Financial FDI in CEECs revisited – in the context of the dependent

market economies modelZoltán Gál and Magdolna Sass

Centre for Economic and Regional Studies of HAS,

Budapest, HungaryRSA Research Network on Geographies of Finance and Post-

Socialist Transformations , Bratislava workshop, 16-17 of May, 2013

Outline

• Work-in-progress• Research question• Theoretical background/review of the

literature on the topic• Method• Data and facts – NMS and Visegrad+Slovenia• Main findings• Conclusion

Research question

• The role of FDI in financial services in post-transition economies (Visegrad+Slovenia): the impact of foreign ownership during the crisis years in terms of financial stability

• Hypothesis of a dual financial/banking system evolving in the DME (VoC)context and its impact during the crisis years

New variety of Capitalism: Dependent Market Economy (DME) model

• DME is created an unequal power relation between the home countries and CEECs through parent-subsidiary networks of TNCs (Raviv, 2008., Nölke and Vliegenthart, 2009, Myant and Drahokoupil, 2010).

• Foreign credit institutions were never geared towards addressing the developmental needs of the host CEE economies (Raviv, 2008).

• Foreign financiers emerged as a powerful rentier class in Central Europe able to extract rent incomes far in excess of their profits in the west.

• Unprecedented transfer of property rights from local society to foreign investors, but also to increased unsustainable indebtedness and risk.

• TNCs prefer to hierarchically control local subsidiaries from their headquarters as an alternative mode of finance and governance rather than to accept financing by international capital markets and outsider control by dispersed shareholders (LME), or to accept financing by domestic bank lending and insider control (CME) (Nölke and Vliegenthart 2009)

5

Theories on Financial system (re)integration of

CEE revisited • Reintegration & Transition theory: Banking in Transitions Economies,

developing market Oriented Banking Sectors in Eastern Europe. (Bonin et al. 1998)

– How does foreign entry affect domestic money markets? Why do banks establish foreign subsidiaries? (Claessens et al. 2001, Buch, 2003, Berger et al. 2004)

– Entry EU banks and FDI in banking (brownfiled & greenfield privatization (Wachtel 1998)

• Modernization theory: Supporting bank privatization by foreign strategic investors vs. state ownership; key role of foreign banks in institutional development, stability and the increase of financial depth (Várhegyi 1993, Király 2005, Csaba, 2011)

• Impact of foreign bank (FP)presence on financial stability during the crisis: negatively related to domestic credit creation during the crisis and foreign banks reduced lending more than domestic banks in avarage (esp.developing countries), except when they dominated the host banking system (Claessens and van Horen 2012).

• -If FB generated majority of their funding from local deposits were less much likely to reduce lending.

Theories on Financial system (re)integration of CEE revisited

• Unequal parent–subsidiary relations– Concentration of controlling functions over CEE within the

international financial centres (IFC), (Kareman 2008, Wójcik, 2007, Gál, 2010a,b).

– the hierarchy between TNC headquarters and local subsidiaries replaces markets (LME) and associations (CME) as a typical coordination mechanism within these economies.

• Emerging dual banking system and its implication for spatial polarization and uneven development (Alessandrini & Zazzaro, 2009, Gál, 2005)

• Local banking structures are missing or weak, the strong dependence on the foreign banks

• The concentration of large banks with foreign ownership and the weakness of locally founded, smaller indigenous banks (e.g. cooperative savings banks),

Method and facts and data on V4 and Slovenia

SHARE OF FOREIGN OWNERSHIP IN THREE STRATEGIC SECTORS, 2007 Country Automotive Manufacturing Electronics Banking Czech Republic 93.1 52.6 74.8 85.8 Hungary 93.2 60.3 92.2 90.7 Poland 90.8 45.2 70.3 70.9 Slovak Republic 97.3 68.5 79.0 95.6

• We use various indicators of the financial services/banking sectors of CEE/V4+Slovenia

• Comparing pre-crisis and post-crisis (?) period

Financial reintegration of CEE

• Shift ownership from – PUBLIC to PRIVATE

– DOMESTIC to FOREIGN• FDI became the predominant type of inward investment in

the first stage of transition (privatization, country differences)

• Primary target of FDI: banking&Insurance (bank based finance)

• Foreign Banks (understandably) followed commercial principles rather than economic development

PRIVATIZATION = FOREIGNIZATION

Pre-crisis: Market share of foreign-owned banks in total banking assets 2006 (%)

Source: Local Central Banks, EBRD Transition Report 2006 ‘Finance in Transition’.

