INSTITUT D TUDES POLITIQUES DE PARIS

CYCLE SUPERIEUR DE SCIENCES ECONOMIQUES

FINANCIAL SECTOR TRADE

AND

INSTITUTIONAL CONVERGENCE
IN A DUAL ECONOMY FRAMEWORK

Ivan MORTIMER-SCHUTTS

Mmoire prsent pour le DEA dEconomie Appliqu

Filire Relations Economiques Internationales

Directeur du mmoire: Pierre Sauv

2003-2004

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1 1 INTRODUCTION

1.1 PURPOSE AND CORE QUESTION

Financial sector development and institutional frameworks in developing countries have

become important areas of policy focus over the last few years. Growth in some emerging
markets has led to greater financial sector trade with international markets and institutional
convergence. Although this is generally considered to be a positive development, effects of
this convergence on lesser developed economies may be problematic. And for emerging
markets with a dual structure, the impact for the less developed or informal sector is not
necessarily positive. For policy purposes it is important to understand more clearly the impact
of support for different sets of financial sector institutions on both stylised halves of a dual
economy (the modern and the less developed), how the impact can vary according to modes
of trade and what sorts of complementary measures may be called for during a process of
institutional evolution. This paper examines the impact of institutional convergence in the
financial sector on trade in that sector and outlines a potential explanation of how this
convergence may arise through rational economic behaviour. It does this for the case of three
economies in a Heckscher-Ohlin trade model: the international financial sector and the two
constituent parts of a dual economy - a modern sector and a less economically developed
series of local informal economies. More specifically, I ask what the impact is on this dual
economy of increased financial sector institutional convergence between the modern sector
and the international financial sector.

For the purposes of this paper, the institutional environment is composed of standards and
conventions. The former are shared formal rules, procedures or information codes which
financial sector participants follow. Conventions are informal practices, norms or values that
are loosely conformed to by financial sector participants or principles to which they adhere.
Both standards and conventions are important differentiating features of the three economies
that feature in the model.

If institutional convergence is weak, the differences, in terms of standards and conventions,

between economies act as informal trade barriers. Differences in, for instance, available
information, accounting standards, credit scoring or informal business practices1 can constrain
trade through so-called transaction frictions or inefficiencies or elevate transaction costs
between different economies. Although difficult to quantify, these forms of barriers can be
modelled conceptually as tariff equivalents.

If incremental changes to the institutional environment in an economy occur, a process of

financial market integration or divergence may be triggered. This can happen, if individual
financial services providers and their clients find it profitable to invest in order to conform
with standards and conventions in another economy. A process of gradual institutional
convergence may be stimulated. The paper outlines this rudimentary mechanism of
institutional evolution.

Opportunities for trade, adjusted for differences in standards and conventions are what drive
institutional evolution. The precise direction of evolutions depends upon modes of trade in the

1
Mathieson and Roldos 2001

2
financial sector. Critically for the paper as a whole, standards and conventions are also a
criteria according to which modes of trade are defined. In the traditional trade literature,
modes of trade are defined with regard to political boundaries and the location of buyers and
sellers2. In this paper, relevant boundaries are defined also in terms of the standards and
conventions to which partners to trade adhere or comply. So although for example physical
presence of a seller in another country (mode 3) may generally imply compliance with local
standards and conventions, this does not necessarily have to be the case. A firm could offer
services abroad but in accordance with its own home economy standards and conventions. It
is also worth noting that a firm or financial services provider is capable of operating in
accordance with more than one set of standards and conventions. The term migration is
often used in the paper to refer to compliance with foreign economy standards and
conventions. This does not however necessarily imply any kind of physical migration. Nor
should the use of the terms compliance or jurisdiction in this context be understood
necessarily as references to formal legal structures.

The paper seeks to expand our understanding of the impact of convergence in international
financial markets in terms of standards and conventions. It is motivated by a need for
complementary approaches to assessing the benefits and potential dangers of alternative
institutional frameworks for financial markets; And it introduces a basic model that can
account for institutional evolution or convergence through rational profit maximising
behaviour.

1.2 METHOD

The analytic sections of this paper start with a simplified modelling exercise in order to
illustrate some of the key dynamics to be expected in the stylised framework under
investigation. I employ a Heckscher-Ohlin type model of trade between three economies: a
dual economy, composed of a (i) modern transitional economy and a (ii) set of local,
predominantly informal, economies, and the (iii) international modern economy, referred to
simply as Rest of the World (hereafter RoW). The key elements dividing these economies are
institutional standards and conventions. Absence of conformity between economies to the
same standards and conventions creates transaction barriers.

Trade Analysis I
Firstly I analyse the potential impact of integration in the form of exogenous reductions in
institutional differences. I also briefly relate reductions in financial sector barriers to changes
in trade barriers applicable to goods. The impact of changes are considered in individual two
economy models and subsequently combined to look at potential indirect effects on the
underdeveloped part of the dual economy of integration between the modern sector of the
dual economy and international economy.

