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'z’rég, 43“},1‘. a . ,r .u ' n ’ u u-o m... ..A ‘, (“;.< o»... .n», .n. .. nu”... n .. -..u - -w-.. 1'- ‘ w: vi ' ‘ . . '55 1.“. .l'; r I ~--.... ...... . n a... . '41.»..-- . . o n.-... .oq IIIIIIII"'°"I°‘"I IIIIIII II III I I III IIIIIIII I W W LIBRARY Michigan State J.— University This is to certify that the dissertation entitled TAI‘JJAI‘V'S IN‘I‘ERI‘IATIOIIAL LYV'ES‘I‘L IQI‘ITS AM) FIIIAIECIAL ll'iTEiflHEDIARIES: OPTIP’IAL Li'flRA'iHsGlIsS FDR A GKAUUATIIJG, DEVELOPING ECOIIOI-IY presented by Chai-Liang Huang has been accepted towards fulfillment of the requirements for Ph.D Economics degree in #:13er krofessor' DateJ4‘0Y /0{ [990 MS U is an Affirman've Actinn/ Equal Opportunity Institution 0-12771 PLACE IN RETURN BOX to remove We checkout from your record. TO AVOID FINES return on or before dds duo. ' II DATE DUE DATE DUE DATE DUE I MSU Is An Affirmdlvo ActIorVEqunl Opportunity Indltutlon TAIWAN'S INTERNATIONAL INVESTMENTS AND FINANCIAL INTERMEDIARIES: OPTIMAL STRATEGIES FOR A GRADUATING, DEVELOPING ECONOMY BY Chai-Liang Huang A DISSERTATION Submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Economics 1990 ((i4{p- 548’ ABSTRACT TAIWAN'S INTERNATIONAL INVESTMENTS AND FINANCIAL INTERMEDIARIES: OPTIMAL STRATEGIES FOR A GRADUATING, DEVELOPING ECONOMY BY Chai—Liang Huang Rapid economic growth and export expansion have led to a major trading role for Taiwan in the global economy. In most recent years, this growth has been characterized by large current account surpluses.and.high levels chdomestic savings. However, the banking system is not yet sufficiently developed; both domestic and foreign investments have lagged behind. These indicate the dimensions of the need for structural reform and economic transformation, of which a key aspect is the growth of Taiwan's international banking and financial capability. This is the focus of this dissertation. A well developed banking mechanism with an international capacity is the objective of the government of Taiwan, since it will be needed whether or not current account surpluses continue. An optimal strategy for developing international investment and. banking' is derived. through examining' the theories of competitive advantage, locational choice, organizational form choice and international portfolio investment. Because the experience of Japan in the 19705 bears so many similarities.to the current situation of'Taiwan, it is explored in detail. The strategy for’ Taiwan. must begin with the establishment of a basic international network of banking. This must include at least two branches. Additional branches should be established in those locations possessing the most competitive advantages. Initially, the branch is the best organizational ‘form. Thereafter, subsidiaries become desirable since they allow a greater degree of flexibility. Representative offices enable a bank to gain experience in a new area. Given the potential for both internal and external political crisis, international portfolio investment will grow in importance as Taiwanese investors aim at minimizing risks by investing overseas. Historically, the financial system in Taiwan has been overly regulated and domestic-oriented, but this has begun to change. Although the government has lifted many restrictions, it must still vigorously pursue policies aimed at developing international investment and banking capacity. This will be in line with long-term development objectives for Taiwan. ACKNOWLEDGEMENTS I wish to express my sincere gratitude to my dissertation chairman, Dr. Subbiah Kannappan, who so generously gave of his time and energy, providing detailed guidance on every aspect of this study; to Dr. Anthony Koo, who provided much needed encouragement, economic data, and useful cements; to Dr. Andrew Brimmer and Dr. Norman Obst, who both contributed numerous constructive suggestions and valuable comments. I would like to thank my wife for her unwavering support, assistance, and for her diligent typing of this dissertation, as well as Teresa Howes for her editorial assistance. In addition, I would like to express my indebtedness to my parents for their support throughout my graduate studies. Finally, these acknowledgements would not be complete without an expression of gratitude to Buddha and my Buddhist teacher, Min-Hui. ii TABLE OF CONTENTS CHAPTERONE-INTRODUflION ......OOOOOOOOOOOOOOOO ..... CHAPTER TWO - INTRODUCTION OF TAIWAN HISTORICAL BACKGROUND AND FINANCIAL SYSTEM ......... I. Background of Taiwan Economy ............ ...... A. B. C. D. Two Stages of Economic Development .... ...... 1. Import Substitution ....................... 2. Export Expansion .......................... Import and Export 1. Rising International Trade ................ 2. Increase in Trade Surplus ................. Saving and Investments ...................... 1. Sources of Domestic savings ............... 2. Usage of Funds ............................ 3. Net Saving Analysis ................. ...... Existing Problems Since 1980 ................ 1. Imbalance in Saving and Investment ... ..... a. Saving and Investment in Different Sectors ................................. b. Possible Reasons for the Decline in Investment .......... (1). Potential Political Crisis in the Late 19708 and 19805 ........ ........ (2). Environmental Protectionism .... ..... (3). Increase in Unit Labor Cost ......... 2. Trade Imbalance ........................... a. Trade Imbalance with Important Trade Partners ................................ b. New Conflict and Protectionism ..... ..... 3. International Payment Imbalance ........... a. Foreign Exchange Control ........... ..... b. Accumulation of International Reserves... II. Financial System Background ................... A. B. Taiwan's Financial System ................... 1. Financial Institutions .................... 2. Financial Markets ......................... a. Money Market ............................ b. Capital Market .................... ...... Current Problems of Taiwan's Financial System ...................................... l. Cartel-Type Oligopolistic Banking System... iii 10 10 11 11 12 13 13 14 14 15 16 16 17 18 18 20 20 21 23 24 25 26 27 28 29 30 32 32 33 33 35 35 36 a. Entry Restriction .............. ......... b. Government Ownership .................... c. Consequences ............................ (1). Low Operating Efficiency ...... ....... (2). Outdated Technology .................. (3). Sluggish Development of International Banking .......... ...... 2. Underdeveloped Capital Market ........ ..... a. Small Scale Capital Market .............. b. Imbalance in the Proportions of Individual and Institutional Investors... c. Small Scale Security Firms .............. d. Handicap in Underwriting ......... ....... e. Consequences ................. ..... . ..... (1). High Turn-Over Ratio ........... ..... (2). Sluggish Development of International Investments ........... (3). Sluggish Development of International Investment Banking .... III. Interaction Between the Real Economy and the Financial System ..... ......................... A. Potential Inflation Rate .................... B. Abnormal Development in Stock Market ........ C. Abnormal Development in Real Estate ... ...... D. Excess Funds in Financial Institutions ...... CHAPTER THREE - INTERNATIONAL BANKING ................. I. Introduction ............................ ...... II. Literature Review ............................. A. International Trade: A Macroeconomic Approach B. Industrial Organization Approach: Microeconomic Approach ...... ........ ... ..... C. Foreign Direct Investment Approach: An Eclectic Theory ........................ ..... III. Competitive Factors for the Development of Multinational Banking ................... ...... A. Microeconomic Competitive Factors ........... 1. Imperfections in Product Markets .......... 2. Imperfections in Factor Markets . .......... a. Money Capital ................ ........... b. Information Capital ..................... c. Human Capital ........................... B. Macroeconomic Country: Specific Factors ..... 1. Surplus Funds Advantage ................... 2. Foreign Direct Investment ................. 3. International Trade ....................... 4. Nationality ............................... IV. The Potential Gains From Multinational Banking. A. Increases in Current and Expected Profits ... 1. Interest Rate Arbitrage ................... 2. Regulatory Arbitrage ................ ...... 3. International Fund Transfers and Services.. iv 36 38 4O 40 41 42 42 43 44 44 48 49 49 49 50 50 51 51 52 52 54 54 55 55 56 57 59 59 59 61 61 61 62 63 63 63 64 65 66 66 66 67 68 4. Information Transfer and Relationship Preservation .............. ..... ..... ...... 69 5. Human Capital Transfer and Training ....... 69 6. Technology Transfer ................. ...... 70 7. Economies of Scale .................. ...... 70 B. Reduction in Risk ..................... ...... 71 1. Reduced Earnings Variability .............. 71 2. Increased Stability of Funds Sources ...... 72 3. Reduction in Regulatory Risk .............. 72 4. Reduction Threats by competitors .... ...... 72 5. Reduction in Default Rate of Loans and Capital Loss .............................. 73 V. Location Choice .......................... ..... 74 A. Interest Rate Arbitrage ..... .......... . ..... 74 1. Commercial Loan Rate Arbitrage ............ 74 a. Foreign Direct Investment Advantage ..... 74 b. International Trade Advantage ........... 75 c. The Growing Foreign Market .............. 75 2. Security and Foreign Exchange Rate Arbitrage OOOOOOOOOOOOOOOOOOOOOO00......0.0 76 B. Increase in the Security of Fund Sources .... 76 C. Avoiding Regulatory Costs and Constraints ... 77 D. International Fund Transfers and Services ... 77 E. Information Transfer and Relationship Preservation ......... ..... ..... ...... . ...... 78 F. Information Collection ................. ..... 79 G. Technology Application and Transfer .... ..... 79 H. Economies of Scale and the Reduction in Default Loss .. ............................. 80 I. Summary for Location Choices ................ 80 VI. Evolution of the International Banking Business 82 A. Funds Usage ................................. 82 B. Sources of Funds for Overseas Operations .... 83 VII. Organization Forms of Overseas Expansion ...... 85 A. Representative Offices ...................... 85 B. Agencies ............................. ....... 86 C. Branches ........................ ............ 87 D. Subsidiaries ................................ 88 E. Conclusions .................... ...... .. ..... 88 CHAPTER FOUR - INTERNATIONAL INVESTMENT .......... ..... 90 I. One Parameter Model ..................... ...... 90 A. Microeconomic Type Foreign Direct Investment. 92 B. Macroeconomic Type Foreign Direct Investment. 93 II. Two parameter model ........................... 94 A. Domestic Portfolio Theory ................... 94 B. International Portfolio Theory .............. 97 1. Diversification of Market Risk ............ 97 2. Expansion in Choice Set ................... 100 3. Implication of Two Parameter Model ........ 101 III. Relationship Between Risks and Investment Behaviors ..................................... A. Absolute Risk Aversion and Relative Risk Aversion .................................... B. Empirical Evidences ......................... C. Implication for International Portfolio Investments and International banking ....... IV. Investment Behavior of the Central Banks ...... A. Factors Determining the Magnitude of Precautionary Foreign Exchange Reserves ..... B. Factors Determining the Currency Composition of Foreign-Exchange Reserves .... C. Principles of Portfolio Management .......... 1. Precaution-Oriented Reserve ............... 2. Investment-Oriented Reserve ............... CHAPTER FIVE - JAPAN'S EXPERIENCES ... ................. I. Introduction ............................. ..... II. The Japanese Experience ....................... A. Internationalization of Japanese Financial Institutions ................................ 1. Commercial Banks Overseas ................. 2. Securities Companies Overseas ............. 3. Insurance Companies Overseas .............. B. International Investment Strategies ......... 1. Stock Investment .......................... 2. Bond Investment ..................... ...... C. Evaluation .................................. CHAPTER SIX - TAIWAN'S PAST EXPERIENCES AND FUTURE STRATEGIES FOR INTERNATIONAL INVESTMENTS AND FINANCIAL DEVELOPMENT ............... I. Taiwanese Past Experience in International Investment .................................... A. The Magnitude of Precaution-Oriented Reserves B. Currency Composition of Foreign-Exchange Reserves .................................... C. Portfolio Management ........................ D. Big Loss .................................... II. New Policies of Reserve Management and Current Experience ............................ A. Central Bank Policies ....................... 1. Relaxation of Capital Control ............. 2. Increase in Gold Purchase ................. 3. Diversification of Currency Composition and Securities Portfolio .................. 4. The Overseas Economic Cooperation and Development Fund (1988) ................... 5. Support for the Interbank Dollar call Loan Market ............................... 6. Support Foreign Branches of Domestic Banks and Domestic Firms .................. vi 102 102 103 105 106 108 109 110 110 111 112 112 113 117 118 126 131 134 139 143 145 149 149 151 153 155 156 158 158 158 158 159 160 161 161 B. Foreign Direct Investment .... ...... ......... 162 C. Portfolio Investment ........................ 166 1. Stock Investment .......................... 167 2. Bond Investment ........................... 169 III. Strategy for International Portfolio Investment. 170 A. Expectation for the Future Development ...... 171 B. Individual Investors ........................ 172 C. The Institutional Investors ................. 173 IV. Sluggish Development of International Banking in the Past ........................... 174 V. Current Development of International Banking .. 175 VI. Strategy for International Banking Development. 178 A. Continued Growth in Export .................. 178 B. Rise in Foreign Direct Investment ........... 179 C. Continuous Current Surplus .................. 180 D. Analysis and Strategy Suggestions ........... 181 CHAPTER SEVEN - CONCLUSION ............................ 186 APPENDIX A: THE EXISTENCE OF POLITICAL CRISIS ......... 194 APPENDIX B: THE ACCOUNTING FRAMEWORK .................. 196 APPENDIX C: FOREIGN BANKS IN TAIWAN . ...... . ..... . ..... 197 APPENDIX D: THE KUWAITI EXPERIENCE .................... 198 APPENDIX E: TAIWAN'S CURRENT ACCOUNT SURPLUS .......... 211 APPENDIX F: A MULTILATERAL APPROACH ................... 219 BIBLIOGRAPHY ......OOOOOOOOOOO...OOOOOOOOOOOOOOOOOOOOOO 224 vii TABLE \DmflmmbuNI-J ...: O 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 LIST OF TABLES Indicators of the Taiwanese Economy ............ International Trade ............................ Saving and Investment The Ratio of Net Saving to GNP ................. Pollution Control Equipment Expenditures ....... Growth Rate in Unit Labor Cost ................. Export and Import in 19803 ................ ..... The Ratio of Current Account Surplus to GNP .... Key Indicators of Financial Development in1961-87 ..OOOOOOOOOOOO Assets and Units of Financial Institutions in Taiwan, ROOOCO 0.0.0.0... Shares of Commercial Banks Out of All Financial Institutes .............. Profits Rates of Domestic Banks and Foreign Banks OOOOOOOOOOOOOOOOOOO Taiwan, Tokyo, New York and London Stock ExChanges OOOOOOOOOOOOOOO Stock Transactions by Types of Investors ....... Share Ownership in Taiwan, Selected Years ...... Share Ownership in Japan, Selected Years ....... Foreign Exchange Profits and Losses ............ Japanese Foreign Direct Investment ............. Japanese Bank Offices Overseas ........... ...... Earnings Per Share of Major Japanese Securities Firms ........ Key Indices for Japanese International Investments The Japanese Purchase of Foreign Stock, 1981-87. The Japanese Purchase of Foreign Bonds, 1981-87. Flow and Stock of Foreign Reserve .............. Taiwan's Sources and Used of Funds ............. Central Bank of China Gold Holdings-~Stock ..... Amount of FDI by Taiwanese Firms ............... Percentage of FDI by Taiwanese Firms ........... The Taiwanese Purchases of Foreign Stock Through U.S. Financial Intermediaries, 1981-1988 ....... The Taiwanese Purchases of Foreign Bond Through U.S. Financial Intermediaries, 1981-1988 ....... Taiwanese Banks Overseas viii 10 14 15 17 22 24 25 28 31 34 36 40 45 45 47 47 68 121 122 130 139 140 144 151 157 160 165 165 168 169 174 32 33 34 35 36 37 Contributors to Output Expansion ........ ....... 179 Exports by Selected Countries .................. 211 Dollar Exchange Rate and CPI ................... 213 Import Quantum by Commodity Groups ............. 215 Composition of Imports ................... ...... 216 Import From U.S.A. ......OOOOOOOOOOOOOOO ........ 217 ix FIGURE (”b-UMP LIST OF FIGURES The Theory of International Capital Movements ... 91 The Efficient Frontier .......................... 95 Effect of International Diversification on Risk . 97 Various Efficient Frontiers ................ ..... 99 Gains From Trade ................................ 220 CHAPTER 1 INTRODUCTION Taiwan's economy has enjoyed a high growth rate since the 1950s. A high level of domestic investment and savings is a major reason for the rapid growth. Financial intermediations play a successful role in channeling savings into investment. Another reason for the growth is the rapid expansion of foreign trade. From 1952 to 1987, foreign trade and exports increased 700 times and 1,160 times respectively. By 1987, Taiwan became the thirteenth largest trading country in the world. This rapid growth in real international transactions, however, outpaced the development of international financial intermediaries. This has mainly been due to government restrictions, which prohibited banks from operating beyond the country, and an Oligopolistic banking system characterized by low operating efficiency. The negligible volume of international investments, reflecting restrictive measures, also impeded the growth of international banking. Since 1980 domestic investments have slowed down dramatically, causing the current account surplus to surge to an awkwardly high level, especially when compared to other surplus countries in terms of the ratio of surplus to gross national product (GNP). The small size of international investments and the underdeveloped nature of the international banking system 1 2 impeded capital outflow in the 19805. International reserves thus continued to accumulate. At the end of 1987, the foreign exchange reserves of the Central Bank of China This ranked third in the whole world. The ratio of international reserves to imports was probably the highest in the world. To efficiently utilize the surplus funds, Taiwan can invest internationally, both in foreign direct and portfolio investments. Taiwan can also give official and commercial loans, export and import credits, etc. So far, Taiwan has undergone successful structural adjustment. The share of agriculture in gross domestic product was 32.5 percent in 1951, and declined to a mere 5.6 percent in 1986. The share of industry, which was 23.9 percent in 1951, rose to 51.4 percent in 1986. The service sector showed no change or held its own during the same period. The export of agricultural products and processed agricultural goods dominated export trade prior to 1962. After that, industrial goods emerged as the major export items. The ratio of industrial goods exports to the total exceeded 60 percent in 1967 and has stayed at 90 percent since 1979. The past success of manufacturing development in Taiwan was characterized. by’ product. cycles of jprocessed foods, textiles, shoes, and electrical machinery which took forth as leading industries. The successful adjustment of the production and export structures contributed to the rapid 3 economic growth. However, in the 19805, increases in labor and land costs, and environmental protectionism had an adverse impact on Taiwan's economic growth. Export success also had an adverse impact because of appreciation of Taiwan's currency. The labor-intensive and lower value-added manufacturing industries are no longer as profitable. Although Taiwan is a major trading country, her foreign trade is not well diversified. One reason is the degrees of undevelopment of her industrial structure. She must improve on this by expanding the output shares of technology-intensive and high-value-added manufacturing industries by introducing advanced technology from foreign countries and by shifting comparative disadvantage industries abroad. Foreign direct investment in the advanced industrial countries can also help in the transformation of Taiwan's economy. Investing in low labor-cost, resource abundant developing countries will also insure the supply of raw materials and extend the life of comparative disadvantage industries. Taiwan is also weak in her international marketing network and skills. To expand foreign market share and diversify foreign trade, opening sales and service branches in the major trading countries and potential markets will be necessary. Supplying export credits to foreign firms is important for export expansion and trade diversification. Setting up foreign. bank; branches will also provide the necessary financial support and information assistance. 4 Rapid appreciation of the local currency since 1986 and rising international protectionism in the late 19808 will slow down Taiwan's export expansion. This may also dampen the rate of economic growth. One needed step will be to increase domestic demand. Given the slow growth in the manufacturing sector due to sluggish export expansion, development of the domestic service sector may provide a good alternative. The Taiwanese government already treats the banking industry as one of the key industries to reach that goal. Taipei is also targeted to rival or replace Hong Kong as an international financial center after 1997. Liberalization and internationalization of the banking system has occurred in the past two years. Taiwan revised her banking law in 1989 and changed her attitude toward the banking sector even earlier. By lifting existing restrictions, the new law allows the establishment of new private banks ending the monopoly enjoyed by government- controlled banks in the last 40 years. The new banking law also permits foreign banks to engage in a wider range of investment banking activities, such as the lucrative business of underwriting public stock offerings. On the other hand, the government also encourages Taiwan's banks to open overseas branches. The goal is to have six new foreign branches of domestic banks set up in 1991 and ten branches in 1992. In addition to profit maximization and economic growth, national security is a major objective of the government in 5 its desire to develop international financial capability. Internal political instability and isolation internationally has spurred Taiwan in this direction. For example, the Taiwanese government prefers to maintain control over her reserves by depositing them in foreign branches of her own banks. This measure will guarantee a source of funds to purchase arms were Taiwan invaded by Mainland China in the future. The development of an extensive international financial network will also contribute to Taiwan's integration into the world economy which will in turn increase political support from other countries within the international community. Given the fact that Taiwan does not have much experience in international banking but is interested in developing her own international banking system, the question of whether Taiwan can successfully develop her own international banking system must be examined. What will be the optimal strategy for attaining this goal? Specifically, where are the best locations to set up foreign branches? Which organizational form will be the best? The Taiwanese government lifted most capital control measures on July 15, 1987. However, the large current surplus cannot be resolved by suddenly relaxing exchange controls. The level of international investments is still insignificant. Whether international portfolio investment can help the payment imbalance is an important question to be answered. 6 What government policies can be undertaken to promote the future development of international portfolio investment? Any discussion of the adjustment of payment imbalance which neglects the preceding questions would be incomplete. In recent years, a few papers have studied Taiwan's international payments imbalances in the 1980s from the financial liberalization and internationalization ‘ They focus on the liberalization of the perspective. domestic banking system and the introduction of foreign banks into Taiwan. However, they do not directly examine the international development of domestic financial intermediaries and international investment. While foreign banks can help channel surplus funds outward, they do not possess the same advantages in credit-worthiness and good will as the local banks. Further, language, customs, tradition, and social networks constitute barriers that can be difficult for foreign banks to overcome. In contrast, domestic banks can provide better service with lower production costs. Chen and Su (1989) and. two papers from. the Chung-Hua Institute for Economic Research (1988a and 1988b) are the only studies on Taiwan's international investments. However, these three papers focus only on foreign direct investment by domestic firms. Seth and McCauley (1987) is the only study which 1 Liang (1988), Ho (1988), and Lee and Peng (1985) examine the international payment imbalance problems from the financial liberalization perspective. In contrast, Tai (1986) and Shea (1988) take a financial internationalization approach to the same problems. 7 discusses Taiwan's international portfolio investments and related issues. Their study compares portfolio investment behaviors of Taiwan, Korea, and Japan, but does not discuss all the important issues related to international portfolio investment, or any aspects of the international banking system. My study will fill an important gap in the literature. The purpose of this study can be considered as fourfold: (1) to find out the basic reasons for and consequences of the current surplus and accumulation of international reserves; (2) to examine the issues involved in encouraging overseas portfolio investment and international financial intermediations by the developing countries with a surplus: (3) to set up a theoretical framework for assessing optimal strategies in this above respect; and (4) to discuss implications for government policy. This thesis begins with a brief summary of the economic development of Taiwan and its financial system, which will focus on the basic reasons for the current account surplus and the accumulation of international reserves. It follows with a review of theoretical and empirical studies which might.have a bearing on optimal strategies for international investment and the development of an international financial system. A framework of international banking will be developed, based on 8 the theories of international trade, industrial organization, and foreign direct investments. The model will help in shaping the strategies for choosing the location and organizational form of overseas expansion. The theories of portfolio investment by individuals will also be discussed. To reinforce a prior exercise, we will also examine Japanese experience in international investment and the development of international financial intermediaries. The Japanese experience in the 19705 and 19805 represent the most recent relevant examples. This will be contrasted with the current development of Taiwanese international investment and financial intermediaries. The experiences of Japan, as in combination with general theories, should provide valuable lessons for Taiwan. The research for this study reflects the above purposes, as well as the availability and reliability of data. Both the quantitative and qualitative aspects will be covered, For the most part, the data go back to 1952, and terminate with 1987, the last year for which the bulk of the data was available, although data from 1951 and 1989 will be included when available. Chapter two discusses Taiwan's economy and her financial system, and the current problems relating to the surplus. In chapter three, the competitive factors of international banking are carefully examined. The potential gains from the development of multinational banking and consider the 9 questions of choice of location and organization will also be discussed. Chapter four discusses international portfolio investments. Chapter five examines Japanese experiences in international investments and the development of international financial intermediaries. Chapter six focuses on the implications of the Japanese experiences for Taiwan, incorporating the theoretical framework developed in chapter three and four. A strategy for international investment and the development of international banking will also be suggested. Chapter seven presents the summary and conclusions. CHAPTER 2 TAIWAN'S HISTORICAL BACKGROUND AND FINANCIAL SYSTEM I. G A W NO Taiwan has achieved remarkable economic progress in the past four decades. From 1952 to 1987, in a period of 35 years, the gross domestic product in real terms grew by a. factor of 19.1 (see table 1). Real income per capita increased by a factor of 8.3 during the same period. The growth of international trade is even more remarkable. In 1987 the level of exports was 1,160 times the level of 1952; comparable figures for imports and total trade were 434 and 700 respectively. Table 1. Indicators of the Taiwanese Economy (Base:1952=100) Year GNP Per Capita Export Import Trade GNP 1952 100.0 100.0 100.0 100.0 100.0 1955 129.5 116.7 130.6 124.2 126.5 1960 179.1 137.2 406.4 426.3 419.0 1965 281.5 185.9 1,225.3 880.2 1,006.8 1970 448.7 263.1 4,036.6 2,412.6 3,008.4 1975 682.8 364.5 13,724.0 8,940.4 10,695.5 1980 1,128.7 546.4 48,514.6 28,086.6 35,581.8 1985 1,544.2 689.3 83,304.1 31,656.0 50,606.1 1987 1,914.3 836.3 116,019.6 43,406.8 70,049.1 Source: Taiwan Statistical Data Book, 1988, Council for Economic Planning and Development. 