Pre-crisis: Foreign ownershipDomination of foreign banks as a financial intermediariesForeign banks control the majority of assets (mainly West European), and penetrated very early in retail segmentSHARES OF FOREIGN BANKS: 20% in OECD; 50% outside OECD

Post-crisis: Foreign shares in international comparison

- Relatively large (compared e.g. to the level of economnic development)

• FDI flew into the banking sectors: unprecedented shares of foreign ownership

– Developmental needs of CEE (pull )

– Market pressures for foreign banks (push)

- Similarly to global processes: foreign bank entry is regionally concentrated, main investors: banks from traditional/strong economic and trading partner countries, i.e. mainly eurzone countries for CEE

- However, trend for intra-regional banking integration (main player: the Hungarian OTP)

12

Total Assets(1)

EUR bn

Net Profit(2)

EUR mnNumber of Branches

Countries of presence(3)

OTP

KBC

Raiffeisen

Erste

UniCredit

IntesaSP

121.6 2,577

1,569

4,005

3,231

2,099

1,940

2,609

1,781

1,573

19

16

7

12

16

11

9

SocGen 1,201

112%

..% Contribution of CEE in Group Net Profit (After tax, after minority interests)

Notes: (1) 100% of total assets, and profit after tax (before minority interests) for controlled companies (stake > 50%) and pro rata for non- controlled companies (stake < 50%). (2) After tax, before minority interest. (3) Including direct and indirect presence in the 25 CEE countries, excluding representative offices. (4) KBC Group recorded a loss in 2008. (5) SocGen including ProFin Bank in Ukraine. Source: UniCredit Group CEE Strategic Analysis

1,078

958

(4)

53%

2051%

157%

41%

5%

n.s.

CEE, % share in Group Assets

85.4

79.3

71.6

65.9

42.5

35.2

309

186

12

54

39

20

6

7

100

(5)

OTP Group is the only local player in CEE region, with 100% of group assets in the region

DATA AS OF 2008

Post (?)-crisis: FDI in financial services in NMS, 2010 (source: WIIW)

Crisis years + post-crisis: FDI in financial services, Visegrad+Slovenia

(million euros, 2006-11, source: national banks)

Post-crisis: Foreign shares…Share of foreign-controlled companies in the gross value-added of Financial

services (CZ, HU)

Source: statistical offices, national accounts

Sources of Finance in DME model

Stock Market Capitalization

Domestic Credit to Private Sector

Inward FDI stock RATIO INWARD FDI

STOCK/ OUTWARD FDI

Country

(Percentage of GDP) (Percentage of GDP) (Percentage of GDP) DME (DEPENDENT MARKET ECONOMIES)

Czech Republic 31.0 33 48.0 15.3 Hungary 29.5 46 51.8 6.4 Poland 30.1 28 24.9 9.7 Slovak Republic 25.0 31 31.5 23.6

LME (LIBERAL MARKET ECONOMIES) U.K. 138.9 156 37.8 0.8 U.S. 136.9 249 12.7

CME (COORDINATED MARKET ECONOMIES) Austria 41.3 106 22.7 1.0 Germany 43.7 112 16.4 0.5

17

Implications for unequal parent-subsidiary

relations: transnational network connectivity

• SHIFT in key decision making/control functions to the parent banks (outcome of previous FDI)

• Reduce the information available for host country supervisors• Power relations: CEE centres is subordinated by West European IFCs• Connectivity through parent-subsidiary network

– Concentration of outdegree connections (sender IFCs) forms Western gateways to CEE (Vienna, Paris, Athens, Frankfurt)

– Concentration of indegree connections (hosting hubs)forms bridgehead centres in CEE (Moscow, Warsaw, Budapest)

• Lack of control function in IFCs located in CEE capital cities– Only exception is Budapest: control functions of OTP Bank (OTP is

the only regionally based MNC with regional subsidiaries network)

18

Parent (HQ)-subsidiary (CEE) relations-- degrees of financial connectivities

Kareman,2008, Gál, 2010

19

Concentration of control functions of parent-subsidiary relations

Kareman,2008, Gál, 2010

Dependency on parent bank finance: Out of a “liquidity-crisis mood”, but funding availability and cost remain a

constraint for CEE banking

3.5%

8.5%

10.5%

16.0%

17.4%

18.7%

21.5%

23.8%

26.8%

27.2%

29.5%

30.3%

31.0%

32.7%

44.6%

52.5%

53.9%

Slovakia

Czech Rep.

Turkey

Russia

Serbia

Poland

Croatia

Bulgaria

Ukraine

Romania

Bosnia

Slovenia

Hungary

Kazakhstan

Lithuania

Estonia

Latvia

0

50

100

150

200

250

300

350

400

450

2005 2006 2007 2008 2009F

0%

5%

10%

15%

20%

25%

Volumes (l.s.)

