assefSrntOfal 0.05 0.07 0.25 0.00 0.69 0.16 0.21 0.23 0.06 0.02 0.91 0.34 0.35 0.12 0.06 0.62 0.09 0.02 0.03

Source of raw data: Claessens et al. (2001). Notes: (a). as in the source of the data, a foreign bank is defined to have at least 50 (b).

(c).

percent foreign ownership. Figures reported are ratios of number of foreign banks to total number of banks and foreign bank assets in each country, respectively, averaged over the 1988-1995 period. Total number of banks is for 1995. Reported figures for the Philippines were recent available data on the commercial banking system (total number of commercial banks is for September 2001 and foreign bank asets in total were for the average of 1994-June 2001 period) No available data for Vietnam.

countries, foreign share of total insurance premiums averageat around 27 percentofGDPin the nonlife sector,and 39 percentofGDPin the life sector. Only life-foreign insurers are mostactive in Malaysiaand Taiwanwith foreign shareof total insurancepremiums asa percentofGDP averagingat around 41 percent. Measuring commitments and actualpracticesin Imancial servicestrade At the outset, trade in financial servicesis managedprimarily through restrictions on entry and operations of foreign providers (commercial presence) and on cross-border exports and imports of financial servicestrade. More generally,financial regulations canbe identified as: licensing requirements,

THE ROLEOF THE GATS-F$A 351

Table 7. Foreign participation in Asian insurance markets, 1997 Foreign share of total Number of foreign non-life insurers Domestic foreignowned companies

Number of foreign life

Foreign- Foreign- Domestic owned branches foreignjoint owned ventures companies

Foreignowned joint ventures

Foreignbranches

China India Indonesia

0 0

0 22

5 2 7 12

0 0

22 0

Japan Malaysia Philippines Singapore South Korea Taiwan Thailand Vietnam

0 0 5

0 0

2 0

0 0

4 2 4

2 11

0 0

12 5 0

0 0 0

Source:

5 15 1 0

premiums Nonlife

Life

0.4% 0.0% 20.3% 4.7% 9.6% 13.6% 57.3% 0.3%

0.8% 0.0% 23.4% 3.8%

57.6% 32.6%

525% 0.3%

7.8% 24.9"/0

17.7"/048.90/. 0.0% 0.0%

Swiss Re, sigma (1999).

encountered by ilie oilier approachesmentioned abovehavebeen pardyovercome wiili ilie availabilityof GATS.The nature of a frequency-basedapproach to measuring impediments to financial servicestrade is describedbelowbased on previous studies undertaken using ilie said approach. Frequency-basedapproach The pioneering work of Hoekman et al. (1995) on using frequency-based measuresof impediments on servicestrade wasapplied using the information contained in the country schedulesof the GATS and refer to all four modes of supply. The quantification of country schedules on servicesproceeded by allocating a number to each possible market accessor national treatment commitment in each mode and in each industry subsector.15 If a member country is bounded to a sector with no limitations, a weight of 1 is allocated. If, a member country hasagreedto bind to a sectorwith somelimitations or restrictions a weight of 0.5 is allocated.However,if a member country hasrecorded unbound entry or simplydid not made any commitment to a sector,a weight of zero is allocated. Thus, the greater the number for each specific sector,the more commitments made. However,asargued by Brown

15Warren and Findlay (2000).

352

FINANCIAL LIBERALIZATION,MANAGINGRISKS ANO OPPORTUNITIES

and Stern (2000), the Hoekman frequency-basedmeasuresare intended to indicate the relative degreeof restriction and are not to be taken asindicating a measure of a tariff equivalent in services.In addition, the different limitations or restrictions are given equal weight and are not distinguished according to their economic impact. Notwithstanding the limitation mentioned above,a number of previous studies applied the frequency-basedapproach, specifically to financial services trade. Claessensand Glaessner(1998) used the approach in quantifying the extent of actual commitmentsand regulations in the financial services markets of eight Asian economies.16Their index used five waysin which finanl.~: servicesare commonly and typically restricted, namely,establishment and ownership, offices and automatic teller machines,lending and business activity,universal banking, and residencyrequirements. Each entry category wasassigneda scorefrom one to five,one being mostclosedand five being the most open. Weightings were applied to the five entry categoriesfor banking, and three of the five categoriesfor securitiesand insurance services. Mattoo (2000) takes a broader scope in his study by examining the market accesscommitments on financial servicesby developing and transition economiesin the financial servicesagreement.However,Mattoo adopted a simpler approach in the construction of his own version of a frequencybased index. In the first two modes of supply of services (crossborder and consumption abroad), a numerical value of zero wasassignedto entries of unbound and a value of one to entriesof none (without limitations in commitments~. In the presence of restrictions or limitations, a value of 0.5 wasassigned. Notice that unlike the Claessensand Glaessner (1998) study, the Mattoo studydoes not make anydistinctions about how the forms and typesof restrictions in the first two modes will take. However,with respectto the third mode of supply of services(commercial presence)a more sophisticated approach wasadopted. 171tis to be noted that the studyexcludes the presenceof natural personsfrom the analysis,and focusesonly on direct insurance, both life and nonlife and the acceptance of depositsand lending services.The liberalization index for a member country in a sub-sectoris the weighted averageof all numerical values.

16The eight Asian economies included were Hong Kong, India, Indonesia, Korea, Malaysia, the Philippines, Singapore, and Thailand. 17Reier to Appendix III for the weighting used for commercial presence.

THE ROLEOF THE GATS-FSA 353

Identifying and classifyirig the commitmentsof APEC member economiesin the f"mancialservicesagreement (FSA)18 The commitmentsof APEC membereconomiesin the financial servicesagreement were identified and classified based on a number of sources.19The schedulesof specific commitments in GATSare intricate and complex documents. These contain for eachmember: market access,national treatment and additional commitments, on eachsub-sectorsof financial servicestrade. The levelsof commitments were distinguished depending on whether a "fullbinding" wascommitted or designated as "none" entry, suggesting the absenceof limitations; "limited" bindings, refer to those entry of commitments in the schedule as the intermediate case when there is a limitation; and, "unbound" refersto no bindings.The form of the limitation(s) or restriction(s) on market accesswere enumerated previouslyin SectionII of the paper. Tables 8 to 10 show the resultsof the analysisof commitments for the three main sub-sectorsof financial servicesof APEC economies.We observe from Table 8 that very fewAPEC member economies,made commitments in Mode I (crossbordertrade) either on a limited or full commitment basis,with the exceptions of Australia, Canada, Indonesia, United States,and Japan. Aside from Indonesia, the other three are high-income countries and can be regarded ashaving well functioning and developed financial systems.Almost all of the APEC economies considered in the analysishave made commitments under Mode III (commercial presence)but no country made full bindings in both modes of supply. Full liberalization acrossthe two relevantmodesof supplyis slightly rare in insurance than in banking (Tableg). Justlike in banking, more than half of the APEC economies considered made commitments using Mode III. Only

18The details of the assigning

of scores for the entry categories, and the weightings

used for

the sub-sectors included in the study are to be found in Appendix III, 18Thirteen out of the fifteen APEC member countries that participated in the financial services negotiations and made commitments in the Fifth Protocol were evaluated. The commitments of APEC economies that were identified are as follows: Australia, Canada, Chile, Hong Kong, Indonesia, Japan, South Korea, Malaysia, Mexico, Philippines, Singapore, Thailand, and the United States. China was excluded because it was not yet a WTO member when the FSA was reached. In addition, in spite of China's huge potential in financial services trade, admittedly, China is the least liberalized of all and faces a major challenge in its bid for WTO membership to develop market-based institutions, particularly in the financial services sector (Dobson, 1998). It is worthwhile mentioning that the presentation of the results of the commitments emphasized the only two relevant modes in financial services trade crossborder trade (Mode I) and commercial presence (Mode III). Commercial presence is the dominant mode of trading financial services trade because proximity of between supplier and consumer are necessary for providing most financial services trade (Tamirisa et al. 2000).

