Study on foreign direct investment in emerging market financial sector

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One, the introduction

Before the mid-1990s, foreign Direct Investment (FDI) in the real economy Sector was the focus of domestic and foreign scholars. Few scholars focused on Financial Sector For -eign Direct Investment (FSFDI). This was mainly because FSFDI had been too small to attract attention. Since then, with the acceleration of economic globalization and the continuous improvement of regional economic integration, the amount of global FSFDI, especially the amount of FDI flowing to the financial sectors of emerging market countries, has grown rapidly, and some foreign scholars have begun to pay attention to this issue. For example, the committee on global financial systems (CGFS) of the bank for international settlements published a report entitled “financial sector foreign direct investment in emerging market economies” in March 2004, which explored issues related to FSFDI in emerging market economies in the previous decade. In the same year, the commission organized three workshops in Seoul, Mexico City and Warsaw to deepen its study of the issue. Since then, FDI in financial sectors of emerging market countries has attracted extensive attention from foreign academic circles. What are the main reasons for the rapid growth of FDI in the financial sector of emerging market countries? What impact will FSFDI have on the financial sectors of emerging market countries? What should emerging market countries pay attention to when absorbing FSFDI? In view of the fact that China’s three state-owned commercial Banks, as well as some joint-stock Banks and urban commercial Banks have introduced overseas strategic investors, it is of great theoretical and practical significance to seriously study these issues.

Ii. FDI in financial sectors of emerging market countries

The main reason for the rapid growth is that before the mid-1990s, FSFDI accounted for a low proportion of the total transnational direct investment in the world, which was mainly manifested as the convection between developed countries, while the amount of FDI flowing to the financial sector of emerging market countries was small. Since then, with the acceleration of economic globalization and the continuous improvement of regional economic integration, the total FSFDI in the world has increased significantly, especially the amount of FDI absorbed by the financial sectors of emerging market countries. For example, the central and eastern European countries in transition introduced a large number of overseas strategic investors in the banking system reform process, and the FDI flows to the financial sector of central and eastern European countries increased rapidly. After the Mexican financial crisis in 1994, western European countries represented by Spain and the United States began to significantly increase their FDI in the financial sector of Latin American countries. After the Asian financial crisis in 1997, some east Asian emerging market countries began to gradually introduce foreign investors into the banking market. In terms of quantity, during the period from 1990 to 1996, the total FDI attracted by the financial sector of emerging market countries was only about 6 billion us dollars. This increased to $70 billion in the period 1997-2001, with $20 billion in 2001 alone. The author believes that there are four main reasons for the rapid growth of FSFDI in emerging market countries:

First, economic globalization and the acceleration of regional economic integration are the direct reasons for the rapid growth of FDI in the financial sector of emerging market countries. Since the 1990s, the process of economic globalization and regional economic integration has been greatly accelerated, and the economic dependence between developed countries and emerging market countries has been continuously increased, resulting in the substantial increase of foreign direct investment in emerging market countries. As a result, large Banks in developed countries increased their direct investment in the financial sectors of emerging market countries in order to continue to provide financial services for domestic transnational corporations, which is the so-called “follow thecustomer” strategy (Williams, 2002). This is an early and influential theoretical explanation for the entry of foreign Banks into emerging markets. From the perspective of practice, the rapid growth of FDI in the financial sector of ceecs benefits from the accelerating process of regional economic integration of the eu (such as the eastward expansion of the eu). The rapid growth of FDI in the financial sector of Latin American countries is attributed to the establishment of the north American free trade area and the u.s.-led efforts to construct the free trade area of the americas.

Second, since the mid-1990s, emerging market countries have loosened financial regulation one after another, accelerated the process of financial liberalization, and thus lifted the policy barriers for foreign financial capital to enter their financial sectors, making the large-scale growth of FSFDI possible. In the early 1990s, central and eastern European countries in transition generally carried out large-scale bank non-performing asset liquidation, capital injection and domestic privatization, but such top-down reform led by the government was costly and had little effect. After the mid-1990s, these countries gradually began to loosen financial regulation, introduced overseas strategic investors in the process of banking reform, and finally chose to fully open to foreign Banks. The process of financial liberalization in Latin American countries also accelerated significantly after the mid-1990s, mainly through financial deregulation and the opening of capital accounts; After the Asian financial crisis, emerging market countries in east Asia gradually began to open their banking markets to foreign Banks. These measures have removed the policy barriers for international financial capital to enter emerging market countries through direct investment and raised the enthusiasm of large transnational Banks to enter emerging market countries.