2
For the World Trade Organisation, supply (trade) is defined in four modes. Mode 1 implies cross-border trade
with buyers and sellers remaining in their respective home countries. Mode 2 implies that buyers purchase in the
country of the seller. Mode 3 implies the physical presence of the seller in the economy of the purchaser. Mode 4
implies the that purchasers buy and consume in the country of the seller

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Trade Analysis II
Secondly I allow scope for the cost of adapting to foreign institutional structures to vary
according to individual borrowers and financial institutions. In this structure, enterprises can
choose to invest and alter their status with regards to conventions and standards. By investing
in their ability to operate in foreign markets which adhere to different standards and
conventions, companies can effectively circumvent the transaction frictions that operating in
an unfamiliar environment would normally engender. This enables banks and borrowers in
the same economy to be capable of displaying different institutional characteristics and gives
them the choice of more efficiently engaging in trade with the foreign financial sector. I refer
to this as a form of non-physical migration to different institutional jurisdictions (no legal
obligation implied). Through changes in market liquidity, choices made by lenders and
borrowers can have externalities that impact the decisions of others. This allows for the
prospect of gains from trade to incite institutional transformation and innovation in an
international context and hence a gradual evolution in the stylised institutional divisions
between the international financial sector and the dual economy, as well as the nature of the
division within the duality.

In the analysis section II, trade dynamics are considered in terms of the patterns that arise
under different assumptions regarding endowments and differences in institutions as well as
supplementary trade barriers. I also consider the beneficial impact of trade in terms of cost of
funding, reduction of information asymmetries between borrowers and lenders, liquidity and
portfolio diversification. This section then consolidates effects in a more graphic analysis and,
like in analysis I, extends it to the indirect effects on the underdeveloped part of the dual
economy of integration between the modern sector of the dual economy and international
economy.

1.3 MAIN CONCLUSIONS

The paper firstly illustrates with the simplified three economy model, that differences in
relative endowments of capital and other factor inputs can provide ample incentive for less
developed countries to gradually seek to adopt advanced economy institutions, standards and
conventions in the financial sector. This can be the case up to a point even if these foreign
standards and conventions still leave room for improvement and are not fully adapted to the
developing countrys home market economic, legal and social features. The study does not
deny the relevance of attempts to identify optimal institutional frameworks but asserts that
such frameworks are inherently bound to their surrounding environment. With the exception
of autarchy, the surrounding environment is always partly composed of trading partners that
operate in accordance with other institutional frameworks. A balanced understanding of the
role of standards and conventions must recognise not only the role that local circumstances
play in designing institutions for an efficient financial sector but also the practical constraints,
benefits and risks presented by opportunities to trade with foreign banks that benefit from
more developed home markets in which the price of capital relative to labour is lower. The
dual economy framework presented herein helps to reveal some of these different forces.

Beyond these primary conclusions, the analysis itself draws attention to more specific results
concerning the potential impact of increases in financial sector integration and trade. It
explores a structure in which small innovations or random variations in the operational
character of banks through externalities - can initiate a gradual shift in dominant standards
and conventions in a given economy i.e. it can engender institutional evolution such as

4
changes in product structures, legal frameworks for project lending or stock exchange
operations.

The analysis shows that reductions in informal transaction barriers - as conventions and
standards - lead to the traditional gains from trade as well as those derived from pro-
competitive effects. It is important to note that although the introduction of standards and
conventions can facilitate trade, compared to a situation in which there is an absence of such
institutions that can be communicated to potential trading partners, trading with partners that
adhere to different standards is less efficient than trading with actors that share the same
standards. In the three economy model studied here, the net impact of changes in one trading
relationship on the third economy is ambiguous. This result is coherent with anecdotal
evidence available from empirical studies on foreign bank entry. Crucially the overall impact
depends on the boost to economic growth in the transition economy that increased financial
sector efficiency stimulates. As other dual economy studies have found, under assumptions
about relative productivity in each half of the duality, diminishing availability of credit in the
informal economy may not be as bad an outcome as one might expect, particularly if this
decrease is due to or compensated by expanded opportunities in the modern sector3.

Lastly, the analysis illustrates how market tiering may occur through choices made by
individual borrowers and lenders regarding standards and conventions. In particular it
indicates some of the potential consequences of trade and integration in terms of liquidity and
costs of financial services. It is shown that in some cases integration can foster a process
favouring polarisation divergence - towards extreme standards and away from the middle
ground.

The rest of this paper is structured as follows:

The next two sections provides further discussion of key concepts and policy issues which
help to clarify the context or relevance of the subsequent analytic sections The latter section
also reviews literature of particular relevance to the methods and overall approach that I have
pursued herein. Section four is an introduction to the basic modelling framework. Sections
five and six deal with two forms of analysis of changes in the informal trade barriers defined,
as described above. In essence, the first analysis looks at the impact of exogenous changes in
institutional transaction efficiency barriers i.e. I assume that qualitative differences between
standards and conventions in two economies decline and hence the tariff equivalent cost of
doing business with partners operating with other standards and conventions also declines.
The second (in chapter 6) operates within the same model, but with heterogeneous firms and
externalities related to chosen standards and conventions. It considers the circumstances
which lead agents (lenders or borrowers) to engage in trade or institutional migration,
allowing standards and conventions as core institutions for the financial sector to become
partly endogenous. The paper then sums up the important issues in a conclusion and outlines
ideas on possible extensions and further research. An annex provides elements of work in
process concerning further investigation of the relationship between informal barriers to trade
in the financial sector and export barriers on consumption goods.

3
See for example the study by Paul Mosely on Micro-Macro linkages

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2 KEY CONCEPTS

In this section I provide a further discussion of institutions, dualism and the idea of financial
sector integration. I outline the sense in which these concepts are employed throughout the
paper and provide examples where relevant.