354

FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

Table 8. Market access commitments in banking (deposits and lending)

Country

Full

Commitment Crossborder Trade) Australia Canada

Limited Commitment (Cross-

border

Full (Commercial

Limited Commitment (Commercial

Presence)

Commitment

Trade)

v" v"

,( ,(

Chile

Hong Kong Indonesia

,( ,(

,;'

Japan Sourth Korea

Malaysia Mexico

Philippines Singapore Thailand United States

,( ,(

Table 9. Market access

Country

commitments

in insurance

services

(life and nonlife)

Limited Commitment (Commercial Presence)

Full

Limited

Full

Commitment

Crossborder Trade)

(Cross-

Commitment (Commercial Presence)

border Trade)

Australia Canada Chile

'" '" '"

Hong Kong Indonesia yI'

Japan Sourth Korea

Malaysia Mexico

Philippines Singapore Thailand United States

./ ./

yI'

,;' ,;' ,;' ,;'

,;' ,;'

356

FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

Table 11. Grandfather Foreign equity related ~o.untry .~rovision-

provisions

in banking, insurance

and securities

Indonesia

Banking, Insurance and Securities. Share ownership of foreign service suppliers is bound at the prevailing laws and regulations. The conditions of ownership and the percentage share of ownership as stipulated in the respective shareholder agreement establishing the existing individual joint venture shall be respected. No transfer of ownership shall take place without the consent of all parties in the joint venture concerned.

Malaysia

Banking. Entry is limited to equity participation by foreign banks in Malaysian-owned or controlled commercial and merchant banks with aggregate foreign shareholding not to exceed 30 percent, but the thirteen wholly-foreign owned commercial banks are permitted to remain wholly-owned by their existing shareholders. Insurance. New entry is limited to equity participation by foreign insurance companies in locally incorporated insurance companies with aggregate foreign shareholding not ot exceed 30 percent. Foreign shareholding not exceeding 51 percent is also permitted when (i) existing branches of foreign insurane companies are locally incorporated, which they are required to be by 30 June 1998, and (ii) for the existing foreign shareholders of locally incorporated insurance companies which were the original owners of these companies.

Philippines

Insurance and banking. New investments of up to 51 percent of the voting stock, but existing investment of foreign banks will be maintained at their existing levels.

Legal fonn-~~ Hong Kong

Banking. The condition that branches of foreign banks are allowed to maintain offices in one main building and no more than two additional offices in separate buildings, does not apply to banks incorporated outside HKSAR licensed before May 1978 in respect of full licensed banks and before April 1990 in respect of restricted license banks.

THE ROLE OFTHE GATS-F$A 357

Indonesia

Banking. Existing branches of foreign banks are exempted from teh requirement imposed on new entrants to be in the form of locally incorporated joint venture banks.

Thailand

Banking. While the establishment of new branches is subject to discretionary licensing, existing foreign banks which already had the first branch office in Thailand prior to July 1995 will each be permitted to open no more than two additional branches.

General Insurance. Limitations in market access listed in the specific insurance sub-sectors do not apply to existing wholly or majority foreign-owned authorized insurance/reinsurance companies as of the entry into force of the WTO Finacial Services

Philippines

agreement. Source:

Mattoo (2000)

tered, the rights of the incumbents or that were already in the market are guaranteed and preserved,while new entrants are placed at a competitive disadvantage.20 However, the scheduling innovation resolve potential conflicts in the negotiationsbecausefor mostcountriesdomesticlawhad changed since the foreign firms first establishedcommercial presence,and therefore countries were unwilling to make commitments which reflected the status quo with respect to commercial presence.21Nonetheless,according to Low and Mattoo (2000),the 'triumph of moral overeconomicreasoning'hasmeant that the GATSmade marketslesscontestable. Quantifying the commitments and actual practice of APEC member economies on rmancial servicestrade22 As earlier mentioned, the analysisof Claessensand Glaessner (1998) on actual financial servicesregulations in selectedAsian countries, and Mattoo 20As pointed

out by Low and Mattoo (2000), this is based on the evidence

differences in ownership and legal form affect firm performance. 21One case in point is Malaysia where it began to implement its indigenization

that country policy after

several fully foreign-owned firms were already operating in the market. In the foreign incumbents' view making just status quo commitments will weaken what they regard as "acquired rights, which Malaysia supported as a view (Low and Mattoo (2000). 22Refer to Appendix III for the details of the frequency-based approach used in the paper.

358

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

(2000) on the 1997financial servicesnegotiations of developing and transition economies used a frequency index to measure the degree ofliberalization and opennessof countries. The studyof Mattoo establishedthe numerical coding by covering the three modesof supply.and the two areasofbanking (deposits and lending), and insurance (life and nonlife).25The liberalization index for a sector is the weighted averageof all numerical values. Qian (2000) extended the Mattoo study using similar coverageof sectors,countries, and methodology. The Claessensand Glaessnerstudy measured the actual regulations and barriers of Asian countries covering all three broad su1>-sectors of financial servicestrade. The paper takes the elaborate tasksof quantifying distinctly and separately the actual regulatory financial servicestrade and the committed and bound schedulesof APEC economies in the financial servicesagreement of 1997. The specific commitments of individual APEC economies covered in the studywere gathered from the wro website.The actual or practiced regulations in the financial servicessectorwere obtained from the Sectoral and Trade Barriers Databaseof the European Commission and the recent National Treatment Studyof the United StatesDepartmentof Treasury.Asnoted previously. arriving at an index that will accurately depict and capture the extent of opennessin actualregulations of countries relative to the extent of their commitments should be subjectto the caveatthat with respectto issues of internationalization of financial services,in practice there are only two relevant and important modes of supply for financial services.These are: commercial presenceand cross-bordersupply.21 The results of the estimation using a frequency-basedindex for most APEC economies are shown in Tables 12 to 14. Based on the estimated indexes for banking (depositsand lending) from Table 12. the variation in the degree of commitments range from the relativelylessliberal Chile (0.2125) to the most liberal japan (1) in deposits. Likewise,the range of variation in actualpractice is from the most closedChile (0.2125)to the most open countries of Australia, Canada,Hong Kong. and the United States(0.7875). In lending, the range of variation in the degree of country commitments is the sameas in depositsfrom the relativelylessliberal Chile (0.1875)to the more liberaljapan (0.875). The range of variation in actualpractice is from the most ~

23Mode IV (Movement of Natural Persons) was not included in the measurement. 24As in Mattoo, consumption abroad (Mode II) is not included. However, the paper adds in the sector coverage the securities sub-sector, which unlike in Malloo, banking and insurance were the only sub-sectors analyzed.