Third, the pursuit of profits by big Banks in developed countries and the need to expand their business globally are one of the main reasons for the rapid growth of FDI in the financial sector of emerging markets. Since the 1990s, the internal integration of banking markets in developed countries and regions has made their domestic financial markets increasingly saturated, and the profit margins of financial institutions, especially commercial Banks, have been gradually reduced. In search of bigger assets (to avoid being bought by other financial institutions) and bigger markets to increase profitability, big Banks in the developed world have increased their direct investments in the financial sectors of emerging markets. George Clarke et al. (2001) pointed out that the unsaturated, underdeveloped and inefficient financial markets (in emerging market countries) can bring higher returns and better development prospects for foreign Banks. In addition, it is also the need to gain economies of scale and spread operational risks around the world. Although some scholars Amihud, etc., (2002) argues that FSFDI does not necessarily can effectively disperse the management risk of the foreign Banks, the potential gains may be offset by new business risks, and whether FSFDI can improve the efficiency of foreign Banks is questionable (Berger, 2000), but it is generally believed that the FS – FDI can improve the diversity of the assets of foreign Banks and is conducive to the decentralized management risk on a global scale, at the same time can improve operational efficiency and gain economies of scale benefits.

Fourthly, the progress of communication technology, the popularization of information network and the convenience of transnational transportation reduce the information cost of FSFDI, which is more conducive to the organization and management of transnational financial institutions. Farouk(2004) pointed out that information cost is one of the important factors affecting FSFDI, among which geographical distance and cultural difference have the largest impact on information cost. Buch(2001) also showed that geographical distance has always been an important factor for foreign Banks to consider when making transnational investment decisions. Since the 90 s, the progress of science and technology, especially the rapid development of communication technology and international transportation convenience greatly reduces the information cost caused by geographic distance, and the rising popularity of information network in the emerging market countries, but also to the branches of foreign Banks in different countries (or subsidiary) and information sharing between business, which make it easier for the parent line improve the efficiency of the organization and management and scale economic benefits
Iii. Impact of FSFDI on financial sectors of emerging market countries

1. Impact of FSFDI on capital allocation efficiency and financial market development it is generally believed that FSFDI will strengthen the competition in the banking system of emerging market countries, thus improving the efficiency of financial institutions. A large number of empirical studies have proved that the entry of foreign Banks can effectively reduce the operating costs and improve the efficiency of the banking industry in Host coun-try countries (emerging market countries absorbing FSFDI in this paper) (Claessens et al., 2001; Claessensand Laeven, 2003; Martinez and Mody, 2003). Even so, the entry of foreign Banks does not necessarily lead to increased profits. One explanation is that foreign Banks are more conservative than domestic Banks, taking higher provisions for non-performing loans and implementing strict loan risk assessment programs. Another explanation is that increased competition makes loans cheaper, makes it easier to borrow from Banks, and transfers the benefits of lower costs and greater operational efficiency to customers. The improvement of the efficiency of the host country’s financial system improves the credit allocation and controls the relationship financing. This is mainly because when making loan decisions, foreign Banks will exclude those applicants who do not meet loan standards and have high moral hazard according to their standardized loan conditions and risk-weighted prices, thus reducing the possibility of non-performing loans. In emerging markets, there is a widespread concern that tighter lending conditions by foreign Banks will make it more difficult for some companies, such as small and medium-sized enterprises, to obtain loans from foreign Banks. For example, Berger et al. (2001) pointed out that large Banks controlled by foreign capital have defects in financing small and medium-sized enterprises with low information transparency. However, there are also opposing views. For example, Peek and Rosengren(1998) and De Young et al. (1999) have shown that foreign Banks tend to allocate a small portion of loan shares to small and medium-sized enterprises, but small and medium-sized enterprises are not very active in applying for loans from foreign Banks. The study of Marc Farnoux et al. (2004) also proves that foreign Banks do not discriminate against smes in host countries in credit allocation.

