Financial FDI in CEECs revisited – in the context of the dependent market economies model

1. Financial FDI in CEECs revisited – in the context of the dependent market economies model Zoltán Gál and Magdolna Sass Centre forEconomic and RegionalStudies of HAS, Budapest, Hungary RSA Research Network on Geographies of Finance and Post-Socialist Transformations , Bratislava workshop, 16-17 of May, 2013

2. Outline • Work-in-progress • Research question • Theoretical background/review of the literature on the topic • Method • Data and facts – NMS and Visegrad+Slovenia • Main findings • Conclusion

3. Research question • The role of FDI in financial services in post-transition economies (Visegrad+Slovenia): the impact of foreign ownership during the crisis years in terms of financial stability • Hypothesis of a dual financial/banking system evolving in the DME (VoC)context and its impact during the crisis years

4. New variety of Capitalism: Dependent Market Economy (DME) model • DME is created an unequal power relation between the home countries and CEECs through parent-subsidiary networks of TNCs (Raviv, 2008., Nölke and Vliegenthart, 2009, Myant and Drahokoupil, 2010). • Foreign credit institutions were never geared towards addressing the developmental needs of the host CEE economies (Raviv, 2008). • Foreign financiers emerged as a powerful rentier class in Central Europe able to extract rent incomes far in excess of their profits in the west. • Unprecedented transfer of property rights from local society to foreign investors, but also to increased unsustainable indebtedness and risk. • TNCs prefer to hierarchically control local subsidiaries from their headquarters as an alternative mode of finance and governance rather than to accept financing by international capital markets and outsider control by dispersed shareholders (LME), or to accept financing by domestic bank lending and insider control (CME) (Nölke and Vliegenthart 2009)

5. Theories on Financial system (re)integration of CEE revisited Reintegration & Transition theory: Banking in Transitions Economies, developing market Oriented Banking Sectors in Eastern Europe. (Bonin et al. 1998) How does foreign entry affect domestic money markets? Why do banks establish foreign subsidiaries? (Claessens et al. 2001, Buch, 2003, Berger et al. 2004) Entry EU banks and FDI in banking (brownfiled & greenfield privatization (Wachtel 1998) Modernization theory: Supporting bank privatization by foreign strategic investors vs. state ownership; key role of foreign banks in institutional development, stability and the increase of financial depth (Várhegyi 1993, Király 2005, Csaba, 2011) Impact of foreign bank(FP)presenceon financial stability during the crisis: negatively related to domestic credit creation during the crisis and foreign banks reduced lending more than domestic banks in avarage (esp.developing countries), except when they dominated the host banking system (Claessens and van Horen 2012). -If FB generated majority of their funding from local deposits were less much likely to reduce lending. 5

6. Theories on Financial system (re)integration of CEE revisited • Unequal parent–subsidiary relations • Concentration of controlling functions over CEE within the international financial centres (IFC),(Kareman 2008, Wójcik, 2007, Gál, 2010a,b). • the hierarchy between TNC headquarters and local subsidiaries replaces markets (LME) and associations (CME) as a typical coordination mechanism within these economies. • Emerging dual banking system and its implication for spatial polarization and uneven development (Alessandrini & Zazzaro, 2009, Gál, 2005) • Local banking structures are missing or weak, the strong dependence on the foreign banks • The concentration of large banks with foreign ownership and the weakness of locally founded, smaller indigenous banks (e.g. cooperative savings banks),

7. Method and facts and data on V4 and Slovenia • We use various indicators of the financial services/banking sectors of CEE/V4+Slovenia • Comparing pre-crisis and post-crisis (?) period

8. Financial reintegration of CEE • Shift ownership from • PUBLIC to PRIVATE • DOMESTIC to FOREIGN • FDI became the predominant type of inward investment in the first stage of transition (privatization, country differences) • Primary target of FDI: banking&Insurance (bank based finance) • Foreign Banks (understandably) followed commercial principles rather than economic development • PRIVATIZATION = FOREIGNIZATION

9. Pre-crisis: Market share of foreign-owned banks in total banking assets 2006 (%) Source: Local Central Banks, EBRD Transition Report 2006 ‘Finance in Transition’.