10 11 A. Tag Stagaa Q: Eggagmic Qeveiopmeat The economic development of Taiwan thus far may be divided into two important stages. The first stage of economic development was characterized by import substitution. The second stage of development displays export expansion. 1- WW Prior to 1950, Taiwan was predominantly an agricultural economy. To industrialize the economy, Taiwan started out with import substitution in nondurable consumer goods and their inputs in the early 19505. A system of incentives, such as tariffs and import restrictions, was adopted to 2 Import substitution in support inward-oriented policies. textiles, clothing, and shoes and other leather products contributed to the rapid growth of industrial production in Taiwan during this period. As a consequence of the cessation of import substitution in these industries toward the end of the 19505, Taiwan experienced sluggish growth and balance-of payments difficulties. Because the small size of domestic markets in Taiwan raised product costs and restricted the scope of import substitution in intermediate products, machinery, and consumer durable goods, Taiwan switched to export-oriented policies around 1960. The system of incentives was changed from one 2 The system of incentives for import substitution was a bias against exporting manufactured goods and thus against balance of payments. 12 supporting inward-oriented policies to one supporting outward- oriented policies based on the profitability of exports. 2- W These latter policies allowed Taiwan to specialize in labor intensive goods by taking advantage of a well-motivated labor force with a high level of education and relatively low wages. The expansion of labor-intensive exporting sectors also absorbed unemployment. In the fifties and early 19605, the unemployment rate was persistently above 6 percent. The unemployment rate began to decline in 1964, reaching 4.2 percent in 1966, and 3.4 percent in 1969. Thereafter, that the unemployment rate stayed within a range of 2.0 - 3.0 percent throughout the 19705.3 The growth of exports also allowed firms to apply large scale production methods in consumer goods industries and achieve high capacity utilization, leading to improvements in technology and product quality. Both import substitution and export expansion have contributed to the successful development of Taiwan's economy. Export expansion freed the economy of balance of payments constraints and permitted rapid economic growth. The GDP growth rate was 7.6 percent in 1952-60, 9.6 percent in 1961-70 and 9.7 percent in the period 1971-80, in real terms. It slowed down slightly to 7.5 percent in 1981-87. 3 See Kuo (1983), Table A1.4 Unemployment Rate. 13 B. o o s 1- WW While imports were already over $200 million in 1954, exports did not exceed $200 million annually until 1961, giving rise to an unfavorable trade balance in the 19505.“ The net effect of the measures taken to restrict imports during the era of import substitution was to raise the prices of imported raw materials and capital goods, hindering the expansion of the export sector. Since the adoption of outward-oriented policies in 1960, there has been a rapid expansion of trade. Exports reached $1 billion in 1969, broke the $10 billion mark in 1978, and surpassed $50 billion in 1987. Imports also rose from $1 billion in 1969 to $10 billion in 1978 and over $30 billion in 1987 (see table 2). Whereas the value of‘annual trade had never exceeded $0.5 billion prior to 1961, it grew at an increasing rate reaching $1 billion in 1965 and over $10 billion in 1974. It surpassed $50 billion in 1984, and reached nearly $90 billion in 1987. Taiwan is now the thirteenth largest trading country in the world. ‘ The "S" sign will be used throughout to represent the U.S. $ unless otherwise specified. 14 Table 2. International Trade Xaa; 3x293; IEPQIE Iota; Igade Trade Sugpius 1952 0.1 0.2 0.3 -0.1 1955 0.1 0.2 0.3 -0.1 1960 0.2 0.3 0.5 -0.1 1965 0.4 0.5 1.0 -0.1 1970 1.5 1.5 3.0 0.0 1975 5.3 6.0 11.3 -0.6 1980 19.8 19.7 39.5 0.0 1985 30.7 20.1 50.8 10.6 1987 53.6 34.5 88.0 19.0 Unit: $ billion Source: WM.- 1988. The Council for Economic Planning and Development. 2. ea e ' t ade 5 lus Despite the rapid expansion of exports, the trade balance remained unfavorable, with a trade deficit existing until 1970. In the 19505 and 19605, the annual trade deficit was about $90 million. Taiwan has had a trade surplus every year since 1971 except for 1974 and 1975 in response to the oil shock. The trade surplus reached $10 billion in 1985, and increased to $19 billion in 1987 (see table 2). C. Savings and layesgment Rapid economic growth in Taiwan was also associated with increases in the savings and investment rates. The ratios of savings to GNP were around 15 percent in the early 19505. It increased to 20 percent in 1964, and 30 percent in 1972. Except for a brief decline in 1975, the ratio has remained above 30 percent since then. In 1987, it reached 40 percent. The ratio of investments to GNP was also close to 15 percent 15 in 1951. However, it soon outpaced the rate of saving, reaching 20 percent in 1960, and 30 percent in 1974. It peaked in 1980 at 34 percent and declined steadily to 16 percent in 1986. The ratio of investment to GNP climbed slightly in 1987, but remained well under 20 percent. Table 3. Savings and Investment Xaa; SayingLSNE InvestmentZGNP Net savingfiSNP 1951 15.76 14.53 1.23 1955 14.63 13.40 1.23 1960 17.86 20.30 -2.44 1965 20.82 22.83 -2.01 1970 25.71 25.69 0.02 1975 26.96 30.81 -3.85 1980 32.74 34.32 -1.58 1985 33.10 17.56 15.54 1987 40.31 18.77 21.54 Unit: Percentage Source: National Income, DBAS. 1. Sougcas 0; domestic savings Gross domestic savings can be divided into three categories, namely, corporate, government, and household savings. The ratio of corporate savings to gross savings never dropping below 40 percent until 1971. After that, the ratio declined to the 30-40 percent range. In 1987, corporate savings accounted.for'32 percent of total savings. ‘Except for the early 19505, the ratio of government savings to total savings never exceeded 30 percent during 1951-1987. In 1987, government savings accounted for only 15 percent of total savings. In contrast, the ratios of household savings to 16 total savings were lower in the 19505 at under 30 percent of total savings. .After 1961, the household sector’had around 40 percent of total savings most of the years. From 1980 to 1987, the ratio of household savings increased from 36 to 52 percent. This shows the household sector has dominated role in gross saving of Taiwan economy. 2. Us 0 u Gross domestic investments can also be classified into three categories: corporate, government, and household investments. The ratio of corporate to gross investment was the highest, above 70 percent from 1951 until 1981 excluding 69 percent in 1977. After 1981, the ratio fell below 70 percent. Government investment ranged between 10 to 20 percent from 1951 to 1987. Household investment ranged between 5 and 15 percent during the same period. 3. Ne s v' a 5'5 The ratio of net savings to GNP for different sectors is shown in table 4. The household sector has been the principal supplier of funds and the corporate sector the principal demander until 1984 when it, too, became a net saver. The government sector has been a net saver except for four years in the 19605.5 Before 1969, the total net saving ratio was negative for most years. This implies that domestic savings were not 5 The four years in the 19605 during which the government was a net.demander of funds were 1962, 1963, 1964, and 1967. 17 sufficient to cover domestic investment; foreign savings were needed to help domestic capital formation. After 1969, net savings became positive for most years with the exception of 1974, 1975 and 1980. Since 1980, net savings have expanded at a relatively fast pace. Table 4. The Ratio of Net Savings to GNP Isa; Heusshgld ngernmsnt gerpgrats 22251 1952 1.01 3.46 -4.50 -0.02 1955 1.55 3.23 -3.56 1.23 1960 2.57 1.70 -6.71 -2.44 1965 6.37 0.25 -9.13 -2.01 1970 9.13 0.53 -9.70 0.02 1975 7.32 2.65 -14.31 -3.35 1930 7.09 3.40 -12.07 -1.53 1931 3.74 2.32 -9.73 1.34 1932 9.46 0.52 -5.04 4.95 1933 11.33 1.71 -4.00 9.03 1934 11.60 2.11 -1.57 12.15 1935 11.34 1.92 1.73 15.54 1936 16.83 1.16 4.45 22.44 1937 13.67 2.50 0.37 21.54 Source: National Income, Directorate-General of the Budget, Accounting and Statistics, Executive Yuan, ROC. D. Exisgiag Engiems Since i9§0 The major problems since 1980 have been imbalances in savings and investment, foreign trade, and balance of payments. They will be examined carefully in the following sections. The implications of these factors for the development of international banking will be reserved for chapter six. 18 1. W Since 1980, the ratio of savings to GNP increased steadily from around.30 to 40 percent in 1987, while the ratio of domestic investment to GNP declined dramatically from 35 percent in 1980 to 16 percent in 1986. As a consequence, the net savings ratio increased rapidly from -2 percent in 1980 to around 22 percent in 1986 and 1987 (see table 4). a. v v tmen ' d' ere 5e 0 5 To obtain a better understanding of savings and investment problems, the behavior of different sectors must be carefully examined. The household sector rapidly increased savings from NT$170 billion in 1980 to NT$655 billion in 1987'.6 The annual growth rate of savings in household sector was 22 percent during 1981-1987. During the same period, the annual growth rate of the corporate sector and government sector was 11.5 and 8.7 percent respectively. In 1987, the share of gross savings by the household sector was 52.5 percent, while the corporate sector and government sector held only 32.3 and 15.2 percent respectively. While savings in the household sector increased rapidly, investment in the household sector remained constant during the period 1980-1987. The annual growth rate of investment in the household sector was only 2.3 percent during this period. Therefore, the net savings in the household sector increased rapidly from NT$104 billion in 1980 to NT$578 billion in 1987. 6 "NTS" represents the New Taiwan dollars. 19 The ratio of net savings to GNP in the household sector increased steadily from 7 percent in 1980 to 19 percent in 1987 (see table 4), further'evidence that.the household sector plays the prominent role in supplying funds. How to channel and use these surplus funds more efficiently have become important policy issues for Taiwan's government since 1980. The government sector maintained a small budget surplus since 1951.7 During 1980-1986, the budget surplus was under NT$50 billion but reached NT$77 billion in 1987. Net savings in the government sector were below 2.5 percent of GNP during this period. While corporate savings increased rapidly from NT$193 billion to NT$394 billion in 1986 and NT$403 billion in 1987, corporate investment dropped from NT$370 billion in 1980 to NT$270 billion in 1986. This translated into a growth rate of 13 percent in corporate savings, and a decline in corporate investment of -4.5 percent during 1980-1986. Consequently, the corporate sector, the "regular" borrower, turned into a net lender from 1985 on. While the corporate sector still borrowed NT$177 billion from other sectors in 1980, it had NT$123 billion net savings in 1986. The investment decline in the corporate sector was the major reason for the net savings in the economy. 7 The corporate sector maintained a negative net savings during 1951-1984. It borrowed funds from other sectors. 20 b. 22ssibls_rsas2n5_f2r_the_dssline_in_inxe§tmen§ Three possible reasons may be listed for the decline in investment: the political crisis of the late 19705, rising environmental protectionism, and the increase in labor costs since the mid-19805. (1). o" 'c ' 's ' t 7 5 d 80 In 1979, the Carter administration broke official ties with Taiwan.8 Prior to this, the Nixon administration had opened the doors to Beijing in 1972. Since the United States was Taiwan's most important trading partner and ally, the termination of diplomatic relations in 1979 resulted in a political and economic crisis. In addition, the withdrawal of Taiwan from the IMF in 1980 and isolation from the international community during the 19705 and early 19805 made investors face threatened, shaking their confidence in Taiwan. By 1980, South Africa, Saudi Arabia, and South Korea were the only major nations to maintain official relationships with Taiwan. Altogether, only 23 nations continue to recognize Taipei's claim of being the legal ruler of China.9 Doubt about the island's viability and stability in the face of the People's Republic of China's efforts at reunification dampened the willingness of local 8 See Sutter (1933), p.14-15. 9 See Eaggmgnay (1987), Feb. p.32. 21 businessmen to invest in expensive plants and equipment with uncertain returns.10 In an economic sense, given the high risk they perceived, local investors sought a higher premium from investments. Investments with rates of return below the required premium were rejected by individual investors and firms. This can explain the decline in domestic investment and, in particular, the decline in corporate investment. Gross domestic investment fell from NT$504 billion in 1980 to NT$438 billion in 1986. A more detailed summary of the political situation can be found in appendix A. (2). Snvizonmaatai pgotecgionism A rise in environmental protectionism may also have contributed to the decline in investment. Rapid economic growth has not been without costs. Taiwan's cities are choked with smog and its rivers with waste due to a general lack of concern with pollution control. According to statistics provided by the Council for Economic Planning and Development, ROC, expenditures on pollution-reducing equipment were below NT$60 billion or below 0.3 percent of GNP until 1985 (see table 5). Total spending on environmental protection is far below the range of 2 to 4 percent typical of developed countries. As a result, industrial waste, auto fumes, agricultural refuse, and sewage have turned Taiwan into a ” See Gold (1986), p.103. 22 polluted islandu ‘The capital city of Taipei has become one of Asia's most polluted cities.11 Table 5. Pollution Control Equipment Expenditures 1991 Inx99tm9a9_in.599123939_1NT§_91111931 2929999999 1933 10 0.05 1934 36 0.16 1935 53 0.23 Source: Council for Economic Planning and Development, ROC. Concern over environmental degradation has led to popular protests. Demonstrations by various groups have become a daily occurrence in Taipei since martial law was lifted on 15 June 1937.12 Some investments have been successfully blocked by environmentalist groups. 2D1 a number of instances, demonstrators have forced the suspension of operations at factories alleged to be polluting as well as the postponement of new plant construction.13 In 1988, for example, fishermen in Southern Taiwan shut down a petrochemical complex, protesting that pollutants had poisoned their catch. " See Saging§§_flaak (1989), November 6. n See "Social Unease-the Price of Development." Fa; Easgazn E9909mi9_39xi99. 15 September 1988- ” See A9ian_Eall_§tr999_199rnal. 24 April 1989- 23 (3) - W Increase in unit labor costs is the third factor contributing to the decline in domestic investment. The wage rate in manufacturing has increased rapidly in recent years. From 1982-1988, the average annual growth rate of wage in Taiwan was 12.6 percent, which was higher than Korea, Japan, the U.S., and Singapore, as shown in table 6. However, the gain in productivity fell behind the increase in the Wage rate. As a result, the unit labor cost increased by 5.1 percent, just behind Japan but far ahead of other trade competitors, like Korea and Singapore, and the most important trade partner, the United States. In 1988, the growth rate of nominal wages in manufacturing grew 24.9 percent in Taiwan which was far above the rate for Japan, the U.S., and Singapore. In contrast, Taiwan's improvement in productivity was 6.6 percent, which was below that of Korea and Japan. Taiwan's growth rate in unit labor cost was highest, at 20.5 percent, in 1988. Rising environmental protectionism and increases in unit labor costs became two important catalysts for foreign direct investment by domestic firms, which in turn influences the development of international banking. The existence of potential for political crisis strengthens investor's motivation to diversify internationally, speeding up the process of international investment, especially portfolio investment. 24 Table 6. Growth Rate in Unit Labor Cost EIQ!£h_B§E§_ .1991 Countrv Taiwan gogaa Japan U.S. Singapore Nominal 1982-88 12.6 10.3 10.9 3.5 6.4 wage rate Productivity 1982-88 6.7 12.0 5.2 3.8 4.6 Unit labor 1982-88 5.1 -1.7 5.7 -0.3 1.1 cost Nominal 1988 24.9 29.0 13.5 2.6 4.5 wage rate Productivity 1988 6.6 14.9 11.3 3.1 --- Unit labor 1988 20.5 14.1 2.2 -0.6 --- cost Source: Table 16-1-7 International Unit Labor Cost Comparison, Annual Report 1988, Council for Economic Planning and Development, ROC. 2. 12999439919399 A second problem during the 19805 was a significant trade imbalance. While imports grew at a moderate pace between 1981 and 1987, exports grew at a rapid rate due to strong world demand. During the period 1980-1987, the annual growth rate of exports was 16.1 percent. In contrast, the annual growth rate of imports was only 8.8 percent (see table 7). While exports increased from $20 billion in 1980 to $53 billion in 1987, imports increased from $20 billion in 1980 to just $32 billion over the same period. The imbalance between exports and imports caused the rapid growth of a trade surplus. The annual growth rate of this surplus from 1981 to 1987 remained over 50 percent, even when the extreme value of 1981 is excluded. The trade surplus in 1980 was only $77 million. It surged up to $1.8 billion in 25 1981 and $3.6 billion in 1982. By 1987, the trade surplus had surpassed $20 billion (see table 7). The growing trade imbalance aggravated tensions between Taiwan and her trading partners. The next sections will discuss these bilateral relations. a. ' a e w' 'm t a e a ne 5 The United States and Japan are the most important trading partners for Taiwan. For historical and geographical reasons, Japan initially occupied this role. During the 19505, Japan's share of trade (exports plus imports) ranged between 35 and 40 percent, while the United States' share ranged between 25 and 30 percent with the exception of 34 percent in 1954. No other trading partner has ever accumulated more than a 5 percent share. Table 7. Export and Import in 19805 199: ___5399r99 1329;99_______..419999.§9£9199___ Angunt 999993.9399 339939 9:9993_r999 339939 9:9993_9999 1930 19.6 --- 19.5 -—- 0.1 --- 1931 22.4 14.5 20.6 5.6 1.3 2270.1 1932 21.3 -2.3 13.1 ~11.9 3.6 99.3 1933 25.0 14.9 13.3 3.5 6.3 71.9 1934 30.2 20.6 21.0 11.7 9.2 47.3 1935 30.5 0.9 19.3 -7.9 11.2 21.0 1936 39.5 29.6 22.6 17.3 16.9 50.9 1937 53.2 34.3 32.4 43.3 20.3 23.3 Avg. 31.3 16.1 21.3 3.3 10.0 396.2 Unit: 5 billion Source: Statistical Yearbook 1987; Taiwan Statistical Data Book. 26 As the economy grew, however, this pattern changed. The United States replaced Japan as the leading trade partner from 1967 on. The U.S. share of trade increased to 30 percent and stayed around that level through the 19705, while Japan's share fell to below 30 percent and reached 19 percent in 1980. The U.S. share continued to increase after 1980 reaching a peak of 38.4 percent in 1985 and falling back to 35.5 percent in 1987;. Japan's share was, on the other hand, remained below 21 percent during 1981-1987. Taiwan's dependence on the United States is reflected clearly in export value. The U.S. share of exports was less than 10 percent in the 19505 and below 30 percent until 1967. After that, it steadily increased to a peak 42 percent in 1972. In response, the Taiwanese government tried to diversify her trade markets. Diversification policy was partially successful during 19705, bringing the UQS. share down to 34 percent in the period between 1975 and 1980. After 1980, however, the share of exports to the United States increased rapidly to a peak of 49 percent in 1984, staying above 44 percent in 1987. b. Neg cgafilig; and protectioaisa Prior to 1967, Taiwan was a net importer from the United States. Taiwan's bilateral trade deficit ranged between $50 and $100 million. After 1967, Taiwan turned her trade deficit into a trade surplus. In 1968, this was $38 million, but it reached $1 billion in 1976 and continued to increase 27 thereafter as follows: 1985, $10 billion: 1986, $14 billion: and 1987, $16 billion. Taiwan's trade surplus has contributed about 10 percent to the U.S. trade deficit since 1980. This has roused protectionist sentiments in the U.S. Congress. The rise of international protectionism has become one of the main reasons for domestic firms to invest overseas, which in turn has had the positive effect of encouraging the development of international banking. 3. ' e 'mb a ce Another problem in 19805 has been excess current account surplus coupled with inadequate capital account movement. As predicted by the absorption approach, an expansion of net domestic savings in Taiwan has resulted in an increase in the trade surplus and, as a result, the current-account surplus. A simple accounting identity for this is illustrated in appendix 2. The current account surplus increased from negative $0.9 billion in 1980 to $16.2 billion in 1986 and $17.9 billion in 1987. The significance of Taiwan's current account surplus can be clearly illustrated through a comparison with Japan and Germany. Even though Taiwan's current account surplus in term of absolute value was far behind Japan and Germany, as a percentage of GNP it was much higher (see table 8). In 1986, Taiwan had a current account surplus of $16.21 billion, while Japan had $85.83 billion and Germany had $39.85 billion. 28 However, Taiwan's surplus was 22.5 percent of its GNP, much higher than the 4.4 percent ratios of both Japan and Germany. The ratios of current account surplus to GNP in these three countries dropped in 1987, but Taiwan's current account surplus ratio of 16.2 percent was still far above Japan's and Germany's, at 3.8 percent and 4.0 percent. respectively. Table 8. The ratio of current account surplus to GNP Xaa; Country. 19.11911 __p_nJa a 521-3339 1980 -2.8 -o.9 -1.7 1981 1.3 0.6 -0.5 1982 4.9 0.8 0.76 1983 9.0 1.9 0.8 1984 12.1 2.9 1.6 1985 15.5 3.8 2.6 1986 22.5 4.4 4.4 1987 16.2 3.8 4.0 Unit: Percentage Sources: International Financial Statistics Yearbook 1989, IMF; Financial Statistics-Taiwan district, the Republic of China, May 1989. a. ' co 0 In contrast to the huge current account surplus, capital outflow is limited mainly due to foreign exchange control and restrictive foreign investment policies. In 1949, due to a severe shortage of foreign exchange, Taiwan adopted foreign exchange control measuresw Beginning in .January, 1950, official approval was required to import any foods from abroad. After May 1970, citizens were allowed to make only minimal remittances abroad with an annual ceiling of $200. 29 This was increased to $2,000 in 1984.“‘ Citizens were not allowed to travel abroad as tourists until 1979. Under this framework, the capital account was stable during 1980-87, but the current account surplus increased rapidly. During 1980-1987, the balance of capital movement stayed within a range of negative and positive $1 billion except for 1980 and 1981. The exchange control and restrictions on foreign investment had an extremely dampening effect on overseas portfolio acquisitions and foreign direct investment. 10. W The rapid increase in the current surplus being incorporated into the small, but and stable capital account resulted in a quick accumulation of international reserves. The foreign exchange reserves of the Central Bank increased rapidly from $2.2 billion in 1980 to $76.7 billion by the end of 1987. The reserves to imports ratio increased steadily from 11.3 percent in 1980 to 232.5 percent in 1987. I n 1987, Taiwan's international reserved ranked third in the world, behind only Japan and Germany. In 1988, Taiwan surpassed West Germany and trailed only Japan. Taiwan's per capita reserves were the world's highest by 1987 at $ 3,900. In terms of the reserve to import ratio, Taiwan's ratio of 230 percent in 1987 also ranked first in the world. This implies an import coverage of around two and a-half years. The 1‘ See Lee and Peng (1985), p.30. 30 reserves in 1987 represent over 80 percent of the island's GNP. I How to utilize this large reserve effectively is the paramount problem for Taiwan. If not resolved, continued accumulation of reserves may need to be stopped. II. C GROUN Over the past -- Years, Taiwan has been successful in financial deepening (see table 9). By this we mean the growth of financial assets at a pace faster than the accumulation of nonfinancial wealth.15 A conventional index of financial deepening is the degree of monetization, which can be reflected by the ratio of “13 to GNP or the ratio of M2 to GNP.“ The ratio of M", to GNP increased from 12.4 percent in the 1961-1965 period to 28.9 percent in the 1981-1985 period and surged up to 45.9 percent in 1986-1987. The M2 to GNP ratio also increased from 28.6 percent in 1961-1965 to 86.2 percent in 1981-1985 and then surged up to 127.0 percent in 1986-1987. These two ratios show that monetization in Taiwan has progressed rapidly. M2 deflated by the wholesale price index, which represents the real lending capacity of the monetary financial 5 For details see Shaw (1973), P.vii. m M1 includes currency outside monetary institutions, checking accounts, passbook deposits; M13 includes “11 and passbook savings deposits; and M2 include M13 and quasi-money. 31 institutes,17 grew 150 times during 1961-1987. This increase in liquidity facilitated credit expansion of the commercial banks. The assets of domestic banks as a percentage of GNP increased from 33.5 percent in 1961-1965 to 77.2 percent in 1981-1985, surging up to 98.3 percent in 1986- 1987. The ratio of total financial assets to GNP, the so- called financial ratio, increased from 58.7 percent in 1961- 1965 to 246.0 percent in 1986-1987. These figures clearly indicate the progress of the financial system in Taiwan. Table 9. Key indicators of financial development in 1961-87 13919999r9_ Y9ar 1291295 19§§-7g 1971-75 1976-SO 1981-85 i986-S7 Ratio of 12.4 15.5 20.2 27.2 28.9 45.9 MB to GNP(%) Ra io of 28.6 37.9 49.9 66.1 86.2 127.0 to GNP (:3 /WPI 26 65 193 619 1817 3864 (billion) Net assets of 33.5 42.1 54.5 78.4 77.2 98.3 domestic banks as percentage of GNP (%) Financial 58.7 76.3 104.1 148.6 169.6 246.4 ratio (%) Sources: (1) 'wa tat'st' a ata ook, Council for Economic Planning and Development. (2) National Income in the Taiwanese Area of the Republic of China, DGBAS. (3) Financial Statistics Monthly, Taiwan District, ROC, the Central Bank of China. '7 See Mckinnon (1973). 32 A. 'w ' ' c'a ste Taiwan's financial system consists of financial institutions and markets, with the former being, more well- developed than the latter. 1- 21W There are twelve (different types of financial Institutions in. Taiwan. They can be grouped into two categories, monetary institutions which can create money and other financial institutions which cannot. In 1988, the monetary institutions consisted of the Central Bank, 16 full service domestic banks, 8 medium business banks, 35 branches of foreign banks, 74 credit cooperative associations, and 304 units of the farmer's and fishermen's credit association. The monetary institutions held about 85 percent of the assets of all financial institutions, with two-thirds of total assets belonging to the Central Bank (41 percent) and full service domestic banks (25 percent). Other financial institutions include a postal savings system which had over 1,000 branches nation-wide, 8 investment and trust companies, 9 life insurance companies, 14 fire and marine insurance companies, 3 bills finance corporations, and 1 securities finance company.18 In contrast to the large share occupied by the monetary institutions, the others held only 15 percent of the assets, which included the strong m In addition, the financial system in Taiwan also included 37 leasing companies, one export-import bank, and a rapid increase in securities houses in 1988. 33 postal savings system. The postal savings system which is the fastest. growing financial institution, accounting for 10 percent of the assets, had 1168 post offices and 415 postal agencies in September, 1988. The investment companies, insurance companies, bill finance corporations, and securities companies made up much.smaller share of, as shown in table 10. 