2.1 INSTITUTIONS
I define institutions in this analysis as standards and conventions and relate them specifically
to operations in the financial sector. In what follows, the short-hand expression institutions
should be taken as interchangeable with standards and conventions, unless specifically being
used to refer to providers of financial services under the term financial institutions. There
are always caveats in trying to delimit the broad field of institutions. I try to avoid unwieldy
generalisations by citing examples where relevant. Another common problem when
discussing institutions is that they are easily depicted in such a way as to appear static. The
trade analysis in chapter 6 explicitly tries to address this concern by outlining a structure
which is not only capable of accommodating changes to institutions but also provides an
explanation of why institutional change takes place.

Most importantly for their impact on the model that follows, institutions as I define them are
an important component of what I think of as the production technology of financial services
delivery. This technology has to be adapted to the economic structure that surrounds it and
other institutions (e.g. political, social etc.). The technology has two components, namely (i)
an element shared with the rest of the financial community through standards and (ii) an
element in the form of conventions that corresponds to behaviour by financial institutions and
can be changed unilaterally by them.

Standards are essentially a form of public good of use specifically to the financial sector.
They benefit from the traditional feature of network externalities namely that the marginal
value of using them increases with the number of users, adjusted for their market share in
terms of value of business in the sector. They may be provided by private or public
enterprises. They are things like accounting standards, funds transfer infrastructure, credit
rating systems or shared databases on credit exposure, defaults and assets of clients. They
require coordination among users to be altered; there is no point in one firm setting up a new
standard by itself unless it hopes to gain other adherents to it by force of undeniable cost or
quality advantages. However nothing requires that a given set of standards are optimal in the
sense of minimising information asymmetries or maximising value to beneficiaries. But it is
assumed that for standards to be at all effective they must be well adapted to local
circumstances. This implies that transplanting foreign standards without appropriate
modification in a new environment will not yield results as efficient as in their home market
and may even yield results that leave the sector worse off than it was with old standards. But
nothing stops existing standards in a given jurisdiction being very inefficient for the economy
as a whole and therefore leaving ample scope for the adoption of foreign standards to create
improvements in terms of financial sector efficiency.

Conventions, in contrast to standards, are the informal internal rules, values or norms of
behaviour that are followed in the sector. Banks, borrowers and other financial institutions are
not obliged legally to follow them. They can change their informal behaviour at will. But like
language, it only serves to alter the conventions that one follows if the persons with whom
one wishes to interact also understand and appreciate them too. Hence as with standards, there

6
are network effects related to conventions. Not surprisingly, there is also a strong
interdependence and correlation between conventions and standards.

Examples of conventions might include financing, pricing or product structures, codes of

conduct, internal management culture; Communication methods and networks, although
much more abstract, are also key elements of conventions. They can play an enormous role in
the expansion of international trade through better market knowledge and connections. One
way in which better communication and networks are now often formed is through the
expansion of business schools and informal alumni networks from top ranking international
firms. Personal contacts and relationships which derive from these forms of integration can be
extremely important mechanisms for gaining access to new markets, especially in services
where personal relationships play a key role. Firms can leverage this mechanism, for example,
to converge on international conventions by investing in more employees with experience and
background in the environment into which they aim to expand their business.

In financial services, conventions also extend to the ability of intermediaries to efficiently

interpret client behaviour and independently assess risks to their businesses. Finance is
ultimately all about taking the right risks at the right price. To asses clients projects one
requires a keen understanding of the environment in which clients operate as well as how to
read signals coming directly from the borrower. Monitoring is a costly activity; one which it
takes time to improve when entering a new market. If the local conventions predominant in a
given market are different from those to which a foreign financial intermediary adheres, trade
by this intermediary with the local market will require an adjustment in terms of conventions
by the lender, the borrower or both. In this sense differences in business practices can create
transaction frictions or informal barriers to trade. They are however barriers which firms can
potentially in the long run reduce by making up-front investments in training, equipment,
staff.

The combination of standards and conventions contributes to locally adapted production

technology. The same technology does not necessarily produce efficient results in all
markets. Actors (both borrowers and financial services providers) have scope for innovating
and adapting their conventions and, through coordinated efforts, can even have an impact on
market standards. In Europe for instance, payment cards are gradually moving towards a
common standard using integrated chips4 , but this has required sector wide coordinationto
changes standards. In less developed markets, for instance South Africa, technology has used
to adapt Automated Teller Machines to serve illiterate low value clients5 and thereby make
services to them less costly and more effective. The forthcoming analysis starts from this
conception of institutions while considering the impact of changes to the level of institutional
convergence and the circumstances that may initiate a shift towards new equilibria.

2.2 DUALISM

Although many defining characteristics of an economy are to a large extent congruent with
political boundaries, in a world of declining tariff barriers, increasing trade and gradual

4
French standard smart cards with integrated PIN number verification are being slowly introduced in the UK
market.
5
E-Plan has developed inter-active ATM screens using symbols that can be more easily understood by users
with low levels of literacy

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convergence on orthodox macroeconomic policy6, the relevance to development policy of
other parameters is being raised. In particular within emerging economies the different degree
of formality of economic activity and standards of living that coexist side by side can be
particularly startling. Focusing on less traditional lines of demarcation is warranted even if the
boundaries are fluid rather than the sharp divisions employed in stylised models. A dual
economy structure provides a simplified manner in which to look at economic divisions along
other dimensions, in this case institutional. I distinguish between a modern or transition
economy, which corresponds to the more advanced (in economic terms) or modern part of the
duality, and local informal economies which are to a large extent autonomous and cut-off
from practice in the modern economy. The barriers between them are in reality vague and
fluid, but for analytical purposes a stylised division between the two is particularly helpful.

