Discuss how the entry of foreign banks may prove growth-enhancing in a developing country - Essay Example

? Discuss how the entry of foreign banks may prove growth-enhancing in a  developing country Introduction The concept of globalization gained increasing acceptance among countries across the world. It encourages nations and their authorities to consider themselves as a part of the international community. It urges countries to increase their contacts with the outside world and engage in various economic exchanges in the global market. Accordingly, nations have undertaken various measures to accomplish this goal. The concept of globalization has also pervaded the international financial sector. An increasing number of international banks have expressed the desire of expanding their business activities across the globe. Their preferred target of location has been the economies of the developing countries. Most of the developing nations used to operate as closed economies and were served only by the domestic indigenous banks. The operations of these domestic banks were restrictive in their scale and could cater to the financial requirements of a limited section of the population. Thus, the international banks found these economies as ideal locations for establishing their business activities. This research has tried to evaluate the effects of the operations of the foreign banks on the economies of the developing countries. Foreign Bank Entry in Developing Countries Foreign bank entry in a specific country is defined as the procedure by which international banks establish their operations in an economy. This is primarily accomplished by introducing a new branch or by setting up a subsidiary bank in the host nation. Tschoegi (1985) has observed that the current trend of globalization has also been observed in the international banking sector. Countries have undertaken efforts to integrate their respective banking and financial sectors under a single universal system under the international economy. Such a trend was once discerned in the global financial markets during 1913-1914, just before the advent of the First World War. In recent times, the international community has witnessed an increase in the entry of foreign banks in developing countries. This has been especially true in the case of ‘Argentina, Chile, the Czech Republic, Hungary, Polland and so on. According to the World Bank Report (200), over 50 per cent of the banking sector assets of these nations are owned by international banks. The foreign banking institutions have also expanded their business activities in the developing countries of Asia, Africa, the Middle East region and the Soviet Union. However, the rate of expansion of the banks’ operations has been comparatively slower in the second group of nations. Economists have been tempted to question why the foreign banks have found the developing economies to be suitable locations for expanding their business. Analysts have also evaluated the effects of the foreign bank entries on the developing nations. This paper has attempted to examine the microeconomic impact of the entry of international banks as reflected upon the developing nations. (Clarke, 2001, p.1-5) The Transition Efforts of Developing Countries Ever since the industrial revolution in Europe in the 1780s, countries across the world have experienced different degrees of industrialization and hence economic development. The rate of economic development of a nation depended on how effectively it adapted its existing economy to the new machine methods of industrial production. Countries which rapidly integrated these new technologies into their prevailing production processes witnessed a high rate of economic growth. Contrarily, nations which were slow to adapt to the innovative production technology experienced a much lower rate of economic progress. In this way, the rate of economic development has varied between the different countries of the world. Economists have classified the countries into three main categories based on their present level of economic development: the developed countries (DCs), the developing countries and the less developed countries (LDCs). DCs like USA, UK, Germany, France etc. have a high rate of industrialization in their economies while the LDCs are still fraught with a low level of industrial activities and hence economic development. The countries which are in the process of industrialization in their efforts to transform themselves from a less developed nation into an industrialized economy are known as developing countries. They are also sometimes referred to as the “middle-income countries”. There have also been political factors which have influenced the economic development of countries. The national policies in the different spheres are usually determined by the political authorities of the different nations. During the advent of the industrial revolution in Europe in the late 18th century, most of the countries in the world used to function as closed economies. They concentrated on various economic activities within their own geographical boundaries and paid little heed to the developments in the outside world. These countries usually prohibited foreign enterprises from entering their economies and engaged in minimum or no trade practices in the global economy. These closed economies might have been late to adapt themselves to the changing industrial technology which the world witnessed after the industrial revolution. Since they interacted less with the international community, they were probably late to realize the benefits of the new production techniques. Thus, they were late in adopting these techniques to their own production methods. This was an important reason behind the slow rate of industrialization of certain economies. However, the concept of globalization has gained acceptance among a wide spectrum of countries. Nations have realized that if the international economy is considered as a single integrated economy this would help the economic progress of most of the countries. Nations which might have followed the policy of a closed economy in the initial days have realized the importance of opening up their economic sector to international forces. In this way, developing nations are presently in the process of undertaking economic reforms which would help them to attain a high degree of industrialization. Apart from opening up