The entry of foreign Banks can promote the development of financial markets in emerging market countries, such as fund market, securities market and derivative financial instrument market. This is because in the emerging market countries with underdeveloped financial markets, an important means for foreign Banks to expand business is to occupy market share through financial innovation (such as providing customers with new financial products and services), and the emergence of new financial instruments inevitably requires the development of corresponding financial markets in these countries. In addition, in order to avoid and hedge risks, foreign Banks will assist the financial authorities of host countries to develop relevant financial markets by providing corresponding technical support and Suggestions on building legal framework.

2. The study on the impact of FSFDI on macroeconomic and financial stability shows that the financial innovation activities of foreign Banks will become a catalyst for the financial regulatory system reform in emerging market countries. Its financial innovation will prompt the financial regulatory authorities in emerging markets to constantly update their regulatory concepts and methods, improve the quality of regulatory practitioners, and thus strengthen the security and stability of the financial system. In addition, in order to avoid risks (especially systemic risks), foreign Banks have a strong internal driving force to maintain and maintain the stability of the host country’s financial system. Therefore, in the medium and long term, FSFDI can enhance the ability of the host country’s financial system to withstand external shocks, thus making the host country’s macroeconomic and financial stability more stable. For example, Demirguc et al. (1998) found that the number of foreign Banks is negatively correlated with the possibility of bank crisis in the host country, so foreign Banks have the role of stabilizing the financial system in the host country. Bonin et al. (2003) believed that in some Latin American countries and central and eastern European countries in transition, compared with the chaotic situation at the beginning of privatization reform, foreign Banks played a role in increasing the stability of the banking system in the host country. Specifically, foreign Banks, as transnational Banks, have strong capital strength, high degree of asset diversification and strong credit risk management ability, so they are less sensitive to the business cycle fluctuations of the host country and can provide relatively stable loans to the customers of the host country. Cross-border loans and local bank loans, which are more sensitive to the business cycle in the host country, do not. In addition, foreign Banks may act as a “stability anchor” during times of financial crisis. Because foreign Banks have strong capital strength and will get financial support from their parent Banks when necessary, they can maintain the continuity and stability of operation during the financial crisis in the host country, and the bankruptcy probability is relatively low, which is conducive to the financial stability of the host country. Moreover, emerging market countries during the financial crisis is often accompanied by large-scale capital flight, this is mainly due to investors lose confidence in the financial institutions, the foreign Banks can act as the host country during crisis “safe haven” of domestic capital, allowing capital flight into the host country’s financial system internal funds transfer (i.e., funded by domestic Banks to foreign Banks), reduce the capital flight that exchange rate and interest rate formation pressure and the negative impact on the real economy.

First of all, major decisions of foreign Banks, such as risk management and credit assessment strategies, are often decided by the headquarters of the host country, while foreign Banks in the host country are only responsible for daily management and operation. Therefore, FSFDI makes foreign Banks in the host country integrate into the global business strategy of their headquarters and lose their independence. On the one hand, foreign Banks in the host country will be more focused on domestic business, which will lead to a decline in the degree of internationalization and difficulty in spreading risks around the world. On the other hand, it makes the host country more vulnerable to external shocks from the country where the foreign bank is headquartered. For example, in special circumstances, when the headquarters of a foreign bank is in trouble, the resulting overall contraction may have a negative impact on the host country. This can be seen as a contagion effect. In addition, changes in the operational strategy and risk appetite of the headquarters of foreign Banks may also have an impact on the host country. For example, the headquarters of a foreign bank may reduce its financial products in the host country for the purpose of adjusting its business strategy, which may be at odds with the target function of the financial regulatory authority in the host country. Secondly, FSFDI may lead to information loss and further aggravate information asymmetry. When the headquarters of a foreign bank decides to delist its subsidiaries in the host country and stop listing, market information will be lost. On the one hand, the price signal function of stock market disappears; On the other hand, since subsidiaries no longer need to release information about the company’s financial status and business status, market transparency will decline, and market analysts are unable to evaluate and analyze the bank’s business status, which will aggravate the information asymmetry and weaken the effectiveness of the market. In such circumstances, prudent and effective financial regulation would also be difficult. Since it is difficult for regulators to accurately measure the operation status and risks of foreign Banks, financial regulators in emerging markets are required to take corresponding measures to make up for the information asymmetry caused by the lack of information.