In the literature, the variety of differences used to define the nature of the duality is probably
as great as the number of studies on dual economies. For the purposes of this study, a dual
economy framework is useful for focusing on the impact of differences in institutions
between the transition and the local economies of a dual economy. The principle differences
are in terms of the financial sector standards and conventions that dominate in each of half of
the duality.

Large minorities or even the majority of people in the underdeveloped local economies of
such countries do not even have a bank account. They are often served instead by informal
providers such as money lenders. Hence it is easy to see that standards and conventions do
differ considerably between the two sectors. Public policy often even explicitly acknowledges
and encourages different standards and conventions for the two sectors. For example, most
dual economies have programmes in place for developing the formal financial sector and
others for promoting the development of micro-finance and rural lending. Governments are
often concerned about how to reconcile the two sectors within their regulatory and
supervisory frameworks. Less obvious may be stylised differences between the two halves of
the dual economy in conceptions about value, access to information, risk assessments, notions
of fair compensation.

Other differences often found in dual economies relate to the degree of commercialisation, the
structure of production functions and levels of efficiency. These all could in principle be
modelled in conjunction with differences in financial sector institutions combined with
different levels of endowments of financial capital. Extensions to this paper and its line of
investigation could certainly benefit from the incorporation of these types of assumptions.

The problems of dual economies persist even though many emerging markets have achieved
important levels of economic growth in the last few years and made strides towards
development of their financial sectors. Problems of inequality and low rates of formal sector
penetration are slow to be resolved and have in some cases appeared to intensify. Often the
economic divide is further aggravated due to its close correlation with ethnic, cultural or
political divisions, as for example in Malaysia and South Africa.

Finally, it is also worth reflecting on use of the concept of duality beyond its usual confines.
In principle there is nothing to stop advanced economies from suffering from a degree of
dualism as well. If we turn our attention towards an evolution of standards and conventions
that corresponds to higher levels of efficiency and wealth, it is possible to invoke situations in
6
By this I mean to refer to Washington consensus policies regarding, for example, fiscal discipline, strong
protection for investors, market transparency and support for competitive market structures.

8
which differences slowly begin to appear within a developed economy, just as they have
appeared in todays emerging markets. One could indeed argue that certain OECD economies
that display higher degrees of inequality also suffer from problems akin to those present in
classic dual economy structures7.

2.3 FINANCIAL SECTOR INTEGRATION

Integration is defined in this paper firstly in terms of a convergence in the institutions -

standards and conventions operating in the financial sector of these economies. This
convergence can imply a movement by one economy towards the other or a simultaneous
shift of both economies standards and conventions. Secondly, integration is conceptualised as
a process of financial portfolio diversification or mounting holding of international assets.

In terms of institutional convergence, what we mostly observe today is a gradual upgrading

of standards and conventions in emerging markets and transition economies towards a best
practice set of those prevalent in more advanced economies8. In the case of foreign bank
expansion into emerging markets or modern sector banks into local economies, one may also
argue that a certain degree of down-scaling also takes place i.e. foreign banks adapt to some
extent to local standards9. In either case, the primary effect of this convergence is to reduce
the differences in financial intermediation technology suited to the different economies. This
translates in the modelling into lower tariff equivalent barriers and hence lower transaction
costs for exporting or importing financial services.

In more concrete terms, we can think of this sort of convergence more easily by referring
back to the section on institutions, standards and conventions. Regulatory harmonisation or
harmonisation of accounting standards would be clear examples of convergence. But as was
also suggested above, informal convergence can also be very significant and can be
stimulated by less obvious means such as the rise of international business schools that help to
create self-sustaining informal networks across different sectors and economies. Banking and
corporate leaders that have studied together and then spread out to work in emerging markets
are likely to bring conventions and outlooks from their studies with them and may advance
them within the enterprises that they run. Their personal connections with other businessmen
in advanced economies will also foster greater business contact with developed markets and
enhance the value of adapting standards common in those countries.

Financial asset diversification as a component of financial sector integration is of relevance

in particular to the second stage of analysis (chapter 6). This is the sense in which much of the
literature on financial globalisation and stability is based. Integration can in this case be
7
OECD countries with relatively high degrees of inequality, such as the US, may find that the poorest segments
of society benefit little or more slowly from growth in the advanced part of the economy. A permanent
underclass may evolve. Alternatively particular may suffer from chronic economic under-development and call
for extended structural funding support as is frequently the case in Europe. In Spain or the UK for instance, some
structural development activity may have brought about long term benefits, but there are also regions in which
social transfers have failed to revive local economies, perhaps due to an high level of internal migration by
qualified workers to more prosperous areas of their own country or Europe as a whole.
8
An example - World Bank and IMF programmes such as FSAP and RoSC actively encourage this trend.
9
Spanish banks have for example established remittance-backed mortgage schemes in Brazil. Standard &
Chartered has developed local practices in India for consumer credit scoring due to the absence of a national
credit bureau; South African banks have been developing the low income market several years, admittedly with
strong government encouragement.

