International Trade as an Engine for Development Financial Services Liberalization, Foreign Bank Presence and Growth Hamid Rashid, PhD Director General (Multilateral Economic Affairs) Ministry of Foreign Affairs, Government of Bangladesh Outline Trade-Growth linkages Gains of trade Trade liberalization and its effects on consumption Trade liberalization: Effects on employment, wages and investment Industrial policy and dynamic comparative advantage Effects on fiscal policy and public sector spending Effects on financial sector Financial services liberalization, foreign bank entry and its impact on growth Trade-Growth linkages Trade cause growth or growth causes trade? Economists are yet to solve the simultaneity problem in standard trade models Trade is endogenous in most growth models Trade volume (export plus import) is an incorrect measure of trade openness – it is an outcome variable not a policy variable Weighted average tariff is a more appropriate measure – no causality between trade openness and growth (Rodrik), let alone between trade and development Trade is, at best, a necessary condition but not a sufficient condition for growth For trade to be an engine for growth and development, governments must play an active and positive role not only in areas of trade policy, but also in fiscal policy, monetary policy, industrial policy and human resource development Trade-Growth Linkages Source: Rodrik, Dani: “Global Governance of Trade as if Development Mattered”, UNDP, July 2001 Gains of Trade Trade liberalization can lead to growth and higher income, exploiting comparative advantage and economies of scale Trade liberalization improves incentives and increases competition – another source of gain Gains of trade is there, but surely exaggerated There are clear winners and losers after liberalization – but winners seldom want to compensate the losers (re-distribution of gains is almost impossible to implement) But more importantly, conditions under which trade liberalization can increase national welfare is highly restrictive and these conditions – such as, no unemployment, no externalities or other form of market imperfections, no increasing return to scale, no adverse effect on fiscal balance, no large trade deficit etc. - are typically not satisfied in most developing countries Trade Liberalization and Its Effects on Consumption Trade liberalization expands the opportunity set for consumption Consumption growth can be instantaneous, whereas production often exhibits a lag Excess demands are met through imports, often with consumer loans, adversely impacting savings and crowding out private investment Liberalization can lead to the rise in ‘conspicuous’, ‘competitive’ or ‘invidious’ consumption in developing countries 34.4 million mobile phone users in Bangladesh at the end of 2007, up from 21.8 million in 2006 and 9.5 million in 2005 Negative impact on domestic savings and investment and also on balance of payment Strong import demand (for goods and services) encourages central banks to maintain a strong exchange rate, often at the expense of export competitiveness – it negatively impacts growth Trade Liberalization: Effects on Employment, Wages and Investment With trade liberalization, labor often moves from low productivity import-competing sectors into unemployment, not to high productivity export sectors - result is that there is often increased unemployment – adjustment is costly and takes time In Heckscher-Ohlin framework of trade: given the technology, trade liberalization increases demand of the relatively abundant factor and hence increases the price of that abundant factor and lowers price of relatively scarce factor In developing countries, this should lead to reduced wage inequality, but in fact, inequality increases because of labor market imperfections and also because of the preferential treatment of capital (capital is mobile, but labor is not) As liberalization is often associated with greater volatility in income and exchange rates, “risk premium” for the country that liberalizes can increase, which can discourage investment Industrial Policy and Dynamic Comparative Advantage Liberalization argument is often based on a static model of comparative advantage and offers a one-time efficiency gain But it largely ignores dynamic comparative advantage Static models can trap a country in a low-skill, low-value added equilibrium – if a country is excessively dependent on low-skill exports, then demand for skills may go down, which may, in turn, dampen demand for education – the country will continue to produce and export low-skill intensive goods (Rodrik and Rodriguez 2001) For a country to exploit its dynamic comparative advantage, it must have an industrial policy to ensure transitions from low to medium to high skill intensive production Industrial policies can include long-term skill development, policies of financial restraint, targeted lending and other institutional support for specific sectors at specific stage of development But free market proponents scorn industrial policy as central planning Effects on Fiscal Policy There is general consensus that increasing human capital through education is critical for economic growth, poverty reduction and income distribution – even Milton Friedman supported public sector spending for education (“Neighborhood effect”) Dabla-Norris and Matovou (2002) find that reducing private costs for primary education has the largest impact on growth and poverty reduction It is also shown that public spending on tertiary education can have the largest impact on growth once universal primary schooling has been achieved Public sector spending on education positively affects growth, but government must have a predictable revenue source Trade liberalization can deprive government of a predictable revenue source – losses in tariff revenues is not readily compensated by other forms of tax revenue Countries like Korea and Ireland had significant public sector outlays for education, which was largely financed by predictable tariff revenues In 1970, over 20% of government revenue in Ireland came from import duty – the highest for any country in that income group (per capita income of $5000-$8000) and the share did not drop until 1986 Public Sector Spending on Education Matters – Evidence from Few Countries 1970 Argentina Greece Ireland Korea Ghana 1975 1980 1985 1990 1995 2000 Spending Per Child[1] 121 161 237 100 246 327 459 GDP Per Capita 6,823 7,310 7,785 6,347 6,422 7,422 8,174 Spending Per Child 194 236 324 404 482 670 1,119 GDP Per Capita 7,487 9,299 10,442 10,459 10,875 11,242 13,175 Spending Per Child 415 586 729 769 926 1,350 1,938 