their economic regime, they have also implemented several measures within their countries to speed up the process of industrialization. All these measures have generated favorable effects within the international community. The Primary Effect of Foreign Bank Operations on the Developing Economies With the liberalization of these economies, international financial institutions have gained access to the markets of these developing countries. These include the foreign banks which have which have displayed a marked eagerness in expanding their operations in the developing economies. This has proved to be mutually beneficial for the financial institutions as well the middle-income nations. The banks have gained access to unexplored markets and a new spectrum of population in order to generate increased revenues and profits with respect to their business activities. On the other hand, the developing economies have been benefitted by the services of these lending institutions. An increased number of banks in the countries signalled the provision of extra financial resources for the economy. In the absence of the foreign banks, the countries would have to depend on their indigenous national and private sector banks for financing the various development projects. If the resources of these institutions proved to be inadequate then the developing nations had to request for external financial assistance from foreign countries. The entry of the international lending banks into their economies solved a lot of these problems. Organizations in these countries could now borrow corporate loans, construction loans, real-estate loans from these financial institutions. These funds could then be utilized effectively to finance projects promoting economic development in these nations. This has been the foremost impact of the operations of the foreign banks in the developing economies. However, all developing countries have not been equally receptive to the idea of opening their respective economies to the entry of the international banks. The developing nations belonging Latin America and Central Europe have been fast in granting permission to the foreign banks to operate in their respective economies. This includes countries like Argentina, Chile, the Czechoslovakian Republic, Hungary, Polland, etc. In comparison the developing nations in Asia, Africa, the Middle East region and the former Soviet Union have taken some time in allowing the entry of the international ending banks. (Clarke, 2008, p5-12)s Economic analysts have been skeptical regarding the impact of these foreign bank operations in the economies of the developing countries. Apart from the immediate positive effect of gaining access to an increased pool of financial resources, the analysts have certain adverse effects for the nations. They have feared that the entry of the international banks would weaken the operations of the domestic banks and eat into their market share of business. These foreign banks will be governed partly by the financial regulatory authorities of the developing economies and partly by the monitoring authorities in their native countries. Since the regulatory bodies of the developing countries would not have complete control over the operations of the international banks, this would not prove to b a healthy sign for the overall economy. This might have an adverse impact on the indigenous banks and even lead to the overall decrease in power of the national regulatory authorities to monitor the operations of all financial institutions. The international banks would always be affected the economic conditions of its native country of origin. Therefore, the developing economies would be affected by the existing economic cycles in the banks’ native countries. Most of the international banks had their headquarters in the Western countries like USA, UK etc. The developing economies would now be linked to the western economies through the operations of the foreign banks. This linkage would prove to be beneficial in the case of an economic boom in the western countries. The developing nations would be able to witness some effects of this economic upsurge through the activities of the banks. Alternatively, the linkage might prove to be detrimental in the case an economic recession prevailing in the developed economies. In such a case, the adverse effects of the economic downturn would also intrude into the developing economies. Though the developing nations themselves might be in a state o0f sound economic condition they would not be able to prevent the adverse effects of the Western economic recession from trickling into their country. Economists are also concerned about the policies of the international banks towards the small and medium scale enterprises (SMEs) of the developing countries. The economies of these countries are characterized by the presence of a large number of SMEs which contribute a significant portion of the nation’s GDPs. Majority of the economic activities of these countries are carried out by these firms. Therefore, it is important to provide the SMEs with a steady source of financial resources for their various projects. Often these are important projects from the point of view of the economic development of the developing countries. In such cases, it becomes vital for the SMEs to gain access to the adequate resources for this purpose. However, the large foreign banks are used to lending their finances to large corporations operating in the developed economies. Thus, economists remain skeptical about the whether the foreign banks would provide their resources to finance the projects of the SMEs implemented in the developing economies. (OECD, 2006, p.2-12) Microeconomic Impact of Foreign Bank Entry into the Developing Countries: Structure, Conduct and Performance Studies Some of the concerns voiced by the economists regarding the entry of the foreign banks in the developing economies have turned out to be true in real life. In 2007, Cull had conducted a research on the impact of the foreign entrant banks on the banking sector of the developing countries. For this, he had studied the trend in the financial assets owned by the international banks which were operating in more than 100 developing nations during 1995-2002. The findings revealed that foreign bank participation tended to increase the risk of a banking sector crisis in the developing economy. The results also indicated