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disassociated from the means by which it arises in other words for this type of integration it
does not matter how international exchange of assets and liabilities has taken place (equity
stake, FDI, goods trade), it just matters what type and value of assets has been exchanged and
with whom. Ideally my analysis should aim to achieve a clear separation between trade in
financial services and international capital flows. Unfortunately these are often difficult to
separate empirically. The second analysis that follows (in chapter 6) considers the impact of
financial sector integration on portfolio diversification and trade together. The key assumption
that I introduce is that both trade and portfolio diversification contribute to changes in
aggregate risk profiles and liquidity. This has the important effect of influencing equilibrium
prices for financial services.

3 BACKGROUND AND JUSTIFICATION

The role that standards and conventions play in financial sector activity has risen in
importance over the last few years for a number of important reasons. As a result of the
emerging market crises of the late 1990s, efforts to improve standards and regulatory
frameworks in financial markets have intensified. One of the more important initiatives has
been the joint RoSC and FSAP programmes which have focused attention directly on
harmonising and improving standards in the financial sector. Foreign bank entry has also
made the differences in financial sector structure and behaviour more apparent to key players
in the international private sector. Efforts to stimulate growth in developing countries have
turned attention to the growth potential in efficient and pro-active financial services providers.
And finally, increasing financial sector trade and international portfolio diversification have
exposed differences in governance and market structures, sometimes generating significant
private sector pressure from developed economies to push through pro-investor reforms in
emerging markets. I provide a brief discussion of each of these issues.

Overall the developments mentioned above have raised the importance of questions for the
public and private sector regarding financial sector institutional development in an
international context: Should we be advocating the adoption of universal standards and best
practice across all sorts of economies? How do we translate universal principles into local
practices? What are best practices in the financial sector? By what criteria are we to measure
their relative merits? What complementary measures must be taken to ensure that institutional
change is successful for all? What instruments are available to the public sector to encourage
institutional change and evolution?

Charles Goodhart10 recently expressed one of the main issues well: in a perfect world, the
framework for regulation and supervision would be uniform across all countries, emerging
and developed;In practice, however, there may need to be a transitional period in emerging
markets during which the effectiveness of international standards may be constrained. The
same is true for standards and conventions beyond the narrow confines of regulation that
make up the rest of the institutional framework for the financial sector. And even this view
may underestimate the complexity of the issue. It implicitly applies a positivist philosophical
methodology to the study of economic phenomena. Economic phenomena arguably call for
use of a different methodological foundation. The idea that there may be one set of optimum
best practices overlooks or oversimplifies the interdependent nature of economic systems.
Even if one believes that Goodharts implied positivist methodology is sound, it is clear that

10
Charles Goodhart (1998)

10
the transitional period to which he refers can be long and may be at risk of derailment by
volatile political forces if large sections of society are dissatisfied by the side effects of
transition.

3.1 STANDARDS AND BEST PRACTICE

For both advanced economies and emerging markets, policy objectives and market forces
have put pressure on countries and financial institutions to change, improve and often
converge on common standards, conventions and practices. In Europe, a conscious effort has
been underway for the last ten years to harmonise institutions that frame the financial sector.
Emerging markets have undertaken efforts to improve the standards and regulations of their
financial sectors and attract more investment. Developing countries have been the focus of
studies sifting through different institutional structures in search of the optimal framework for
stimulating financial sector development. But the details of which standards to improve, to
follow, which regulations to implement and how to do it all remain challenging questions.
Overall there has been an almost surprising degree of consensus concerning not only the need
to strengthen standards but also on the choice of standards and institutions to promote. This
dominant Washington consensus type view is beginning to be altered as the more subtle
elements of standards overcome ideological positions11. And for underdeveloped sections of
the economy the informal sector other standards and modes of operation are widely and
strongly promoted. For those economies that seem to be situated somewhere in between, it is
less clear to which standards one should aspire.

Debate concerning advanced economies

For OECD economies, market forces favouring integration have led to increasing focus on
improvements to and harmonisation among different markets. With greater similarity in terms
of economic structure, much debate has centred on individual rules within conceptual
frameworks to which most members already adhere. Certain discussions may be dominated
by an interest for each country or its enterprises to avoid bearing short term costs of adapting
to new standards. Other debates centre around differences, for instance concerning accounting
rules of corporate governance obligations, that can have a more substantial long term impact.
Often the two are mixed, difficult to separate and their relative importance fundamentally
problematic to measure12.

With regards to changes with insignificant longer term consequence to an overall economy,
the key issue is that individual firms may have to shoulder adjustment costs in the short term.

11
An example concerns transparency. Heralded by authoritative bodies as a key virtue of efficient markets,
transparency can go too far and discourage market participants from conducting financial transactions. Once
investors intents are revealed, the market prices can move enough to discourage the planned transaction. This
effect on price movements can often be more important than liquidity; those participating in the market without
information will favour greater transparency, those with valuable information will seek to retain it; see
publications by Ruben Lee for further discussion on this issue.
12
Discussion of standards is hindered by the difficulty of measurement of the effects of specific changes to
individual rules within an overarching system of supervision and governance. Recent discussions on a European
level in the forum provided by the Committee of European Securities Regulators (CESR) for example have
highlighted both the lack of cost benefit analysis for individual measures and the lack of clarity between best
practices and minimum regulatory standards. This should not be surprising given the complex inter-relationship
between standards and institutions and the economic structure in which they are embedded. Although it is
relatively easy to identify the cost of compliance of individual banks with new rules, it is difficult to assess the
(supposed) benefit of a new rule to the community as a whole.