360

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

Table 14. Degree of openness/restrictiveness of APEC economies (securities)

~ou.n~

services

Commibnent

Practice

0.875 1 0.125 0.75 0.625 875 0.375 0.5 0.25 0.25 0.25 0.25 0.875

0.875 0.75 0.375 0.875 0.5 0.75 0.5 0.125 0.5 0.75 0.75 0.5 0.875

Australia Canada Chile Hong Kong Indonesia Japan Korea Malaysia Mexico Philippines Singapore Thailand United States Note:

to trade in financial

The higher the score, the more open is the financial services market. Scores range from 0 to 1 with a score of 1 being the most open and a score of 0 being most closed.

Table 15. Financial

services

Banking (Deposits)

agreement:

Banking (Lending)

market access

in APEC economies

Insurance

(Life)

(Non-life)

Securities

Commitments greater than Practice

Japan Malaysia

Indonesia Japan South Korea Singapore Thailand United States

Canada Indonesia Japan Malaysia

Commitments Equal to Practice

Australia Canada Chile Indonesia United States

Austrialia Canada Hong Kong Mexico

Australia Canada Hong Kong Mexico

Australia United States

Commitments Less than Practice

Hong Kong South Korea Philippines Singapore Thailand

Hong Kong South Korea

Chile Malaysia

Philippines Singapore Thailand

Philippines

Chile Malaysia Philippines

Chile Hong Kong Sout Korea Mexico Philippines Singapore Thailand

THE ROLEOF THE GATS-FSA 361

closed countries of Chile and Malaysia(0.1875) to the most liberal countries of Australia, Canada,Hong Kong,Singapore,and the United States(0.8125). It was in the insurance sectorwhere a lot of APEC member countries made commitments greater than their actual practice both in the life and nonlife sector. These countries were: Indonesia, japan, South Korea, and Singapore (seebelow). However,on the whole, mostAPECmember countries have tended to be lessforthcoming in their commitments in banking and securitiesby opting to bind current and existing policy regimes rather than committing to new market opening measuresin a multilateral framework. In addition, as shown in Figures1 and 2, most of the larger and higher income countries in APEC that were expectedto be open and liberal in their commitments and actualpracticesin lending and depositswere confirmed by the indexes. These countries were Australia (depositsand lending), Canada (deposits and lending), Hong Kong (lending), and the United States (deposits and lending). On the other hand, most of the smaller economies of APEC have generally tended to be lessforthcoming in liberal commitments compared to the larger ones. However,Indonesia is a notable exception. Indonesia's computed indexes in its commitments and actual practices in lending and depositsare almost comparable to computed indexes in large and higher income countries in APEC. Compared to other developing economy membersof APEC,Indonesia had been quite aggressiveand liberal in their multilateral commitments aswell asin their actual practices in banking and securitiessub-sector.This maywell be attributed to the Pakto reforms of 1988that allowed not only domesticbut also foreign entry into Indonesia's financial markets.25Moreover,basedon Figures3 to 5, the earlier observation that the larger and higher income countries in APEC are liberal in commitmentsand actual practicesare alsoconfirmed in the insurance and securities sub-sector. Notice also in Figures1 to 5 for all sub-sectors of financial servicestrade, estimated indexes in actual practice for japan are quite low which pales in comparison to the very high indexes of its commitments. This obviouslysuggeststhatjapan had been very aggressivein the financial servicesnegotiations to a binding multilateral opening of the sector.A possibleexplanation for the liberal stanceof japan wasthe seriesof bilateral financial servicesagreement concluded with the United States between 1994 and 1996. With the multilateralization of the agreementsin 'WIO other countries asidefrom the

2SDobson

and

Jacquet

1998

364

FINANCIAL LIBERALIZATION,MANAGINGRISKS ANO OPPORTUNITIES

In addition to japan, some other APECcountries' actual practices substantially deviate from specific commitments. The countries whose existing regime is substantiallylessliberal than its binding commitments were: .Indonesia (insurance). The stipulation that foreign firms can own 100 percent of publicly listed firms will also apply to the insurance sector. Furthermore, although Indonesia continues to prohibit establishing insurance branches,insurancefirms will be allowed to operate 100 percent owned subsidiaries. .South Korea(insurance). SouthKoreaofIered to bind its current practice of allowing foreign insurance firms to establishsubsidiaries or branches. In addition, South Korea hascommitted to allow foreign insurance firms to hold 100percent ownership of domestic firms. .Singapore (insurance).Foreign entry into Singapore'sinsurance sector is difficult, howeverin Singapore'sGATS-FSAcommitment, foreigncompanies were allowed to have management control with 49 percent ownership of domestic insurance firms. .Malaysia (securities). Foreign fund managers in Malaysiaare not permitted to own more than 30 percent of a trust fund, and foreign assetmanagersare not permitted to hold more than 49 percent of a foreign joint venture assetmanagementcompany.Under its GATSFSA commitments, thesewere easedwherein foreign firms will be allowed to have majority ownership of asset Management companies,subjectto prior authorizationfrom the Malaysiangovernment 27 On the other hand, the countries whoseexisting regime is substantially more liberal than its binding commitmentswere. .Hong Kong(deposits). In the financial servicessectorin general, Hong Kong, has relatively fewlimitations on market accessor on national treatment, but Hong Kong's existing regime is more liberal than its binding GATS-FSAcommitments, suchasmaintaining the restriction that licensesfor deposit-takingcompaniesare extended only to locally incorporated subsidiaries. .South Korea(lending,securities). As part of an overall financial sector program agreed upon with the IMF, SouthKorea hasgone considerably beyond its GATS commitments in the banking sector.Restrictions on foreign bank subsidiarieswere removed. Foreign banksare now allowed to acquire SouthKorean banksand restrictions on land 27Dobson and Jacquet 1998

THE ROLEOF THE GATS-F$A 365

ownership have been removed Asin the banking sector,changes in the securities sectorgo beyond the commitments contained in South Korea's offer. limits on foreign portfolio investment have been liberalized and an OTC market is now allowed. Limits on foreign equity participa:tion in investment crustcompanies and investment advisory companies have been lifted. Foreign securities firms may now establish subsidiaries in South Korea and may purchase Korean securities firms.28 Singapore(lending, securities).Singapore's GATS commitments largely reflect the current liberal regulatory environment. The major exception occurs in cross-border trade, wherein the relatively few restrictions on Singapore residents buying financial services of all kinds abroad were not committed. Thailand (lending, securities).Thailand's current regime governing the participation of foreign securities companies goes beyond its commitment in the GATS-FSA.The Asian financial crisis has caused the Thai government to ease restrictions on foreign ownership of securities firms. Starting in 1997, the Thai government allowed foreign ownership in finance companies, finance-cum-securities companies to exceed the previous 25 percent ceiling and to exceed 50 percent for a maximum period of10 years. Mexico (securities).The implementation of the North American Free Trade Agreement (NAFTA) in 1994 permitted foreign securities companies, in particular, the United States and Canadian securities firms to enter the Mexican market through subsidiaries. Non-NAFTA country firms may enter the Mexican market under NAFTA's provisions via their United States or Canadian subsidiaries. This allowed them to circumvent the fact that Mexico's GATS-FSA offer is less liberal than treatment accorded under NAFTA.29

Someissuesin the liberalization of financial servicestrade Linkf

between trade and finance

Empirical evidencepoints to a strong positivecorrelation betweentrade opennessand financial sector development.50Trade can exert significanteffectB on the functioning and development of the financial system.Foreign traders, investors,and domestic producers can find their cost of doing businessre-