2. W999 Financial markets consist of money and capital markets. While the money market deals with financial instruments maturing in less than one year, the capital market deals with instruments maturing in periods longer than one year. a. 119.891.2939; In the money market, the short-term bills sub-market has grown substantially since its establishment in 1976. The inter-bank, called the loan sub-market, also experienced rapid growth from its beginning in April of 1980. Three bills finance companies have been established since 1976. The volume of money market instruments outstanding increased from NT$8 billion in 1976 to NT$480 billion in 1988. Most of the years, bankers' acceptances and commercial paper constituted the majority of the short-term bills of exchange. The trading volume on the inter-bank call loan market increased from NT$390 billion in 1980 to NT$2,925 billion in 1988. Table 10 34 Assets and Units of Financial Institutions in Taiwan, R.O.C. Institutes Monetary institutions Central bank Domestic commercial banks Local branches of foreign banks Medium business banks Credit cooperative associations Farmers'& fishermen's credit associations Other financial institutions Postal savings system Investment & trust companies Life insurance companies Property & causality insurance companies Bills finance companies Securities finance company of No. of 435 1 16 32 8 74 304 36 1,814 0 650 3 238 301 622 1,345 1,168 34 59 73 11 0 Assets mm— 7,539 2,249 3,723 193 429 551 453 1,399 933 181 217 263 172 243 As a percent of total assets of financial Institu- tion 84.45 22.99 41.38 2.15 Assets Unit: in billions of New Taiwan dollars; as of the end of 1988. Note: No. of branches is for the end of Sept. 1988. Sources: Financial Statistics Monthly, Taiwan District, ROC. 35 b- M Taiwan's capital market consists of stock. and bond markets. Historically, Taiwan's capital market is dominated by the stock market. Taiwan's stock exchange was established in February, 1962. The number of listed companies increased from 18 in 1962 to 163 in 1988. Total market value increased from NT$7 billion in 1962 to NT$3,383 billion over the same period. In contrast, the corporate and government bond markets are very small; however, volume has been increasing significantly. In 1961, the corporate and government bonds outstanding accounted for NT$0.1 billion and NT$0.8 billion respectively; by the end of 1988, they had grown to NT$52 billion and NT$184 billion respectively. B. e ms a'wan's ' anc'a S s em Although Taiwan's financial system has deepened and developed greatly, it is not adequate to allow her to become a fully successful open economy. The system is too domestic- oriented, and. the cartel-type Oligopolistic structure of banking has been slow in developing the technology required for international banking. The underdeveloped capital market also retards the development of international banking and international investment. These shortcomings have become even more pronounced with the mounting site of the surplus in the 19805. 36 1. - ' o s 'c ban 'n s ste Among the financial institutions, commercial banks play the dominant, albeit diminishing, role. In 1961, commercial banks accounted for 63 percent of total financial assets held by all financial institutions. The share has dropped more than 20 percent from 1961 to 1988; it still remains above 40 percent, however. During the same period, the commercial bank share of deposits was over 45 percent, and its share of loans and investments was over 65 percent (see table 11). Table 11 Shares of Commercial Banks Out of All Financial Institutes 193.1: 119.9999 9913991119 Lo_n_a s _9___1_n__111_0 erat‘o u 'ts 1961 62.9 75.6 82.2 19.2 1965 53.1 63.6 74.2 20.5 1970 54.4 66.5 76.7 21.6 1975 53.2 62.7 73.1 20.9 1980 51.4 55.5 67.7 18.9 1985 43.8 47.7 67.4 17.6 1988 41.4 48.8 67.9 18.5 Source: Financial Statistics Monthly, Taiwan District, the Republic of China. The above figures show that commercial banks have played an important role in channeling funds from savers investors. type oligopolistic structure characterized by barriers to entry and government ownership. a-Wfim financial institutions but also the establishment of new However, the picture is marred by their cartel- Not only the establishment of domestic and foreign new 37 branches has been highly restricted by Taiwanese authorities. There were ten domestic banks in Taiwan at the end of 1961. By the end of 1988, the number had grown to sixteen. Over a period of more than twenty-five years, only six new banks had been established. Even though the number of operating units of domestic banks (including main offices and branches) increased from 260 in 1961 to 648 in 1987, the rate of increase was slow relative to the proliferation of other financial institutions during same the period. This can be shown by the ratio of operating units of commercial banks to all financial institutions. Beginning at 19.13 percent in 1961, this ratio reached its peak at 22.15 percent in 1973 and then declined steadily to 17.6 percent in 1986” (see table 11). In 1968, the average commercial bank operating unit served 595 companies. This average increased to 962 in 1987, which indicates that entry restrictions impede the development of domestic banks. Restrictions on establishing overseas financial institutions also impede the development of international banking by domestic banks. At present, there is little increase in ‘the. number' of financial institutions abroad. Fereign banks can gain access to domestic markets without the same harsh restrictions; however, their branches, locations and operations are still strictly controlled. A. w The ratio recovered back to 18.14 percent in 1987. 38 detailed discussion is provided in appendix 2. In short, banking in Taiwan continues to be highly regulated.20 b. 9999r3m9nt_993919319 As a reaction to the rampant inflation and financial chaos that.prevailed in Mainland China after World War II, the government has retained firm control of the banking industry since moving to Taiwan in 1949. Government ownership has typified the banking system and private entry has been restricted. Of sixteen banks, twelve are government owned. Of the four private banks, two are small, and one is a small joint-venture company. Only the International Commercial Bank, an off-shoot of the Bank of China in 1971, is a significant private participant in banking activities. The Taiwanese government achieved such dominance by taking over the ownership of Ibanks from. the IMainland and. acquiring majority shares from .Japanese ‘partners in. private local banks.21 Government banks accounted for 82.9 percent of the total assets of all banks in 1986. It is natural and easy for commercial banks to collude as a cartel under the same single owner - the Taiwanese government. As a result, an m The restrictions on the operation of foreign banks have been relaxed gradually as steps toward financial internationalization are taken. Some authors, such as Shea (1988) and Tai (1986), have already called attention to this. However, no study gives detailed discussion on the process of setting up financial institutions abroad. “ See Gold (1936), p.103. 39 oligopolistic cartel-type banking system has arisen. Leading economic theory suggests that this leads to a social welfare loss and allocative inefficiency. Further inefficiency arises due to bureaucratic organization, with the following three major problems highlighted in the literature.2 (1) (2) (3) 2 Government banks are subordinate to monetary policy and pressures from those with influence in government. The directors and senior management of the banks are government appointed, and, as a consequence, are not necessarily experienced bankers. They devote too much of their time to haggling with legislators instead of concerning themselves with bank business. Further, bank employees are civil servants, which limits their managerial scope to develop flexible policies of personnel management, including hiring and firing. The bank budgets and operating decisions are subject to lengthy prior approval and audit procedures by the authorities: in the case of the budget, two years in advance. Loans are constrained by burdensome regulations and loan officials are discouraged from risk assumption, which is essential to banking. The net result is that these have become cumbersome bureaucracies rather than competitive institutions exercising discretionary judgement in the context of market changes. 22 See Lee and Tsai (1933) , p.208-210. 40 C- 993999993999 The cartel-type oligopolistic banking system results in low operating efficiency, outdated technology, and slow development of international banking. (1). w t ef ' 'e c To understand the operating efficiency of domestic banks, It is necessary to compare the profit rates of domestic banks with local branches of foreign banks. During the period between 1978 to 1985, local branches of foreign banks earned higher profit rates than did domestic banks, except for 1984. The difference in profits rates was especially large prior to 1980. Table 12. Profits Rates of Domestic Banks and Foreign Banks Xaar Sonastic Banks Lanai Sranches of Foreign Banks 1978 25.98 38.58 1979 27.92 42.45 1980 30.61 36.36 1981 27.51 34.35 1982 26.25 26.34 1983 19.54 19.82 1984 23.12 20.87 1985 22.90 23.86 Average 25.48 30.33 Source: Ho and Yan (1987), p.19, table 2. The average profits for domestic banks are 25.48 percent and the average profits for foreign banks are 30.33 percent OVer that same period. This illustrates the lower operating efficiency of domestic banks (see table 12). 41 ( 2) - WHY. Outdated technology is clearly evident in the lag in computerization of the banking operation. Computerization of the banking system can be divided into three different stages. The first stage in creating an on-line system is to establish the files of individual accounts, making withdrawals and deposits at any branch of a particular bank possible. The second stage:of’an on-line system.is characterized by integrated processing of banking transactions. This allows banks to expand business by using ATMs (automatic teller machines), and other devices which are easy to link, thereby reducing operating costs by using fewer personnel. An inter- bank and world-wide branch network can also be developed in this stage. The final stage of an on-line system includes the replenishment of the information service system and establishment of connection with outside systems, such as POS (point of sale), home banking,” and INS (advanced information communication system).“ Taiwanese banks have so far accomplished only 25 percent of the first stage and 10 percent of the second. This can be 3 Home banking means that it is possible to engage in banking transactions from one's home through telephone service, pay-by-phone service, etc. 2"The advanced information system aims at integrating the telephone, telex, and data telecommunication into one single net work in order to supply a more advanced information communication service. 42 contrasted with Singapore and Hong Kong banks which have reached 85 and 70 percent of the first and second stages of an on-line service system service. U.S. and Japanese banks are at 100 and 90 percent respectively in the first two stages of the on-line system.25 ( 3) - Was The internationalization of the banking industry has been a slow process. Foreign banks gained easier access to Taiwan financial market in 1980, and local branches increased in number to 33 by the end of 1987. Some of the operational restrictions on foreign banks have also been lifted in recent years. Despite these steps, the process of branching out abroad by domestic banks has been unsatisfactory. Before 1961, the International Commercial Bank of China had four branches overseas. By 1987, only a few additional foreign branches had been established by the First Commercial Bank and Bank of Communication. Of these three banks, only two have branches in more than one foreign country. International banking by Taiwanese banks will be discussed again in chapter six. 2. v o a ' a k t The capital market in Taiwan is under developed compared to the financial institutions and the growth of the real economy. 2‘ See gang-Ia]. Daily News, 6 March 1990. 43 a. W Listed firms represent less than 10 percent of all registered companies in Taiwan having sufficient capital to meet listing requirements. Close examination of the ratio of capital of listed companies to the capital of all registered companies quickly reveals that the stock market is not a significant.place to raise funds; this ratio remained.under 18 percent from 1968 to 1987. The ratio of the market value of stocks to GNP varied between 6 and 25 percent over the period 1964-1986. This compares with a ratio for the U.S. of 183.9 percent in 1983. The ratio of increase in capital of listed firms to national savings was between 3 percent and.9 percent from 1972 to 1987. In 1987, the ratio indicated that only 3.92 percent of the capital was raised through the stock market. The small scale of the Taiwanese stock market is shown in table 13. The total number of listed companies on the Taiwan Stock Exchange is smaller than one-tenth of the three major stock markets, Tokyo, New York, and London. The total volume of stocks traded on the Taiwan Stock Exchange were 39 and 77 billion shares in 1986 and 1987, which was very small relative to the three other'markets. Table 13 also shows that Taiwan's total market value of equity of listed domestic companies was much smaller in magnitude than for the other three stock markets. 44 IMQLQQQQ in Eng 2:0 20 OEEiODS Of t t' o a v to In a well-developed capital market, institutional investors usually play the most important role. In Japan between 1981-1985, individual investors accounted for only 40 percent of the stock transactions, whereas individuals accounted for over 90 percent of the stock transactions in Taiwan between 1981-88 except 1984 (see table 14). A glance at share ownership yields the same picture. Individual Taiwanese investors owned more than 40 percent of the capital of all listed companies during 1962 to 1988 (see table 15). During the same period, financial institutions in Taiwan owned less than 9 percent of outstanding stock. In Japan, by way of contrast, individuals owned less than 30 percent of the outstanding stock 'value of all Japanese companies, while Japanese financial institutions owned about 40 percent (see table 16). c. Snail Sgaia aacurities fizns At.the end of 1988, Taiwan had 102 securities brokers, 88 being private brokers, and fourteen bank brokers. Almost all commercial banks in Taiwan have brokerage licenses. Among the 88 private brokers, eight companies combine the functions of broker and dealer. 45 Table 13. Taiwan, Tokyo, New York and London Stock Exchanges Total Market Value Volume of Equity Shares of MW of Domestic Companies T9931. 1291399919 19:91.93 Ming __Li_t9's L (in $ billions) Taiwan 1987 141 141 0 77 49 1986 130 130 0 39 15 Tokyo 1987 1,620 1,532 88 1,757 2,726 1986 1,511 1,499 52 955 1,794 New york 1987 1,647 1,577 70 1,889 2,132 1986 1,575 1,512 63 1,389 2,128 London 1987 2,658 2,061 597 316 679 1986 2,685 2,101 584 113 472 Source: Wiener and Knight (1989), table 3, p.9: Taiwan Stock Exchange, Statistical Data, 1989. Table 14. Stock Transactions by Types of Investors Xear Taiwan Japan Indivi- Juridical Forei- Indivi- Juridical Forei- QualL 29:99.0— sniers_ QQLS _r__rL__Pe so $14—he s 1981 95.6 4.0 0.6 42.2 46.9 10.9 1982 93.9 5.6 1.0 40.9 47.8 11.3 1983 92.2 7.4 0.5 43.0 42.2 14.8 1984 87.8 11.7 0.7 42.7 42.1 15.2 1985 91.5 8.1 0.8 38.9 47.7 13.4 1986 92.0 7.6 0.3 --- --- --- 1987 94.4 5.4 0.2 --- --- --- 1988 97.8 2.1 0.1 --- --- --- Unit: Percentage Source: 1988 SEC Statistics, Securities & Exchange Commission, Ministry of Finance, ROC: Directory of World Stock Exchange (1988). 46 While trading by dealers is negligible, securities transactions are conducted, for the large part, by private brokers. The percentage were 82 percent in 1988. The remaining' 18 percent ‘were Ihandled. by ‘the fourteen Ibank brokers. The size of private security firms is smalla The average capital of private firms was NT$273 million in 1988. Only eight out of fourteen private brokers have one branch, as government regulations discourage establishing branches. Before the revision of the security exchange law in 1988, brokers were not allowed.to trade for themselves on short sale financing. The only income was brokerage commissions which was officially set at a low level. The average size of bank brokers is even smaller. Bank brokers average only NT$123 million in capital. However, the network system of bank brokers is comparatively better. Fourteen bank brokers have twenty-one branches. One of them has six branches, two of them have four. Generally speaking, the firm size and number of branches of Taiwanese securities firms are very small compared to U.S. or Japanese. Securities firms of such small size and weak branch networks find it difficult to underwrite and distribute securities in the international arena. 47 Table 15. Share Ownership in Taiwan, Selected Years Year Indivi- Financial Investment Cop- Govern- Foreigner duals Institu- Trust pora- ments $19119 9191.19 1962 51.73 2.44 --- 7.80 36.88 1.15 1965 44.32 2.87 --- 8.67 42.96 1.18 1970 57.32 8.94 --- 10.50 20.19 3.05 1975 55.20 8.54 --- 9.82 22.61 3.83 1980 53.77 4.69 --- 12.51 25.52 3.51 1985 41.09 8.54 0.10 15.18 25.99 9.10 1986 40.27 7.50 0.32 15.17 27.11 9.63 1987 43.52 5.78 0.48 14.81 25.94 9.47 1988 46.72 4.74 0.75 16.61 21.56 9.62 Unit: Percentage Source: SEC Statistics 1989, Securities & Exchange Commission, Ministry of Finance, ROC. Table 16. Share Ownership in Japan, Selected Years Year In- Financial Invest- Secu- Cor- Govern- Foreigner divi- Institu- ment rities pora- ments gnala Signs Tnnsta nouaes nions 1950 61.3 12.6 --- 11.9 11.0 3.1 --- 1955 53.1 19.5 4.1 7.9 13.2 0.4 1.8 1960 46.3 23.1 7.5 3.7 17.5 0.2 1.4 1965 44.8 23.4 5.6 5.8 18.4 0.2 1.8 1970 39.9 30.9 1.4 1.2 23.1 0.3 3.2 1975 33.5 34.5 1.6 1.4 26.3 0.2 2.6 1980 29.2 37.3 1.5 1.7 26.0 0.2 4.0 1985 25.4 39.3 1.4 2.1 25.6 0.2 6.0 1986 23.9 43.5 1.8 2.5 24.5 0.9 4.7 Unit: Percentage Source: Tokyo Stock Exchange. 48 Bank brokers, on the other hand, are in.a better position to deal with international securities transactions than private brokers. Commercial banks already possess trained and qualified personnel and much of the necessary capital equipment for these activities. In addition, commercial banks can more easily expand their brokerage network via extensive bank offices at home.” d- HEW There .are ‘thirty' securities ‘underwriters in 'Taiwan. Thirteen of them.are bank underwriters. .Almost every bank.has securities broking and underwriting licenses.”’ In Europe and America, an underwriter generally purchases all new debt and equity securities issued by private or government borrowers, either competitively or through direct negotiation. They then resell or distribute these securities in smaller units to individual and institutional investors. In Taiwan, an underwriter usually serves only as broker and assists in the search for compatible savers” The main reasons for this are the small number of new issues annually, and the low, government controlled commissions for dealers. u Discussion in this thesis of the development of international banking for commercial banks will include investment banking activities, especially securities brokerage. 27'See footnote 22. 49 e. QQHHEQEEHQEH The small amount of investment and the short-term maximizing behavior of dominant individual transactors result in a high turn-over ratio. Due to the small scale of securities firms and their limited ability to distribute and underwrite, the development of international investment and investment banking, are impeded. (1). Hign nuzn-over natio The turn over ratio, which is the transaction value of listed stocks divided by their market value, can be used to examine the stability of the stock market. The turn over ratio in Taiwan was higher than 100 percent for most years after 1970, reaching unprecedented highs of 192 percent in 1987, 233 percent in 1988, and 412 percent in 1989. The turnover reached a peak of nearly $8 billion one day in August 1989, outpacing even the New York Stock Exchange.28 This high turn-over ratio indicates that investors are speculating on short-term gains rather than investing on a long-term basis. In the process, the vital function of the stock market as a vehicle for investment is impeded. (2). S u 's eve o me of te nat'ona ' vestments One possible reason for the absence of long-term behavior on the part of investors is the great uncertainty concerning Taiwan's political and economic future. Lack of knowledge is 28'See "The Other China Is Starting to Soar", Susiness Weak, 6 November 1989. 50 another factor. As it is, the general public is unfamiliar with the long-term prospects and investment process in the domestic market; they are even less familiar with foreign markets. Exchange control acts as a further impediment. International diversification and investment are not yet a part of Taiwanese investors' way of thinking. Even institutional investors are risk averse and domestic-oriented, which does not help the development of international investment. (3). Singgian aeveionnenn 0: international investment banking Small scale domestic private brokerage firms cannot afford expensive research on foreign investment and stocks, which makes it impossible for them to establish foreign branches.29 The handicaps in terms of the lack of underwriting experience and opportunities limit the development of expertise in international banking as well. III- INIEBAQIIQH_B§IH§EN_IH§_BEAL_ NO S Part-I has emphasized the issue of surplus funds in the domestic economy, while part II focused on the dearth of intermediaries equipped for international investment. The end result is an excess of funds, an increase in the potential for escalating inflation, abnormal stock market and real estate 3 However, this problem can be overcome by large domestic banks. 51 prices, and dominance of speculative over long-term investment behavior. A. £99939191.Inf199193_3999 The money supply in 1986 and 1987 rose annually by 47.32 percent and 42.20 percent respectively, despite the issuance of huge amounts of treasury bills, CDs and savings bonds. The increase in 1986 was the highest recorded since 1952. Although the price level was rather stable in the early and mid-19805 due to cheaper oil and low import prices arising from the appreciation of NT dollars, the potential for a spiraling inflation rate is now a serious problem.30 The consumer price index increased from 1.28 percent in 1988 to 4.41 percent in 1989. The GNP deflator also increased from 1.07 percent in 1988 to 3.10 percent in 1989. 8- Abn9rmal_D9x9l92m9nt_9f_939_§9995_nark99 Liquidity arising from the trade surplus and the scarcity of investment outlets is reflected in the stock market.” The value of traded stocks was NT$195 billion in 1985, but rose sharply to NT$7,868 billion in 1988. The Weighted Stock Index which was 745 points in 1985 rose to 2,138 points in 1987 and 5,822 point in 1988. The growth rate of the stock m Monetarists believe that high rates of money growth produce high inflation. " See A9193_E911_§tr999_199rnal. 9 January 1989. 52 index was 126 percent in 1987 and 173 percent in 1988. On June 19, 1989, the stock index passed the 10,000 point mark. C- W In some metropolitan areas, the price of real estate increased approximately 50 percent in 1986, and nearly 100 percent in the first half of 1987 according to China Industry (1988). It continued to accelerate in 1988 and 1989. Speculation on land and stocks will surely contribute to inflation in the future. D. ' ' c' s ' 'o In addition to rapid growth in the money supply, the balance—of—payments surplus has also caused the financial institutions in Taiwan to be inundated with deposits. At the same time, the demand for loans has decreased owing to the drop in domestic investment. Consequently, the ratio of loans and investments over deposits has dropped steadily from 109.27 percent in 1981 to 58.15 percent at the end of November, 1987. The build-up of idle savings not offset by loans in Taiwan's financial system at the end of 1988 amounted to NT$1.7 trillion ($60 billion), half of the gross national product for that year. The country is bulging with so many idle funds that some banks are discouraging deposits.32 In 32 See "After the Kio, the T10", W, July, 1988. 53 short, limited international investments and an underdeveloped international banking system are the main reasons for the rapid accumulation of surplus funds and the adverse economic consequences. Not only is the international banking system unable to channel surplus funds overseas itself, but it also impedes foreign direct and international portfolio investments. So far, Taiwan's own financial intermediaries do not have the capacity to help Taiwanese investors invest internationally. Chapter three will, therefore, discuss the importance of steps that can be taken to build this capacity. While individual firms are aware of foreign direct investment, international diversification and portfolio investment are still vague concepts in the individual investor's mind. Chapter four will deal with these issues. CHAPTER 3 INTERNATIONAL BANKING I- INIBQDQQIIQN Historically, the links between Taiwan and the world's financial system were quite limited. Also as mentioned before, the development of international financial intermediaries, especially international banking has been very slow.1 This has impeded the effective utilization of Taiwan's capital surplus in external money and capital markets, as well as reduced efficiency in capital allocation. Financial investors, in particular, are denied gains through international portfolio diversification. As Taiwan's trade surplus and international reserves have increased, the opportunity costs of this financial impediment have risen sharply. The development of international banking capability is thus more necessary now than ever before. The question is how should Taiwan go above it? If‘ Taiwan decides to develop 'her own international financial intermediaries, a couple of important questions must be answered. Is it possible for Taiwan to develop her own international banking system successfully? What are the policies which must be adopted by the Taiwanese government in order to accomplish this task? What locational considerations should apply in branching abroad? Which organizational form, f Hereafter, the international banking system will be used instead of international financial intermediaries. 54 55 such as agency, branch, or subsidiary, of foreign direct investment by banks is the best? A comprehensive theoretical framework of international banking focusing on these questions will be derived in this chapter. International banking activities can be conducted directly from banks' domestic offices or through foreign branches and subsidiaries. The former is the traditional way of international banking; The establishment of foreign branches and subsidiaries is, however, a more ambitious venture into multinational banking. In the following sections, the focus will be on the latter.2 II. LIIEBAIQBE_B§EIEE3 A. International Tzade -- A Magnoegononig Appgoacn One set of hypotheses about the multinationalization of banks is based on theories of international trade. Aliber (1976) argues that the banks with lower production costs have comparative advantage over other banks in producing banking products and are likely to serve foreign markets. Lower production costs can be attributed to abundant factor 2 Multinational banking include offshore banking and host- country international banking. Only host-country international banking will be discussed in the following sections. For a detailed definition, see Giddy (1983), P.202. 3 On international banking, most focus on the empirical aspects and very few on the theoretical aspects, although a larger number of studies here been done. 56 endowments. He also mentions that government regulations may change banks' comparative advantage and production costs. This explains the reason for international banking, but it does not explain the location of banks. It clearly points out that banks with a comparative advantage can conduct international operations at home offices via correspondent relations, or through the establishment of overseas branches and subsidiariesqiibut it does not explain overseas branches should be established or where these branches should be set up. mmnmwuw 3129:9993 Another set of hypotheses about the multinationalization of banks is based on industrial organization theories. These claim that the behavior of firms in a market is determined by structural factors of market, such as the concentration ratio, freedom of entry, product differentiation, and other factors influencing market performance.5 Aliber (1976) points out that banks from countries with higher concentration ratios tend to have higher profits and appear to be better able to raise the funds needed for eXpansion overseas. Grubel (1977), Hymer (1976), Caves ‘ ‘liereafter, "branches" will be used to represent the following foreign units, namely, representative offices, (agencies, branches, and subsidiaries. 5 See Giddy (1933), p.203. 