11
Choice of technology for common settlement and trading systems might be a relevant
example. Although there certainly are differences for example between the set up of Euroclear
and Clearstream, it would seem difficult to persuasively argue that the financial sector would
fundamentally be different according to which one gained dominance. Differences would
exist but may in this instance be essentially short term and focused on certain users.

In contrast, some debates clearly do centre around substantial issues, even if the consequences
of adopting different standards are difficult to identify. Different Accounting standards or
capital requirements may for instance have more substantial consequences. Recent discussion
about valuation of derivatives has raised attention to the problem that certain methods may be
more favourable for managing foreign currency exposure than others. For US companies
operating and filing in US Dollars, these methods would be of less relevance. But for
European companies filing accounts in local currency but operating largely in dollarized
markets, changes to valuation methods for currency hedges may have real consequences.

Another concern in developed economies focuses on the relative benefits of using common
institutions and standards versus the benefits of encouraging on-going competition between
different sets of standards and stimulating innovation13. Finding a balance between
harmonisation and sustaining competition also calls for a way of evaluating the impact of
using different standards on an individual economy and a group of economies.

Finally, standards in emerging markets are also of concern to advanced economy participants
in the financial sector, for instance when it concerns investor protection. Institutional
investors in advanced economies have increasingly raised concerns not only about their
access to invest in emerging markets but also the need for such markets to improve standards
and conventions that protect (minority) shareholder rights and ensure better governance and
disclosure. Certainly some complaints regarding levels of investor protection are warranted.
But it is also possible that some issues raised by investors primarily reflect a preference for
doing business on familiar terms.

Debate concerning emerging markets

In emerging markets, policy focus on improving financial sector standards was strengthened
following the various crises in the late 1990s. These prompted calls for better regulation, more
and higher quality information about markets, companies and risks. The joint IMF World
Bank programmes RoSC and FSAP were expanded to enable peer review to assist in the
identification of weaknesses and the subsequent improvement of standards14. The benchmarks
have become well established some more detailed than others but many emerging market
actors have reminded us that one size does not fit all15. Others have made complementary
criticisms, reminding us that, in terms of information standards, what matters ultimately is not
how or what information is disclosed but how it is interpreted and acted upon16. For a good
general presentation of issues for advanced and emerging markets, see Schneider 2003 and
Litan et al. (2002).

But there is virtually no vocal dissent on the overall principles and objectives to support and
there is in reality very little room for choice in the matter of recognised standards. Most

13
T5 policy paper on financial markets
14
Other programmes, such as the DFID led FIRST, have been launched by bilateral donors to provide funding to
recipient initiated programmes to improve institutions, standards and regulatory bodies in the financial sector
15
T.C.A. Anant: CBC 2002 conference paper International Financial Standards and Codes
16
Griffith-Jones 1999

12
institutional elements of the international financial sector are now represented by a dominant
world-wide recognised industry or regulatory body that issues principles and standards. And
there are few alternatives. To be slightly provocative, one could argue that discussion about
which standards to promote is of little practical relevance market participants will act
together to expand the use of their standards and there is not much that public policy can
efficiently do to alter their course of evolution. Talking about what other standards might
change is in this view purely academic. Of course discussion does go on and differences
between and within groups advocating certain standards do arise. But as this paper shows,
market forces play an important role in the actual course of evolution.

In parallel there has been an enormous increase in interest in institutions for financial services
in the informal, rural or generally under-developed sectors. Here there is little doubt that
developed economy standards cannot function. It is in this area that public policy is most
often heard calling for innovation both in terms of means of delivery and regulation17. So
clearly if the principles for good financial sector development remain universally valid, the
challenge we face is to apply them efficiently to diverse circumstances. Somewhere between
developed and under-developed rural economies, the spectrum of relevant and efficient
standards shifts, but it is unclear how and at what points.

Standards and best practices are a central although somewhat less tangible part of the
production technology of financial services. But as they are man-made and to a certain extent
economy specific, increasing trade and financial integration will continue to fuel debates on
their role, relative merits and ideal forms.

3.2 FOREIGN BANK ENTRY

Expansion of foreign bank into emerging markets has been extensive during the 1990s. This
trend has been strongest in Latin America and central Europe where barriers to entry have
declined and increased stability or prospects for domestic growth have attracted investors. But
there have also been important developments in China, India and south east Asia that have
attracted international banks to acquire local institutions or invest in creating local operations.
This expansion of foreign banks into emerging markets has raised concerns about its impact,
whether it is on balance a good or a bad thing for emerging markets and how to respond to it.

Most studies have concluded that on balance, the effects for emerging markets are positive,
especially due to pro-competitive effects. But concerns have also been expressed that foreign
bank domination may lead to greater volatility during an interim period and the net effect on
lending to small and medium size enterprises (SMEs) is ambiguous18.

The entry of international banks into emerging markets is also often expected to help
stimulate the adoption of international best practice, expand know-how and competence in the
market place and put pressure on public sector authorities to increase their skills. This is
clearly a manner in which institutional convergence can occur both in terms of formal and
informal standards and conventions. But greater policy attention and investigation into the

17
Innovation in this context applies not only to a wide area of micro-finance initiatives but also with greater
relevance to this paper in the area of trade finance. Initiatives by the UNCTADs ITC and organisations such
as the PTA bank have helped to encourage commercialisation and transform future trade receipts into funding.
18
Good general reviews are provided by Claessens et al. 1998 and 2003, Clarke et al (2001) and the Bank for
International Settlements (March 2004).