28US Treasury (1998) 29US Treasury (1998) 30See World Economic

Forum (1996\

366

FINANCIALLIBERALIZATION, MANAGING RISKSANO OPPORTUNITIES

duced significantly becauseof accessto technologies and innovation which help them to improve or raise efficiency. They therefore emphasizeto the government and the financial servicessector to improve their servicesand policies. Similarly,asfar astrade in financial services,the literature suggeststhat international opennessin financial servicestrade brings more thanjust traditional gains from trade. liberalization or internationalization of financial servicestrade also facilitates the transfer of knowledge or skills and technology, especiallythe liberalization of commercial presence,asfirms take advantage of economiesof scope.31Financial servicestrade alsoleadsto improved variety and quality of financial servicesand financial products available in the market. This is becausegrowing trade createsa demand for more sophisticated financial services,and ultimately leads to financial sectordevelopment.32Increasedopenness in financial servicestrade enhances competition and efficiency,which lowers prices, and averagecosts.A setof empirical studies has demonstrated that the liberalization of the financial servicessectorcan boost income and growth through improved quality of investment. Levine (1996, 1997)and King and Levine (1993)have shownthat countries with more open and liberalized financial sectorshave grown faster than countries with closed or inward looking financial sectors. The salient and important points raised abovefind their relevance in actual practice through the issueof whether to grant greater and enhanced foreign bank participation in domesticfinancial marketsof countries. Several arguments have been raised in favor of granting greater accessof foreign banks.These are the following: .First, foreign banksencourageadoption of bestpracticesand transfer of skills in the banking industry. By allowing foreign banks the immigration of their skilled banking personnel, and since these banks will also hire local bankers with a better knowledge of the local economy,over time, local bankerswill learn from the practices of international banksand acquire skills which they bring when they move back to domesticbanks.33 .Second, foreign banks enhance the capability of financial institutions to effectively measure and manage risk. Foreign banks can easilydemonstrate the latest in risk management techniques and 31Zutshi (1995); Agosin et al. (1995) 32World Bank (2000) 33Eichengreen (1999); World Bank (2000); IMF (2000)

THE ROLEOF THE GATS-F$A 367

thus lead to improved management of risk and better allocation of credit in the domestic banking system by spreading these practices to local or home country regulators.M Third, foreign banks are argued to improve the quality, pricing, and availability of financial services, either directly as providers of such services or indirectly by stimulating competition with domestic financial institutions. The crosscountry study by Claessenset al. (2001) showed that foreign bank participation was associated with lower overhead costs, however with lower profitability for domestic banks. 55 In addition, performance indicators for a sample of emerging markets for 1996 to 1998 seemed to confirm that foreign banks in these markets are relatively more efficient than domestic banks. In Latin America as in other countries that went through a relaxed foreign bank entry early in the sample period (for example, Argentina, Colombia, Peru, and Venezuela) have on average higher returns on average equity, and lower cost-ta-income and problem loan ratios, than domestic banks. 56Similar results were also observed with Hungary, Spain, Ireland, Portugal, and others.57 Fourth, foreign banks are generally regarded as well diversified in their portfolios than domestic banks and usually have access to sources of funds through their parent company located abroad. Because of diversification foreign banks are exposed to less risk and less.exposed to negative shocks that might hit the local economy. Having a large foreign component to the banking sector helps insulate the banking system. However, this is subject to the caveat that economic shocks are country-specific, region-specific, or industryspecific. In caseswhere the foreign bank comes from the same region the usefulness of diversification is diminished if region-specific shocks hit the local economy.58

However,argumentsin favor of local presenceof foreign banksare not without its critics. Costsor risks often mentioned as accompanying foreign bank participation in local financial marketswere the following:

34Mishkin (2003); Goldberg et al. (2001); IMF (2000) 35Yoshitomi and Shirai (2000) 38IMF (2000) 37Clarke et. al. (2003); Claessens and ~Iingebiel (2001) 38Mishkin (2000); World Bank (2000)

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FINANCIAL LIBERALIZATION: MANAGING RISKSAND OPPORTUNITIES

First, foreign financial institutions may "cherry pick" or target the most lucrative or profitable segmentof the domestic market or customerslike servicinglarge corporations or high-income households. The costsand risks are borne by domestic financial institutions, which are forced to serveother more riskycustomers. Second, the ability of domestic regulators in supervising and regulating a complex financial systemwith the added presence of foreign financial institutions maybe limited. Instead, this maylead to greater systemicrisksasforeign financial institutions cannot be supervised, monitored, and regulated.59 Third, the infant industry argument for protection depends upon the conventional wisdomof learning by doing. The industry should be given protection because local production would give rise to learning by doing that would eventuallylower local costsof production. In such circumstances,local production startsand revealsthe country's comparativeadvantage.Asarguedby Mattoo (2000),in the financial sector the rationalization for protection is the vulnerability of domestic financial firms that is related to a much bigger concern regarding the stability of the financial system.The inefficient domestic financial firms if exposedto competition may fail and setoff a systemicrisk. However,the perceivedfailure of the infant industry argument is that the protected firms are forever stuck in perpetual infancy, and this is due to the inability of the government to credibly commit to somefuture date to liberalize."째 Fourth, related to the infant-industry argument is the belief that the financial sector is a special or strategic sector of the economy that should bestbe controlled by domesticinterests.Moreover,although consumers ultimately stand to gain from any design of a liberalization strategy,there may be political backlashfrom those who lose from sectoralreforms. Ymancialservicestrade and capital accountliberalization A second major issueconcerns the relationship between capital account liberalization and market accesscommitments in the financial servicesagreement. It is now widely held and accepted that capital account liberalization in

39Claessens and Glaesnner (1998) 40It can be argued that the GAST -FSA offers countries the opportunity of credibly commiting to liberalization

at some future date.

THE ROLEOF THE GATS-f$I 369

the presenceof inadequate supervisorypolicies and prudential regulations, and inadequate macroeconomic policies can contribute to seriouseconomic and financial difficulties. The introduction and intensification of competition causesdomestic banks' profit margins to decreaseas confirmed by the Claessenset al. (2001) study.This will force banks to expand risky activities and' gamble for redemption' at levels that exceed their capacityto manage them. In addition, by exposing domestic banksto sophisticatedand complex financial service products makes regulation, monitoring and evaluation of bank balance sheetbecomesdifficult. The removalof restrictions on international capital movementsand d1e opening of d1edomesticfinancial servicesmarketsto foreign competition are two interrelated, yet distinct, componentsof d1einternationalization of financial services.i]A country may allow foreign firms into its market yet restrict capital inflows and outflows from abroad. Moreover,d1eextent to which trade in a financial serviceis linked to d1eunderlying capital.movementsgenerally depends on d1etype of d1efinancial serviceand d1eway it is supplied, d1atis, acrossborders or d1rough commercial presence.In od1erwords, d1e crucial issuehere is which type of financial servicestrade encouragesstable capital flows, at levels which canbe absorbedby d1eeconomyand would not undermine d1estability ofd1e financial system. It appears d1atd1erelationship betweentrade in financial servicesand capital flowsis particularly close under cross-bordersupply (or Mode 1). Take for example,lending. If governmentsallowforeign banksto provide loans to domestic residentsinvolving international capital, d1e movement of capital related to d1eunderlying transactionis analogousto liberalizing capitalmovements,wid1a strong bias to volatile short-term lending.i2 On d1eod1erhand, 4' Capital movements

includes

capital transfers,

acquisition

or disposal

of nonproduced,

nonfinancial assets; direct investment, portfolio investment, and other investment-arise from investment or loan operations or the transfer of personal assets (for example, by emigrants) and generate payments of interest, dividends, rent or profit. While, trade in financial services- insurance, banking, securities trading and portfolio management servicestakes place when services are provided in exchange for payment of fees, commissions and other charges. These include including intermediary service fees (such as those associated with letters of credit, bankers' acceptances, lines of credit, financial leasing, and foreign exchange transactions), commissions and fees related to transactions in securities (for example, brokerage, placement of issues, underwritings, redemptions, and arrangements of swaps, options and other hedging instruments), commissions of commodity futures traders, and fees related to such services such as asset management, financial market operational and regulatory services, security custody services). Free trade in financial services means that domestic consumers may use services of foreign financial institutions, and domestic financial institutions may provide services to foreigners (Tamirisa 1999) 42Cornelius (2000)