GDP Per Capita 7,908 9,334 10,895 11,871 15,084 18,453 27,796 Spending Per Child 70 103 153 281 387 585 846 GDP Per Capita 2,381 3,153 4,078 5,551 8,310 11,493 13,628 Spending Per Child 15 18 9 6 9 14 13 GDP Per Capita 474 407 383 313 343 369 400 Education Spending Per Child and GDP Per Capita Source: World Development Indicators, the World Bank Tariff Revenue is Often Least Volatile Tariff or import duty has been, more often than not, the least volatile source of revenue for many developing country governments Tariff revenue is less volatile than total tax revenue (including income tax and other forms of taxes) and ODA Average Volatility (Coefficient of Variation) during 1991-2001 in Low Income Countries GDP Per Capita (constant 1995 dollars) 0.052 Per Capita Education Expenditure (constant 1995 dollars) 0.164 Per Capita Health Expenditure (constant 1995 dollars) 0.155 Per Capita Import (constant 1995 dollars) 0.133 Per Capita ODA (constant 1995 dollars) 0.268 Per Capita Tax Revenue (constant 1995 dollars) 0.199 Per Capita Tariff Revenue (constant 1995 dollars) 0.106 0 Effects on Financial Sector Trade liberalization is often associated with tight monetary policy, which may inhibit job creation – effects of high interest rates and strong exchange rates: Lower level of borrowing and investment Reduced export competitiveness This is because most central banks are mandated to focus on inflation and balance of payment considerations than on job creation Banks move away from long-term lending to short-term consumer loans and trade credits for imports Liberalization in goods is often accompanied by liberalization of financial services (capital market liberalization), leading to larger presence of foreign banks Foreign banks tend to lend less to the real sector Lending to SMEs go down More trade finance Impact of Foreign Bank Entry: Before and After Before: Domestic banks enjoy monopoly rent High profitability leads to higher equity value Higher equity provides higher lending base More lending not only to large corporations, but also to SME After: In a Bertrand Competition, domestic banks are forced to raise deposit rates to retain customer base Even if domestic banks do it optimally, it loses a significant amount of deposits to foreign banks Lower lending base of domestic leads to less lending overall Impact of Foreign Bank Entry In a partial equilibrium analysis, higher foreign bank presence makes the multinationals (MNC) in the host country better off but makes the small and medium enterprises worse off (lower overall lending base) In general equilibrium analysis, even the multinationals are worse off – as SMEs face limited growth, the demand for the output of multinational companies go down Overall, negative impact on growth rates Higher profitability of foreign banks do not impact foreign banks’ equity base in the host country – foreign banks repatriate their profit Larger the foreign bank presence, higher the demand for foreign currency to repatriate their profits Holding everything else constant, higher and more volatile demand for foreign currency make the host country currency more volatile Financial Liberalization: Bank Credit in Low Income Countries BANKCREDIT_GDP .318476 .180995 1990 2003 year Bank Credit in Other Country Groups BANKCREDIT_GDP 1.91239 BANKCREDIT_GDP .991827 .493286 1.11508 1990 2003 year Asian Miracle Countries 1983 2003 year France, Germany, Japan, United Kingdom and the United States 0 .5 1 1.5 Foreign Bank Share in Low Income Countries and Availability of Total Credit 0 .5 1 FOREIGNBANK TOTALCREDIT 1.5 Fitted values 2 Foreign Banks Lend Less! 0 domestic banks 1 foreign banks LOAN_TOTALASSET .47618 .343765 1996 Year 2003 Foreign banks allocate a smaller share of its total assets for loans in the low income countries – this is, in fact, true for all income groups Foreign Bank Presence and Availability of Credit We find strong negative correlation between foreign banks’ share in the banking sector (as a percentage of the total banking sector assets) and the loans to private sector in the low income countries – holding everything else constant, a 1% increase in foreign banks’ share leads to a .14% decline in domestic banks’ loans to the private sector We find that for the full sample, and also for both low and upper middle income groups, foreign banks’ holding of other earning assets (securities etc) is positively and significantly correlated with domestic banks’ holding of other earning assets Foreign bank presence lowers the availability of credit to the domestic private sector – this is true even when we control for capital market development (possible alternative source of finance) The results are based on cross-country regressions on 36 Low Income Countries whose GNI per capita was $765 or less and 54 Middle Income Countries whose GNI per capita was higher than $765 and less than $9,385 0 .5 1 1.5 2 2.5 Foreign Bank Presence and the Terms of Credit 0 .5 1 AV_FBCLAIM AV_SPREAD 1.5 2 Fitted values Both Interest Rate Spread and Real Lending Rate are positively correlated to the share of foreign bank claims 0 .05 .1 .15 Foreign Bank Presence and Volatility of Exchange Rates 0 .2 .4 .6 AV_FBCLAIM1 AV_VOLATILITY .8 1 Fitted values Foreign bank share is strongly and positively correlated with exchange rate volatility both in low income countries as well in our full sample .02 .04 .06 .08 .1 .12 Foreign Banks and Growth 0 .5 1 AVFOREIGN AVGROWTH 1.5 2 Fitted values We find that foreign bank presence is negatively correlated to growth in low income countries – the effect is less pronounced for upper middle income countries (GNI per capita between $3,036 and $9,385) Concluding Remarks Trade liberalization can be a positive factor for growth But much will depend on the pace and sequence of liberalization Liberalization must take into account the dynamic comparative advantage, not just the static gains – industrial policies can help optimize the gains of trade over time Developing countries should first welcome liberalization in sectors where it has comparative advantage (labor intensive goods and services) and not in sectors such as financial services Financial services liberalization and large presence of foreign banks can negatively impact lending to the real sector, interest rate spreads, exchange rate volatility and growth in the developing countries Foreign bank entry can have positive impact on growth only if they can be duly regulated against pro-cyclical behaviors Negative impacts of foreign bank presence can be minimized with policies such as Community Reinvestment Act in the US, branching requirements and sound monetary policies with focus on job creation