Belarus Accession to the WTO: The Banking Services Dimension

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1 IPM Research Center German Economic Team in Belarus PP/01/03 Belarus Accession to the WTO: The Banking Services Dimension Summary This paper analyzes whether the restrictions on foreign participation in the ownership of Belarusian banks and the prohibition for entry of foreign bank branches into the country, as required by the Banking Code, and Belarus offer under the GATS negotiations are congruent with the aim of improving the stability and efficiency of the domestic banking system. Evidence is provided that the safeguards existing within GATS are adequate to ensure that, on the one hand, the liberalization commitments do not threaten the stability of the banking sector or compromise the ability to pursue sound regulatory policies. On the other hand, the crucial need for developing the Belarusian banking sector makes the above noted limitations unnecessary and undesirable. Moreover, the presence of foreign bank branches can be a significant factor for attracting FDI into country. Contents 1. Introduction The Current Situation of the Banking Sector in Belarus The Banking Sector and GATS Negotiations The current state of negotiations Economic analysis of the two main offers of Belarus Conclusions Zakharov Str., Minsk, Belarus. Tel./fax: +375 (17) , bmer@ipm.by, internet:

2 1. Introduction Belarus trade negotiations at the WTO are underway. One major concern is the accession commitment concerning banking services under the General Agreement on Trade in Services (GATS). The reason is that banking services have always been an important economic activity, and it is feared that liberalizing foreign access to this market may strongly affect not only the competitiveness and soundness of the domestic banking system but, according to a conventional view, macroeconomic stability, economic growth and development as a whole. This paper examines whether these misgivings are well grounded as regards the Belarusian banking system. The GATS defines trade in services in terms of four modes of supply: cross-border supply (mode 1), consumption abroad (mode 2), commercial presence (mode 3), and the movement of natural persons (mode 4). It should be noted that the GATS schedules of commitments are complex documents, containing for each member state, market access and national treatment limitations on up to twelve sub-sectors of banking services, with respect to each of the four "modes. In order to capture the essential elements of these commitments, without complicating the analysis, this paper focuses on the market-access commitments, emphasizing commercial presence (mode 3). 2. The Current Situation of the Banking Sector in Belarus Before turning to the issue of the pattern of the banking services commitment under the WTO accession negotiations, it is worth taking a quick look at the Belarusian banking sector performance. Almost 90% of the banking sector assets are concentrated in six so called authorized representatives, or in other words system-forming banks (Belarusbank, Belpromstroibank, Belagroprombank, Priorbank, Belinvestbank, Vnesheconombank), which provide 87% of all lending to enterprises and over 90% of lending to households, while the vast majority of the remaining Belarusian banks are rather small. The banking sector is dominated by state ownership (80% in statutory fund). The profitability of the banking system is rather low: return to assets swing from 0.91% to 0.67% in the first half of 2003, and return to capital from 4.43% to 2.27% over the same period. The Belarusian banking sector is relatively small by international standards (see Table 1). Broad money (M2) amounted to 15% of GDP, while claims on the private sector were only 8% of GDP. Table 1. Financial Market Depth in 2001 (% of GDP) Country M2 (Money and Quasi-Money) Claims on the private sector Belarus 15 8 Russia Czech Republic Hungary Slovak Republic Poland France 51* 95 Germany Italy 56* 80 Netherlands 89* 178 United Kingdom Japan United States Source: IMF * end of 2000 The volume of domestic credit relative to GDP is regarded as one of the conventional measures of the development of the banking sector and its financial depth. It is widely accepted that this ratio indicates the extent to which an economy relies on a formal banking sector in financial 2