In short, the operational strategies and financial innovations of foreign Banks may generate new financial vulnerabilities, and how to deal with these problems has become a major challenge for financial regulatory authorities in emerging markets. In 1998, at the joint BBS held by the Basel committee on banking supervision, the international securities commission and the international insurance regulatory commission, the participants made in-depth studies and discussions on how to strengthen the supervision of large transnational financial groups, and put forward many constructive Suggestions. It emphasizes that the information sharing and cooperation between the financial regulatory authorities of the host country and the country to which the foreign bank belongs should be strengthened to build an information exchange platform so as to avoid the crisis to the greatest extent and ensure the prudent and effective financial supervision on both sides.

Iv. Problems that emerging market countries should pay attention to when absorbing FSFDI

1. Strengthen prudent and effective financial supervision and strive to eliminate the asymmetry of regulatory information. Since the mid-1990s, the form of foreign Banks’ direct investment in the financial sectors of emerging market countries has changed, that is, from opening branches alone to establishing holding subsidiaries through mergers and acquisitions of local Banks. In central and eastern European countries, for example, by the end of 2003, more than 85 per cent of foreign Banks were operating as holding subsidiaries. Between 1994 and 1998 the number of foreign-owned Banks in Latin America increased from six to 56. The reason for this change is that the establishment of branches requires a large amount of investment, which will affect the liquidity of financial institutions, while the holding subsidiaries can use the leverage effect to play a larger role with the same amount of capital. However, the more important reason is that branches do not have independent legal status and can only carry out various businesses in the name of the head office, thus playing a limited role. A subsidiary is a legal entity independent of the head office, which is not only conducive to the diversification of the head office, but also can effectively cope with the varying degrees of centralization in emerging market countries and avoid various regulations on the branches of foreign Banks. Changes in the form of FSFDI increase the difficulty of financial supervision in emerging market countries, and to some extent, intensify the asymmetry of supervision information. Therefore, emerging market countries financial regulatory authorities should continue to strengthen the prudent and effective financial regulation, reform the old financial regulatory framework, to improve the quality of the financial supervision practitioners, and foreign bank belongs to the financial regulatory authorities to strengthen communication, sharing regulatory information, to eliminate asymmetric information may cause regulation regulation shall be invalid.

Although FSFDI can bring a series of positive effects to emerging market countries, more FSFDI is not better. Therefore, it is of vital importance to reasonably control the quantity of FSFDI. On the one hand, high FSFDI ratios may make emerging market countries more vulnerable to external shocks from the home countries of foreign Banks. On the other hand, FSFDI has a strong positive incentive to the financial institutions of the host country, so theoretically, a country has a reasonable ratio of FSFDI. Generally speaking, small open economies are more likely to benefit from financial liberalization and can maintain a relatively high FSFDI ratio, while larger countries need to be cautious in absorbing FSFDI. In addition, emerging market countries should encourage their financial institutions to become more international while reasonably absorbing FSFDI. As mentioned above, FSFDI makes foreign Banks in the host country integrate into the global operation strategy of large transnational Banks, thus losing their independence, reducing their internationalization degree and making it difficult to spread risks globally. Therefore, the financial authorities of emerging market countries should encourage their financial institutions to improve the degree of internationalization, actively participate in the process of financial globalization, and face and accept the competition and challenges of foreign Banks. At the same time, improving the degree of internationalization is also the objective requirement to achieve diversified development and disperse business risks.

