Financial-Sector FDI and Host Countries: New and Old Lessons

Abstract

* The financial sectors of many developing countries are being reshaped dramatically by the rise in foreign direct investment, or FDI. * The growth in financial sector FDI, in which banks in industrialized countries establish branches and facilities in emerging markets, has drawn attention to the consequences of foreign ownership of banking resources. * An analysis of research on FDI--investment into manufacturing and primary resource industries--suggests that lessons in these industries also apply to the financial sectors of host countries. * Real-side and financial sector FDI can heighten the host country's integration into world business cycles through improved allocative efficiency, higher technology transfer rates, and greater wages. In banking and finance, financial sector FDI can potentially strengthen institutional development in the host country through improved regulation and supervision. 1. Introduction In the 1990s, foreign direct investment (FDI) became the largest single source of external finance for many developing countries. (1) Most discussions on the causes and effects of FDI have focused on flows into manufacturing and real production sectors, where this type of investment has traditionally been concentrated. More recently, however, FDI into the financial sector has soared, and the sector is being reshaped dramatically. Financial sector FDI, a relatively new phenomenon, typically takes the form of banks in industrialized countries establishing branches and facilities in developing countries. Following the dissolution of the Soviet Union, bank entry into Central and Eastern Europe in the early 1990s led to foreign ownership in local banking systems; today, such ownership often exceeds 80 percent of local banking assets. In addition, the liberalization of financial sectors in Latin America was likely spurred in part by foreign direct investment, especially in countries facing potential competitive losses to Asian economies. Within Latin America, the financial crises of the mid-to-late 1990s provided additional opportunities for foreign entry, as countries sought to recapitalize their banks and improve the efficiency of their financial systems. Banks in the United States, Spain, the United Kingdom, and other countries with highly developed financial systems are the main sources of financial sector FDI (Chart 1). Parent banks based in industrialized countries have assumed substantial, if not majority, control of assets in host-country financial systems. This growing trend is illustrated in Chart 2, which shows the evolution of foreign control of emerging market financial assets between 1994 and 2004. Whereas foreign control was typically below 10 percent of assets in 1990, it more often surpassed 40 percent by the late 1990s. Acquisitions of local banks continued through the early 2000s, significantly expanding foreign bank presence into majority ownership in many countries. From 1999 to 2004, the largest change in structure occurred in Central Europe, where the foreign ownership share rose to 77 percent. (2) As one might expect, these dramatic shifts in investment into foreign financial sectors have raised concerns about the consequences of ownership of banking resources. In this article, we emphasize that some of the consequences are already well established in studies of foreign investment, although that work does not focus specifically on the financial sector. In the broad literature on FDI, the authors draw their results primarily from investment--that is, activity in manufacturing and primary resource industries. And although a new line of inquiry is concentrating on financial sector FDI, it typically ignores the lessons documented in the research on real-side investment that also apply to the financial sector. The stylized facts derived from the literature on the causes and consequences of real-side FDI are usually based on theoretical arguments supplemented by case studies. …