3 intermediation. It is noteworthy that the average ratio of total domestic credit in terms of GDP has remained virtually the same for Belarus over the period from 1997 to 2002, varying only by a negligible margin (14.3% in 2002 compared to 13.0% in 1997). The only significant increase happened in 1998 (27.8%), probably as a result of the impact of the Russian financial crisis. This trend contrasts sharply with the rapid deepening in the financial sector observed in most transition economies in Central and Eastern Europe and the Baltic region. For most of these counties, the ratio of total domestic credit to GDP steadily increased due to the impact of financial liberalization with the highest increases occurring in Estonia and the Czech Republic (75-80%) and more moderate ones in Latvia (37%). Looking at the decomposed sources of domestic credit, the ratio of domestic credit to the public and private sectors in Belarus continued to remain at a rather low level (5.8 and 5.3% respectively). It is worth mentioning that most of the European and Baltic transition countries 1 tend to show an increasing share of domestic credit to the private sector over time, as Figure 1 indicates, confirming the importance of credit expansion to the private sector. Figure 1. Credit to Private Sector/GDP Belarus Latvia Lithuania Estonia Czech Republic Poland Hungary Sources: International Financial Statistics, World Economic Outlook All this suggests that the depth of the banking sector development in Belarus has lagged behind and that the banking system is currently not able to provide the desired level of support for Belarus economy. Therefore the fundamental issue of how to stimulate competition in an environment dominated by the state banks should be considered a matter of priority. In this context, the relevant question for the trade negotiators is whether the WTO commitments can help to increase the stability and efficiency of the domestic banking. The economic trade-offs between the risks and returns can be identified in order to better inform the process of decision-making. 3. The Banking Sector and GATS Negotiations 3.1. The current state of negotiations Before turning to the analyses of the most significant feature of the Belarus offer under the banking service negotiations, a brief mention must be made of some other features of the agreement that are also relevant to the discussion that follows. The GATS covers all measures taken by member states affecting trade in services within all service sectors. The first of the important general obligations is transparency, which requires that "all relevant measures of general application" affecting trade in services should be published promptly. The second is the most-favored-nation (MFN) principle, which prevents members from discrimination among their trading partners. The core provisions of the GATS relate to market access (Article XVI) 1 In Russia, Ukraine and Kazakhstan this share was 12%, 9%, and 13% respectively (end of 2000). 3

4 and national treatment (Article XVII). The market access provision prohibits six types of limitations, unless a member has inscribed them in its schedule. These are: (a) limitations on the number of suppliers; (b) limitations on the total value of service transactions or assets; (c) limitations on the total number of service operations or on the total quantity of service output; (d) limitations on the total number of natural persons that may be employed; (e) measures which restrict or require specific types of legal entity or joint venture; and (f) limitations on the participation of foreign capital. In the scheduled sectors, the existence of any of these limitations has to be indicated with respect to each of the four modes of supply, described above. National treatment is defined under Article XVII, as treatment no less favorable than that accorded to domestic services and service suppliers. In contrast to the General Agreement on Tariffs and Trade (GATT) approach, however, members may inscribe limitations on national treatment in their schedules with respect to each of the four modes of supply. The main method of negotiation on trade in services is the request-offer approach. WTO members submit initial requests for the removal of existing limitations, reducing their levels of restrictiveness, "unbound" entry and etc. The exchange of requests as a process has traditionally been purely bilateral. An applicant would submit an offer in response to all the requests that it had received, but would not necessarily have to address each and every element contained in those requests in its initial offer. Unlike a request, which is usually presented in the form of a letter, an offer is normally presented in the form of a draft schedule of commitments. Unlike requests that are addressed bilaterally to the negotiating partners, offers are traditionally circulated multilaterally. Belarus has received requests concerning banking services from the EU, the USA and Canada. These requests are related to unconstrained access by all modes of supply, removal of all types of limitations on foreign banks and capital entry. In its turn, one of the most significant features of the Belarusian offer is a foreign equity limitation of 25% of the total aggregate banking equity, as well as restrictions on the legal forms of any commercial banking presence, requiring this presence to be in the form of locally incorporated entities and not allowing entry through branches. The points made in the offer agree with the current Banking Code and its regulations. It is worth noting fact that Belarus reluctance to liberalize its banking sector contrasts strongly with the fairly liberal commitments made by several CIS, Eastern European and Baltic countries, which made deep market-opening