13
mechanisms of change and the indirect effects on institutions and borrowers in the
underdeveloped elements of a dual economy is warranted.

3.3 FINANCIAL SECTOR DEVELOPMENT

For those concerned with stimulating growth in less developed countries, the role that
standards and conventions play in the overall institutional framework for financial services
has also gained attention. Getting the institutional framework right has been a high profile
point on the development agenda for a number of years. Studies focused on the financial
sector have focused on investigating whether the financial sector can in the sense of
Schumpeter, play a key pro-active role in economic growth. Consequently, interest has
focused on identifying the impact that different institutional structures have on financial
sector development. In its broadest sense, this includes the role of standards and conventions.

Several studies by Levine and King have looked at the role of legal systems, levels of investor
protection, market versus bank led systems and other qualitative criteria. Although none of
these studies are capable of establishing conclusive causal relationships, they have raised
significant interest in the debate and spawned other studies19 that investigate the context
specific efficiency of different institutional arrangements. The tension between universal and
context specific policy recommendations is well exposed here.

Practical policy initiatives have ventured into different sorts of ratings of compliance20 with
best practice standards or levels of openness. There have also been empirical surveys of the
role that information and standards in different markets play in the decision making processes
of institutional investors21. It is probably too early to see what role the creation of new ratings
of this kind will play in the long term behaviour of investors. But greater clarity on
differences in standards is certainly the first step towards identifying their impact in general
and in combination with different structural characteristics.

3.4 BACKGROUND TO METHOD AND APPROACH

Beyond the policy background introduced above, this section introduces two specific essays
of relevance to the method employed in this paper and which have provided important
inspiration. I then briefly discuss other more general areas of economic method which have
been helpful in developing the approach of this paper.

Information, the Dual Economy, and Development (Banerjee and Newman)

Banerjee and Newman analyse the impact of different levels of information asymmetries
between the two portions of a dualist economy on the cost of consumer lending and decisions
by individuals in the informal economy to stay or migrate to the modern economy. The

19
Other studies on institutions include: Ergungor (2003), Bae and Goyal (2003) and La Porta, Lopez-de-Silanes
and Shleifer (2003)
20
The E Standards Forum provides a consolidated source of news on changes to financial sector regulation and
compliance across the world. They also regularly publish a ranking of countries level of compliance with
benchmark standards.
21
Gottschalk 2003

14
dualism is defined primarily in terms of institutions. Nothing in their model excludes the
possibility of the traditional and modern sectors sharing the same geographical space. The
concept of migration also refers to a decision to conform to a different structure and set of
rules in the other sector i.e. to assimilate.

Productivity in the modern sector is assumed to be higher than in the informal sector but high
information asymmetries make consumer lending more costly; default rates are higher due to
the relative ease of evasion; lending may be curtailed as a consequence. Individuals have to
make a trade-off between superior access to credit in the traditional sector and higher
expected income in the modern sector. For wealthier individuals that have no borrowing
requirement - or those that are highly qualified - there is a clear incentive to move to the
modern sector. For the very poor who are unable to borrow in either sector, the stronger
incentive may also be to move to the modern sector because their expected earnings in the
modern economy are higher, even if there is a significant probability that they will not find a
job in it. But for those in between that need to and can borrow in the traditional sector,
maximisation of consumption may favour that they remain in the informal economy. This is
because they can benefit from lower interest rates in the informal economy due to lower
information asymmetries between themselves and lenders. By contrast, in the modern
economy, information asymmetries and a higher chance of being able to default (and
successfully evade creditors) would raise the cost to such borrowers.

Banerjee and Newman find that decreasing interest rates in the modern sector encourages
migration to the modern sector as the cost of defaults decline. Greater growth in the modern
sector also encourages more migration.

There are three important differences between their model and the analysis that I present in
this paper. Firstly, they employ a two zone model, whereas this paper focuses on interaction
between three economies. Secondly, whereas they assume that all borrowing is by households
for consumption, I model all lending as being to firms that produce final goods. Lastly,
information asymmetries in the modern economy between borrowers and lenders are static,
whereas I would assume that progress over time can be made in reducing these asymmetries,
for instance through the introduction of credit bureaus. Hence, in the medium to long term the
overall efficiency of financial intermediaries may increase because they find ways of
cooperating and exchanging information with other lenders and they learn to more effectively
match characteristics of clients (social status, job profile) with risk of default and levels of
long term purchasing power.

Globalization, Dual Economy, and Economic Development (Sachs, Yang and Zhang)

Sachs, Yang and Zhang investigate the importance of transaction efficiency within dual
economies and the evolution of trade relations between them. Although there are numerous
important differences between their study and this paper, They share an interest in the
interaction between informal transaction barriers in a dualistic economy and the role they play
in the dynamics of trade relations with the rest of the world22. Sachs et al. also highlight the

22
In their model they also consider the conditions under which an economy will choose not to trade at all i.e.
to remain in autarchy. This is an important question, but one which I regrettably do not investigate in this paper.
The choice not to trade in their model is influenced by not only transaction inefficiency and productivity
differences but also the distribution of preferences. The latter may play a very important role at low absolute

15
significance of non-tariff type barriers as barriers to exploiting greater division of labour
specialisation and productivity.