10. Pre-crisis: Foreign ownership Domination of foreign banks as a financial intermediaries Foreign banks control the majority of assets (mainly West European), and penetrated very early in retail segment SHARES OF FOREIGN BANKS: 20% in OECD; 50% outside OECD

11. Post-crisis: Foreign shares in international comparison Relatively large (compared e.g. to the level of economnic development) FDI flew into the banking sectors: unprecedented shares of foreign ownership Developmental needs of CEE (pull ) Market pressures for foreign banks (push) Similarly to global processes: foreign bank entry is regionally concentrated, main investors: banks from traditional/strong economic and trading partner countries, i.e. mainly eurzone countries for CEE However, trend for intra-regional banking integration (main player: the Hungarian OTP)

12. 25 OTP Group is the only local player in CEE region, with 100% of group assets in the region DATA AS OF 2008 Number of Branches Countries of presence(3) CEE, % share in Group Assets Net Profit(2) EUR mn Total Assets(1) EUR bn UniCredit 53% 121.6 2,577 4,005 19 12 Raiffeisen 2051% 85.4 3,231 1,078 16 54 157% Erste 79.3 1,569 2,099 7 39 112% (4) KBC 71.6 309 1,940 12 20 SocGen 41% (5) 65.9 2,609 1,201 16 6 IntesaSP 5% 42.5 186 1,781 11 7 OTP n.s. 35.2 958 1,573 9 100 ..% Contribution of CEE in Group Net Profit (After tax, after minority interests) Notes: (1) 100% of total assets, and profit after tax (before minority interests) for controlled companies (stake > 50%) and pro rata for non- controlled companies (stake < 50%). (2) After tax, before minority interest. (3) Including direct and indirect presence in the 25 CEE countries, excluding representative offices. (4) KBC Group recorded a loss in 2008. (5) SocGen including ProFin Bank in Ukraine. Source: UniCredit Group CEE Strategic Analysis 12

13. Post (?)-crisis: FDI infinancialservicesin NMS, 2010 (source: WIIW)

14. Crisis years + post-crisis: FDI in financial services, Visegrad+Slovenia (million euros, 2006-11, source: national banks)

15. Post-crisis: Foreign shares… Share of foreign-controlled companies in the gross value-added of Financial services (CZ, HU) Source: statistical offices, national accounts

16. Sources of Finance in DME model

17. Implications for unequal parent-subsidiary relations: transnational network connectivity SHIFT in key decision making/control functions to the parent banks (outcome of previous FDI) Reduce the information available for host country supervisors Power relations: CEE centres is subordinated by West European IFCs Connectivity through parent-subsidiary network Concentration of outdegree connections (sender IFCs) forms Western gateways to CEE (Vienna, Paris, Athens, Frankfurt) Concentration of indegree connections (hosting hubs)forms bridgehead centres in CEE (Moscow, Warsaw, Budapest) Lack of control function in IFCs located in CEE capital cities Only exception is Budapest: control functions of OTP Bank (OTP is the only regionally based MNC with regional subsidiaries network) 17

18. Parent (HQ)-subsidiary (CEE) relations-- degrees of financial connectivities Kareman,2008, Gál, 2010 18

19. Concentration of control functions of parent-subsidiary relations Kareman,2008, Gál, 2010 19

20. Dependency on parent bank finance:Out of a “liquidity-crisis mood”, but funding availability and cost remain a constraint for CEE banking Banking sector external liabilities(% on total liabilities, June 2009) CEE external liabilities(1) (1) CEE-17 Source: UniCredit Group CEE Strategic Analysis