370

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

trade in servicesvia commercial presencerequires foreign direct investment to establish such presence. In this case,when foreign-owned affiliates (typically, subsidiaries)are incorporated in the host country, they are considered residentsof this country. In addition, financial servicesthat typically give rise to current transfers and paymentswithout necessarilyinvolving crossborder capital movement are servicessuch asinsurance intermediation, stock brokerage, provision and transfer of financial information, consulting, advisory servicesas well as non-life insurance services(for example, motor services) and manyother consumerfinancial services,whichinvolve few,if any,investible funds. They thus have fewer linkages with capital account liberalization, and intema~onalization of these servicesmight proceed more independently of other financial reform processes.13 In light of the severefinancial turmoil over the lastfewyears,one should appropriately ask on the form and the speed that countries liberalize their financial servicestrade. Rather than dismantling barriers to trade in financial servicesacrossthe board, it might be preferable for them to maintain restrictions under cross-bordersupply.This applies primarily to countries with weak and inadequate financial systems.Thus, countries are advisedto limit their commitments to the commercial presenceof foreign institutions, which require only a limited liberalization of capital flowsunder the financial services agreement.11As pointed out by Kono and Schuknecht (2000), the liberalization of commercial presence resultsin lessdistorted and lessvolatile capital flows and more stable financial sectorsthan cross-bordertrade. Commercial presence improves the institutional environment through better accessto information and transparency. Better information facilitates proper risk-assessment,which leads to the reduction of herding behavior and irrational responseofinvestors. Thus, this points to the important prerequisites for yielding the full benefits and minimizing or controlling the risks from liberalizing financial servicestrade. Financial servicestrade and financial sectorstabilityare complementary if they are accompanied by consistentmacroeconomic policies and an adequate prudential regulation and supervision, in particular, with respectto liberalizing commercial presence!5This is the preferred and dominant option of supplying financial servicesacrossmostAPEC economies,and it should be accompanied by the strengthening of prudential regulation and

43Claessens and Glaessner 44Cornelius (1998) 45World Bank (2000)

(1998)

THE ROLEOF THE GATS-FSA371

supervision. This is necessary to ensure that only 'sound' foreign service providers enter and operate in the domestic market. However, crosscountry experience and theory show that there is a tradeoff between enhancing competition through increased market-access measures and guaranteeing financial stability. Because services are often not tradable and intangible, market-access barriers are frequently enforced "behind the border" and are embodied in regulations such as control in entry and operations of firms, limitations on foreign equity holdings or nationality constraints, or requirements for professionals to re-certify as a condition for operating in the market. As financial services are regulated by many prudential rules, the distinction between protection and prudential is blurred.46 We could identify two possible waysto proceed which minimize tradeoffs between financial regulation and competition. First, market-based measures are currently be!ng considered through the development of international standards and codes of good practices in the areas of financial services and accounting of financial transactions and institutions. Such efforts are expected to reduce the possibility that domestic standards and codes are perceived by other countries as burdensome or effectively constitute barriers to trade!7 The efforts of the Basel Committee's Core Principles for developing effective banking supervision with minimum requirements in this regard are extensive and well-documented!B The International Organization of Securities Commissions IOSCO, and International Association of Insurance Supervisors IAIS conduct similar work in the areas of securities and insurance. Among numerous other codes and standards, IOSCO has produced the Statement of Objectivesand Principles ofSecuritiesRegulation and International DisclosureStandardsfor Cross-BorderOfferingsand Initial Listings byForeignIssuers.IAIS has produced the SuperoisoryStandard on Licensing,as well as other standards!9 In this regard, improvements in communications and dialogue between regulators across countries are necessary preconditions for achieving progress. Second, differences in prudential regulation between countries can be reduced, if not eliminated, if countries recognize the prudential measures of other countries with high standards of prudential regulation and supervision. Such rec-

46Sorsa (1997) 47WTO (1998) 46According to these principles, in particular, the licensing process should include an assessment of the banking organizationDs ownership structure, directors and senior management, its operating plan and internal controls, and its projected financial condition, including its capital base (Tamirisa et al. 2000). 49WTO (1998)

372

FINANCIAL LIBERALIZATION:MANAGINGRISKS AND OPPORTUNITIES

ognition may be based on an agreement or arrangement with the countries concerned, or maybe accordedunilaterally.50This hasthe implication that as Mattoo (2000) points out, there are limitations which canbe achieved at the multilateral level, and that the regulatory aspectscan be handled at the national or bilateral level. Related to the issueof capital account liberalization and financial servicestrade is the linkage betweenmonetarypolicy and financial servicestrade. The conduct of monetarypolicy maybe affectedby the degreeof opennessof the financial servicessector.This is becauseby allowing newforeign financial servicesproviders, they may introduce a new classof financial instruments, which mayaffect the behaviorof moneydemandand make monetarymanagement more difficult. This is definitely an empirical matter which goesbeyond the scopeof the paper. However,initial indications will reinforce similar arguments raised earlier in the paper that the link between financial services trade and monetary policy depend on the type of financial services.As long as few investible funds are involved (such as nonlife insurance servicesand many other consumerfinancial services),the link betweenhaving a prudent monetary managementof sophisticatedfinancial instruments and the decision to open up or to 'internationalize' the financial servicessector maybe a trivial issue. Treatment of foreign financial ~tutions financial servicessectorS)

in the Philippine

Banking

With the exception of four 'grandfathered' foreign banks, the entry and licensingof new, wholly foreign-owned bankswasprohibited under the 1948 General Banking Act. Foreign participation waslimited to a maximum of 30 percent of a bank's voting equity (with an increaseto 40 percent possiblewith specific presidential approval upon recommendation by the then Central Bank). However, with two recent amendmentsto the Act, the conditions of entry as well as the scope of operations of foreign bankshave been substantially improved. The first amendment wasRA 7721 (An Act Liberalizing the Entry and Scopeof Operations of Foreign Banks),which wassigned into law on 18May 1994,and mostrecently,Republic Act 8791 or the GeneralBanking Lawsigned and approved in May2000.These reform initiatives were carried

50Hoekman (1997) 51This section draws heavily on U.S. Treasury Sectoral

and Trade Barriers

Database (1999).