commitments as part of their WTO accession. Since Belarus negotiations are now underway at the WTO, it is worthwhile to consider what influences the country s refusal to commit the banking sector to liberalization in the context of the GATS. The term liberalization applied to banking services in the WTO refers to market opening that is the removal of restrictions on market entry for foreign service providers. We will restrict our attention to the market access commitment under Mode 3 (it entails the commercial presence of a supplier of one member in the jurisdiction of another member) in the banking service industry. The reason is that over 60 percent of all measures are concentrated in Mode 3 due to its crucial significance, while, by contrast, there have been very few limitations scheduled in Mode 1 and 2 (it is common that countries have kept these Modes either fully bound or unbound). Empirical evidence confirms that a government s decision to liberalize is primarily affected by the economic environment, by the existing market penetration by foreign firms, and by the quality of the prudential measures. The next chapter examines some of the common arguments against banking liberalization: that liberalization increases the chances of a financial crisis; that finance is a "special" or a "strategic" sector and therefore must remain in domestic hands and tightly regulated; and that participants in the sector (and sometimes the government itself) will be hurt in bearing the burden of adjustment Economic analysis of the two main offers of Belarus The banking system often faces a trade-off between the concern that an increased foreign bank participation may lead to financial sector instability arising from increased competition, and the likelihood of significant economic benefits due to a more effective mobilization of domestic savings, expansion of the supply of credit available to domestic investors, and as a result, an improving banking sector development. 4

5 This section considers whether restrictions on foreign bank entry 2, as stipulated in the Banking Code and Belarus offer under the GATS negotiations are congruent with the aim to improve the stability and effectiveness of the domestic banking system, and whether the fears mentioned above can be justified. (i) Foreign equity limitation of 25% of the total aggregate banking The main concerns are the following: Concern 1: Liberalization increases the chances of a financial crisis. There is very little evidence that foreign entry impairs the functioning of the domestic banking system as such, on the contrary, many existing cross-country investigations have confirmed that FDI in the banking sector has provided net benefits in terms of stability. Moreover, the diversified geographic structure of foreign bank parents also means that host country banks may escape local crises and provide badly needed stability. In the case of the Belarusian banking system the 25% restriction on foreign equity is counterproductive. - The share of foreign equity in the total banking equity varied between 3% and 9% from 2000 to 2002, and rose to 9.8% in 2003 (first quarter). The National Bank considers this figure to be absolutely insufficient, but since the government steadily increases its share in the Belarusbank and Belagroprombank due to the need to channel financial resources to agriculture and to house construction, it is quite unlikely that the ratio will increase in the near future. - The National Bank intends to decrease the share of state ownership in the banking sector from 80% to 50%, e.g. by selling NBB-held shares in Belpromstroibank, Belinvestbank, Vnesheconombank, Mezhtorgbank. This would require substantial foreign direct investments. It should be noted that countries with successful experiences in opening up to foreign financial firms (Brazil, Chile, Hungary, Ireland, Poland, Portugal, Spain and others), following to a process of domestic deregulation, reaped substantial gains as a consequence (World Bank, 2001). - Foreign banks have also been able to help reduce the costs of resolving the financial problems of some banks, and of re-capitalizing some problem financial institutions, e.g. Minskkompleksbank. - Some Belarusian banks have problems with their minimum capital requirements. In 2001, the NBB took a step in the direction of mandating banks to be better capitalized by increasing the minimum capital level to EUR 5 m (the minimum capital level applied within the European Union), and to EUR 10 m for banks dealing with households. These changes represent a considerable tightening of the current legal framework, specifically as applied to small banks. Since 28% of all Belarusian banks cannot meet the second requirement, foreign equity participation could help to solve this capital constraint. - Foreign banks can enhance a country s access to international capital. Concern 2:Banking liberalization may lead to substantial foreign control over this sector while finance, as strategic sector must remain in domestic hands. Undoubtedly banks play a major role in the transmission of monetary policy to the economy, but recent evidence demonstrates that the effectiveness of monetary policy depends more on the exchange rate regime and the degree of capital mobility than on the presence or absence of foreign banking institutions. - In Belarus the number of totally foreign-owned banks, as a proportion of all banks, is 20%, while the share of banks that have more than 50% foreign ownership is 31%. This means that more than half of the banks are mostly foreign-controlled. At the same time - as mentioned above - the proportion of foreign equity in the total banking equity is only 9.8%. Thus, the high share of foreign-controlled banks does not imply any substantial market penetration or control of the host-country banking sector. 