8. Develop a global partnership for development
7.2 Bank lending = ‘quite good’ fl ow?
Historically, bank lending has been considered to be more favourable than portfolio flows (but less so than FDI flows) because of its relative stability.
However, this assumption has been widely questioned in recent years, not least because of the role played by short-term bank lending in the Asian crisis of 1997/8.
As can be seen from Figure 7.7 below, the proportion of short-term debt in total external debt holdings of the developing regions showed considerable variability from the late 1980s to 1997. In 1988, 20.4% of East Asia’s external debt was short-term (i.e. less than one year maturity). Of this short-term debt, 13.6% was accounted for by commercial bank lending, with the remain- ing 6.8% comprised of short-term bond issuance. By 1996 (i.e. just before the onset of the Asian crisis) the proportion of short-term debt in the region had risen to 33.4%, with more than 29% of this being accounted for by com- mercial bank loans. That is, by 1996, almost a third of developing Asia’s external debt was comprised of short-term loans from international banks.
Latin America shows a similar pattern of short-term debt build-up to Asia over the period. However, in Latin America this peaks in 1994 (i.e. just before the ‘tequila’ crisis in the region), and fell steadily thereafter. In contrast, Asia continued to build up short-term obligations through 1995 and 1996, when the process actually accelerated.
The situation was more mixed in Europe, and it is interesting to note that
Figure 7.7 Proportion of foreign debt comprised of short-term loans, 1988–1997.
Source: Rodrik and Velasco, 1999.
only Africa and the Middle East, of the regions given above, had a lower proportion of short-term debt in 1997 than was the case in 1988.
As we shall discuss below, many commentators have pinpointed the cause of the Asian crisis in this area: the build-up of short-term debt. This situation raised the possibility of a liquidity (as opposed to a ‘solvency’) crisis, where borrowers become unwilling to roll-over short terms loans thereby triggering a default. There is a ‘collective action’ issue at work here, as banks may be unwilling to roll-over loans if they assume that other banks may also be unwilling, though each would be prepared to roll-over the loans if they knew that other banks would do so.
Much of this understanding of the danger of reliance on short-term bank lending is relatively new. As pointed out above, bank lending had long been considered to be comparatively stable. In such an environment, there was logic in developing country borrowers opting for short-term lending, for the simple reason that borrowing short-term is inherently cheaper than borrow- ing long-term.5 And if the loans are simply rolled-over – as is common prac- tice under normal conditions – the borrower is effectively obtaining very cheap long-term finance.
Despite the lower margins that they can earn, shifting towards shorter loan maturities in developing countries also made sense from the perspective of the lending banks. From their perspective, the volatility of developing and emerging economies made longer-term lending relatively unattractive. The banks assumed, wrongly as it turned out, that restricting maturities would enable them to get out of the situation quickly should problems emerge in the countries concerned. Clearly, however, this cannot be true for every bank – though it may be for individual banks. A consequence of all banks trying to close off their short-term loans at the same time, however, is to seriously worsen the economic difficulties that they are trying to remove themselves from. Individually rational but collectively irrational behaviour of this kind is known as a ‘fallacy of composition’, and is by no means uncom- mon within financial markets operating, inevitably, under conditions of uncertainty (Kindleberger, 1978).
Following the Asian crisis and its aftermath, net bank lending to all devel- oping regions collapsed, and remained negative until 2002 – this reflected both an unwillingness to lend and an unwillingness to borrow on the part of developing countries, who had seen the consequences of doing so in Asia.
Since that point, some important changes can be observed in the pattern of bank lending. First, average loan maturities have lengthened. As can be seen from Figure 7.8 below, in June of 1997 the ratio of short-term to total inter- national bank lending in developing countries was 56.5%, and the figure for Asia was 62%. By March 2000 the corresponding figures were down to 46.6%
and 46.8%. Since that point, the ratio for all developing countries has remained relatively constant, averaging 46.6% to December 2006.
Following declines from the high of 1997, most other developing regions also follow this pattern, the exception – somewhat surprisingly – being the
Asia and Pacific region. Here, the low point for short-term lending came in March 2001, where the ratio fell to 44.5%. Since then, however, there has been a steady increase, so that by September 2005, the figure was again above 60%.
Secondly, there has been an increasing trend for international banks to
‘cross the border’, either by buying domestic banks in developing countries, or by establishing their own branches within the country. In both cases, the international banks have tried to fund their lending from domestic activities, therefore eliminating any currency mismatch risk from their perspective.
Lending from international banks through domestic subsidiaries grew by almost 30% per year from 1998 to 2002 (ibid.).
Table 7.1 above shows this trend clearly. In 1996, emerging markets received
$556.7 billion in cross-border bank lending and $97.8 billion from local subsidiaries of international banks. By 2002, however, the figures were
$336.9 and $422.8 billion respectively. Lending through subsidiaries grew at around 30% a year over the period, while cross-border lending fell by around 6.5% per year. The pattern holds in all the emerging regions covered in this table.