National Treatment

Study (1998) and EU

THE ROLEOF THE GATS-F$A 373

out in order to enhancethe efficiencyof the domesticfinancial systemthrough increased competition, and to make the Philippine banking systemmore globally competitive capable of facing the challengesof a changing and dynamic external environment. The 1994Act allowed three possiblemodesof entry, if authorized by the Monetary Board: (i) by acquiring, purchasing or owning up to 60 percent of the voting stock of existing banks; (ii) by investing in up to 60 percent of the voting stock of a new banking subsidiaryincorporated under the lawsof the Philippines; or (iii) by establishingbranches with full banking authority. In turn, RA 8791 or the GeneralBanking Lawof 2000expanded the coverageof RA 7721 by allowing a foreign bank to acquire up to 100percent of the voting stockof one bank, but only within sevenyearsfrom the effectivityof R A 8791. This provision also applied to foreign banksthat had acquired 60 percent of the voting stockof a bank under the 1994reform. The 1994Act also opened a five-yearwindow permitting up to 10 new foreign banks to enter the market as full service branches. All 10 foreign branch licenseshavealready been issued,therefore, additional foreign banks are, in effect, restricted from entering the Philippine banking industry in branch form. Subsequently,the GeneralBanking Law of 2000formalized the moratorium on new bank entry within three yearsfrom the effectivity of the GeneralBanking Law. A foreign bank cannot have both a subsidiarybank and a bank license. Criteria used for the granting of licenseswere: (i) a foreign bank seeking to enter the Philippine banking industry has to be widely owned and publicly listed unless more than 50 percent of its equity is held by its home government, (ii) the bank is considered widely owned if there are at least 50 shareholders, with no individual owning more than 15 percent of the bank's stock, and (iii) a bank had to be among the top 150 banksworldwide (by net worth) or among the top five banks in its home country. Foreign-<>wned banks and branchesare prohibited from collectivelycontrolling more than 30 percent of the banking system'stotal resourcesor assets. Each new foreign bank is permitted to open a total of six offices, but three are required to have Bangko Sentral ng Pilipinas Monetary Board approval with regard to location. The 1994 reform allowed the four existing foreign banks established prior to 1948,to add up to six new subbranches. Foreign branches must permanently assigna capital of not lessthan Php 210 million for the first three and for the next three will require Php 35 million. Foreign banks seeking the right to operate an expanded bank will need a total capital of at least Php 2.5 billion, the sameas domestic banks. Capital

374

FINANCIALLIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

adequacyratios and legal lending limits are basedon the locally incorporated capital of the branch instead of consolidated global capital, and net-due-tohead-()fficeborrowings need to be fully convertedto pesosto qualify as capital for certain regulatory requirements. These restrictions mitigate much of the benefit in establishing branches. Im-urance Since 1974, foreign shareholding in domestic insurance companies was limited to 40 percent and in spite of the approval of the Foreign Investment Act ofjune 1991, maintained the ownership limit at 40 percent. The 13 foreign companies established prior to 1974 had been grandfathered because of the passage of the Foreign Investment Act of 1991. However, with the enactment of RA No. 8179 in March 1996, foreign insurers are now deleted from the negative list in the Foreign Investment Act of 1991. Consequently, foreign insurance companies can take over 100 percent ownership of existing local companies and can establishwholly-<>wnedsubsidiaries and branches. However, only five licenses will be granted over the next two years for each of the latter categories, but may be increased to 10 each with the approval of the President of the Philippines upon recommendation of the Secretary of Finance. The criteria applied for entry are similar to those applied to bank licenses; (i) the companies had to belong to the top 200 foreign insurance or reinsurance in the world or (ii) among the top 10 in their country of origin, and (iii) had been in the industry for at least 10 years. To qualify as a branch or as a new company incorporated in the industry, a company also had to be widely owned and publicly listed in its country of origin, unless it was majority owned by the government. For a company to be considered as widely-owned, no single stockholder of the company must own more than 20 percen t of its voting stock. Foreign insurance companies established in the Philippines appear to be generally granted national treatment with certain exceptions. First, capital requirements are differentiated for foreign joint ventures or foreign companies, according to their share of foreign equity. For an insurance company, a minimum paid-up capital ofPhp 250 million and a contributed surplus fund of Php 50 million are required where foreign equity is 60 percent or more. Where foreign equity is less than 40 percent, capital requirements fall to Php 50 million and Php 25 million contribution to surplus fund. There exists an intermediary category for foreign equity ownership comprised between 40 percent and 60 percent. The same differentiated treatment for foreign reinsurance companies, though with much higher amounts of capital.

THE ROLEOF THE GATS-FSA 375

Secondly,special deposit requirements are imposed. For instance,foreign insurance companies are required to deposit with the Insurance Commission eligible form of securities that have an actual market value not less than the minimum paid-up capital required of domestic insurance companies. It is specifically required that at least50 percent of the securitiesshould representevidencesof governmentdebt and governmentowned or controlled corporations. In the caseof domestic companies,they had to deposit 25 percent of minimum paid-up capital with the Insurance Commission, with the samerequirement that it should be in the form of government securities. Securities

Philippine residentsnot sourcing foreign exchangefrom the banking system may freely investoffshore without government-imposedlimits or approval. If the foreign exchangefor investmentis obtained from the banking system,the limit is US$6 million per investor per year. Securities brokers/ dealersincorporated under foreign laws cannot set up asa branch in the Philippines. However,theyare free to establisheither a representative office or a wholly-ownedsubsidiary.In the caseof investment houses,foreign participation is limited to 60 percent ownership or less.Underwriting activitiescan be led through total or joint ownership of local investment houses or commercial banks. The foreign ownership limit on firms engaged in trust activities and mutual fund managementis 40 percent. Foreign companies establishedin the Philippines appear to be generally granted national treatment with certain exception, for instance,foreignowned companies are not allowed to trade in government securities for the account of their customers,but they are allowed to trade on their account. Foreign investorscan only own "B" sharesof local corporations. Possible negotiation strategies for the Philippines in the next round of servicesnegotiations No attempt is made to offer a comprehensive negotiation strategy for the Philippines in the next round of servicesnegotiations. This is beyond the scopeof the paper. However,an arrayof specificand broad negotiation strategiesand proposals in financial servicestrade are offered which can guide our negotiators in pushing for commitments that will contribute in the strengthening of the domestic financial system,while at the same time enjoying the benefits of greater competition due to a higher level of accessand participation of foreign financial servicesproviders in the Philippine financial services sector.These are the following:

376

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

The recent reform in allowing foreign equity participation of 100 percent in the banking sectorasprovided in the General Banking Law of 2000should be committed. This will improve on the 1997 commitment that allows foreign banks to acquire only up to 51 percent of an existing domestic bank or a newlyincorporated bank subsidiary, The actualpractice of allowing foreign insurancecompaniesto take over 100percent of existinglocal companiesand establishbranches in the Philippines should be committed, respectively.This will improve on the 1997 commitment that foreign insurance firms may hold only up to 51 percent of existing or newlyincorporated Philippine companies in life and nonlife insurance and the commitment of allowing foreign insurance companiesto establishonly assubsidiaries, respectively, The actual practice of allowing foreign investmenthousesand foreign financial leasingto a maximum of 60 percent equity should be bound. This will improve on the 51 percent allowed equity for investmenthousesand 40 percent allowed equity for financial leasing in the 1997agreement, The Philippines should consider binding actual practice in asset management which allows 40 percent foreign equity limit on mutual fund management, The Philippines should consider binding actual practice of allowing foreign securitiescompaniesto establisha representativeoffice and subsidiary,while at the sametime allow and commit the establishment of a branch, The Philippines should also gather support and consensuswithin APEC to address the issuesof: -Movement of natural personsthat will recognizethe greaterfreedom for transfer and employmentof foreign workers, and -Recognition of qualifications obtained overseas, In order to addressuncertainty asto the scheduling and interpretation of commitments, encouragemembers to use the classification list outlined in the Annex on Financial Serviceswhen scheduling commitments in financial services, The Philippines should gather support and consensuswithin APEC with regards to the improvement in regulatory oversightsystemsin two facets: (i) Establishinga program of technical assistanceamong