2 Interesting to note that the Government and The Central Bank of Russia do not impose foreign equity limitation. 5

6 - Foreign banks have been active in developed and developing countries for many years. In the United States, the banking operations of foreign banks accounted for 26.1 percent of US banking assets in 1998 (Institute of International Bankers 1998). In Latin America, Citibank's operations began 80 years ago. In the 1990s, a few large European and Canadian banks with global strategies have made numerous acquisitions of local institutions. Yet, in the seven largest Latin American countries, foreign banks control on average only 15 percent of total loans and 16 percent of total deposits, with shares ranging from 10 percent in Brazil to 35 percent in Argentina and Venezuela. In most cases, foreign banks control over 50 percent of the voting stock of local institutions in which they are partners, yet their effective control of assets averages around 11 percent. - The trend towards opening up domestic financial markets has been pronounced, especially in the transition economies of Central and Eastern Europe. Table 2 shows the number of foreign banks relative to the total number of banks in each country in 1995 and It also compares the share of assets of foreign owned banks. Country Table 2. Share of foreign banks in domestic banking systems (in %) Number of foreign banks in total number Foreign bank Number of foreign assets in total banks in bank assets total number Foreign bank assets in total bank assets Bulgaria Czech Republic Estonia Hungary Kazakhstan Latvia Lithuania Poland Romania Slovak Republic Source: Bankscope database Note: A foreign bank is defined as one having at least 50% foreign ownership. - A foreign bank is likely to have positive effects in terms of transfer of technology, introduction of new products, price reductions, and quality improvements. The benefits come not only in the form of technological innovations but also in terms of improved management and credit assessment techniques, as well as higher standards of transparency and self-regulation. - Foreign financial institutions can be expected to increase the system's efficiency and through inter-sectoral linkages develop and maintain a competitive export sector. (ii) No presence of foreign banks in the form of branches In addition to the above-mentioned concerns, there is the uncertainty concerning control of possible foreign bank branches in the country. That brings up the important issue of homecountry versus host-country regulations. Having only home-country regulations, Belarus insists that foreign bank may not have branches in the country, but must be locally incorporated. It is worthwhile to explain why such an approach is inappropriate. Undoubtedly instability in the banking system can affect the whole economy. That is why the financial services Annex of GATS (Paragraph 2) states that the governments have the right to take prudential measures, such as those for the protection of investors and depositors, and those required to ensure the integrity and stability of their financial system. Please note that the annex does not provide a clear definition or an indicative list of such measures, which leaves each country with considerable discretion to choose its own prudential measures. One widely used stipulation is that suppliers able to provide services 6

7 must obtain certification or licensing. For example, India allows entry only in the form of branches of foreign banks licensed and supervised as banks in the home country. It committed itself under the GATS to issue 12 licenses per annum. The Slovenian schedule states that the Bank of Slovenia shall, when considering issuing a license, take into account "the national economic preferences for certain banking activities." Egypt imposes an economic needs test on the branches of foreign banks. The Brazilian commitment states that the "establishment of new branches and subsidiaries of foreign financial institutions is only permitted when subject to a case-by-case authorization by the Executive Branch, by means of a presidential decree." South Korea s commitments concerning foreign banks state that the "only branches of foreign banks which rank among the world's top 500 banks in terms of assets size or representative offices are