that the entry of international banks tended to increase after the nation had witnessed such a crisis. In these situations, the foreign banks usually came forward and acquired the distressed banks of the domestic country. Their motive was not to expand their business activities in the developing economy. The research showed that the foreign bank entry in a situation post-financial crisis did not result in an increased credit supply to the private sector of the economy. In such cases, the international banks were engaged in bailing the domestic financial sector out of the crisis, rather than expanding their own business prospects. This case study has thrown up interesting facts regarding the foreign banks’ entry in the developing countries. On the negative side, foreign bank participation in a developing economy exposes it to trends in the international financial market, which may not always be good for the economy. If the domestic nation is not strong enough to withstand these movements, its economy may get affected by the shocks emanating from the international market. In this situation, an economic and financial sector crisis becomes inevitable for the domestic nation. Thus, the activity of the foreign banks actually establishes a link between the developing economy and the international financial market. In times of crisis, this proves to be detrimental for the domestic country and may even result in a banking sector recession. However, not all is negative in this situation. When a developing economy is plagued by a financial crisis, the international banks have found to extend their support to the domestic sector banks. Some developing nations have even witnessed an increased participation from foreign banks in such a situation. The international banks have come forward to help the distressed financial institutions of the domestic economy and have even acquired them in extreme cases. The foreign banks have not been guided by profit motives in these cases. Instead they have genuinely attempted to be a source of financial support for the domestic country in the time of crisis. Therefore, the operation of foreign banks in developing economies has its share of benefits as well as disadvantages. (Cull, 2007, p.2) Effect on the Domestic Banks of Developing Nations There has also been a considerable body of research that has examined the impact of the entry of foreign banks on the domestic banks of a developing country. Analysts like Micco, Panizza and Yanez (2004) and Milan (2003) had undertaken respective studies to determine the effects of international bank entry on the domestic banking sector of both the developed countries as well as the developing nations. The results revealed that foreign bank participation usually generated favorable impacts on the growth and operational efficiency of the domestic banks. These effects further spread across the entire banking system of the host countries. However, economists have argued that the international bank entry tends to decrease the profitability of the domestic financial institutions. While this argument has been found to be true, the participation of the foreign banks have also increased the efficiency of the domestic banking sector. In 1998, Claessens and other conducted a research to verify these claims. They considered a sample of 80 developed and developing countries and evaluated the impact of foreign banks’ participation on their respective banking sectors. The findings exhibited two kinds of effects. On one hand, the international banks did have an adverse effect on the profitability of the indigenous banks. However, on the other hand, the domestic banks also witnessed a decrease in their non-interest income and overall expenditure as a result of the entry of the foreign banks. This second effect concerning the increase in the domestic banks’ efficient post the foreign banks participation also throws up an interesting point. Majority of the indigenous banks of developing countries are used to operating in a closed economy and do not face any competition from the international financial institutions. In addition, they have to encounter very limited competition from their other domestic counterparts. These factors result in increased profits for the domestic banks aided by the restrictions of the developing economies. However, this situation changes with the entry of the foreign banks into the economy. With the increase in competition, the indigenous banks experience a decline in their profitability. But, one has to keep in mind the earlier operating environment of the domestic banks. Functioning in a protected economy for a long is not the ideal of situations for a financial institution. Though it results in increased profits, the banks never learn to deal with serious financial challenges, as present in the international market. After the developing nation liberalizes its economy, foreign banks are allowed to establish their operations in the domestic sector. With this sudden entry of competition, the domestic banks witness a decline in their profits. However, one must also consider the effect on the efficiency of the indigenous banks. A decline in important variables like non-interest income, the overall expenses etc. results in a higher level of operational efficiency for the domestic banking sector (World Bank, n.d, p.87) Impact on the Financial Sector of the Developing Economies Traditional economists and policy makers of developing nations were averse to the entry of international banks in their domestic economies. However, recently developing countries have deviated from the mindset and have encouraged the participation of international banks in their domestic sector. They have adopted such a strategy with a specific objective in view. The developing nations hope to strengthen their indigenous financial sector implementing liberalization efforts in their economies. Subsequently, financial analysts have tried to ascertain the effect of the entry of foreign banks on the domestic financial sector of developing nations. Studies were undertaken by Focarelli and Pozzolo in 2005 and by Goldberg in 2007 with this aim in view. The findings of the researches have revealed that the operations of the international banks have generated beneficial results for the developing economies. Further, Claessens et al (2000, 2001), Claessens and Lee (2002) and Byraktar and Wang (2005) conducted cross-sections