THE ROLEOFTHE GATS-F$A 377

developed countries to help enhancesystemsof prudential regulations and supervision in developing countries, including the Philippines, and (ii) Facilitating greater liberalization through an appropriate phase-inof liberalization overa certain transition period. During this transition period, while a program of technical assistance to upgrade supervisorycapabilities set in place, the Philippines may further consider some piecemeal market opening measures,some of which mayrequire prior legislativeaction: -The moratorium on granting of new licenses for establishing branches in banking and insurance, -The economicsneeds testin granting licensesfor foreign banks and foreign insurance companies, -The number of branchesa foreign bank is permitted to operate, and -The lending limit based on locally incorporated capital of the branch, asopposed to consolidatedglobal capital of the foreign bank. Identification of existing or potential achievements of comparative advantagein the Philippine {"mandalservicessectors: the impact of technology In a seminal paper by Arndt (1988), an important point wasraised that the standard neo-classicalexplanation of comparativeadvantage,the HeckscherOhlin explanation in tenns of different factor endowmentsamong countries and different factor proportions among products,haslittle relevanceto trade in financial services.Interestingly, then, that the reason why countries with abundant capitalhavea comparativeadvantagein trade in financial servicesis not that the financial servicesindustry in thesecountries is capital intensive. Instead,Arndt pointed out, that the sourceof comparativeadvantageis due to economies of scale and development of specializedskills that goes with a large domestic banking market. More importantly, the rapid change in technology, particularly in infonnation technology,has a crucial role to play in enhancing and developing comparative advantagein financial services,because of the ability of changesin technology in creating new skills requirementsand new marketswhich, consequently,createseconomies of scale. Likewise, technological changesare having a profound effect on the wayfinancial companies conduct their businessand on the wayfinancial servicesare provided to customers.New technologyhasmade it possibleto alter the manner in which financial servicesare carried out, and it has also facili-

378

FINANCIAL LIBERALIZATION,MANAGINGRISKS AND OPPORTUNITIES

tated a greater separation of production from delivery, both in terms of geographic relocation within the organization and acrossfirms (Lewis 1999). This whole revolution in 'integrative services' in financial servicesis made possible by developments in information technology. In this view, the rapid spread and the dynamic growth of information technology greatly contributed to the expansion of financial servicestrade on a global scale.This allowed developedcountries to 'transfer' or outsource their comparativeadvantage in financial servicestrade from high-cost locations in major financial centers to low-cost areas, primarily in developing countries. The so-called back-{)fficeactivities or operations ofintemational financial firms are shifted overseas,and are separatedfrom front office activities. For the Philippines, just like other developing countries, it does not have the capital and technical capability to establish on a substantial scale commercial presencein financial servicesin other APEC countries, however, there are significant opportunities in terms of the human resource aspectof liberalization in financial servicestrade. Aspointed out earlier,opportunities exist for the Philippines in highly skilled back-room office activities, which can be complemented by skills in electronic dataprocessingand entry, product design, and computer programming. 52These are activities which are increasinglyoutsourced and traded acrossborders. As pointed out by Lamberte, the pool of highly skilled informatics workforce in the Philippines, will be the country's key to sustainedcompetitive advantagein servicesin the future. This is basedon the evidence that the number of information technology graduateshad increased significantly in recent years.This is further reinforced by a recent finding by a local consulting company that the financial servicessectoris one of the more aggressive usersof information technology in the Philippines. And a growing number of banksand other financial institutions are seeinginformation technology asa critical component of their business.53 Conclusion

The analysisof the commitments made acrossa major sampleofAPECmember economies resulted in severalcrucial and important policy implications. First, few commitments were made in crossbordertrade asa relevantmode of supply in financial services.This stemsprobably from the close relation betweenliberalizing crossbordertrade in financial servicesand liberalizing the 52Avilan (undated) 53Hunter Consulting

(2001)

THE ROLEOF THE GATS-F$A 379

capital account. As it is now widely held that liberalization of the capital account in the presenceof inadequatesupeIVisorypolicies and prudential regulations, as well as inappropriate macroeconomic policies, can contribute to seriouseconomic and financial difficulties. In light of the financial turmoil in EastAsia and Southern Cone regions, this is a risky gamble that most APEC economies will not again dare to tread. Second,mostof the commitmentsmadewere on the dominant mode of supply in financial seIVices(commercial presence)though on a limited basis. Two possible explanations are given here. First, the so-calledhome-country bias will have a role to play sinceconsumersin the host-countrywill definitely prefer to purchase financial seIVicesfrom familiar local suppliers (including foreign-owned ones) rather than foreign suppliers located abroad. This is especiallytrue in the caseof insurance. Second,most of the limitations made on commercial presenceby mostAPECeconomieswere to restrict new entry and introduce new competition in the local market while allowing increased foreign equity participation in local financial institutions. This may well be attributed to the pressingneed of most developing countries within APEC to have well-capitalized and well-diversified foreign financial firms to help in the strengthening and recapitalization of troubled and weakdomestic financial institutions which were badlyburned by the recent financial contagion in EastAsia and in some parts of the Southern Cone. In addition, increasing foreign equity participation in the local financial market is the preferred option rather than having foreign financial institutions coming in as new competitive and efficient playersin the market, which will drive their domestic rivals out of the market.51 Third, as expected most of the larger and higher income countries within APECmade commitments that bind their alreadyliberal financial servicesmarkets. Meanwhile, mostof the smallercountries opted to bind current and existing policy regimes rather than commit to new market opening measuresin a multilateral framework. Likewise,the Philippines pursued negotiation strategies that mirrored observedpatterns for smaller countries within APEC,namely,bind current and existing policy regimes in place; more commitments on commercial presencethan on crossbordertrade, and emphasize increasedforeign participation againstallowing entry for newforeign financial servicesproviders. Nevertheless,recent reform initiatives in the Philippine financial sector since the conclusion of the financial servicessector ne-

54 Mattoo

11998)

380

FINANCIAL LIBERALIZATION, MANAGING RISKSAND OPPORTUNITIES

gotiations in GATSoffers newdirections for Philippine negotiatorsto elevate national financial refonns in a multilateral framework during the next round of negotiations. Multilateral agreementssuch as the GATS-FSArender refonns of the domestic financial sectorto becomecredible and sustainable.This is because commitments to refonn mustbe bound if they are to havecredibility. Binding refonn preventswhat is necessarilya gradual process,suchasa financial sector refonn from falling into reversal. On the other hand, the concern for Philippine negotiators is that as a trade agreement, the GATS exclusively focuseson market opening measures,and maynot giveappropriate consideration to the economics of financial refonns. This leavesthe responsibility to national authorities the appropriate sequencingof financial sectorrefonns.55 In view of these,three crucial questionsare put forward: First, do the other countries that were not forthcoming in liberal commitments, and fell short of their commitmentsto actualregime in place,have to commit to a progressiveliberalization in the future? And, will there be a further need for those countries that have committed to a standstill policy, particularly the Philippines, to open up? Finally, prior to pre committing to progressiveliberalization and a liberal stancein the future, do countries have to push other countries within the APECgrouping, and other member countries within GATS to liberalize aswell? On the first question,Article XIX of the GATSrequires that signatories enter into further rounds of negotiations for progressiveliberalization within five years of ratification of the agreement. In other words, under GATS-FSA rules, signatories are committed to provide a built-in mechanism for the incremental broadening of market-<>peningmeasures.Meanwhile, at the outset,standstill bindings havemerit. They provide the market participants with the assurancethat the conditions on which their decisionsare basedwill not be overturned by suddenpolicy changesor reversals.Nevertheless,for countries that were not forthcoming in their commitmentsand countries that have maintained the statusquo or have committed existing regimes in place, it should be borne in mind that opening and precommitting to future liberalization is in the self-interest of all countries not only large and developed countries, but alsoincluding the smalldevelopingcountries,particularly within APEC. As earlier emphasized,an efficient financial sector is one of the core "infrastructures" in the economy.This is becauseit provides financial inter55Dobson and Jacquet