% on total liab. (r.s.)

CEE external liabilities(1)

(1) CEE-17Source: UniCredit Group CEE Strategic Analysis

Banking sector external liabilities(% on total liabilities, June 2009)

21

High level of financial dependency on global (EU) financial institutions

“great capitalist transformation” of Eastern Europe has been expressed over the last decade by a high level of debt and financial dependence on Western European banks, which is without precedent since decolonization… Samary, 2009 (Towards a Western/Eastern Europe Banking and Social Tsunami)

„Adopt our ways, the EU said, and you will share our prosperity and freedom. Eastern Europe responded eagerly. Paradoxically, their very eagerness opened the way to their current problems. Their adoption of EU rules made leading banks feel safe to lend to them. Money flowed in, helping the region start catching up with the half-century it had lagged behind its western neighbours' economic growth. And then the financial crisis hit. The lending that sustained east Europe's current account deficits until last year was largely provided by local subsidiaries of central and west European banks; it has now evaporated. The region's governments - many of which managed their finances more prudently than many western countries - find themselves unable to plug the yawning financing gaps. … Smaller member states are often the most committed to the EU, but they can do little when their big neighbours cynically undermine it.” Financial Times, 2009.febr. 19.

„Argentina on the Danube” (The Economist , 2009 February)„Subprime Europe”

22

The dual-banking systems• CEE suffer from a a “de-nationalised dual banking system”,

consisting of large foreign banks and small local banks (Gál, 2005, 2009; Alessandrini and Zazzaro, 2009).

• Pros– Acess to resources of parent banks, transfer reputation– Institutional efficiency; efficiency in credit allocation (?)– Contribution to financial/macroeconomic stability – foreign banks branches are channels of modernization– Introductions of efficient rules of governance– More stable credit sources for the local economy during economic downturns?

• Cons– The „dual banking system” is more prone to transmit adverse shocks across

borders and serves as a propagation channel for potential regional shocks – Extremely high centralisation of HQ function in capital cities– Lack of strong locally-regionally based banks: savings cooperatives with weak

financial standing– Financial exclusion (lower accessibility to services on certain territorial level )– Transfering adverse shocks across borders

23

Problem originating from a parent banks during the crisis

1. Parent banking background is helpful (Haas-Lelyveld, 2009)– Supportive effects– Substititional effects (reallocation of bank capital by risk and expected yield)

2. Cross-border lending channels deliver shocks (Goldberg, 2009)– Foreign banks played a significant role in the transmission of the current crisis

to EMEs3. Maturity mismatch, lending in foreign currencies (swaps),

– High loan/deposit ratio– High exposure in foreign liabilities (carry trade, currency swaps) 1000 Bn USD– Different regulations in parent and subsidiaries’ countries (Highest net foreign

debt of the private sector in Hungary)– Liqudity crisis in CEE, Suden stops in cross border interbank lending

4. Stages of shock transmission– Pre-Lehman Brothers: risk premium, narrowing liquidity, decreasing parent

supply– Post-lehman Brothers: solvency problems, fall in share values, and

downgrading ratings at parent banks• Capital flight? Parent banks generated capital outflow from their

subsidiaries; difficulties in subsidiaries’ finance

24

Conclusions 1• Role of FDI/foreign banks in Visegrad+Slovenia financial services:

evolution of a dual banking system (Slovenia: the outlier)• The role of FDI in economic growth revisited (Balogh, 1982, Rajan et

al 2006)– Negative correlation between growth and FDI stocks in EME– Positive correlation between growth and FDI stocks only in developed c.– Foreign bank presence in low income countries generates less credit– During crisis reduce their domestic credit more than domestic banks

• The impact of the dual system during the crisis years revisited in the framework of the dependent market economies model

• Crisis years: analysis of the geography of the changing network (parent-subsidiary) relations– Parent banks generated current account imbalances (substituted local

houshold savings)– Stronger substitution effects: reallocation of resources within banking groups

(OTP Banks, IMF loan, capital flights?)

Conclusions 2

Implications for transformation of the crisis-prone European financial landscape •In 2009 CEE was the main crisis spot•In 2010 EMU in debt and fiscal crisis •Future of banking subsidiaries in CEE (relocation, consolidation, Foreign bank exits)•Increasing role of the nation state (regulation, taxation)•Weakening states in CEE (no ability to support their banking, taxation banking)•To strenghten local financial structures (EBRD CEO warning)