57 (1971), and Kindleberger (1969), argue that banks may establish foreign branches to exploit monopolistic advantages. Giddy (1983) suggests that it would be relatively more profitable for banks to enter markets which are oligopolistic, although it would be difficult to do so. In contrast, it is easier to enter countries with low barriers, competition will be greater and profits lower. This approach offers a partial answer to the question of location choice. However, it ignores other important factors such as availability of funds, volume of international trade, and scope for foreign direct investment. C. . -3-. .' - -.v-stg-nt :oo o. 1 -- A1 c-- t3 -geog. The experience of multinational enterprises with foreign direct investment led to an eclectic theory of international production in the late 19705 that further supports overseas expansion (Dunnig, 1977, 1979, 1980). This suggests that incentives for foreign direct investment arise from three inter-related advantages: ownership, internalization, and location advantages. The ownership advantages include proprietary technology, patented trade marks, raw materials, information, human capital, etc. These generate greater benefits to the investor through internalization of foreign direct investment than 58 through sales in external market.6 'The host country can also offer locational advantages, such as lower transportation and communication costs, and a better climate for investment. All three factors are required for foreign direct investment: otherwise exports will be preferred. Gray and Gray (1981) is the first study which attempted to apply the eclectic theory of international production to multinational banking. They identify three internalization- specific and three location-specific advantages for multinational banking. However, they fail to investigate ownership-specific advantages and thus cannot identify the total potential gains from international banking.7 Yannopoulos (1983) and Cho (1986) refine this approach and explore the three different advantages further. However, both studies fall short of an adequate analysis of competitive behavior' in. multinational banking, since focus on firm- specific ownership advantages and ignore those that are country-specific. They also ignore locational choice and organizational form choice as regards foreign branches. The purpose of this chapter is to asses the gain from ownership, internalization, and location advantages. Location theory will then be developed after the discussion of the these gains. This will be followed by a discussion of __ 6 External sales include licensing, technical service agreements, or sale of turnkey projects, etc. 7 Some of their locational advantages are actually ownership advantages. See Gray and Gray (1981). 59 business evolution and organizational forms of international banking.8 III- QQMREIIIIEE_EAQIQB§_EQB_IHE_DEEELQ£H§HI Q£_MHLIINAIIQEAL_BAN§IN§ Multinational banks are endowed with advantages specific to their ownership. These advantages are among the factors which enable them to compete in foreign markets with indigenous banks and multinational banks from other countries. Lacking ownership-specific advantages, a successful development of multinational banking is impossible. The ownership-specific advantages of multinational banks may include both microeconomic factors (either bank-specific or industry-specific) and macroeconomic factors (country- specific). The micro-type competitive factors may be attributed to imperfections in the product and factor markets of the banking industry. A. ' e ' om e ' 'v a o s 1. e ec ' s i roduc ma kets According to industrial organization theory, imperfections in product markets stem from barriers to entry and product differentiation. Barriers to entry for foreign banks vary from complete prohibition to free entry. Banks in countries with.high.barriers to entry will be characterized by 8 Organizational forms include representative offices, agencies, branches, subsidiaries, etc. 60 output restrictions and higher prices, and will earn higher profits compared to banks in countries with free entry.9 Higher profit rate may also be conducive to their overseas expansion. Product differentiation reflects differences in technology and reputation. Any difference in processing, product innovation, management, and marketing may result in the differences in technology. Since banks provide a variety of financial services, the whole service package is relevant. Product differentiation in banking can thus be defined as the difference in the package of services provided by each bank, including both the range and quality of services. These result from past experience, know-how, and specializations. The (differentiated. package thus goes beyond service and product quality, to include the quality of management, and its consequences for service speed, convenience, and courtesy. For example, Japanese bank managements "produce" trouble-free loans by paying attention to detail and working hard to ensure the accuracy of every part of a transaction.10 A bank's reputation is an integral part of product differentiation. Customers prefer to deal with banks that are well-know to them. The bank's name is positively associated with its size, profitability, credit-worthiness, and network. 9 This assumes that they have identical production costs. '0 See Wright and Pauli (1937). 61 2. W In addition to the above, a bank's endowments include three capital inputs: money, information, and human resources. These inputs are important to every branch, and can be shared or transferred within the same bank quickly and cheaply. In other words, foreign branches possess correspondent owner- specific advantages or can take steps to generate their internalization. This is more difficult to do when banking operations fall under different managements. a. W Imperfections exist in both local and international financial markets. Due to domestic imperfections, some banks are able to raise deposits at lower interest rate and enjoy lower operating costs. Due to segmentation of financial markets among countries, this constitutes a competitive advantage over banks in other countries. However, this advantage is country-specific rather than bank-specific. It can be integrated with a country's surplus fund to generate a competitive advantage for banks. Details will be discussed in section B. b. 1W1 Another type of imperfection in factor markets is the segmentation of capital-market information. Banks vary in the quality of their business intelligence, including credit risks and the nature of their customers. Through continuous transactions and other commercial contacts with their 62 customers, banks have a monopoly on specific information. Such information, shared freely within the bank, is a source of competitive advantage in investment and portfolio management in terms of both operating costs and yields. The trust and relationship between overseas units and customers takes time to develop. The existing bank-client relationship in the home country provides an initial and continuing source of advantage. This proprietary goodwill enables banks to service their multinational enterprises and allows them access to other businesses connected with these enterprises at low costs. Lastly, knowledge about the home country's market, customs, and operations is another type of information which is internal to the bank. Much of this may be unavailable to other banks abroad or available only at a prohibitive cost. 9. 391393.9991391 Human capital, including skilled personnel and other managerial resources, important for any industry, is especially important in banking. Developing financial expertise in risk assessment would be costly in terms of both time and effort. Expertise in international finance is even more demanding. Internal reallocation or development of human capital within the same bank is often more practical or cheaper than hiring in the open market. Further, human capital is relatively mobile among banks with the same nationality, but 63 is rather immobile between banks with different nationalities. Therefore, if required talent is not available domestically it would be impractical to acquire the required financial expertise from the open market. B. Magnoegononic Cguntzy-Snegifig Eactors 1. Su us ds dvanta e Macroeconomic factors, such as higher saving and lower investment rates, strong export expansion and its consequent surplus can result in lower costs of securing funds for banks. Due to the high leverage characteristics of bank business, even small differences in these costs can have a significant impact bank's profit rates. For current account surplus countries, the accumulation of international reserves led central banks to place surplus funds with private banks at attractive rates. This put these banks in a better position to extend credit both at home and abroad. The increase in reserves also enhanced the credit- worthiness of these countries whose central banks could now act as lenders of last resort.11 2. W Foreign direct investment reinforces the gains from multinational banking. Foreign direct investment may be classified into two categories, the monopolistic and defensive " This points is mentioned by Terrell (1979). 64 types.”t The monopolistic type refers to overseas investment by domestic firms to exploit monopolistic advantages deriving mainly from their advanced technology. Defensive type investments aim at extending business life overseas, when domestic conditions deteriorate due to events such as increases in labor and land costs or appreciation in the exchange rate. Even though both types of foreign direct investment help multinational banks, the defensive type is more :relevant. for' countries experiencing' current account surplus with export-led policies. For these countries, the growth of exports stimulates the economy leading to increases in input prices and thus defensive type foreign investment. Rapid increases in surplus strengthen protectionism abroad. To avoid world protectionism, firms will increase their "defensive" direct foreign investment. Appreciation of the exchange rate also re-enforces this tendency both by raising prices of exports and by lowing the cost of acquiring assets abroad. Increased direct investment in turn will increase demand for international banking services. 3. Tntennanionai gnade An importance macro-type factor favoring international banking is the growth of foreign trade. An increase in trade increase the need for related credit extensions and '2 See Kojima (1973), chapter 4. 65 transactions of foreign exchange, payment transfers, clearing, and other banking services. 4- 1191919991192 National affiliations of banks result in product differentiation. Countries with higher economic growth and political and economic stability provide asset security and appreciation of national currency which induce confidence among depositors or investors. Banks from a home country with a key currency, enjoy four major advantages: reduced transaction costs, fewer exchange risks, access to cheaper funding sources, and protection provided by a central authority acting as lender of last resort. Banks conducting transactions in key currencies can reduce costs and exchange risks by maintaining adequate deposits in these currencies. Such banks also have superior access to domestic retail deposits, and enjoy a competitive advantage compared to other banks. Japan stands as a good example (Terrell, 1977) . Japanese banks had to pay a premium for CD5 in the U.S. market before 1976. But with the growing reserves of the Bank of Japan, Japanese banks have been able to market their CDs on terms comparable to U.S. banks. In short, ownership-specific advantages are a necessary condition for engaging in international banking with any prospect of success. The associated gains are generated 66 through internalizing such advantages and appropriate locational decisions. We now examine these gains. IV- THE_EQIENIIAL_QAIE5_EBQM_MHLIINAIIQNAL_EANKIH§ The potential gains from international as opposed to domestic banking fall into two categories: an increase in returns and an decrease in risks, both current and expected. A. Ingnaaaas in gnzzent and Expectea Pnofits The main benefit of overseas expansion is an increase in current and expected.profits. One source is the interest rate and regulatory arbitrage. The other is the more effective use and augmentation of funds, information, human capital, technology, and plant capacity provided by internationalizing operations. LEW In the real world, interest rates vary widely among markets and countries. Overseas operations enable banks to channel funds from markets with lower interest rates to markets with higher interest rates.13 Since loans are the principal asset of commercial banks, such arbitrage is a major profitable activity. For example, Japanese overseas branches absorbed external funds to finance domestic industrial expansion in the 19505 and 19605. When domestic growth slowed down in mid-19705, Japanese foreign a Credit markets are influenced not only by industry and firm specific conditions but also by national conditions. 67 branches channeled surplus funds outside Japan. The banking industry emerged as one of the most profitable industries in the 19805. A second major source of profits is a widened portfolio of other financial assets, especially foreign exchange and securities.“ The importance of foreign exchange holdings is indicated by table 17 which lists the top 10 American banks with positive foreign exchange profits during 1977 and 1973.15 2. 89911199919191.9299 The regulatory environment affects overall profitability as well as that of different banking operations. Restrictions at home can be avoided abroad, and thus constitute an incentive for overseas expansion. One of the earlier examples is given by Brimmer and Dahl (1975) . When the U.S. Department of Commerce executed a Voluntary Foreign Credit Restraint Program and imposed restraints on capital outflows in 1965, U.S. banks expanded overseas. Terrell (1979) remarks further that foreign investment may be the only way for banks to avoid legal restrictions. For example, the Mcfadden Act and state 1‘ For banks emphasizing investment banking activities, foreign securities and exchange arbitrage are more important. ‘5 In fact, Giddy (1983) reports that almost all of the top 30 American banks that reported their foreign trading results had positive profits during 1977 and 1978. 68 Table 17. Foreign Exchange Profits and Losses Bank .1211. .1219. 1. Bank of America 54.1 51.7 2. Citibank 123.0 240.1 3. Chase Manhattan 48.5 74.7 4. Manufacturers Hanover 6.1 10.2 5. Morgan Guaranty 40.3 56.4 6. Chemical Bank 5.6 16.2 7. Continental Illinois 15.6 24.7 8. Trust Bankers 9.5 NA 9. First National-Chicago 8.8 14.1 10. Security Pacific 4.0 5.1 Unit: Million of U.S. dollars. Note: "NA" means not available. Source: Giddy (1983), Table 9, p.217. legislation prohibit multistate branching of U.S. banks. Many banks go abroad in order to expand their deposit and loan activities. On the other hand, some countries attempt to protect their financial markets by restrictions on entry and operational ability. Multinational banks are better able to circumvent such regulations. 3- MW International payments and related services are important activities undertaken by multinational banks. A world-wide network would reduce the costs of international payments operations among branches of the same bank. Therefore, the net returns from 4discounting bills of exchange, foreign exchange transactions, issuing letters of credit, money transfers, etc., will increase. The multinational bank will also generate ‘more such activity due to both cost and convenience factors. It offers its investors a much greater 69 opportunity to diversify their currency and security portfolios into a greater range of maturities and currency denominations than a national bank.16 Multinational banks thus widen their service range and customer base. 4. ' t s e a ela 'ons ' e e ’o The other benefits of branching out are the reduction in costs of acquiring and utilizing relevant information. Information capital, which is diverse and localized, is easily mobilized on a global basis. For instance, the data bank and the analysis of customer credit worthiness can be widely shared at little additional cost. This information capital creates a differential source of comparative advantage for some national banks over others. Its potential value also provides an incentive for banks to go multinational, particularly if it is difficult or costly to obtain relevant information through other sources, including existing multinational banks. 5. Hanan capinai tgansfer and tnaining Human capital as well as the flow of services from such capital, can.be:more easily and cheaply transferred within the same bank than between different banks. Overseas expansion can provide practical training for bank staff in foreign markets. '6 For banks specializing in investment banking activities, international funds transfers and services are extremely important. 70 6. W Financial technology, is a combination of process technology, product innovation, management know-how and marketing skills." If a bank enjoys any proprietary advantages in this respect, it is relatively easy to internalize it in its overseas operations. Such transfers between locations could be done at low marginal cost. For example, multinational banks can apply marketing skills to penetrate protected and oligopoly-type markets and then apply a lending technique developed at home to earn high profits. Conversely, the .banks may’ have access to new financial technology available or potentially available as a result of its overseas operations. International operations are thus conducive to both efficient use of technology and its augmentation. 7- 999999199.9f.999l9 Production costs can also be reduced by economies of scale. With respect to both withdrawals of deposits and defaults on loans, banks are subject to the law of large numbers. Risks of sudden withdrawals and defaults can be reduced as size and number of deposits and loans increase. Therefore, the ratio of reserve money to deposits and ratio of equity capital to loans can be lower for multinational banks. Consequently, operational efficiency will be higher for multinational banks. '7 See Lewis (1937). 71 An increase in bank size and operational efficiency would add to the bank's name and attract more customers. Economies of scale would also lead to more efficient use of funds, information, human capital, and technology guided by the global intelligence network of the bank. This has important implication for small countries.18 B. Raguction in Risks The second major gain from multinational banking is the associated reduction in existing and expected risk. This includes reductions in earning variability, instability of funds sources, regulatory' risk, competitive 'threats, and default rates. These flow from locational advantages with the exception of the reduction in the competitors' threat, which is secured by both locational and internalization advantages. 1. Rafingeg aagnings variability International diversification of bank assets reduces the risks of variable earnings. Interest from loans and securities and service charges for bill exchange and financial payments operations are important sources of earnings. A global network frees these earnings from being too closely tied to local business cycles. International diversification also enables banks to profit from price differences on non ‘3 Niehan (1983) points out that multinational banking may be a means for banks from small countries to achieve a more efficient size and reduce production costs. 72 tradable factor inputs due to incomplete arbitrage.19 In addition, earnings variability can be reduced by asset and liability management on a global basis shifting funds from locations with weak demand and/or strong supply to those with strong demand and/or weak supply. 2. In9r99999_9t9911192.9f.19999_9999999 The establishment of foreign branches helps banks to directly access diverse sources of funds including interbank and retail depository market sources, and, most importantly, the lender-of-last-resort. This increases the stability of sources and reduces exchange risks. 3- B99999199.19.£9991999IY_I199 Banks can reduce regulatory risk by international diversification which will enable them to adjust their operations rapidly as conditions change. Overseas branches also serve as antennas which enable banks to anticipate modifications of the regulatory framework due to changing international economic conditions.20 4. B9d99in9.93:9999.bx.99999919919 Global networks reduce the threats posed by foreign competitors. They can service domestic firms with investments overseas, which. would otherwise turn to foreign banks. Without branches overseas, banks risk losing clients' ‘ ‘9 See Rugman (1979) and Grubel (1977). 2° Niehans (1983) supports this argument. He claims that locational decisions by banks will take into account the regulatory framework as well as expected future changes. 73 subsidiary business in foreign countries as well as parent business at home.21 5. ;-._ -02 '1 .- ._ .t- o o.n .12 .97 4 _- The geographic diversification of loans, securities and currency holdings can reduce risks arising from default. Loan defaults may be attributed to individual firms or general market conditions. .According to the law of large numbers, the default rate due to specific firm factors can be reduced as the number of loans increases“ The default rate due to market factors can also be reduced by international diversification because credit market cycles are not perfectly correlated among nations. Capital losses of security holdings can also be reduced by international diversification. In the foreign exchange market, fluctuations in exchange rates may result in a substantial loss. This loss can also be reduced by holding a variety of currencies. In short, diversification of bank assets can reduced both lending risks and capital losses.‘22 2' See Grubel (1977). 22 In some sense, the default of loans is one type of capital losses. 74 V. LQQAIIQN_QHQIQ§ Banks must choose foreign locations with a view to their potential for internalizing the different ownership advantages and maximizing gains . 23 AW The most important gains arise from the potential for interest rate arbitrage because differentials persist due to micro-type imperfections and macro-type national factors. I-WWELEhn—xage The following situations are favorable in this respect: (1) large foreign direct investment: (2) a huge volume of international trade: and (3) expectations that the foreign countries or markets will experience rapid economic growth. a. o ' ' ' v me t a v The increase in foreign direct investments by domestic firms spurs banks to branch overseas. ‘The loss of business to foreign competitors or domestic banks with foreign branches encourages branching out and following the client. It is a "defensive" measure to secure business with domestic parent corporations (Grubel, 1977: Gray, 1981). Foreign subsidiaries also generate new demand for funds vvhich widen the banks' loan base. Industrial foreign :subsidiaries may even offer higher loan rates. Branching out ¥ 23 These are inter-related will be discussed together. 75 may thus also be an "offensive" operation for banks who are ready to move abroad.to seize such opportunities for profits. Follow-the-client implies that banks follow their clients or move about the same time. In fact, banks branch out if they see a trend of industrial foreign direct investments. They will locate foreign branches in places where investment by domestic firms already is or is expected to be large. b. Ingennagignal tzada advantage International trade is another aspect of country-level ownership advantageu ‘When its volume is large, the demand for related loans and payment services is strong. Higher loan rates are also likely if credit markets are segmented. It follows that the best locations for foreign branches would be commercial centers or ports. International trade is highly correlated with foreign direct investments, because multinational enterprises are trade oriented. It has been estimated that US multinational enterprises accounted for about 60 percent of US international trade in 1983. They make up nearly 77 percent of US exports and 46 percent of US imports.“ c. T99.9:91139.f999199.mark99 The strong demand associated with growing markets would invite an inflow of funds and create good opportunities for :foreign banks. As we will see later, foreign branches may ¥ 2‘ See Federal Reserve bank of Chicago (1986). Int9rn9tion9l_L9999r. N0-561. August. 76 have a comparative advantage in loans even if they do not in raising deposits, due to the fact that these foreign branches will be located in centers facing rapid economic growth. 2- WWW Investment and arbitrage in foreign securities and international markets are important and profitable. Multinational banks normally favor well-developed financial centers, growing economies and financial markets in their portfolio and locational decisions. The requirements of currency arbitrage and diversification may also favor a global network which includes, international financial centers as well as financial centers in the home country of currency holdings. B. t ecu ° u Sour es There are two ways to raise fund in the target countries. One is to borrow funds in the interbank money markets. The other'is to scrounge for funds through the banks own branches. Where well-developed money markets exist, multinational banks may setup their own foreign units there.25 Usually these are in international financial centers but occasionally in.national financial centers, also. .Both the country and the city must be considered in locating foreign branches. For example, ‘many' non-U.S. multinational banks establish :5 Sometimes, money markets may exist but may not be accessible due to government restrictions. 77 themselves in the United States, especially in New York, Chicago, and Los Angeles. On the other hand, if well-developed interbank markets are not available, then a branch network must be established. To minimize operating costs, the banks will initially concentrate on one or two countries. C. v ' ' e o os s a stra' ts Banks' profits can be increased and the scope of operations can be extended by locating their branches in countries without the same legal restrictions. For example, Japanese banks have avoided domestic restrictions through establishing a foreign subsidiary to engage in investment banking business.“ The growth of offshore banking also illustrates this point. D. Tntaznagionai EHDQ Tzansfens ana Services International operations enable banks to maximize earnings from the demand for fund transfer services associated with the growth of international trade and investments. Customers include trading companies, industrial enterprises, individual investors, tourists and others who deal in a variety of financial instruments, foreign currencies, bills of exchange, bank transfers, and so forth. Accordingly, bank operations and locations emphasize these sources of earnings. ”'See Viner (1988), for details. 78 In addition to financial centers, commercial centers and the centers of :multinational firms, key ‘tourist. centers are favored.because travelling businessmen and tourists are major customers. E. ingognagion Tnansfe; and Reiationsnip Presegyation Multinational enterprises can be classified into four categories, namely, both foreign subsidiaries whose parents are or are not clients at home, and foreign companies with and without businesses in the home country of multinational banks. Overseas branches can increase the linkages between home- based multinational firms and banks in either a foreign country or home. Further, the foreign branches can establish good relationship with foreign subsidiaries whose parents are not clients at home. By providing information about a home country's :markets, custom, operations and. consulting investments and. business opportunities, foreign branches establish close contacts with foreign companies and associates in their home country. Despite the difficulty in penetrating, foreign multinationals without business in the home country, good relationships can be established if banks provide services not duplicated by others. Preserving relationships and information leadership is the main focus of the first group, and the move abroad can be classified as "defensive". For the other groups, however, the creation of relationships and information is the main concern, 79 and the move abroad is "offensive". Multinational banks assume a "lead-the-client" rather than "follow-the-client" role. They assist domestic firms. in investing abroad and foreign firms in investing at home. Therefore, the location of foreign bank branches must be considered for all four groups of multinationals. F. Infigznagion Qoliection Customer relationships can be increased at the least cost by locating branches in the centers of multinational enterprises, since business information can be acquired at low cost in financial centers. An efficient system of information collection and dissemination would lead to economies of scale and reduce production costs. G. Tachnoiggy Anniicatign and Transfar Banks' earnings can be increased by applying advanced technology developed at home to appropriate financial markets. These include both the protected and free entry markets in developed and developing countries. In protected financial markets, usually located in developing countries, existing marketing techniques may be very profitable, whereas innovation would be important in more open financial centers. Learning new technology is generally easier in developed international financial centers, where both financial expertise and new technology are available. 80 H. _910u.