21. High level of financial dependency on global (EU) financial institutions „Argentina on the Danube” (The Economist , 2009 February) „Subprime Europe” “great capitalist transformation” of Eastern Europe has been expressed over the last decade by a high level of debt and financial dependence on Western European banks, which is without precedent since decolonization… Samary, 2009(Towards a Western/Eastern Europe Banking and Social Tsunami) „Adopt our ways, the EU said, and you will share our prosperity and freedom. Eastern Europe responded eagerly. Paradoxically, their very eagerness opened the way to their current problems. Their adoption of EU rules made leading banks feel safe to lend to them. Money flowed in, helping the region start catching up with the half-century it had lagged behind its western neighbours' economic growth. And then the financial crisis hit. The lending that sustained east Europe's current account deficits until last year was largely provided by local subsidiaries of central and west European banks; it has now evaporated. The region's governments - many of which managed their finances more prudently than many western countries - find themselves unable to plug the yawning financing gaps. … Smaller member states are often the most committed to the EU, but they can do little when their big neighbours cynically undermine it.” Financial Times, 2009.febr. 19. 21

22. The dual-banking systems CEE suffer from a a “de-nationalised dual banking system”, consisting of large foreign banks and small local banks (Gál, 2005, 2009; Alessandrini and Zazzaro, 2009). Pros Acess to resources of parent banks, transfer reputation Institutional efficiency; efficiency in credit allocation (?) Contribution to financial/macroeconomic stability foreign banks branches are channels of modernization Introductions of efficient rules of governance More stable credit sources for the local economy during economic downturns? Cons The „dual banking system” is more prone to transmit adverse shocks across borders and serves as a propagation channel for potential regional shocks Extremely high centralisation of HQ function in capital cities Lack of strong locally-regionally based banks: savings cooperatives with weak financial standing Financial exclusion (lower accessibility to services on certain territorial level) Transfering adverse shocks across borders 22

23. Problem originating from a parent banks during the crisis Parent banking background is helpful (Haas-Lelyveld, 2009) Supportive effects Substititional effects (reallocation of bank capital by risk and expected yield) Cross-border lending channels deliver shocks (Goldberg, 2009) Foreign banks played a significant role in the transmission of the current crisis to EMEs Maturity mismatch, lending in foreign currencies (swaps), High loan/deposit ratio High exposure in foreign liabilities (carry trade, currency swaps) 1000 Bn USD Different regulations in parent and subsidiaries’ countries (Highest net foreign debt of the private sector in Hungary) Liqudity crisis in CEE, Suden stops in cross border interbank lending Stages of shock transmission Pre-Lehman Brothers: risk premium, narrowing liquidity, decreasing parent supply Post-lehman Brothers: solvency problems, fall in share values, and downgrading ratings at parent banks Capital flight? Parent banks generated capital outflow from their subsidiaries; difficulties in subsidiaries’ finance 23

24. Conclusions 1 Role of FDI/foreign banks in Visegrad+Slovenia financial services: evolution of a dual banking system (Slovenia: the outlier) The role of FDI in economic growth revisited (Balogh, 1982, Rajan et al 2006) Negative correlation between growth and FDI stocks in EME Positive correlation between growth and FDI stocks only in developed c. Foreign bank presence in low income countries generates less credit During crisis reduce their domestic credit more than domestic banks The impact of the dual system during the crisis years revisited in the framework of the dependent market economies model Crisis years: analysis of the geography of the changing network (parent-subsidiary) relations Parent banks generated current account imbalances (substituted local houshold savings) Stronger substitution effects: reallocation of resources within banking groups (OTP Banks, IMF loan, capital flights?) 24

25. Conclusions 2 Implications for transformation of the crisis-prone European financial landscape • In 2009 CEE was the main crisis spot • In 2010 EMU in debt and fiscal crisis • Future of banking subsidiaries in CEE (relocation, consolidation, Foreign bank exits) • Increasing role of the nation state (regulation, taxation) • Weakening states in CEE (no ability to support their banking, taxation banking) • To strenghten local financial structures (EBRD CEO warning)