permitted." Thus Belarus too, can reflect in its schedule some measures as those discussed above in order to ensure that branches of foreign banks fit its particular political and economic needs. For example it might be a combination of licensing with requirement to foreign bank to belong to world s top 500 banks. One of the reasons why countries may have chosen a particular combination of policies, i.e. to restrict new entry while allowing foreign equity participation, is probably because they would like new foreign capital to help strengthen their weak domestic financial institutions, rather than to arrive in the form of highly competitive modern banks, which might drive their domestic rivals out of business. It should be noted that branches as a rule serve the interests of home-country firms, which operate in the host-country. This kind of financial institution concentrates on providing sophisticated financial products rather than retail banking services.allowing foreign bank branches to be established can be considered as a way of reassuring potential foreign investors and strategic partners in different sectors of economy. The presence of foreign banks in the form of branches can influence an investor s decisions. FDI responds to various specific determinants, though one common motive for such investments is a market-friendly environment. Foreign bank branches can add credibility. As foreign firms coming from abroad to invest have to face a certain degree of risk and uncertainty the opportunity to work with a banking partner that is familiar can be a substantial factor in attracting FDI into the country. In fact market-opening commitments under GATS with regard to foreign branches do not imply that this kind of financial institutions will inevitably appear in the country s banking sector. For example the Kyrgyz Republic has been a WTO member since 1998 but so far only two foreign bank branches have been established: one each from Pakistan and Kazakhstan). The same is true of Armenia 3. This means that the entry of foreign branches depends on many factors, with macroeconomic conditions being in first place. 4. Conclusions This paper considers whether the restrictions to foreign bank entry, which exist in the Banking Code, and Belarus offer under the GATS negotiations are in line with the aim of improving the stability and efficiency of the domestic banking system. The main findings are: The depth of the financial sector development in Belarus has lagged behind and the banking system is currently not able to provide the desired level of support for Belarus economy; Foreign bank entry as a consequence of banking sector liberalization in the context of GATS can help to decrease the level of state ownership in the banking sector in accordance with the NBB s intentions, and might lead domestic banks to be better capitalized, thus enabling them to make more loans; The financial services negotiations under GATS can contribute to the creation of a stable banking system. Firstly, foreign equity participation may serve as a vehicle for transferring technology and know-how. The benefits come not only in the form of tech- 3 According to Federal Law On Banks and Banking Activities it was permitted to open the foreign bank branches in Russia. 7

8 nological innovations but also in terms of improved management and credit assessment techniques, as well as higher standards of transparency and self-regulation. Secondly, foreign entry might stimulate improvements in the legal and regulatory frameworks for providing financial services, the development of the underlying bank supervisory and regulatory system, and better disclosure rules. Thirdly, it can help to solve the problems with minimum capital requirements, which exists for 28% of Belarus banks. The diversified geographic structure of foreign bank-parents also means that host-country banks may escape local crises and provide badly needed stability; Given that there exist adequate safeguards within GATS to ensure that the liberalization commitments do not threaten the macroeconomic stability, or compromise the ability to pursue sound regulatory policies, the reason for the foreign equity limitation of 25% in the total banking equity, and the restrictions on the legal form of commercial bank presences, i.e. requiring banks to be locally incorporated entities and not allowing foreign bank branches, are not be needed in the Belarus offer under GATS. The presence of foreign banks in the form of branches can be a substantial factor in attracting FDI into the country. To conclude, for Belarus it will be preferably to refuse any forms of foreign equity limitations, and allow the presence of foreign banks in the form of branches. Belarus as well, can reflect in its schedule some measures in order to ensure that branches of foreign banks fit its particular political and economic needs. For example, it might be a combination of licensing with requirement to foreign bank to belong to world s top 500 banks. Authors: Irina Tochitskaya, Stephan von Cramon-Taubadel, Dzmitry Kruk (lector) Minsk, August