“ .7 _ . - .1. _ - ;--uct'- '_ D- a- oss In general, geographic diversification is conducive to economies of scale and reduction of all kinds of capital loss and withdrawal instabilities. The ratios of reserve money to deposits and equity capital to loans can be brought down. These factors all favor establishing branches in different cities and countries as well as developing an extensive global network. I. u fo t'o o'ces From the above analysis, several conclusions can be drawn with implications for location choices among countries and local markets, and size of branch network. To secure sources of funds and expand the scope of operations, the ideal locations for foreign branches are the home countries of key currencies, and countries whose legal restrictions do not duplicate those of the banks' home country. Ranging from the country level to the local market level, there are four location alternatives for foreign branches: the agglomeration of multinational enterprises, financial centers, commercial centers, and tourist centers. Since multinational enterprises are important clients for multinational banks, the center of multinational enterprises would be an ideal location for foreign banks. If clients' foreign direct investments in a particular place are large or expected to increase, this location would be appropriate. Locations where a non-clients' 81 foreign direct investment is large and their correspondent banks do not have the ability or intent to set up a branch and subsidiaries would also be an appropriate choice. For banks specializing in international trade related business, commercial centers would be good locations, particularly if they reflect growth in bilateral trade and markets. Financial centers are good for absorbing and investing excess funds. They also provide a favorable environment for high rates of return, growth of technology, convenience of fund transfer, and freedom from regulatory constraints. Tourist centers, although initially not as important, gain in importance as tourism. grows. These constitute good locations for banks specializing in this area, such as the American Express Company. An emphasis on mobilizing funds might focus on particular countries and markets. However, a global network would be more important for diversifying investment opportunities, collecting information, executing fund transfer services, foreign exchange, and regulatory arbitrage. To minimize the operating costs, new multinational banks can start with a basic global network which includes two or three foreign branches. These branches should be located in financial centers in order to take advantage of favorable conditions and get used to the environment of international banking. Beyond this basic network, banks can add more branches according to their ownership-specific advantages. 82 The preceding location choice theory tells us about the development of a global network its locations, but it does not provide a clear picture of the evolution of the international banking business and the related organizational form choice. These issues are discussed in section VI and VII. VI.OOU 0 ll; 1!; 1%.: :8 A. 5 5a e The sources and usages of funds change over time, throughout the stages of development. During the early stages, the main borrowers would be multinational enterprises from same countries as the banks. Yet, foreign subsidiaries of firms usually prefer to maintain relationships with a particular bank with which they are familiar rather than with banks they have not previously dealt with. Since local banks do not know the new local subsidiaries, obtaining loans from local banks would be difficult for these new firms. Multinational enterprises are, therefore, the main borrowers initially. The other minor borrower would be foreign firms which are engaging in bilateral trade with home countries of the banks and which.here been customers of'parent banks long before the establishment of foreign bank branches. In the second stage, established foreign firms which engage in bilateral trade with the home countries of bank but were not the bank's client before, and new foreign firms having trade and investments in the bank's home countries may 83 become new customers. This is because the banks can provide information about their own home country markets, customs, operations, and business opportunities at lower costs. In the third stage, overseas branches may finance host- country governments and individual firms, even those not engaged in trade with the bank's home country. Localization and retailing are accomplished during this stage. Loans to individuals in host countries also become important. B. Soupges 9: Funds fo; Ovepseas Operations On the fund sources side, parent banks and other branches are the major sources of financing during the initial stage of development. Interbank borrowing may also play an important, but secondary, role. Usually, only a small portion of the funds comes from the subsidiaries of other multinational banks in host countries. In.the second stage, foreign firms with.businesse5 in the home country of the overseas branch.may also contribute to the deposits of the overseas branch. Ethnic minorities in the host country, especially wealthy immigrants, may prefer to deposit in these overseas branches, but this would be minor. Interbank borrowing still is important. In the third and final stage, the foreign banks may attract deposits from local companies and residents, particularly if the banks have a good reputation and are of adequate size, and of the correct nationality. The 84 nationality effect is important because banks from strong economies offer a differentiated product which give depositors confidence. For both sources and usages of funds, the process of localization proceeds in stages, starting with wholesale international businesses. Retail business follows as the bank is gradually integrated into the national banking environment. The speed and degree of localization depend upon the banks' comparative advantages and organizational form.”' The localization of assets and liabilities lead foreign branches and subsidiaries to become increasingly independent of their parents. With access to local loan markets, the lending base of foreign. branches is enlarged and risks reduced. The parent banks also gain over and beyond those associated with international diversification, by this reduction in local risks and gains in overall stability. The localization of foreign operations has two implications. The first is the maturity of foreign branches and their autonomous ability to develop their local networks and customer base. This is a gradual process and may take more than ten years, on the averaged28 27'A decision to establish a subsidiary is essentially a decision to enter the local commercial and retail market. 23 I would guess that this takes 15 years, on the average, from Japanese banks' experiences which will be discussed detail in chapter 5. 85 The second implication is the similarity in composition of assets and liabilities which emerges between local banks and branches of foreign banks.29 VII. G O O O 0 There are several organizational forms that can. be utilized by foreign banks. Our focus is on the most important, representative offices, agencies, branches, and subsidiariesfi” While the organization of the first three is legally part of its parent, a subsidiary in the host country is a separate legal entity. A. Reppasenpative ogfices Representative offices cannot accept deposits nor make loans but can deliver payments or loan application forms to home offices. Representative offices may perform only liaison, customer solicitation, and information-gathering n Therefore, the gains of representative offices activities. come mainly from closer contacts with local clients and banks. It may also be possible to acquire some new technology through these offices. It is the easiest and cheapest way of a This is supported by the experience of U.S. banks in Japan. See Table 3, Terrell (1979). .m U.S. banks also use domestic organizational form for carrying on international banking activities, such as the Edge Act and Agreement corporation and the International Banking Facilities. See Shapiro (1989) for details. u See Goldberg and Saunders (1981). 86 "landing" in the host country and may serve as a precursor to a larger presence in the future. 3. 999E199 Agencies may make commercial and industrial loans but are prohibited from making consumer loans. They are only permitted to accepts foreign deposits through credit balances, which are usually the undrawn portion of a loan or a receipt from an international transactionfi” However,'credit balances are a very limited way to raise funds from nonbank sources. Agencies must therefor finance themselves by funding from parent banks or interbank money markets. In short, agencies are wholesale-oriented and emphasize the first stage of the international banking business. In general, agencies can gain more potential benefits from mmltinational banks than representative offices. Representative offices may be strengthened by agencies in collecting information, forging closer contact with local clients and banks, and in acquiring advanced technology. Economies of scale, regulatory arbitrage, and escape from regulatory risks may also be realized to some degree. It may also lead to higher foreign rates on loans, an expanding loans base, and diversified lending and earning risks. u Agencies are not permitted to accept deposits in the host country. 87 C- 519119099 Unlike agencies, branches offer a full range of banking services, including making loans and accepting deposits. However, local regulations and lack of extensive networks may make it difficult to accept the full range of deposits. Initially, the main sources of funds will be parent banks and loans from interbank money markets, if available through national or international financial centers. The situation as regards local deposits has been, however, improving over time. On the funds usage side, a branch can evolve from the first stage to the third stage. However, a branch cannot develop its funds collection activities into the third stage due to the lack of an extensive network. Foreign branches. help the parent banks in all key respects: lending, securing sources of funds, reduced risks of default, strengthening networks, improved technology, training, diversification in various markets, and freedom from regulatory constraints. All these have positive effects on costs, earnings and net payments. They are clearly superior to agencies. A foreign branch network allows the multinational banks to offer their customers direct and integrated service in different countries on a consistent policy basis.33 A bank can also exert maximum control over its foreign operations through a branch. 33 See Shapiro (1989) . 88 D. W The last important form is the subsidiary, whose banking power is identical to the domestic banks. It is also regulated in an identical way; Foreign.banks can.gain control of a subsidiary either through acquisition of an existing one or by establishing a new one in the host country.“ Subsidiaries are retail oriented, as compared to branches and agencies which are wholesale-oriented. Buying an existing retail bank will afford immediate access to the local deposit market, and an established network of local contacts and clients. Therefore, subsidiaries emphasize the third stage of international banking activities characterized by retail orientation. Subsidiaries represent the same full range of potential gains as branches. The most distinct one is that gains from diversification of funding sources can be assured, raising the proportion of loans available for local firms and individual. However, the acquisition or establishment of subsidiaries is expensive and highly risky.35 E. W As one moves from representative offices to subsidiaries, there is increasing integration with the local market. But 1“ See Goldberg and Saunders (1981), p.367. 35 See Shapiro (1939) . 89 this process also becomes increasingly more difficult in terms of entry and operation costs. According to bank's micro-type and macro-type factors, and the stage of development of the international banking business, individual banks can choose their foreign locations and organizational forms to maximize profits and minimize risks. When the volume of trade and amount of foreign direct investment are still small and uncertainty for the future still exists, a representative office is the best choice. However, when the volume of trade and.amount of foreign.direct investments are or expected.to be large, and costs of securing funds in the home country are low, the branch option may be the best. Subsidiaries are the best form for banks to take when localization and insuring secure sources of funds are the primary goals. CHAPTER 4 INTERNATIONAL INVESTMENT I. W‘ The traditional theory of international capital movement points out that capital will flow from areas of lower to areas of’higher'marginal productivity, if free movement is allowed.2 In the model shown in figure 1, there are two countries, A and B, and the total capital stock is 0403. MPKA and MPKB are the marginal productivity of capital in A and B respectively. Total output in country A is OAACK0 and OBBDKo in B. When the financial markets of A and B are segmented by exchange controls and other restrictions, the domestic savings of each country is equal to domestic investment at OAK0 and OBK0 respectively. There are no current account imbalances in this world since there is neither lending nor borrowing. The real interest rate in each country (rA, r3) is equal to its own marginal product of capital but will differ and persist. If the two countries relax exchange control measures and other restrictions, equilibrating capital flows will result. The capital outflow country will show current account surpluses and the capital inflow country will show current account deficits. ‘ The one parameter model only concerns the rate of return. In contrast, the two parameter model concerns two factors, i.e., the rate of return and risk. 2 This theory was initially put forth by McDougall (1960). 90 91 Figure 1. The Theory of International Capital Movements Capital movements will continue until real interest rates are equalized, i.e., MPKA = MPKB at r“. The capital stock of country B will then decline from OBK0 to OBK1 by the amount of its net foreign asset, K0K1. The capital stock of country A will increase by the same amount, from OAK0 to OAK1. The domestic product of country B will decline from OBBDK0 to OBBEK1. The national product (national income) of this country under the new equilibrium will be larger than the domestic product by the amount of investment earnings from abroad, which is equal to the area of KOFEK1. Therefore, the national product of country B will increase by the area of the triangle, DFE. On the other hand, the domestic product of country A will increase from OAACK0 to OAAEK1, by the area KOCEK1. The national income increase will be equal to the triangle, FCE, due to interest payments abroad, KOFEK1. World 92 output will have increased by an amount of DCE, which may be regarded as a welfare gain for the two countries. In the absence of controls, capital would flow from surplus countries with higher savings and/or lack of investment opportunities to shortage countries with lower savings or more profitable investment opportunities. However, due to the higher productivity of capital, the national income of both the source and host country will increase. One may generalize the results of this model to the whole world. Capital surplus countries gain from overseas investments and earnings and capital shortage countries gain from investment flows and increased productivity. The international investment consists of foreign direct investment and international portfolio investment. Even though international portfolio investment will be the focus of this thesis, the major theories of foreign direct investment will briefly be summarized. Since McDougall first put forth his original of foreign direct investment, a variety of alternative theories have arisen. Foreign direct investment may be classified into two categories: the microeconomic and the macroeconomic. A. ' oec ' e o e' n ' ec vestment This type of investment is also called monopolistic foreign direct investment, and is emphasized by Hymer (1960), Kindleberger (1969, 1970), and Caves (1971, 1974). They claim 93 that foreign. direct investment enables firms to exploit monopolistic profits by transferring their advanced technology abroad at a marginal cost. Buckley and Cason (1976), Magee (1977a, 1977b), and Swedenborg (1979) extend this work, further exploring the concept of internationalization. Firms invest overseas through internal transactions to avoid high transaction costs, which are caused by the existence of uncertainty and market failure due to novelty and technological change. B. om'c o ' ' ves me The product cycle approach originated with the work of Vernon (1966) . When a new product technology eventually becomes standardized, it becomes less costly to transfer to foreign locations through FDI.3 Due to the appearance of newer models in domestic markets, the most profitable markets for the existing products can be found mainly in foreign countries. In contrast, Koj ima (1978, 1982) emphasized the defensive type of foreign direct investment. He calls attention to the fact that the international transfer of production from.Japan has taken place in industries in which Japanese firms have experienced comparative trade disadvantages. Therefore, foreign direct investment occurs first for industries for 3 Actually, the transfer could be effected via foreign direct investment, licensing, or foreign imitation. 94 which natural resources are domestically unavailable, and then low-technology manufacturing industries, when the domestic wage rate and the prices of other factors of production have risen with the upgrading of the Japanese domestic industrial structure. The general statement of defensive type foreign direct investment was already made in chapter 3, section III. Finally, the eclectic theory by Dunning combines the above theories and uses ownership, internalization, and locational advantages to explain foreign direct investment. This is also mentioned in chapter 3, section III. For international portfolio investment, however, we cannot apply the one parameter model to predict variable investor behavior and portfolio choices since it does not take into account risk and other characteristics of investment. II- IHQ_£ABAMEIEB_MQQEL A. Qomaatic Eoppgoiio Thepny Modern portfolio theory originated with Harry M. Markowitz (1952, 1959), who provided a framework for the selection of optimal portfolios with diversification of risks. Markowitz argued that a rational investor would be willing to assume increased risk only if the expected return is adequate compensation. The rational investor is thus risk averse, preferring minimum risk for a given expected return, or maximum return for a given risk. Markowitz observed further that investors would diversify 95 their portfolio, holding either securities of different types or through different companies. He pointed out that effective diversification can be achieved if the returns on all securities are not perfectly positively correlated. Such a "minimum risk-maximum return combination would yield an "efficient portfolio frontier" for all possible choices. Diagrammatically, this is depicted in figure 2 which shows the expected rate of return r along the vertical axis and the standard deviation along the horizontal axis. Efficiency frontier 0 Standard deviation Figure 2. The Efficient Frontier Clearly, any portfolio combination on the efficiency frontier is preferable to any other'within. For any portfolio A within the efficiency frontier, portfolio B could produce the same expected return but at a lower risk level, while portfolio C‘would have the same degree of risk as A, but would 96 afford a higher expected return.‘ The lower the degree of correlation of returns on all securities, the greater the extent to which risk can be reduced. In practice, returns on securities tend to have a rather high positive correlation, because they are all exposed to the same market or economy risks. Therefore, risks can only be reduced to a limited extent by diversification in a specific market. In fact, risks which affect all securities cannot be eliminated by such means, but while those which affect only specific companies or industries. As the number of securities held increases, the specific risk can be eliminated rapidly. This is illustrated graphically in figure 3. If more than 15 securities are included in the portfolio, over 90 percent of the specific risk can be eliminated. The remaining risk.in the portfolio*will almost be the same as the market risk. The curve is asymptotic to a line which represents the market risk, the risk which cannot eliminate through diversification. Individual market risks differ from each other. In the UK it is possible to diversify away about 65 percent of total risk, and the figure is over 70 percent for the United States (Kitchen, 1986). ‘ See Cohen, Jerome 8.: Zinbarg, Edward D.; & Zeikel, Arthur (1987), p.134. 97 risk % Specific risk 27 ---------- ' ------------------ Market risk 0 No. of Securities Figure 3. Effect of International Diversification on Risk B. o ' eo 1- W The principle of risk diversification can be extended to international investment. This possibility has been extensively studied (e.g., Grubel, 1968: Levy and Sarnat, 1970; Bruno Solnik, 1974; Lessard, 1975; and Witt, 1978) . Grubel initially explored what happens when capital control and other restrictions of two isolated economies are removed. He illustrated that international diversification would reduce risks. Levey and Sarnat (1970) analyzed the effect of international diversification on the efficiency frontier. They pointed out that as the number of countries in which investments are made increases, the efficiency frontiers shift inward. The efficiency frontier E in figure 4 shows the locus of 98 risk and return combinations from investing in developing countries only. The efficiency frontier D indicates the efficiency frontier when investments are limited to five common ‘market countries. Efficiency frontier C can, be reached, if the investment area is expanded to include eleven western European countries. When all sixteen high income countries are included, the efficiency frontier expands to curve B. Finally, when all twenty-eight countries, including the developing countries, are considered in the international portfolio, the efficiency frontier A is reached. Point F represents a typical fully diversified portfolio in U.S. Efficiency frontier, D and E are dominated by all other investment alternatives. By way of contrast, the efficiency frontier A dominates all other investment opportunities. Even though point F represents a portfolio that is fully diversified within the U.S., this portfolio is not efficient in an international context. This analysis suggests that, as the number of countries for portfolio choice increases, the rate of return for any given level of risk increases, or conversely, the risk level for any given rate of return decreases.5 5 A good summary of Levey and Sarnet (1970) can be found in Francis (1986). 99 A 3 risk C .F //’//””"D \ :LjPI’Jk5”‘=='Ef- \ ‘ \ \ x \ 0 \ \ \‘\ \ Standard deviation Figure 4. Various Efficient Frontiers Source: Levy and Sarnat (1970), p.673, figure 2. By using weekly returns for eight developed countries from 1966 to 1971, Bruno Solnik 1(1974) calculated the proportion of risks that could be eliminated by international portfolios. He found that the risk of a fully diversified domestic portfolio is 27 percent of the total risk in U.S. stocks. In contrast, the risk associated with an international, fully diversified portfolio is 11.7 percent of the risk on a typical stock. This result implies that international diversification may reduce a portfolio's domestic, systemic risk. Lessard (1975) also jpointed. out that investors who restrict their purchases to domestic securities will bear additional risk relative to those who hold an internationally diversified portfolio. He examined the proportion of the variance of the return for stocks in each of several countries explained by a world index. He also examined the proportion 100 of the variance explained by each national index after the effects of the world index had been removed. He found that a large fraction of the variance of an individual security is related to its country index. The evidence strongly suggests that while a world index is important in accounting for risk, country factors are also of great importance. Thus, investors who concentrate on the securities of one country bear substantial additional risk.6 Elton and Gruber (1987) show that the average correlation coefficient between any two indices in the U.S. is quite high, but that the correlation coefficients between the equity markets of different countries are much smaller.7 iLike other similar studies, this evidence indicates that international diversification can lead to lower risk portfolios. 2. s ' i s t International investment increases the range of attractive investment opportunities which may not be available in the domestic market. This is especially the case when the domestic market is underdeveloped, with only a narrow range of financial assets. In the international markets, different forms and 6 For a good summary of Lessard (1975) see Elton and Gruber (1987), pp.242-244. 7 An example they give is that the correlation between an index of the New York Stock Exchange and the American Stock Exchange is above 0.90. The correlation coefficient between countries are much smaller, with the average correlation being 0.133. 101 different types of financial assets are available to accommodate the varying needs of both surplus and deficit units. The assets vary in terms of maturities, yields, and risks, and may includes bonds, stocks, and equityu Investors' welfare is improved because of these wider choice sets. 3. W The two parameter - or rate of return and risk - model predicts that international capital movements will occur with the lifting of exchange control, because investors are risk minimizers. The more pronounced their risk aversion, the stronger will be the tendency to diversify internationally. In an economy, the household sector is the principal source of net savings. For the majority of individuals, security rather than foreign direct investment is most convenient, 'this implies ‘that. international security investments will increase with the lifting of capital control. However, we need to further consider the investor's portfolio compositions, especially since individual wealth accumulates over time. The effect of wealth on the proportion of individual portfolios allocated to risky assets is important for a country with chronic current surpluses. The expected utility model can deal with this question. 102 III. L.-. 0 , ' 9.94- ' SK ‘ D NVES N ; fiVIORS A. 0 ve ' a Re at'v 'sk ve 'o The expected utility model originated with Neumann- Morgenstern, and is based on a set of axioms about the behavior of individual investors and their preference function. It can be used to describe their attitudes toward risk in the context of their growing personal wealth. Pratt (1964) and Arrow (1971) independently developed the concepts of absolute risk aversion and relative risk aversion. According to the absolute hypothesis, investors can be classified into three groups: those who increase the amount iinvested in risky assets as wealth increases (decreasing absolute risk aversion); those whose investment in risky assets is unchanged as wealth changes (constant absolute risk aversion); and.those who>decrease the amount invested in risky assets as wealth increases (increasing absolute risk aversion). The relative risk aversion hypothesis describe how the percentage of wealth invested in risky assets changes as wealth changes. Three responses are distinguished as investors' wealth increases: investors invest declining percentages in risky assets (increasing relative risk aversion); investors invest a constant percentage (constant :relative aversion); and investors invest an increasing percentage (decreasing relative aversion) .8 The evidences ~ ‘3 See Elton 3 Gruber (1937), p.133-139. 103 generally supports the decreasing absolute risk aversion hypothesis, but there is much less agreement concerning the relative risk aversion hypothesis. B- W There are three major empirical studies that attempt to determine investors' relative and absolute risk-aversion behavior. All of them used cross-sectional survey data of individual asset holdings and wealth to draw conclusions about investors' relative and absolute risk aversion. Friend and Blume (1975) examined the U.S. survey data, Survey of Financial Characteristics of Consumers, and found that the percentage invested in risky assets remained virtually unchanged among investors with differing wealth. They concluded that investors exhibit constant relative risk aversion, which implies decreasing absolute risk aversion.9 However, this conclusion rests upon the definition of wealth and risk. When wealth is defined as net worth, exclusive of homes and automobiles, householders exhibit decreasing relative risk aversion. When wealth is defined to include homes and automobiles, increasing or constant relative risk aversion is served, depending on whether homes are treated as risky assets at market value or owner's equity 9 As wealth increases, a constant percentage of wealth invested in risky assets implies more amount of dollar in risky assets. Similarly, the absolute amount of dollars in risky assets rises, when the percentage invested in risky assets increases. 