The impact of credit market liberalization in emerging countries is intensely debated. In the last twenty years or so, several emerging economies such as Argentina, Brazil, Mexico, Thailand, and most Eastern European countries have opened their credit markets to financial institutions from developed economies. Policymakers have often motivated liberalization arguing that the entry of financial institutions from developed economies deepens the financial sector. Sophisticated, multinational banks from advanced economies possess more efficient technologies for financing and monitoring businesses than local, unsophisticated financial institutions of emerging economies (see, e.g., Dages, Goldberg, and Kinney, 2000, for a discussion of the “financial deepening” argument). Therefore, the entry of foreign financial institutions after liberalization would ease the financing of investments, especially hard-to-finance ventures that would otherwise be left idle by local institutions. In the years following the liberalization episodes, however, a gloomier view has gained ground. Several scholars and policymakers have expressed concerns that the liberalization of the credit market tends to have different effects across segments of firms and sectors of activity. In particular, the financial deepening effect could especially benefit internationally active, export-oriented businesses in the tradables sector (that is, the sector with close ties to foreign institutions) but induce a reallocation of resources away from domestic-oriented, non-tradable industries (Giannetti and Ongena, 2009; Hawkins and Mihaljek, 2001; Lacoste, 2005; Mihaljek, 2006). The crises that have hit several emerging economies a few years after liberalization have further spurred such concerns. In fact, distinctive features of these crises were a drop in output and prices primarily concentrated in non-tradable goods industries, such as real estate, and a major reallocation of credit from the non-tradables to the tradables sector (Tornell, Westerman, and Martinez, 2003).
These two conflicting views of financial liberalization naturally elicit fundamental questions: can credit market liberalization have heterogeneous effects across sectors, particularly between tradable and non-tradable industries? If so, what does this imply for the impact of liberalization on credit market conditions and on the aggregate economy (output and asset prices)? Can we learn from this insights into the experience of liberalized emerging economies and, from a policy perspective, into the strategies to follow when opening credit markets to foreign institutions? The objective of this paper is to take a step towards addressing these questions, possibly helping reconcile the above conflicting views. Our starting point is standard. We consider an emerging economy with two sectors: a sector (“manufacturing”) that uses intensively an internationally tradable asset (“materials”) and a sector (“real estate”) that uses intensively a non-tradable asset (“land”). A contractual incompleteness in the credit market limits the appropriability of project returns, depressing the volume of investment projects in both sectors.
We let two typesof lenders domestic and foreign operate in the credit market. In line with the above arguments and with the literature (e.g., Diamond and Rajan, 2001), we characterize domestic and foreign lenders with their efficiency at extracting value from entrepreneurs’ assets. We postulate that, because of their efficiency, foreign lenders possess better skills than domestic ones at monitoring, collecting, or liquidating entrepreneurs’ collateral assets. However, following previous studies (e.g., Boot and Kanatas, 1995; Bulow and Rogoff, 1989; Diwan, 1990; Obstfeld and Rogoff, 1996), we also posit that the efficiency edge of foreign lenders is larger for tradable than for non-tradable assets. In fact, foreign lenders can easily seize tradable assets while they are often unable to seize local, non-tradable assets, especially in emerging economies where laws are porous and poorly enforced. Furthermore, foreign lenders have more experience of tradable assets, which they deal with when financing firms in their own country or internationally active companies.
We show that in such an economy the entry of foreign lenders after financial liberalization produces two effects. The first is an expansionary effect of financial deepening: thanks to their superior efficiency, in both sectors foreign lenders raise the appropriable value of collateral assets, which in turn tends to increase the volume of projects financed. In particular, foreign lenders help finance projects that domestic lenders would steer clear of because of their low success probability. The second is a reallocative effect: because their efficiency is relatively stronger for (tradable) materials than for (non-tradable) land, foreign lenders raise the appropriability of project returns in the manufacturing sector, which uses materials intensively, more than in the real estate sector, which uses land intensively. This leads domestic lenders to reallocate credit from real estate to manufacturing to benefit from the improved credit market conditions in the manufacturing sector. In fact, domestic lenders expect that whenever they co finance manufacturers with foreign lenders - which frequently occurs in emerging economies - they will profit from the increased appropriability of the revenues of manufacturing projects.
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Foreign Banks and the Dual Effect of Financial Liberalization