(199B)

THE ROLEOF THE GATS-F$A 381

mediation, diversification and managementof risks,allocation of capital, and the presenceof a well-developedand competitivelypriced financial serviceis increasingly important to the ability of individual firms to export. These are benefits that are of crucial importance for small, developing countries, especially those with weakand undeveloped financial servicesmarkets. However, given the recent experience with the EastAsianfinancial turmoil and consequently, the need to enhance the soundnessof domestic financial markets through improved quality of prudential regulation and supervision,developing countries are not likely to be aggressivein the next round of financial servicesnegotiations. Therefore, it remains a matter of convincing developing countries on how the GATS-FSAwill lead to maximizing the gains from financial servicesliberalization through sustained improvements in growth and development prospectswhile the risksand costsinvolved in liberalization are reduced or eliminated. This can be done through a higher level of recognition of the special needs and interests of developing member countries. In fact, in the FSA, developing countries felt that they made most of the market opening and other concessions.56 In this regard, there is a need for developedcountries to showpatience and sincerity in the next round of negotiations. As such,facilitating greater liberalization among developing countries should allow them to phase in commitments over a specified period. Although a method for phasing in commitments will have to be agreed upon, a favorable development on this matter for developing countries will be of crucial importance to the successof the next round of negotiations. Moreover, alleviating and mitigating fears of developing countries with potentially adverse effects arising from liberalization, for instance, through specific safeguardmeasuresprobably patterned after the safeguards-based opening of the Mexican financial market with respectto NAFTA, can be usedasa model.57 In this view, the United States,Canadaand Mexico which form the triumvirate of the NAFTA grouping, can strongly push and support the abovementioned proposals,and, at the sametime, can provide the stimulus and motivation for other APEC membersto undertake liberal commitments in the next round. Moreover,there are clear signsin APECmember countries that advancesin market opening will come from a combination Of different factors. First, member countries of APEC that are in an IMF program due to the Asian crisis have included relaxation in foreign entry asone facet of do56Dobson (2000) 57Sauve and Gillespie

(2000)

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mestic reforms in the said program. This is considered extensiveand faster than what were negotiated earlier in FSA.58 Second,the overarching goal of advancing a senseof community akin to APEC,while promoting the goal of multilateral liberalization inherent to GATS through creating a kind of an international constitution for free trade and market access,should spur liberal commitments in APEC. Third, the growing interest of APEC economies in financial servicesreform as a means of achieving the shared objective of financing the huge long-term infrastructure projects as well as the needs of ageing populations in some of the wealthyAPEC member countries, makes the GATS-FSAa strong complementary mechanism to bound existing and ongoing unilateral opening of financial marketsin APECcountries.59Finally, mostinternational financial centersare located in member countries of APEC (Japan,Singapore,Hong Kong), and have unilaterally proceeded with allowing further foreign entry for fear of being left behind by other financial centers.ooThus, progressin shapingfuture financial liberalization efforts of APEC economieswill come from a combination of severalprocesses,with GATS-FSA being one of these processes,while the others coming primarily from outside of the wrO. The combination of unilateral, regional and market forces also become the mechanisms for APEC countries to engageand lock-in market opening measuresin the wro.

58Dobson (2000).

s9Dobson and Jacquet (1998) 60Dobson and Jacquet (1998)

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ABOUT THE PUBLISHERS

The Philippine APEC Study Center Network (PASCAN)wasestablishedon November 23, 1996by virtue of Administrative Order No. 303, asthe Philippines' responseto the APECLeaders' Education Initiative. Among the goals of PASCANare to promote collaborative research on APEC-relatedissues; facilitate the exchange of information among government and nongovernment organizations,academicor researchinstitutes, businesssector,and the public in general; encourage faculty and students of higher education to undertake studies,thesesand dissertation on APEC issues;undertake capacity-building programs for government agencieson matters related to APEC; and provide technical assistanceto government agenciesand private organizations on APEC-relatedinitiatives. The Network is composed of the Asian Institute Management,Ateneo de Manila University,Central Luzon StateUniversity,De La Salle University Foreign ServiceInstitute, Mindanao StateUniversity,Sillman University. University of Asia and the Pacific,Universityof the Philippines, University of San Carlos, Xavier University,and the Philippines Institute for Development StudiesasLead Agencyand Secretariat. The Philippine Institute for Development Studies (PillS) is a nonstock,nonprofit government researchinstitute engaged in long-term, policy-oriented research. It wasestablished on September 26, 1977by virtue of presidential Decree No. 1201.PillS is envisioned to be a development policy "think tank" for planners, policy and decision makers in government. Its activities are aimed at expanding researchon social and economic development in order to assistpolicy makersand leaders in planning and policy making. The Institute has three programs,namely, research,outreach, and disseminationand researchutilization.

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About the Authors Rene B. Hapitan is an assistantprofessor and vice dean of the College of Businessand Economicsat the De La SalleUniversity.He finished his Masters in BusinessManagementfrom the AsianInstitute of Management. Ponciano S. IntalJr. is the Executive Director of the Angelo King Institute of Businessand Economics. He wasformerly president of the Philippine Institute for Development Studies and former Deputy Director-General of the National Economic and Development Authority (NEDA). Dr. Intal received his PhD in economics from Yale University (New Haven, USA) in 1983. His areasof expertise include international trade, developmentpolicy, and macroeconomic management. GeorgeN. Manzanoholds a doctorate degree in Economicsfrom the Universityof New South Wales.He is presently the commissionerof the Philippine Tariff Commissionand a professor at the School of Economics,and the Universityof Asia and the Pacific. He servedas consultant to the United Nations Economic and Social Commissionfor the Asia Pacific (ESCAP)and asa program adviserfor the Asian Development BankInstitute (ADBI). Dr. Manzano has written papersin areassuchastrade and international economics,APEC, the Asian crisis issuesand regional surveillanceand monitoring. Tereso S. Tullao Jr. is a prof~sor and former dean of the College of Business and Economics at the De La SalleUniversity.He obtained his Ph.D. from the Fletcher School of Lawand Diplomacy,Tufts University,Massachusetts, USA. He servedasvisiting professorat theWasedaUniversityin Tokyojapan; Shanghai University of Finance and Economics in China; Ohio University in Ohio USA; and the Institute for International Studiesand Training in Fujinomiya,

japan. Victor C. Pontines is an assistantprofessor of the College of Businessand Economics at the De La Salle University. He obtained his Mastersdegree in Economics from the Universityof Exeter,United Kingdom. Angelo A. Unite holds a doctorate in Finance from the University of Alberta in Canada. He is presently an associate professor at the College of Business and Economics, De La Salle University.