104 value. If housing is treated as a risk-free asset, the tendency towards decreasing proportional risk aversion emerges. The second major study was done by Cohn, Lewellen, Lease, and Schlarbaum (1975) . Their study examined survey data obtained from questionnaires administered to investors through a national U.S. brokerage firm. They investigated the proportion of individual portfolios allocated to risky assets. They concluded that decreasing relative risk aversion and decreasing absolute risk aversion are accurate description of investor behavior. It must be noted that they used total rather than net assets and that their sample was a select group of stock-owning investors. The third and most recent study by Morin and Suarez (1983) used Canadian survey data and investigated the effect of wealth on the proportion of risky asset holdings in individual portfolios. They concluded that investors exhibit decreasing relative risk aversion when housing is excluded from the definition of wealth or treated as a riskless asset. These studies show that individual utility functions have relative risk aversion properties somewhere between constant relative risk.aversion and decreasing relative risk aversion. Decreasing absolute risk aversion can also be implied. As wealth increases, the investors will definitely hold more dollars in risky assets, with.the percentage invested in risky assets likely to increase or at least remain constant. 105 c. Inpiigapipn fig; Inpaznapipnai egrtfioiig WW Extension of this model to the development of international banking is interesting. After lifting capital control, individual investors will diversify to include international assets for greater safety. Deposits and security holdings in foreign countries will increase. This favors the development of international investment and international banking. As the wealth of individuals grows, individuals will invest more in riskier assets in search of higher yields. The percentage of wealth invested in risky assets is likely to increase, if decreasing relative risk aversion is the case. Even with constant relative risk aversion, the absolute amount of dollars in risky assets increases as long as wealth continues to grow. This predicts that international banking, especially investment banking, will grow. Banks should take this into consideration when they attempt to expand overseas. For banks with competitive advantages in security brokerage, trade and underwriting, international financial centers will be the best locations for their foreign branches. In contrast to commercial banking which requires an extensive network of small branches in major trading countries, investment banking requires large operational units in only a few'major financial centers. If a host country does not allow commercial banks in investment banking activities, 106 subsidiaries become the proper form to take. IV. V F N S This section will study the ivestment behavior of the central banks, which are the most important international investors 'under' conditions of capital control and fixed exchange rates. The investment behavior of central banks is quite different from that of individual investors. First, the basic responsibility of the central banks is foreign-exchange reserve management to service international transactions and obligations. The precautionary and transaction rather than the investment motive are the dominant criterion for foreign- exchange holding. Secondly, this means that central banks must necessarily choose the appropriate currency composition and international portfolio, regardless of yields.1o In 'some cases, central banks do not.have the choice of whether or not to invest overseas. The increase in foreign-exchange reserves may also be automatically invested overseas, and most likely in the form of commercial bank deposits. The available literature does not distinguish between the different motives and assumes that reserve holding is only for precautionary purposes (Williamson, 1973; Hipple, 1974; Frenkel, 1983; Edwards, 1984; and Landell-Mills, 1989). m Central banks usually invest in foreign bank deposits, foreign security, bilateral loans, gold purchases. 107 Actually, the holding of foreign exchange reserve may include an investment motive also. This is particularly true for'balance-of-payment surplus countries. In some cases, the investment purpose may be the dominant one. This was true of the OPEC nations in the seventies after the first oil shock. Oil-producing countries became active in managing their increasing reserves and tried to maintain or enhance the real value of their reserve assets. Their reserve managements were thus investment-oriented. Given the requirements of precautionary foreign-exchange reserve management, a maximum level of reserves must be set aside in order to minimize the opportunity cost of holding lower-yield foreign assets. Reserve beyond that level can be invested in the higher-yield foreign assets. The surplus reserve fund is investment-oriented. The central bank thus has a three-fold task: maintaining a minimum of precautionary reserves, an optimal combination of major foreign currencies, and the real value of reserve 1 This involves continuous portfolio management for assets.1 both precautionary and investment objectives. We will discuss this last point in the following sections. n This is true for the central banks under either the fixed or floating exchange-rate system. Conceptually, a country's demand for precautionary reserves is equivalent to that of an individual. The magnitude of precautionary reserve-holding is positively related to the cost of covering an unanticipated deficit, the national wealth, but is negatively related to the rate of returns on other assets.12 In general, countries that are large and more open to international trade tend to hold higher levels of reserves than countries that are less so. Countries with larger variation in past external payment deficits also have stronger demand for reserve. Beyond this, countries with limited capacities for earning or borrowing foreign exchange, or with highly concentrated or variable sources of earning, should need higher reserves than those with the same foreign exchange needs but sounder earning capacities and better credit earnings.” Edwards (1985) and. Landell-MIlls (1989) discuss the opportunity cost of foreign exchange reserves in terms of the alternative foregone. Since reserves tend to be held in short-term.secure assets with low interest rates, the cost can be calculated as the difference between these lower earnings and alternative returns on the highest-yielding alternatives, ” See Williamson (1973), Hipple (1974), Frenkel (1933), and Edwards (1984) for reviews of the literature. 3 See Landell-Mills (1989), p.709. 109 especially, long-term, but less secure assets. Any increase in yield difference will cause the authorities to reduce reserves . o os o o o - c a s A country's composition of foreign currency holdings is determined by two important factors, the exchange-rate regime and the pattern of international trade and payments (Heller and Knight, 1978). Countries hold a significantly greater proportion.of their exchange reserves in the currency to which their own currency is pegged. Further, the desire to minimize exchange risk and the need to hold balances for intervention in exchange markets are important concerns. Countries also hold a higher percentage of currencies of their important trading partners (Hell and Knight). Studies also show that the composition of foreign-exchange reserves changes as trade shares or expected yields on reserve currencies change. The range of market instruments is also important (Downes, 1989). Countries hold. a higher' percentage of reserves in the currency that offers a wide range of choices. Given the need for liquidity, internationally acceptable and marketable reserves will be emphasized. An optimal composition will include the major world currencies. The target proportions may be in ranges rather than fixed percentages to provide flexibility. 110 C- W 1. e aut - r' te eserve Liquidity, safety, and return are the main factors which influence portfolio choice. The holdings of precautionary reserves are influenced further by openness to trade, the record of variations in deficits, sources of exchange earnings, exchange regime, national wealth, and return on other assets. Since liquidity is a prime concern, a proportion of the portfolio will be in short-term.assets. 'The safety of reserve capital is also an important investment consideration because it is part of national wealth whose loss will lead to unwelcome economic and political repercussions. Central bank holding will thus emphasize foreign government securities, and debt issued by other government-guaranteed agencies, or multinational organizations with AAA rating.“ Since there is an implicit economic cost in holding reserves, an important objective must be to compensate for this cost by managing the reserves portfolio as profitably as possible. Therefore, some longer maturing instruments with higher yields can be considered in the reserve portfolio. In addition, the range of instruments can be widened to include corporate bonds and stocks. " See Downes (1989), p.21. 111 2- W The rate of return is the primary concern for investment- oriented reserve holdings. Liquidity and safety do not deserve the same attention. The choice of portfolio may depend on the preference of each individual country. Without economic and political constraints, however, the investment behavior of central banks would be similar to the investment behavior of individual investors. Decreasing absolute risk aversion theory may be equally applied to the central bank as to the investor. When the amount of investment-oriented reserve increases, the absolute value of risky assets will increase.15 Furthermore, the central bank investors may show constant or decreasing relative risk aversion characteristics. When the investment-oriented reserve increases, the percentage of risky assets will be constant or increasing. In short, the international investment behavior of central banks will become closer to the investment behavior of individual investors. u The wealth of nation refers to the investment-oriented reserve fund. When the investment-oriented reserve fund increase, the Central Bank will increase risk asset holding. CHAPTER 5 JAPAN'S EXPERIENCES I- IHIBQDQQIIQN Japan can also serve as a model for Taiwan. Just like the current situation in Taiwan, Japan has had a huge surplus since 1981. Unlike Taiwan, Japan has a relatively reasonable ratio of international reserve to import. Japan has experience in international investments and has managed to develop a relatively complete international financial system since the 19605. Japan has also been able to increase its international investments through its own financial system, keeping pace with the rate of growth of their current account surplus. Among the OPEC nations, Kuwait has not only the longest history of international investments and the development of international financial intermediaries but also has a clear and interesting investment strategy. The size of Kuwait's current account surplus in the 19705 stemming from oil export revenue is similar to the magnitude of Taiwan's manufacturing export surplus in the 19805. Although it lacked a solid financial system.both domestically and internationally before the first oil shock, Kuwait responded successfully to the sudden surge in current account surplus. Since.both Kuwait and Taiwan belong to the same group of developing countries, Kuwaiti experience in international investments and the 112 113 development of international banking systems also provide some lessons for Taiwan. Due to the data availability and less implication for the development of international banking, however, the Kuwaiti experience will be discussed in Appendix D. II- THE_JAEANE§E_EK£EBIENQE Following the end of occupation in 1952, Japan began a period of sustained high economic growth, which continued into the early 19705. By 1973, Japan was the world's second largest market economy, and its per capita gross national product ranked fourteenth. among"member’ countries of ‘the Organization for Economic Cooperation and Development.‘ Growth of the Japanese economy has slowed down since the mid- 19708. Japan began to enjoy productivity gains in the 19505 by adopting foreign technology. In the 19605 the growth rate went up to 12.1 percent. During the 19705, Japanese technology finally caught up to foreign standards, causing productivity gains to taper off. Profitability also declined leading to reduced investment in new plants and equipment. The net result was a drop in Japan's growth rate to 7.5 percent in the period between 1970 and 1973, and an even further decline to 3.8 percent between 1974 and 1985. ' See Lincoln (1933), p.4. 114 During the high growth era, extremely high demand for corporate sector investment was matched by small government surpluses and high private sector savings. Japan's current account was almost balanced in the 19605. In the mid-19705, due to the decline in output growth and business investment, the corporate sector reduced its external borrowing by 50 percent. The potential for an economic recession emerged. The central government counteracted with an expansionary fiscal policy, increasing the budget deficit by 100 percent. As a result, the Japanese economy continued to grow at a steady pace with only small current-account surpluses. During the 19805, however, the balance between domestic savings and investment did not continue. The Japanese government. steadily reduced. the fiscal deficit, but. the household and corporate sectors maintained the same saving behaviors they had adopted in the 19705. The government budget deficit declined steadily from 5.5 percent of the GNP in 1978 to 0.6 in 1987. Net savings by the household sector stayed between 8 and 10 percent of the GNP during the period between 1980 and 1987, while net borrowing by the corporate sector remained between 4 and 6 percent over the same period. The existence of excess domestic savings since 1981 resulted in a chronic current account surplus which increased rapidly from 0.4 percent in 1981 to 4.3 percent in 1986, leveling off at 3.6 percent in 1987. Channeling surplus funds 115 to foreign countries became an important task for Japanese financial intermediaries. In the 19505 and 19605 Japan had a highly regulated financial system that served the economy well. Financial institutions were restricted to narrow lines of business. Article 65 of Japan's Securities and Exchange Act prohibits banks from participating in the domestic securities business and bans securities companies from domestic banking activities. In addition, the act separates the insurance and securities industries. Article 65 prevents banks from trading and underwriting corporate stocks and bonds. Banks may only own up to 5 percent of any one Japanese securities company. Securities firms are restrained from taking deposits and.dealing in real estate investment. The activities of real estate investment are a monopoly of the insurance industry.2 However, within the Keiretsu framework, securities firms, commercial banks, and insurance company are not completely separate units.3 Cross-share holding among banks, insurance companies, and securities firms creates a high level of integration. Virtually all of the top securities firms and insurance companies are associated with a main bank in the Keiretsu group.‘ 2 See Viner (1933), p.23. 3 Keisetsu means the industry group. ‘ See Pozdena (1989). 116 The government also controlled the interest rate, exchange rate, the number of financial instruments, and capital movement during the 19505 and 19605. The main purpose of the government regulations was to reduce risk and direct funds from financial institutions to corporations. This restricted financial system functioned well during the high growth era. Flow-of-fund patterns and macroeconomic changes in the 19705 initiated the liberalization and internationalization of the domestic financial system. For example, corporations became less dependent on loans from commercial banks and began actively searching for alternative ways to manage their needs. The household sector became more willing to take risks due to continued growth of individual wealth. The government started to float government bonds at the market rate in order to finance rapidly expanding fiscal deficits. In addition, an aging population brought a rapid increase in the number and size of corporate pension funds. Better managements of , and investment opportunity for those pension funds became more important. As a result, Japan's financial markets have changed significantly since the early 19705.5 The Japanese government lifted interest rate controls. Financial institutions have been allowed more freedom in their activities. Increasing foreign direct investment abroad and the emergence of current- 5 See Linclon (1933), p.237. 117 account surpluses increased pressure to deregulate international transactions which encouraged development of the domestic financial system.‘ Since then, capital movement and the internationalization of financial institutions have been accelerating. Exports of long-term capital were about $10 billion in 1980, over $50 billion in 1984, and $132 billion in 1986 and 1987, respectively. Foreign assets, which stood at $160 billion in 1980 reached $727 billion in 1986. Net foreign claims were over $180 billion by the end of 1986, making Japan the largest creditor nation in the world. A. 'o a ' a 'o 0 Ja anese i a c'a s ' tio 5 Japan decided to channel its surplus funds abroad through her own financial institutions. Unlike Kuwait, Japan has a well-developed financial system and sophisticated manufacturing industries at home to assist in solving the problem of current accounts surplus. The rapid increase in foreign direct investment by Japanese manufacturing firms and portfolio investments by individuals and institutions have given Japanese financial institutions strong incentives to 7 expand overseas. The internationalization of commercial 6 For detail see Viner (1988) chapter 1 and chapter 4. 7 Japan was far more advanced financially than any of the OPEC members. 118 banks, securities firms, and insurance companies is examined sequentially in the following sections. 1- W Japanese commercial banks were the first to expand overseas. During the prewar period, Japan's official foreign exchange bank, the Yokohama Specie Bank, operated an extensive network of overseas branches; so did some of the major city banks. They constituted the financial infrastructure of Japan's international trade. Their international operations centered around providing finance for foreign trade by Japanese companies. The Yokohama Specie Bank, however, was turned into a commercial bank under the 1947 directive of the General Headquarters of Allied Forces immediately after World War II. In contrast, a number of other banks were permitted to engage in foreign exchange business as authorized foreign exchange banks by the Ministry of Finance under the Foreign Exchange and Foreign Trade Control Law of 1949. In 1954, the Foreign Exchange Bank Law was passed, and the Bank of Tokyo was designated to specialize in foreign exchange dealings and foreign trade finance. In order to perform these transactions efficiently,8 foreign exchange 8 These transactions included the purchase and sale of foreign currency, receiving and opening of letters of credit, purchase of export bills, payment of import bills, collection of bills of exchange, payment of money for remittance, and the purchase and sale of foreign exchange with customers and with other banks. 119 banks were permitted to conduct correspondent contracts with foreign banks and to establish overseas representative offices and branches. Since 1950, with the trend towards the internationalization of Japan's economy, there has been rapid growth in the number of Japanese overseas branches. These overseas branches, notably in London and New York, quickly broadened their scope and began to absorb external funds to finance domestic industrial expansion.’ During the 19505 and 19605, the shortage of foreign currency resulting from high growth also forced Japan's financial institutions to raise funds from Eurodollars and borrowing from U.S. banks.10 Most Eurodollar loans were taken. up iby the London branches of Japanese foreign exchange banks, passing immediately to the head office in Japan. After changing into Yen, the foreign funds were used for domestic loans. Meanwhile, the foreign exchange 'was used. to import raw 1 materials for the expansion of exports.1 Japanese branches in New York served as agents for borrowing from American banks in the same manner.12 A further expansion of overseas branches occurred when Japanese foreign direct investment was initiated in the latter 9 See Ozawa (1939), p.51-52. m See Skully (1932), p.125. " See Adam and Hoshii (1972), P.481. n See Ozawa (1989), p.52. 120 half of the 19605. Japanese banks appear to have followed their clients abroad just as the United States and European banks had. In particular, major city banks, which had developed very close relationships with industrial groups, and were obliged to follow their customers overseas in order to assist their clients' operations. Had banks not provided their customers with overseas services, they would most likely have lost their business to other foreign or local banks. Japan's relatively smaller regional banks also began to branch overseas in the 19805. This accelerated in the mid- 19805, since their primary customers, the small-and-medium- sized regional firms, began to move overseas due to the pressure created by the sharp appreciation of the Yen.13 Prior to 1972, Japanese foreign direct investment was under $1 billion. The value of Japanese foreign direct investment surged to $2.3 billion in 1972. During the mid- 19705, it stabilized between $2.3 and $3.5 billion, but increased dramatically to $4.6 billion in 1978. Japanese foreign direct investment reached $10 billion in 1984 and $33 billion in 1987 (see table 18). The average annual growth rate of Japanese foreign direct investment was 32.6% between 1977 and 1987. This trend is expected to continue. The Japanese share of foreign direct investment in the U.S. has increased rapidly in recent years. Before 1980, this a See Ozawa(1989), p.55. 121 was about a quarter of total foreign direct investment; by 1986, the share was almost one-half. In general, the high growth rate of Japanese foreign direct investment helps explain the rapid overseas expansion of.Japanese commercial banks in the 19705 and 19805, including the rapid growth of Japanese banking in the U.S. after 1980. Table 18. Japanese Foreign Direct Investment U.S. t Per- Growth Value centage Rate ou Per- Growth centage Rate Year Total Value Per- Growth Value centage Rate 1977 2806 100 --- 686 24.45 --- 2120 75.55 --- 1978 4598 100 63.86 1283 27.90 87.03 3315 72.10 56.37 1979 4995 100 8.63 1345 26.93 4.83 3650 73.07 10.11 1980 4693 100 -6.05 1484 31.62 10.33 3209 68.38 -12.08 1981 8932 100 90.33 2329 26.07 56.94 6603 73.93 105.77 1982 7703 100 -13.76 2738 35.54 17.56 4965 64.46 -24.81 1983 8145 100 5.74 2565 31.49 -6.32 5580 68.51 12.39 1984 10155 100 24.68 3359 33.08 30.96 6796 66.92 21.79 1985 12217 100 20.31 5395 44.16 60.61 6822 55.84 .38 1986 22320 100 82.70 10165 45.54 88.42 12155 54.46 78.17 1987 33364 100 49.48 33364 100 174.49 Unit: $ million Source: International Financial Bureau, Ministry of Finance. Japanese foreign trade has grown substantially since the 19605. From 1970 to 1988, the average annual growth rate of gross foreign trade (exports plus imports) was 16 percent. Japanese foreign trade was below $10 billion in 1960. It reached about $40 billion in 1970 and exceeded $100 billion in 1974. The value of trade was $270 billion in 1980 and $452 billion in 1988. This rapid growth in foreign trade created 122 many business opportunities for Japanese banks, further stimulating overseas expansion (see table 19). Table 19. Japanese Bank Offices Overseas Y§§£§ Organizational 1950 1956 1961 1966 1971 1976 Epzng -55 -60 -65 -70 -75 -80 Branch or Agency 14 16 21 15 50 41 Subsidiary 3 l 1 3 34 32 Representative Office 4 5 9 17 108 97 Total 21 22 31 35 192 170 Source: Sapanaaa_§anking, table 51, by the Financial Times Business Publishing Ltd. The United States accounts for one-fifth of Japan's total imports and takes in one-third of her exports. Altogether, bilateral trade with the United States makes up one quarter of Japanese foreign trade. During the 19805, the growth rate of trade with the United states was higher than the growth rate of trade with other countries“ Since the United States is the biggest trading partner of Japan, expansion of Japanese financial institutions in the U.S. has been rapid. The number of.Japanese agencies, branches, and.subsidiaries in the United States was 28 in November 1972. It increased to 63 in December, 1976 and 111 in December, 1987.“ Since the 19605, Japanese trading companies worked aggressively to expand their business overseas and set up u See Jeffries (1988), Table 13, Growth of foreign banks in the United States. 123 local offices. After a substantial amount of trade had built up, a city bank would open its own representative office. *The representative office attempted to finance Japanese trading and manufacturing companies to meet Japanese commercial needs. If business prospered, the representative office would eventually become a branch office. When legally possible, a locally incorporated subsidiary would be established. The main business of overseas branches and subsidiaries was to finance foreign trade and make loans to Japanese firms, which included the overseas branches of Japanese trading and manufacturing companies. Gradually, banks would extend their business and finance to local firms engaging in Japanese trade. After gaining experience in the international market and loan markets, overseas branches and subsidiaries of Japanese banks have conspicuously developed their activities by participating in international syndicates, gradually moving into local banking business, such as lending to local manufacturers, state and municipal governments, and utility companies.15 At the beginning of the 19705, city banks typically earned a mere 2-6 percent of their net operating income through overseas branches. It is estimated that international business had increased to 6-15 percent in 1980, and 15-30 percent by 1990. The number of overseas branches and 5 See Bronte (1982), p.27; and Federation of Bankers Associations of Japan (1982), p.17. 124 representative offices of 13 city banks and three long-term credit banks are increasing rapidly. By the end of 1986, the 13 city'banks had 147 overseas branches and 230 representative offices, while the three long-term credit. banks had 17 branches and 46 representative office abroad. Japanese banks have entered the markets in almost all parts of the world since 1980. Fifty-four branches are located in Asia, 53 in North America, 43 in Europe, 13 in Latin America, and one in Middle East. No Japanese branches have been opened in Oceania or Africa. Representative offices, have followed similar pattern, 91 offices are located in Asia, 52 in North America, 49 in Europe, 36 in Latin America, 27 in Oceania, 25 in the Middle East, and 3 in Africa.16 Before 1980, none of Japan's banks ranked among the world's top five in terms of deposits, and only one ranked among the top ten. By 1986, the top seven were Japanese. Moreover, there are sixteen Japanese banks ranking among the largest 25 in the free world. In 1986, Dai-Ichi Kanyo became the largest international bank. in terms of asset size, surpassing Citicorp. Furthermore, nearly 36 percent of total worldwide bank assets were held by Japanese banks in June, 1988. Japanese banks have become a major presence in international lending in global markets. Japanese banks have overtaken ‘U.S. banks as the principal lenders in u See Ozawa (1989), p.57. 125 international markets and as principal lenders to final borrowers. At the end of September 1985, net claims by Japanese banks on final borrowers in international markets were $125 billion as compared with $24 billion for U.S. banks.17 According to the Bank for International Settlements, 85 percent of all new international banking claims in 1988 involved funds passing to or from Japan. In summary, the development of Japan's international banking can be divided into four stages. First, prewar overseas branches and representative offices were restored and extended to serve ordinary foreign exchange business following the war. In the second stage, these branches and representative offices began to serve as conduits for capital to finance industrialization at home during the Japanese high growth era. A third stage involved "following-the-business" and "following-the-customer" activities, in which Japanese banks eagerly accommodated their customer's changing needs in connection with the extended foreign marketing, foreign trade, and foreign direct investment since the late 19605. In the final stage of business development, Japanese banks channel surplus funds outward to finance deficit countries and are moving into the local banking business in host countries . ‘8 " See "Japanese Banking's Global Challenge", Me soh Sankar, April 1986, p.46-476. w See Ozawa (1989), p.58. 