analyses of different developing countries to determine the impact of foreign banks entry on the indigenous financial sector of these nations. The researchers found that foreign bank participation resulted in a decrease in the interest margins and overhead expenses of the indigenous banking sector. Though this generated a decline in the profitability of the domestic financial institutions, it increased the overall efficiency of the indigenous financial sector. An efficient financial market is supposed to encourage economic development in a country. Thus, the developing countries were expected to witness a higher rate of economic growth owing to the improvements in their respective financial sectors. In 2006, Byraktar and Wang conducted another study pertaining to this domain. The findings showed that the entry of international banks also tended to generate a higher rate of growth in per capita GDP in some developing countries. Though, there was limited evidence to support this claim, this was indeed a remarkable result. It revealed that foreign bank participation did have a positive effect on the economic development of the developing nations (Alessandrini et al, 2009, p.177-178). Effect on the Operations of Indigenous Firms in the Domestic Economy Policy makers of the developing nations have also expressed their concern over the lending policy of the large international banks. They have argued that the foreign banks only cater to the financial requirements of large corporations. This decreases the supply of credit to the small and medium scale enterprise (SMEs) of the developing economies. This was bound to have detrimental effects on the operations of the SMEs, which carry out a significant amount of economic activities in these countries. However, this argument has not been proved conclusively by empirical evidence. In fact recent studies undertaken in this area, have revealed evidence which conforms as well as refutes this viewpoint. In 2001, Crystal et al evaluated the performance of the international banks operating in the countries of Latin America during the latter half of the 1990 decade. The results of this survey revealed that these foreign banks experienced a high rate of growth in the loans advanced by them. This indicated that they had indeed supplied a major portion of their financial resources as loans to the Latin American firms. Thus, the foreign banks functioning in South America had been able to accomplish its main objective of providing increased financial resources in the host economies. However, the research did not examine the distribution of these loans among the different types of firms. The study revealed another interesting fact: the international banks operating in the South American economies displayed a greater ability of dealing with losses as compared to their domestic counterparts. Most of the foreign banks are strong financial institutions which are supported a large assets base across the world. Thus, it was not surprising that were financially better equipped to handle a financial crisis than the domestic banks (Alessandrini et al, 2009, p.177-178). In 2002, Clarke et al examined the trends in the credit advanced by the foreign banks to a huge sample of more than 2,000 firms belonging to 38 developing nations. They showed that the participation of the foreign banks in the developing economies resulted in an increased volume of credit available to firms pertaining to all sizes. This in turn, afforded the firms to implement a cut in their selling prices. However, the research also revealed that both these positive effects were more pronounced in the case of larger firms (Alessandrini et al, 2009, p.177-178). Other Effects on the Domestic Economy In addition to influencing the domestic financial sector, the indigenous banks and the operations of the native firms, the entry of foreign banks also generate other noticeable effects on the economies of developing countries. In 2004, Martinez Peria and Mody attempted to evaluate the operational strategies of the international banks operating in the developing economies. They found that these foreign banks usually provided credit at a lower rate of interest than the domestic banks in the economy. This definitely accorded an advantage to the indigenous companies and individuals who borrowed financial resources from these international institutions. This finding was supported by the results of another research conducted by Claeys and Hainz in 2007. They also found that the foreign banks charged lower interest rates than their domestic counterparts in the developing economies. However, only those international banks who had newly established their operations in the country followed such a strategy. In 2000, Bonin and Abel conducted a survey on the foreign banks operating in the Hungary’s financial sector. The findings of their research indicated that the presence of international banks in the economy had a positive effect on the other domestic banks as well. The operations of the foreign banks in Hungary increased the competition in the country’s financial sector. As a result, the country’s major indigenous bank was forced to formulate a new strategy for dealing with this increased competition. The domestic bank developed new products and services and also introduced innovations in its existing portfolio to ensure the sustainability of its business. In this way, the operations of the international banks in the developing countries generated a variety of effects on the local economy (Alessandrini et al, 2009, p.180). Conclusion From the middle of the 20th century, most of the developing countries embraced the idea of globalization and started implementing measures to fulfill this goal. Nations which had earlier operated within a closed environment, started opening up their economies to various international forces. They also permitted international institutions to establish their operations in their domestic sector. Foremost among them have been the foreign banks which have been allowed to expand their business activities in the developing economies too. The authorities of the developing nations have hoped that this measure would strengthen their financial sectors and generate positive effects for the economy as a whole. This objective has somewhat been achieved owing to the operations of the foreign banks in the domestic sector. 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