3. Make overall planning for the pattern of FSFDI, so as to avoid the over-concentration of financial assets in the host country in the source country, which will undoubtedly have a complex impact on the economy of the host country. If the degree of economic integration between the host country and the country is high, the consistency of fiscal policy and monetary policy is strong, and the difference between society, history and culture is low, then the host country may benefit from such concentrated FSFDI pattern. However, in reality, it is difficult for emerging market countries to find FSFDI source countries that fully meet the above conditions. In this case, if its FSFDI is too concentrated in a country, it will not only weaken the effectiveness of its macroeconomic policies and deepen its dependence on the country’s economy, but also increase the risk of suffering from external shocks from the country. In addition, emerging market countries often just passively accept FSFDI from developed countries, which makes it difficult to interact with developed countries. In other words, it is difficult for financial institutions of emerging market countries to make direct investment in the financial sector of developed countries. Therefore, it is necessary to make an overall planning for the pattern of FSFDI source countries to avoid the excessive concentration of FSFDI in one country. Currently, Latin American countries have high concentration of FSFDI in source countries. For example, in Chile, Argentina and Brazil, about 91%, 65% and 58% of FSFDI come from Spain each year. About 66 per cent of Mexico’s fs-fdi per year comes from the us; The source country pattern of FSFDI in cee countries is more reasonable. For example, the annual FSFDI in Poland comes from Germany (22%), the United States (21%), Italy (18%), Ireland (14%) and the Netherlands (8%). The main sources of FSFDI in the Czech republic were Austria (39%), Belgium (24%), France (22%) and the United States (12%). Due to the low amount of FSFDI, east Asian emerging market countries have not yet shown an obvious centralized trend.

Five, the conclusion

To sum up, since the 1990s, the acceleration of economic globalization and regional economic integration has led to the rapid growth of FSFDI in emerging market countries. At the same time, emerging market countries loosen financial regulation one after another, accelerate the process of financial liberalization, and lift the policy barriers of FSFDI. The pursuit of profits and the need to expand globally have also prompted big Banks in the developed world to invest more directly in the financial sectors of emerging markets. In addition, the progress of communication technology, the popularization of information network and the convenience of transnational transportation have reduced the information cost of FSFDI, making it easier for transnational Banks to improve the operation efficiency and gain economies of scale. Although FSFDI plays an active role in improving capital allocation efficiency, promoting the development of financial markets and maintaining macroeconomic and financial stability in emerging market countries, it also creates new financial vulnerabilities, posing major challenges to financial regulatory authorities in emerging market countries. Therefore, when absorbing FSFDI, emerging market countries should strengthen prudent and effective financial supervision to eliminate the asymmetry of regulatory information, reasonably control the quantity of FSFDI, encourage their financial institutions to increase the degree of internationalization, and make overall planning for the pattern of FSFDI so as to avoid excessive concentration of source countries.

Finally, it should be pointed out that, the restriction of the policy factors, at present our country financial institutions is the main purpose of the ongoing strategic investment by qualified foreign institutional investors to sell a certain amount of equity, to improve the governance structure of domestic Banks, access to relevant aspects of the technical support, and enhance the overall image and the international competitiveness of domestic Banks. According to “the global financial system committee” interpretation of FSFDI, only those who have finally achieved the investment control of the financial institutions of transnational direct investment to be classified as FSFDI. But in our current laws and regulations strictly limit the bank equity structure allows foreign ownership (such as a single foreign institutional ownership is not more than 20%, the overall foreign investment holds less than 25%), the foreign Banks make it difficult to get control of domestic Banks. Therefore, foreign Banks’ direct investment in China’s financial sector is still in the preparatory stage, and the impact of FSFDI on emerging market countries discussed in this paper has not fully emerged in China. However, after the comprehensive opening of RMB business to foreign Banks, the pace of China’s financial liberalization will gradually accelerate, foreign Banks’ direct investment in China’s financial sector will continue to grow, and east Asian emerging markets led by China will become the main force of absorbing international FSFDI. In this context, it is of great practical significance to further study the impact of FSFDI on the economic development of east Asian emerging markets.

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