126 2. S999riti99.993993199.92919999 Securities companies were the second group of Japanese financial institutions to expand overseas. Prior to 1945, Japanese securities firms were small institutions specializing in bond trading. The Japanese securities industry was encouraged by the economic booms of the 19505 and started to expand in the mid-19505, when the industry received additional aid from the Japanese government, through the establishment of securities finance companies, the last resort of the security industry. However, the growth of the Japanese securities industry did not continue very long due to fierce speculation in 1960. Small and medium-sized securities houses which had been over- extended were brought to the brink of bankruptcy, sparking off a round of mergers in the early 19605.19 Japan's economy recovered in the latter half of the 19605 and continued to boom until the first oil shock. The Japanese security companies thus grew steadily during this period. In the mid-19605, the Japanese security industry, led by the four biggest security companies, moved into international 20 business. They' offered. a broad range of services to " See Bronte (1932), p.77. m Actually, Yamaichi opened the first overseas office in New York in 1953. By the mid-19605, each of the "big four" established offices in North America and Europe. Office in Singapore, Hong Kong, and Middle East followed in the 19705. The primary purpose of these overseas operations was the sale of Japanese securities to foreign institutional and individual investors and later the sale 127 domestic and foreign clients after the internationalization policy’was adopted in the early 19705, and by the early 19705, the power of the larger securities houses in the financial community had began to rival that of the banks. Until 1971, equities, bonds, and other foreign assets were subject to declaration and liquidation at request according to the old Japanese foreign exchange law, and each foreign.investment required.approva1. In 1971, this situation finally changed and Japanese investors were permitted to invest in foreign securities, since the country's current account surplus and reserves were beginning to put it in a embarrassing position. All Japanese individuals and institutions, except Japanese mutual funds, were permitted to purchase foreign equities in any amount. At the end of 1972, the Japanese securities houses began marketing shares and beneficiary certificates of foreign mutual funds to Japanese investors. This situation changed abruptly in 1974, with the first oil shock. All short-term foreign investments were banned by the Japanese government to protect the nation's balance of payments position. In 1977, the ban was lifted and foreign equity and bond purchase by residents become fully free. The Japanese emerged as net purchasers of foreign securities for the first time in several years. This surge was largely the result of the of foreign securities to Japanese investors. However, prior to 1979, virtually all of the overseas operations lost money, except for Hong Kong (Viner, 1988, P.21). 128 Ministry of Finance's encouragement of the big institutional investors, notably the life insurance company and pension funds, to diversify their portfolio investment abroad. It was hoped that the capital outflows would balance Japan's international accounts and take some upward pressure off the yen. The decontrol of outward Japanese investment created new brokerage opportunities for Japanese securities companies. The new foreign exchange law, adopted in 1980, continues this fully free policy. .Japanese purchases of foreign securities have continued to grow rapidly in step with the chronically increasing current account surplus of the 19805. Furthermore, as Japanese investors become more sophisticated, they are willing to take risks in pursuit of higher returns, as predicted by the decreasing absolute risk aversion hypothesis. Demand for foreign securities, therefore, becomes even stronger. The sale of Japanese shares to western investors has also increased rapidly due to the superior performance of the Tokyo stock.market and successful Japanese economy which.began.to boom in 1979. This has translated into a real bonanza for Japanese securities companies and contributed to the fast growth of the Japanese security industry.21 Japanese security firms are increasingly becoming a dominant force in international activities. Before 1980, it was uncommon to see a Japanese securities firms among major ” See Wright (1937), p.72. 129 investment banks in the world. In 1986, Nomura Securities surpassed Merrill Lynch in equity as the largest investment firm in the world; in addition three other Japanese firms now belong to the world's top ten. In 1986, the big four security firms already accounted for nearly one-quarter of all underwriting in the buoyant Eurobond market. The big four account for one-fourth of the long-term U.S. government bond trading and are moving in on the equity market. By the first quarter of 1987, Normura had leapt to first place among Eurobond lead managers. Since the mid-19605, the big four Japanese security companies have maintained offices in Europe and the united States. Actually, Yamaichi opened the first overseas office in New York in 1953. In the early 19705, they expanded their overseas networks to include Hong Kong, Singapore, and Bahrain, while the medium-sized security houses began moving abroad for the first time. The international departments of Japanese securities firms are expending their operation year by year. By the end of 1980, a total of 114 bases had been established in New York, London, Frankfurt, Zurich, Hong Kong and other principal cities. Twelve securities companies have made their entry into overseas markets. The number of affiliated companies abroad total 39, in nine cities. Three branch offices were established in London, and 28 representative offices in 12 cities. The primary purpose of these overseas operations was the sale of Japanese securities 130 to foreign institutional and individual investors and, later, the sale of foreign securities to Japanese investors;22 Prior to 1979, these foreign branch networks were unable to generate positive profits. Most security companies made money in London and Hong Kong, but lost everywhere else. The foreign investment boom, which started in 1978, turned the profitability of these overseas network around. The increase in the issuance of foreign ‘bonds 'by .Japanese companies overseas made underwriting business another profitable activity. Furthermore, the new foreign exchange law of 1980 stimulated Japanese investment in foreign securities. Their earnings increased continuously and rapidly (see table 20). Table 20 Earnings per Share of Major Japanese Securities Firms BEBE 2(12S0 align; 2(i982 2Z1282 2(i985 311985 Nomura 23.7 26.3 20.6 29.5 39.2 49.6 Nikko 19.7 18.8 13.5 18.6 27.0 37.2 Yamaichi 16.7 18.1 15.5 18.6 29.3 42.6 Daiwa 16.4 22.5 15.6 22.1 33.4 49.6 Source: Wright and Pauli (1987), Table 6-2, p.69. Japanese securities firms have expanded quickly in the United States since the early 19805. In order to finance the biggest budget deficit in history and to simultaneously keep interest rates low, the U.S. government developed an increasing dependence on foreign investors, especially the 22 See Viner (1933), p.21. 131 Japanese. IU1 1986, gross trading volume (total sales and purchases) of U.S. government securities by Japanese investors averaged more than $150 billion per month.” In 1987, there were 14 Japanese securities firms in the U.S. and they have made every effort to channel their funds into the U.S. Three of the top four Japanese securities firms had seats on the New York Stock Exchange for several years. In 1988, the giant Japanese securities firms took control of 7 of 44 Wall Street securities houses and are currently' recognized as primary dealers by the Federal Reserve Bank of New York. The primary dealers not only have the privilege of conducting business directly with the United States Federal Reserve System but have also acquired substantial prestige, which increases opportunities to underwrite local equity offerings.“ 3- W Insurance firms were the last to enter the international market. Growing at an explosive rate since the end of World War II, Japanese insurance companies have emerged as one of the principal economic powers in the country. They have the highest growth rate of any financial service firm in the world. Their $300 billion-plus assets in 1986 are expected to expand 15 percent annually for the next 15 years. '3 See Viner (1988), p.23. 3" Ibid, p.24. 132 By the end of 1985, there were 23 domestic life insurance and 23 domestic non-life insurance companies in Japan. According to Japan's insurance laws, life insurance companies are not authorized to offer non-life insurance, nor are non- life companies permitted to offer life insurance.”’ Most of the large insurance icompanies are :members of industrial groups. Usually, each of the major industrial groups includes a life and.a non-life insurance companyu These companies make a major portion of their loans and equity investments to members of their own group. The insurance companies, in turn, receive the bulk of the group's life and non-life insurance business. Insurance companies are probably more dependent on their own industrial group for'business than any other'members in the group.”5 Japanese insurance companies placed a large portion of their investments into long-term fixed rate loans to private industry, especially during the economic boom period, when the proportion rose above 70 percent. Although still high at 45 percent in 1985, it has experienced a sharp decline. The non- lifeicompanies invested above 30 percent of their resources in loans in 1975, and 20 percent in 1985. They are a vital source of long-term funds for Japan's heavy industrial a Only private agricultural co-operatives are allowed to sell both life and non-life insurance to their own members. 2‘ See Bronte (1932), p.101-102. 133 companies since most loans are directed to large industrial borrowers . 27 The slow-down in the Japanese economy after the first oil crisis led to a lower demand for long-term loans. Corporations have shifted their preference from indirect financing to direct financing. While the banks have been hit with a simultaneous decline in the growth of their share of loanable funds since the first oil crisis, the insurance companies have also seen a steady and quick decline. ‘This has left the insurance companies ‘with far' more unused loan capacity than the banks. The insurance companies thus have to compete more with the banks for customers. They must become more aggressive lenders both domestically and internationally.28 Japanese insurance companies began making yen-denominated loans to foreign.borrowers in the late 19705. Since then, expansion of yen-denominated loans has grown very fast. This expansion is not sufficient to compensate fully for diminishing investment opportunities at home, however. Companies have chosen to invest some of their excess funds in foreign currency-denominated securities. Such international investments are reinforced by the existing interest differential between domestic and foreign securities due to the relaxation of government regulations. The large 27 Ibid, p.106. 2" Ibid, p.106. 134 interest differential between yen-and-dollar-denominated paper makes overseas investments very attractive. After the Federal Reserve System announced.a major change in monetary policy in 1979, the U.S. experienced wider fluctuations and higher interest rates than other countries, especially Japan. The regulation change regarding portfolio management also accelerated. international investment by insurance companies. In order to halt the rise of the yen, the Ministry of Finance recently raised its foreign investment limit for life companies from 10 percent to 30 percent of total portfolios. Life insurance companies have been allowed to invest in foreign securities since 1970. International investment did not, however, become popular until late 1970, when the above factors emerged. From 1978 to 1983, Japanese insurance company's domestic portfolio of securities increased fourfold. Their investment in foreign securities increased even faster. The share of foreign securities rose from 3.7 percent of the total portfolio in 1978 to 22.2 percent in 1983. In addition to investing in foreign securities, life insurance companies are also interested in real estate overseas. While equity investment is increasing rapidly, investment in the real estate market purportedly tripled in 1986. B. 1W Japan has invested most of her surplus in long-term instruments. The percentage of long-term to total foreign 135 assets increased from 52 percent in 1973 to almost 70 percent in 1985. In 1972, investment in foreign securities (international portfolio investment) exceeded foreign direct investment for the first time. Investment in foreign securities includes the purchase of foreign stocks, foreign bonds, yen denominated bonds and others. Investment in securities overseas has dominated foreign direct investment every year since 1977. In that year, Japanese investment in securities overseas was 1.7 billion U.S. dollars, almost equivalent to its prior peak, before the first oil crisis. The average growth rate of investment in securities was about 80 percent from 1981 to 1986. In 1986, investment in long-term foreign securities by private Japanese investors reached $102 billion which was higher than the entire 1986 account surplus of 86 billion dollars. Private Japanese purchases of $88 billion in long-term foreign securities in 1987, although lower than in 1986, was still approximately equal to the current account surplus of $87 billion. Until 1970, investments in foreign securities were negligible, below 5 million U.S. dollars. This can be attributed to several factors. In the early postwar years, Japan suffered from a critical shortage of foreign exchange. Portfolio investment by the Japanese was restricted. 136 Foreigners' use of the open capital market to raise funds publicly was virtually prohibited prior to 1970.29 Regulatory changes in 1971 encouraged indirect investment outflows, resulting in an increase of net outflows from $62 million in 1970 to $1.787 billion in 1973. The purchase of foreign securities reached a record high of $6.56 billion in 1973. In November and December of 1973, regulations on investments in securities and stocks abroad were tightened significantly, precipitating a fall in outflows in 1974 to $2.051 billion. Net outflows dropped to $141 million in 1974, then plummeted to a record low of $24 million in 1975. Net portfolio investment overseas did not recovered until 1977, when the net outflow of portfolio investment overseas rebounded back to its prior 1973-level of $1.718 billion. Even though foreign equity purchased by residents became fully free in 1975, portfolio investments did not recover completely until a general liberalization of purchases of foreign securities took place in 1977. This is because foreign bond purchases far exceeded foreign stock purchases.” In 1977, almost no foreign stocks were purchased, while the purchase of foreign bonds was about $1.8 billion. As a result of favorable monetary conditions in Japan and a widening of interest rate differentials abroad, net purchases of foreign securities by Japanese residents rose 2’ See Horne (1985), p.144. 3° See Feldman (1986) . 137 dramatically to $5.3 billion in 1978 and $5.9 billion in 1979. During the current account deficit period of 1979-80, the yen bond market was severely regulated, although the outflow of capital related to domestic interests was not. Net purchases of foreign securities by Japanese residents fell to $3.7 billion in 1980 from $5.9 billion in 1979. The new foreign exchange law passed in 1980 allows unregulated acquisition of any foreign securities. As a result, investments in foreign securities surged to a record high of $8.8 billion in 1981. It was the first time that investments in foreign securities exceeded the current account surplus (see Table 21). Within 10 years of portfolio investment liberalization, capital outflows by portfolio investment overseas was able to fully offset the current account surplus. Since 1981, the capital outflow due to portfolio investment overseas has fully offset the current account surplus every year except 1983 and 1984. Even then, about 80 percent and 90 percent of the current account surplus was offset by overseas portfolio investment in 1983 and 1984, respectively. The deregulation of external transactions by the New Foreign Exchange and Foreign Trade Control Law (1980) stimulated Japanese institutions to pursue portfolio 138 diversification via investment in foreign-currency assetsu"1 Since 1980, outflows of portfolio investment by institutional investors has been particularly large. Life insurance companies, especially, whose assets are growing very rapidly, have diversified rapidly away from yen to higher yielding foreign assets. The bulk of the long-term net capital outflow took the form of portfolio investment which almost doubled from $16 billion in 1983 to $31 billion in 1984 and $60 billion in 1985. Between 1980 and 1985, the Japanese bought over $125 billion more foreign securities than they sold. The net portfolio investment overseas reached a record high of $102 billion in 1986, falling back to $88 billion in 1987. The share of total foreign assets held in portfolio investments increased dramatically from 3 percent in 1970 to 77 percent in 1986. Long-term investment in foreign assets includes foreign direct investments, trade credit, loans, and portfolio investment. Portfolio investment replaced the trade credit in 1980, as the most important way of channeling surplus funds outside Japan. The increase in portfolio investment also illustrates the gradual maturity of Japanese investors and financial institutions. ” See 0300 (1935), Table 3, p.22. 139 Table 21. Key Indices for Japanese International Investments a/c Growth Rate in Foreign Investment Increases Current a/b in Foreign in Foreign Account (%) (%) Year Securities Assets Securities Investments (a) (p) (c) JQJ. _L¢J_ (f) 1970 62 2031 1970 3 3 --- 1971 195 2231 5797 9 3 215 1972 1188 5020 6624 24 18 509 1973 1787 8468 -136 21 -1314 50 1974 141 4063 -4693 4 -3 -92 1975 24 3392 -682 l -4 -83 1976 146 4559 3680 3 4 508 1977 1718 5247 10918 33 16 1077 1978 5300 14872 16534 36 32 209 1979 5865 16294 -8754 36 -67 11 1980 3753 10817 -10746 35 -35 -36 1981 8777 22809 4770 39 184 134 1982 9743 27418 6850 36 142 11 1983 16024 32459 20795 49 77 65 1984 30795 56775 35003 54 88 92 1985 59773 81815 49169 763 122 94 1986 101977 132095 85845 77 119 71 1987 87757 132830 87015 66 101 -14 Source: Ministry of Finance, Japan. 1. §£QQK.IDX§§§E§E§ Although net investment in foreign stocks (purchases minus sales) is rather’small compared to investment in foreign bonds, the growth rates have been over 100 percent annually since 1983, excluding 1984. Net foreign stock investment increased rapidly from $240 million in 1980 to $1 billion in 1985 and then to about $17 billion in 1987 (see table 22). About 20 percent of the current account surplus was invested in foreign stock in 1987. In contrast, under 5 percent of the current account surplus was invested in foreign stock prior to 140 1985. An increasing percentage of the Japanese current account surplus is invested in foreign stocks. If the purchase of foreign stocks is examined, we can find that the growth rate accelerated from 20 percent in 1981 to 280 percent in 1986, staying at 240 percent in 1987. In terms of value, the purchase of foreign stocks increased from about $1 billion in 1980 to $71 billion in 1987 (see table 22). No matter the gross or net purchase of foreign stocks, statistics show rapid growth in foreign stock investments in recent years. 'This indicates that the.Japanese are willing to take more risks in order to pursue higher yields. The absolute risk aversion can, hypothesis of decreasing therefore, be supported. Japanese initial preference for foreign bond investment was mainly due to familiarity of bond investment at home. Over time, the Japanese increased stock purchases and adjusted their portfolio in Table 22. The Japanese Purchase of Foreign Stock, 1981-87. Year Purchase Sale Net Growth Rate Growth Rate of Bananase a: Ne; 1981 937 697 240 --- --- 1982 1126 975 151 20.17 -37.08 1983 2106 1445 661 87.03 337.75 1984 1570 1519 51 -25.45 -92.28 1985 5484 4489 995 249.30 1850.98 1986 20917 13869 7048 281.42 608.34 1987 70936 54062 16874 239.13 139.42 Unit: $ million Source: Ministry of Finance, Japan. 141 international investment to obtain an optimal portfolio. This supports the hypothesis of international portfolio investment adjustment process, discussed in chapter four. In the early stages of overseas investment, the Japanese concentrated on US securities. Portfolio investment in US securities began as a trickle in the early 19705 and became a flood by 1985. Commercial banks, securities firms, and insurance companies set up branches or subsidiaries in the United States to take advantage of the growing market. In 1975, purchases of U.S. stocks accounted for 96 percent of Japanese foreign stock investment. During the period 1980-1987, this ratio was still high, above 70 percent despite diversification into Europe and Asia. The stock purchase in US stock dropped from 88 percent of total foreign stock investment in 1982 to 72 percent in 1987, but increased back to 80 percent in 1988. US stock purchased by the Japanese was below $1 billion in 1981. This increased to $21 billion in 1937 and $71 billion in 1933. In 1986, only the UK, and Switzerland purchased more foreign equity investment in the United States than Japan. However, the Japanese increased their holdings at a faster pace, becoming the number one investor in the US stock market in 1988. Japanese investment in UK, Germany, and other European countries is just a fraction of that invested in the United States. Japanese investment in countries, such as Hong Kong, and Singapore is even smaller. However, the Japanese have 142 diversified their international investment into Europe and Asia gradually. Investment in Europe initially took place fitfully in the early 19805, but has increased dramatically since 1987. Japan's net acquisition of equities in Singapore soared 15-fold to $229 million in 1988 from $16 million in 1987. Net investment in Hong Kong equities increased from US$ 26 million in 1987 to US$ 78 million in 1988. The Japanese prefer blue-chip stocks. A company's image, as well as its financial performance, are important to Japanese investors. Among the top-selling stocks in Japan are: (1) American Express, (2) Dow Chemical, (3) Disney, (4) Merrill Lynch, and (5) IBM.32 According to Normura Securities Co. Ltd's Yoshirari Morimoto, most Japanese fund managers have little expertise in foreign equities. Therefore, joint ventures have become an alternative way of handling foreign equity investments. During the last few years, Japanese financial companies have formed an estimated 30 joint ventures and working relationships with U.S. money managers. A U.S. manager handling U.S. securities in a Japanese investment trust is a common situation, and some joint operations are formed in order to share technology.” It takes time for Japanese 32 See Kiley (1937) . 33 See Rosenberg (1988) . 143 financial institutions and fund managers to become mature in international equity investment. 2- 5939.1329993939“ Traditional Japanese conservatism, the lack of experience, and the dearth of timely’ direct sources of information have thus far led the Japanese to invest most of their long-term money in foreign bonds, and little in foreign stocksu"s Prior to 1987, over 90 percent of Japanese foreign securities investment were held in bonds. In other words, foreign bond investment has been preferred by Japanese investors historically. Not only the absolute value but also the growth rate of the acquisition of foreign bonds has been much larger relative to stocks from, 1982 to 1986.:36 The growth rate of acquisition of foreign bonds increased from 81 percent in 1982 to 146 percent in 1984. It accelerated to 417 percent in 1985 and 362 percent in 1986. In 1980, the acquisition of foreign bonds was $14 billion, which was ten times the acquisition of foreign stocks. In 1986, the acquisition of foreign bonds reached a record high $1,346 billion. In 1987, the purchase of foreign bonds decreased somewhat to $1,273 billion, which 3“Excluding the discussion of yen denominated foreign bonds. 5 See Bronte (1932), p.243. 1“ The exception is 1983, when the growth rate of the acquisition of foreign bonds was lower than the growth rate of the acquisition of foreign stocks. 144 still is eighteen times the acquisition of foreign stocks (see table 23). Table 23. The Japanese Purchase of Foreign Bonds, 1981-87. Year Purchase Sale Net Growth Rate Growth Rate of 9L29Eh999 Wm 1981 9401 3591 5810 --- --- 1982 16980 10904 6076 80.62 4.58 1983 22905 10400 12505 34.89 105.81 1984 56348 29575 26773 146.01 114.10 1985 291338 237859 53479 417.03 99.75 1986 1346989 1253965 93024 362.35 ' 73.94 1987 1273829 1200944 72885 -5.43 -21.65 Unit: $ million Source: Ministry of Finance, Japan. Similar to stocks, Japanese purchases of foreign bonds are concentrated in the United States but to a lesser degree. According to the U.S. Treasury Bulletin, purchases of bonds in the United States accounted for 20 to 60 percent of total Japanese foreign bond investment. In 1987, 43 percent of the total Japanese foreign bond investment was in U.S. bonds. Most of the bond investments in the U.S. are (1) treasury bonds and notes or (2) bonds issued by U.S. government corporations and federally sponsored agencies. Since 1977, these two types of bonds accounted for over 80 percent of the securities purchased in the U.S., with the exception of 1980, when they accounted for only 73 percent. This surged up to about 90 percent from 1984 to 1988. 145 C- 319199121911 In the early postwar years, a critical shortage of foreign exchange forced Japan to adopt export-led policies to earn foreign exchange on the one hand, and enforce exchange control policies to eliminate the spending of foreign exchange on the other. When a current account surplus emerged in the late 19605, restrictive capital policies impeded capital movement and caused a huge accumulation of international reserves. The development of the international financial system was retarded by restrictive international investment policies. This situation was met by the Japanese with a quick response. Liberalization and internationalization of the Japanese financial system and investments became the top goals in the 19705. A sequential liberalization of outward investment policies was adopted. International investments, mainly by the private sector, increased rapidly from $1 billion in 1968 to $15 billion in 1978 and to $133 billion in 1987. The liberalization of capital movements consequently helped the internationalization of the Japanese financial system. Japanese financial institutions began to move overseas in the 19705, speeding up this process in the 19805. In 1985 and 1986, foreign 0) or an excess of exports. 196 APPENDIX C: FOREIGN BANKS IN TAIWAN Local branches of foreign banks have multiplied rapidly since 1961. Foreign banks accounted for 0.07 percent of the total number of financial institutions in 1961 and increased to 0.92 percent in 1987. Taiwan. change her restrictive attitude in order to encourage foreign investment in Taiwan after the end of U.S. economic aid in 1965 (Lee and Tsai, 1988). The number of local branches of foreign banks increased quickly from one in 1964 to 13 in 1979. After the termination of diplomatic relations with the U.S. in 1978 and the withdrawal from the IMF in 1980, the authorities gave foreign banks easier access to the domestic market to offset international isolation. The number grew to 33 in 1987. Even though entry by foreign banks has been permitted, the organizational form, location and operations are still strictly controlled. Thus far, they are allowed to open only two branches in Taiwan: one in Taipei and the other in Kaohsiung. Entry into Taiwan is permitted only through branches or representative offices and not through wholly owned subsidiaries. Prior to 1989, foreign banks were also not able to obtain securities underwriting and brokerage licenses. 197 APPENDIX D: THE KUWAITI EXPERIENCE In the past two decades, Kuwait has achieved spectacular success in economic growth, By the end of 1980, the total GNP had grown to KD8.8 billion from only KD1.1 billion in 1971.2 Per capita income increased to KD6,200 ($23,000) by 1980 from KD1,410 ($3,970) in 1971. Although large quantities of oil were discovered in Kuwait in 1938, production did not begin until 1946. Prior to 1973, relatively modest beginnings of economic development were evident in Kuwait. The major increase in oil prices in October 1973, generated substantial revenues, fueling the engines of rapid economic development in the 19703. Cost-of-living indices for Kuwait show an increase of 90 per cent between 1972 and 1980. This inflation played a very significant role in a country almost entirely dependent on imports. Excess money and strong demand, which included an acceleration in public spending in response to the surge of current account surplus, were major reasons for the high inflation rate during this period. In other words, too much money chasing too few assets, led to an increase in financial 2 The "KD" represents the Kuwait Dinar. 