Financial Sector FDI and Host Countries: New and Old Lessons

Financial Sector FDI and Host Countries: New and Old Lessons
Linda S. Goldberg
New York Fed, Jan 2007

The 1990s saw a dramatic rise in foreign direct investment (FDI) into the financial sectors of emerging economies. Many of these countries consequently had banking sectors owned largely by foreign institutions.

An understanding of how financial sector FDI affects host markets is crucial for countries formulating policy with respect to foreign banks, observes author Goldberg. However, there is relatively little research on the topic.

The author suggests that studies on “real-side” FDI—investment into manufacturing and primary resource industries—offer insight that also applies to the financial sectors of host countries. The implications of real-side FDI into emerging markets are well documented by research.

Goldberg’s analysis of the literature finds that foreign direct investment generally has positive effects on host countries, with some effects being particularly notable in financial service industries. Among the findings supporting her conclusion are:

* FDI is typically associated with improved allocative efficiency when, for example, foreign investors enter industries with high entry barriers and then reduce local monopolistic distortions. The presence of foreign producers can also increase technical efficiency, as heightened competition may spur local firms to use existing resources more effectively.

* Higher rates of technology transfer and higher wages can be linked to FDI. While there is evidence of technological improvements from FDI and a presumption that such investment will stimulate growth, the strength of these effects is disputed. In addition, FDI into host countries can lead to higher wages, although these effects are limited to foreign-owned production facilities and do not spill over more broadly.

* Foreign direct investment by well-regulated and well-supervised countries can support emerging market institutional development and governance, improve a host country’s mix of financial services and risk management tools, and potentially reduce the incidence of sharp crises associated with financial underdevelopment in emerging markets.

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