Interestingly, it was North American and Japanese banks that pulled back from cross-border lending the most aggressively, while European banks increased their activities in this area, presumably hoping to gain market share as their international competitors withdrew.
The impact of this major shift in banks’ approach to developing countries is not fully understood. Whilst there is some evidence that the entry of foreign banks raises the efficiency of the domestic banking sector,6 others argue that foreign banks will ‘cherry pick’ the most attractive clients in developing
Figure 7.8 Proportion of international bank loans of less than one-year maturity, June 1990 to September 2006.
Source: BIS.
countries (particularly the larger ones), thereby crowding domestic banks out of this lucrative banking sector. More generally, there are concerns that a banking system dominated by the subsidiaries of large international banking groups will be less prepared to lend to the SME sector, preferring to focus on larger corporate clients. In this regard, Berger et al. (2000) find that in Argen- tina in the late 1990s small firms were less likely to receive funding from foreign banks than from (smaller) domestic banks. However, while Escudé et al. (2001) confirm that foreign banks in Argentina did indeed allocate a smaller proportion of their loan portfolio to the small-and-medium-enterprise (SME) sector, the sheer size of these banks meant that they accounted for more than half of all SME lending in the country.
In a detailed cross-country study, the World Bank7finds that foreign bank entry is positive in terms of access to credit in developing and emerging economies, and argues that it is not the nationality of the bank that influences its policies towards SMEs, but the size of the bank.
Table 7.1 Changing patterns of regional bank lending, 1996–2002 Total lending
1996 (US$
bn.)
Average annual growth 1993–96 (%)
Total lending 2002
Average annual growth 1997–2002 East Asia
Domestic banks 769.5 18.1 876.1 2.4
Local subsidiaries of foreign banks
29.8 15.4 84.9 21.2
Cross-border 282.2 29.0 130.3 −11.6
Latin America
Domestic banks 563.7 17.3 484.8 −2.7
Local subsidiaries of foreign banks
58.5 28.6 241.7 31.2
Cross-border 199.9 6.2 166.1 −2.8
Eastern Europe
Domestic banks 242.5 9.4 252.8 0.8
Local subsidiaries of foreign banks
9.6 80.5 96.3 48.5
Cross-border 74.7 1.6 70.4 −0.6
All emerging markets
Domestic banks 1,575.7 12.7 1,613.7 0.4
Local subsidiaries of foreign banks
97.8 24.4 422.8 29.4
Cross-border 556.7 14.5 366.9 −6.5
Source: UN, 2005.
US-based studies8 in the 1990s demonstrated that large, complex financial institutions are generally reluctant to lend to information-poor SMEs, and in developing countries this would also appear to be the case. The World Bank study of 2001 found that foreign banks behave very much like large domestic banks in this respect.
To summarise, the reversal of the trend towards ever-shorter maturities in international bank lending to developing countries since the Asian crisis is undoubtedly a positive development though, as we have seen, there has been a steady rise in the importance of short-term bank lending in the Asian region since 2001. Furthermore, the fact that international banks have increasingly ‘crossed the border’ into developing countries, by establishing subsidiaries and funding their activities in domestic currency, reduces cur- rency risk for borrowers (who previously would have borrowed cross-border in an international currency such as the US dollar).
However, the decline in cross-border lending also reduces net inflows (i.e. additional external savings) to the economy and contributing to higher investment and therefore growth. By funding their activities domestically, international banks bring no additional capital, but do bring the possibility of other benefits such as increased efficiency of the banking system, greater competition, and so on. However, the evidence on this is currently inconclu- sive, and there remains a real risk that foreign banks could come to com- pletely dominate the domestic banking system in some developing countries.
As shown in Figure 7.9, foreign banks controlled almost 33% of all domestic banking assets in developing countries by 2002. The regions most dominated by foreign banks were sub-Saharan Africa and Latin America, with 45% and 30% of their banking system under foreign control. In contrast, the regions
Figure 7.9 Foreign bank ownership in developing regions, 1995–2002.
Source: Cull and Peria, 2007.
with the least foreign banking presence were South Asia and Asia and Pacific, with 10.4% and 11.7% respectively.
These regional averages, however, disguise some wide variations at the country level. For example, while the 2002 average for Eastern Europe &
Central Asia stood at 35.7%, the figures for the Czech Republic, Estonia and Lithuania were 59%, 73% and 92% respectively.
(Cull and Peria, op. cit.) To recap, we have seen that FDI appears to (just about) warrant its place at the top of the ‘hierarchy’ of capital flows, while bank lending – particularly of a short-term nature – is clearly less beneficial than had been thought.
Before considering how these types of capital flow come together in terms of crises in developing countries, we will briefly consider the role of portfolio flows – long seen as the ‘worst’ type of capital flow.