198 199 assets. Speculation on land and stocks also added tremendous upward pressure to prices.3 The major source of wealth in Kuwait is still crude petroleum : any oil production in excess of current expenditure requirements represents the transformation of oil wealth into non-oil wealth in the form of foreign investments or investments in domestic industrialization. Due to the low absorptive capacity of the domestic market and insufficient domestic investment opportunities, reinvesting oil surplus funds has taken the form of foreign investment. Investing overseas can be viewed as a safeguard against adverse developments affecting oil. For example, the Reserve Funds for Future Generations was introduced in 1976 to serve as a pension fund for one decade after the oil runs outn‘ IMost of the funds are invested in international equity and bond markets. 3 See Hazem (1984), p.166. ‘ The Reserve Fund for Future Generations was given an initial transfer of 50 percent of the State General Reserve Funds, i.e. KD 632.7 million, and was to receive 10 percent of the state revenue annually plus all profits earned on the General Reserve Fund. This fund is not supposed to be used until 2001. By 1987, the Reserve Fund for Future Generations had grown to about $60 billion while the State General Reserve Fund had reached $30 billion. For details see Khouja and Sadler (1979), p.202: The Ecgnomigt, 22 August 1987: and Eugomgnay, March, 1988, p.53. t e 'es When Kuwait began to invest in foreign market in the early 19403, London was the dominant financial center of the world. Kuwait's currency was pegged to the pound sterling at that time, as Kuwait.was still a British protectorate. Due to strong economic and political linkages between Kuwait and Britain, a reserve account was set up in London to handle government surpluses and investments. The Kuwait Investment Board was established in London in 1952 to handle government investments. This board was later replaced by the Kuwait Investment Office.s With the ending of the protectorate agreement in 1961, Kuwait adopted aggressive strategies for economic development, promoting different kinds of industries. In particular, a few investment companies and other financial institutions were established between 1961 and 1965. The Kuwait Investment Company was set up in 1961, followed by the Kuwait Foreign Trading, Contracting and Investment Company in 1965. The former is 50 per cent government owned, the latter 80 per cent. Together with the Kuwait International Investment Company, a privately owned venture established in 1973, these investment companies form the major Kuwaiti actors on the foreign investment scene. 5 For details see Khouja and Sadler (1979), chapter 11. 201 Before the first oil shock, the Kuwait Investment Office not only managed Kuwait's European investments, but also its American investments. However, responsibility for those and all other government investments was returned to officials in the Ministry of Finance in Kuwait when foreign assets increased in response to the first oil shock. Although the Kuwait Investment.Office continued its*work in London.and some new financial institutions were established, an extensive Kuwaiti international banking system was not developed to handle international investment.‘ Except for some international investments managed by Kuwaiti investment companies, stock and equity investments in the other countries are handled by local banks and other financial agents in‘U.S., Germany, Switzerland, France, Belgium, Holland and Japan.7 The government, however, tends to rely on domestic financial institutions as its intermediaries in bonds transactions. The "Three K3", the Kuwait Investment Company, the Kuwait International Investment Company, and the Kuwait Foreign Trading Contracting and Investment Company, are most 6 The Kuwait Investment Office still played an important role in international investments until recent years. Most foreign investments outside the Gulf area are still handled by London Kuwait Investment Office. In 1987, about $45 billion of the total $95 billion international investments were managed by Kuwait Investment Office according to Tha Chemical flaeh (January 20, 1988) pointed out that Kuwait Investment Office has $70-75 billion available, including about $25 billion in an international equities portfolio. 7 Mattione (1985), p.104: Khouja and Sadler (1979), p.200. 202 often involved. During 1974, the "Three K3" and two other banks, the Al Ahli Bank and the Commercial Bank of Kuwait, handled.over fifty bond issues and syndicated loans in foreign markets. By 1975, the "Three Ks" were among the leading issue-managing institutions in the world, with Arab investors accounting for 20 percent of the world's credit securities during the last quarter of 1974. In 1975, the Three Ks" managed or co-managed forty-eight bond issues totaling $1.16 billion.8 During 1974, a number of financial institutions with overseas financial interests were also established. The Kuwait Financial Center was formed to provide financing for brokerage and import/export credits. The Kuwait Commercial and Industrial Investment Company was formed to invest in securities and other projects and to increase channels of investment at home and abroad. This shows Kuwait's attempt to develop her own financial system to deal with of international investments. B. Kuwait's Intern9tion9l Egrgfoiig Tavestmen§ Stgagegy Given the large oil reserve and chronic current account surplus, liquidity constraints caused by a budget deficit are not a major concern for Kuwait. The absence of short-term fiscal demands on surplus funds has allowed Kuwait to follow long-term investment strategies abroad. Given the choice of 8 See khouja and Sadler (1979), p.204-205. 203 foreign direct investment and portfolio investment, Kuwait prefers the latter. Unlike Japan or other industrial countries, Kuwait did not have the expertise or domestic industrial base to establish and operate enterprises abroad. Consequently, foreign direct investment by Kuwait is negligible. Kuwaiti investments abroad are mainly of the portfolio type. Kuwait's portfolio is heavily skewed in favor of long- term rather than short-term assets. Long-term securities, stocks and bonds, with higher rates of return are returned over short-term instruments such as bank deposits and treasury bills. Since oil is an exhaustible resource, reinvesting the revenues into long-term productive assets is essential. International diversification is also important because of the potential for increasing returns and the inherent safety. Kuwait's investments are diversified in the United States, Great Britain, West Germany, Japan and other countries. In 1967, there was a major devaluation of sterling by sixteen percent, resulting in an enormous loss for Kuwait. Since a large proportion of income was still being received in sterling during the early 19603, most of the reserves were deployed abroad via London. This immediately provoked Kuwait into reconsidering her foreign portfolio investment policy. The growing magnitude of her reserves relative to her current account balances, made the problem of portfolio management 204 crucial. In 1974, the first oil price hike increased oil revenue and international reserves dramatically. Further, reserves were assumed likely to accumulate beyond the foreseeable future under a reasonable estimation of the oil market. Global inflation became an important consideration in the management of reserves. Prior to 1974 most of Kuwait's investments were in safe, but low-yielding assets, such as the U.S. and British treasuries. Only occasional investments in equities and other kinds of assets through international investment trusts 9 Beginning ix) 1974, continued to be managed from London. Kuwait's policy on long-term investments changed directions and evolved along new lines. The allocation of the international.portfoliO‘was roughly 60 percent in equities and 40 percent in bonds with maturity between five and seven years. Mattione (1985) estimated that total net holdings of foreign assets by Kuwait were between $85 billion and $87 billion dollars at the end of 19232.‘0 Of this the Kuwait government probably held $64 billion while the remaining $23 billion belonged to the private sector. The government held $12 billion in short-term securities such as bank deposits and British T-bills and $ 52 billion in long-term securities, 9 See Cooke and Muehring (1988), p.182. m The_§gghgmi§§ (August, 1987) estimated about $95 billion dollars in the beginning of 1987. 205 consisting' of equity' holdings ($26 billion), bonds ($18 billion) and loans to the IMF, the Arab Economic Development, Iraq, and other countries ($8 billion).11 1 99993.1919399993 The Kuwaiti government views stocks as the best way of guaranteeing safe and positive real rates of return because they represent tangible real assets and are the best hedge against inflation. Stocks are diversified across sectors and across countries according to the principle of international diversification.12 The United States, Great Britain, West Germany, and Japan account for almost all of Kuwaiti stock investments. Preference for these four markets is due to (1) the existence of variety of financial instruments with different maturities. There are short, medium, and long-term. equity and. debt instruments such as stocks and bonds, treasury bills, and government bonds: (2) the large size of the money and capital markets and their ability to absorb substantial amounts of funds: (3) the availability of organized stock exchange and secondary markets; and (4) the existence of financial legislation to protect investors.13 " For detail see Mattione (1985), p.97-100. u Kuwait's foreign direct investments are concentrated in the oil industry and are relatively unimportant compared to international portfolio investments and will be omitted from the discussion. 3 See Mattione (1985), p.232. 206 Mattione (1985) estimated.that.Kuwait.held.$11.billion in U.S. stock and $2 billion in UK stock, by the end of 1982.“ Nearly all holdings of U.S. stock are under’5 percent for each company because U.S. law requires public disclosure of holdings above that level and the Kuwaiti authorities wishes to avoid such exposure. The American portfolio was diversified across all sectors and included the manufacturing, energy, financial, and service sectors. On the other hand, stock investment in the British market has been concentrated in the areas of insurance, property, and investment trusts. In contrast to its small portfolio holdings of stocks in the U.S., Kuwait has routinely held big shares in British companies. In August 1987, Kuwait had above a 5 percent share in at least 16 big companies in Britain. However, the Kuwait Investment Office has followed a policy of not seeking seats on the boards of companies or a role in the day to day management, even when it is the largest investor.15 Investment in Germany has also been narrow and concentrated in manufacturing industries such as auto, steel, engineering, and chemical industries. Its Japanese portfolio is highly diversified as the holdings are only relatively small. “ In late 1979 Kuwait held between $1 million and $50 million in U.S. stock, predominantly in the top 500 U.S. corporations, according to Khaled Abusuud, advisor to the emir of Kuwait. ” See Vielvoye (1987), 01; & Gas gougaai, p.22. 207 2- 9999.1929999999 Kuwait holds approximately $18 billion in predominantly medium-term bonds with 5 to 7 year maturity issued by governments and corporations in a variety of currencies. The distribution of Kuwait's bond portfolio can be explained by considerations of rates of return, safety and diversification. Only a small fraction of the portfolio has been invested in such safe but low-yielding bonds as British and U.S. Treasury bonds. In general, the higher-yielding Euro-bond issues have been preferred. The composition of the Euro-bond portfolio is similar to that of the stock portfolio. The bond portfolio has been invested in a variety of currencies, predominantly in issues from corporate and public-sector borrowers in developed countries, with a small proportion invested in less developed countries. Using this global diversification strategy, Kuwait has been able to attain high yields without too much risk.“ Bonds denominated in Kuwaiti Dinar (KD) are another effort by Kuwait to achieve its goal of safety. For example, during 1974 several KD private and public bonds were issued by the "Three Ks" for the Asian Development Bank, Sudan, Yugoslavia and Ireland. The policy of using the Kuwaiti Dinar as the transaction currency has the following underlying objectives:"7 (a) the establishment of the dinar as a strong, internationally “ See Mattione (1985), p.122. " See Mattione (1985), p.234. 208 accepted currency: (b) support of the creation of an international financial market in Kuwait; and.(c) providing an alternative market to Kuwaiti lenders without foreign currency risk.18 Obtaining status as a key currency would constitute macro-type competitive factor for Kuwaiti banks and thus aid the development of Kuwaiti multinational banks. However, this attempt was not successful. C. Eyaiuagioh Kuwait represents a typical case of a developing economy characterized by a foreign trade sector relying heavily on the export of a single raw material, and it is accordingly vulnerable to the unfavorable consequences of deterioration in the terms of trade. jFortunately, oil prices were quite stable before the first oil shock allowing Kuwait to accumulate twenty years worth of experience in managing trade surpluses. Even though the average current surpluses were small during those early years, Kuwait had the opportunity to learn about the operation of foreign investments. Although there is evidencethat Kuwait has made attempts to develop an independent international banking system, these efforts have been only partially successful due to her weak domestic economic base. About 65 percent of the GDP could be attributed to the oil sector during the 19703, while only 35 percent stemmed from the non-oil sector. Manufacturing 1' Ibid. 209 accounted for only 5 to 7 percent of the GDP in the late 19703 and early 19803. Although foreign direct investment in the oil-industry has increased, foreign direct investment in manufacturing firms are unlikely to be popular for a country with such a weak manufacturing sector. In 1982, only 3.5 billion dollars were invested in the U.S., with most of it concentrated in the petroleum industry. Unless it broadens its scope by diversifying into a variety of industries, the development of international banking will be difficult for Kuwait. Kuwait responded quickly to the sudden surge in its foreign reserve and has held a sophisticated international investment portfolio since the first oil shock. Since early 19703, Kuwait. has been. trying to increase the relative importance of its investments to complement oil revenues in the total government budget in the short-run and try to replace oil revenue, when oil is ultimately depleted, in the ‘9 While crude oil remains the ultimate source of long run. the nation's economic strength, foreign investment income has become an important source of earnings, providing the equivalent of 75 percent of the oil export revenue, or 25.3 percent of the GNP in 1982. Total government expenditures in 1982 were less than half of the income from investments. By 1986, foreign investment income from Kuwait's estimated $95 billion in investments.had overtaken.oil as the biggest source W See Al-Awadi (1975), p.38. 210 of revenue. In short, Kuwait's international investment strategy has been quite successful, despite an incomplete international financial system. The policy of investing overseas as a safeguard against adverse developments affecting oil has proven itself since 1980. Exports fell in 1980 due to cutbacks in oil sales in order to maintain OPEC prices. Yet income from overseas investment is still stable and healthy, although the level fell with the decline in Euro-market interest rates after 1981-85.20 2° See Wilson (1987) , p.47. APPENDIX E: TAIWAN'S CURRENT ACCOUNT SURPLUS The NT dollar appreciated over 50 percent against the U.S. dollar during 1985-1989. However, exports increased steadily from $30.5 billion in 1985 to $65.9 billion in 1989. This shows that nominal exchange rates are not the only factor affecting export competitiveness. In addition to the domestic inflation rate, changes in the exchange rate and price level of important competitors must be taken into consideration. Historically, Japan, Korea, Hong Kong, and Singapore are the major competitors in exports. ‘Their level of exports is shown in Table 33. Table 33. Exports by Selected Countries 1999 191999 .99999_ K9999 9999.9999 919999999 1983 25.0 145.5 23.2 22.1 20.4 1984 30.2 168.3 26.3 28.4 22.7 1985 30.5 174.0 26.4 30.1 21.5 1986 39.5 205.6 33.9 35.5 21.3 1987 53.2 224.6 46.2 48.5 27.3 1988 60.3 259.8 59.6 63.2 38.0 1989 65.9 269.7 N.A. N.A. N.A. Unit: $ billion Sources: I999r999i999l.£i9999i9l_§999199199. IMF 1989- Eihangia1_§;a§i§§ig§, The Central Bank of China. Inflation in Taiwan was far low that of her trading competitors. Over the period 1985-89, Taiwan's CPI (consumer 211 212 price index) increased only 7 percent. During the same period, the CPI in Japan, Korea, and Hong Kong was above 13 percent (see Table 34). Further, the currency appreciated in all other countries except Hong kong whose exchange rate was linked to the US dollar at a fixed rate of HK$ 7.8 to $1.00.21 As a result, Taiwan experienced a smaller appreciation in its real bilateral exchange rate than in its nominal rate. In 1989, the CPI and exchange rate index of Taiwan were still lower than Japan, the most important competitor. Taiwan can thus continue to enjoy benefits from a lower real exchange rate.22 Since 1987, Korea has experiencing rapid currency appreciation and inflation. Consequently, Korea and Taiwan have been similar in terms of the change in real exchange rate at the end of 1989. Further, worker strikes and political instability since late 1987 have also weakened Korea's export expansion. Without appreciation of the Hong Kong dollar, however, the CPI in.Hong Kong increased rapidly to 116 percent in 1988. In addition, potential absorption by China in 1997 has created a crisis in confidence, which in turn weakens competitiveness in foreign trade. The only country which m "HKS" represents the Hong Kong dollar: rather than intervene in the foreign exchange market, monetary authorities made a commitment to buy and sell Hong Kong dollar notes at the fixed rate. 22'Since 1985, the Japanese yen has sharply appreciated. 213 might gain more from a lower real bilateral exchange rate is Singapore. Table 34. Dollar Exchange Rate and CPI 99999924999 Year lflLJime—w IExchange Rate 39.85 37.84 31.85 28.59 26.41 Taiwan- Exchange Index 100.0 105.3 125.1 139.4 150.9 CPI 100.0 100.7 101.2 102.5 107.0 . Exchange Rate 238.54 168.52 144.64 128.15 137.96 Japan - EXchange Index 100.0 141.4 164.2 184.9 172.0 CPI 100.0 100.6 100.7 101.4 113.0 Exchange Rate 870.02 881.45 822.57 731.47 671.46 Korea - Exchange Index 100.0 98.7 105.8 118.9 129.6 CPI 100.0 102.8 105.9 113.4 119.9 Singa- Exchange Rate 2.20 2.18 2.11 2.01 1.95 pore - Exchange Index 100.0 101.0 104.5 109.3 112.8 ICPI 100.0 98.6 99.1 100.6 103.0 Hong Exchange Rate 7.79 7.80 7.80 7.80 7.80 Kong - Exchange Index 100.0 100.1 100.1 N.A. N.A. CPI 100.0 103.2 108.5 115.9 N.A. Note: Currency units per US dollar: index and CPI, 1985=100. Sources: I999r99_i999l.£in.9919l.§999199199. IMF 1989. Eihahgiai_§;a§i§;ig§, The Central Bank of China. Her exchange index was only 113 percent and her CPI 103 percent in 1989. However, Singapore faces a new problem in the form of a worker shortage, which will hurt her export sector. The effect of NT dollar appreciation was reflected in the slow growth in exports. The growth rate declined from 29.6 percent in 1986 to 9.3 percent in 1989. Given current exchange rate appreciation, however, some low profit margin 214 industries have moved outward, as discussed in chapter 6. The more profitable industries which remained in Taiwan performed well in the new economic environment during these two years. At the end of 1989, the:NT depreciated slightly against the US dollar to its current level, $27.10. Exports growth will continue but can be slowed by currency appreciation. Negative growth is unlikely. On the import side, trade liberalization has been implemented since the late 19703. Average tariff rates dropped to 31 percent during 1980-1984 from 44 percent in 1978. In 1986, a new liberalization program was launched due to the pressure from the United States. Tariffs were cut over 1800 items at the beginning of 1987 and on additional items of interest to the United States in April, 1987. Tariff rates fell to around 20 percent in 1987. Non-tariff barriers have also been reduced. In 1986, the complex system of valuing imports for assessing customs duties was simplified. As a result of trade liberalization, the share of permissible imports for which licenses are automatically approved, has been rising.” Under these measures, total imports increased 43 percent in 1987 and 41 percent in 1988 which far outpaced the growth rate of exports. Among agriculture, mineral, and ‘3 According to a report of OECD in 1988, the permissible imports accounted for about 70 percent of total imports, while controlled imports accounted for 20 percent. The other 10 percent were not subject to licensing. 215 manufacturing products, the manufactured inputs increased relatively rapidly. Table 35 shows that the increase in the import growth of basic metals ranked top among all the manufacturing products. Transportation equipments and precision instruments ranked second and third, respectively. Electrical machineries and apparatus followed. Since most of the increases in imports were capital goods, the share of capital goods picked up (see Table 36). Table 35. Import Quantum by Commodity Groups Group .1299. .1291. .1299. Agriculture products 100 119 121 Minerals 100 111 127 Manufacturing products 100 136 171 Basic metals 100 163 268 Transportation equipments 100 162 247 Precision instruments and equipments 100 163 196 Electrical machineries 100 139 160 Paper and printed matter 100 129 145 Machineries 100 125 139 Chemicals 100 122 139 Chemical products 100 106 139 Textile products 100 115 118 Processed food 100 110 114 Source: Taiyah_§;a§i§§igal_ha§a_figgh, Council for Economic Planning and Development, ROC, 1989. 216 Table 36. Composition of Imports Period Total Capital Consumption Agricultural & Industrial Goods Goods Raw Materials 1985 100 23.8 8.5 67.7 1986 100 26.9 8.6 64.5 1987 100 28.8 8.0 63.2 1988 100 28.0 7.6 64.4 Unit: Percentage Source: WM. Council for Economic Planning and Development, ROC, 1989. As a consequence of the special effort made by Taiwan, the share of imports from.the'U.S. increased from 21.8 percent of total import in 1987 to 26.2 percent in 1988. The import of iron and steel from the U.S. increased from $0.3 billion in 1986 to $3.4 billion in 1988. Transportation equipment increased from $42 million in 1986 to $486 million in 1988. The annual growth rates of both items were over 200 percent (see Table 37). Machinery and tools increased from $1.3 billion in 1987 to $2.7 billion in 1988. Furthermore, chemicals and agricultural products, such as soybeans, wheat, and corn showed a similar pattern. As a result, the trade surplus with. the U.S. dropped to $11 billion in 1988 from $16 billion in 1987. The total trade surplus also declined to $11 billion in 1988 from $19 billion in 1987. This indicates a strong effort on the part of Taiwan to improve both the bilateral trade imbalance with the U.S. and the total trade imbalance. 217 However, the total increase in imports was only $3 billion in 1989, compared to $11 and $13 billion in 1987 and 1988 respectively. In addition to the meager growth .of exports, slow adjustment of consumer behaviors may be a contributing factor to the slow growth of total imports. It takes time for consumers to adjust their consumption behavior. The trade surplus increased.back to $16 billion in 1989. This is evidence that a trade surplus is likely to continue, even though it will diminish overtime. Table 37. Import From U.S.A. Item 1986 1987 1988 Value Growth Value Growth Value Growth .3999. ...... .3999. ...... .3999. Total 5,416 14 7,629 41 13,002 70 Soybeans 382 3 424 11 527 24 Wheat 108 -9 112 4 145 30 Cotton,raw 33 -76 164 394 99 -40 Machinery & tools 1,278 21 1,866 46 2,658 42 Chemicals & pharma- ceuticals 1,207 41 1,534 27 2,285 49 Transportation equipment 42 -62 132 217 486 269 Iron & steel 296 43 756 156 3,370 346 Metal manufactures 33 22 37 13 57 57 Others 2,039 9 2,605 28 3,375 30 Value unit: $ million Growth rate unit: Percentage Source: Taiwah Shatisgica; Data Book, Council for Economic Planning and Development, ROC, 1989. Due to rapid foreign direct investment and the development of international portfolio investment, investment 218 income will become more significant. Investment income increased rapidly from $0.9 billion to $6.6 billion in 1989. This will slow down the decline of the current account surplus caused by smaller trade surpluses. The rise in foreign direct investment will allow the subsidiaries to purchase increased amounts of machinery, intermediate products, etc. , further increasing Taiwan's exports. As a result, the current account may decline very slowly at most. In short, a current account deficit is not expected in the near future. The Council for Economic Planning and Development predicts that the export surplus can be reduced by $1 billion per year from 1990, implying that the trade surplus will continue to exist until 2000. APPENDIX F: A MULTILATERAL APPROACH When I began.this thesis, it.was my ambition to show that policies which encourage Taiwanese investment abroad, will benefit the entire world, as well as Taiwan. I was not able to do so because Taiwanese investments began to flow abroad only recently, and they have not yet diversified long-run foreign direct investment or equity participation. In addition, relatively few empirical studies have been done on Taiwanese investments abroad. Only two papers from the Chung- Hua Institute for Economic Research (1988a, 1988b) examine Taiwan's foreign direct investment. They survey motives for overseas investment. However, they do not study the impact on other countries. As a result, the case for this must rest on general trade theory, which is solid in this respect. The gains from international free trade are well documented in the international trade literatures (Samuelson, 1962, 1939: Bhagwati, 1968: Kemp, 1962; Haberler, 1950: Ohyama, 1972: Dixit and Norman, 1980). International trade raises the real income of the economy by improving the efficiency of resource utilization. Free trade is not only pareto-superior to autarky but also pareto-efficient, being superior to various degrees of trade restriction. 219 220 The main idea is represented in Figure 5, which refers to a large country case. A fuller exposition is in Bhagwati (1983). There are two goods, good 1 and 2, PP represents the production possibility frontier, and the QQ is the Baldwin locus which is derived under the assumption that the economy will engage in free trade. Under autarky, production and consumption are at A and social utility is at U‘. With free trade, production is at F and consumption at C on.EF. The total welfare, therefore, is raised up to Uc. \ Good 1 PQ Figure 5. Gains from Trade This idea has been extended by Dixit and Norman (1980), Krugman (1979, 1981), Markusen (1981), antharkusen.a d Melvin (1982), who relaxed some key assumptions made in the earlier literature. 221 In short, free trade among countries can lead to the allocative efficiency of natural resources and thus maximize the welfare of the individual country as well as the world as a whole. Any restrictions, such as tariffs, quotas, taxes, etc., will impede the development of trade. This will harm the trading countries directly and other non-trading countries indirectly. For example, a total cessation of trade between two countries due to the war, will slow the economic‘growth of both countries. The resulting lower GNP of these two countries will force them to cut their imports from a third country. As a result, welfare of all three countries will decrease.“ This explains why industrialized countries make efforts to reduce barriers to trade. The General Agreement on Tariffs and Trade (GATT) was designed to prohibit new restrictions on trade. It called for not only non-discrimination in trade restrictions but also trade liberalization under conditions of reciprocity. Over forty years, GATT has had great success in accomplishing its objectives. Similarly, world production becomes more efficient if factors move from low to high productivity countries. Foreign investment increases a host country's factor endowments and output growth. It also helps non-host countries serve other countries whose GNP and demand for imports are growing. The case for encouraging international investments by surplus u A cessation of investment has similar effects. 222 countries is very strong. In terms of the benefits for investing nations and others, this has direct relevance to the bilateral trade imbalance between the United States and Taiwan. It is not fruitful for U.S. trade policy to concentrate on exerting pressure on Taiwan to accept more U.S. imports. It seems logical that these objectives should be pursued through encouraging increased capital flows between capital surplus nations and others. A multilateral approach is a necessary alternative to bilateral trade diplomacy which serves to harden protectionist tendencies. The Taiwanese government has already put forth efforts to liberalize her import policy. Further liberalization will serve mutual interests. 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