Their model depends on assumptions about relative productivity in two dualistic economies
and the distribution of preferences of consumer producers. As transaction efficiency increases
they show that dualistic structures disappear, migrating through different constellations
dependent on the level of exogenous productivity advantages in each product and region.
Dualism first disappears in the developed economy and then in the transition economy. The
latter gains from trade though even during an interim phase in which a dual structure
contributes to a deterioration in their terms of trade with the more advanced economy.

For the purposes of my analysis, their paper remains most relevant in terms of their approach.
Explicit recognition that countries do not always present uniform characteristics internally is
critical for the analysis of countries in transition. Once the unit of analysis is situated below
the level of formal political boundaries, investigation is opened up to the interactions between
economic units that may hitherto have been overlooked in terms of their significance not only
to the development process but also the dynamics that they reveal with regard to institutional
transformation.

TRADE: DYNAMICS AND BARRIERS

From a methodological point of view, the paper draws on analytical frameworks from the
literature on trade and development in a dual economy framework. It applies a partial
equilibrium trade analysis to changes in non-tariff institutional barriers between regions
which do not necessarily correlate with traditional political boundaries. General trade
equilibrium dynamics are also employed, particularly as frameworks to analyse the effects of
other trade barriers and immobile factors of production. In particular I employ the Heckscher-
Ohlin model of trade analysis and certain results notably the theorems of Stolper-Samuelson
and Rybczinski from trade analysis within this framework.

Beyond the papers mentioned above by Sachs and Banerjee23 a paper from 1999 by Kono and
Schuknecht has been particularly helpful in clearly outlining the different modes of trade one
can envision for financial sector trade and the concrete forms they take. In the following
sections, it will become clear to the reader that I place significant importance on the different
impact that modes of trade can have on the evolution of standards and conventions. Other
more general works on trade and formal trade barriers that have been particularly helpful in
refining the analysis presented in this paper include Messerlin (1998), Feenstra (2004) de
Melo (1997) and Vousden (1990).

FINANCIAL INTERMEDIATION
A final area of literature of relevance concerns financial intermediation and the impact of
international integration and portfolio diversification. One of the most relevant observations
in this area for this paper is the Feldstein-Horioka puzzle, namely that in spite of the
theoretical benefits to be gained from international portfolio diversification, most investments
are concentrated heavily in peoples home markets. Capital mobility is far smaller than what

levels of wealth, weakening demand for a variety of goods from the modern sector which are very income
elastic.
23
Sachs, Yang and Zhang (2000) ; Banerjee and Newman (1998)

16
theory would have us expect. It is in searching for alternative explanations for this puzzle
that, I argue, informal barriers such as differences in standards and conventions are of
importance. Certain studies support this conclusion. In a recent publication, Claudia Buch,
looks at the various measures of financial integration and the relative roles of regulation and
information costs as factors in hindering integration. She also finds distance potentially as a
proxy for similarity of conventions and standards - has a significant impact on financial
integration24

Nevertheless, financial sector integration is progressing, leading to greater crossholdings of

assets. An important literature has developed focusing on the potential impact of the so-called
internationalisation of financial markets. For the analysis in this paper, I have drawn on the
approach illustrated by Allen and Gale and further developed by Buch, Kleinert and Zajc,
who apply the model of the former to the case of central European financial markets and their
integration into the EU. Allen and Gale emphasise in their analysis that during the process of
integration stability may first decrease as the economy is exposed to new risks and then
increase as the structure of crossholding becomes more complete and symmetric, hence risks
are shared in a larger market. The publication by Buch et al considers the aggregate risk
profile of economies of different sizes in the process of integration (central and western
Europe) and the impact that liquidity shocks in the larger or smaller economies can have on
the others. By definition, with economies of different sizes the impact of liquidity crises are
asymmetric. Crises in small economies that are integrated with a larger economy can be more
easily managed than the reverse. Larger economies on the other hand have little to gain in
terms of stability from integration with smaller economies. It is their treatment of the
externalities of portfolio diversification that have contributed to the manner in which I analyse
externalities from financial sector trade in section 6. I apply concepts from their models to the
impact on liquidity and aggregate market risk of financial services trade between different
sized economies.

24
Geographical distance can also be interpreted in terms of its impact on the exchange of information and the
level of shared institutions; Observation of trade integration between Canada, Australia and the UK would
strongly suggest that cultural ties can go a long way towards overcoming geographical distance.

17
4 BASIC MODEL OUTLINE

4.1 THE MODEL STRUCTURE

I work with a short term model composed of three distinct economies, each with its own
production structure, endowments and a given set of local standards and conventions
according to which the financial sector operates. They form a simple framework which I
extend to investigate the interaction between informal trade barriers in the form of different
institutions- , trade patterns and the cost of financial services. I give these three economies
labels as defined below.

Economy 1, the local economy: a series of (i = 1 to n) identical local, predominantly informal

economies within a dualistic structure. Often the term traditional economies is used, but this
tends to imply a preserved indigenous way of doing business. This represents a form of
idealism which is unfounded. More important, as Sachs et al. emphasise, is the difference
between commercialised and non-commercialised sectors. Alternatively one can also think in
terms of local economies as those in which modern business structures25 are less prevalent.

Economy 2: the transition economy, the more modern and formal half of a dual economy; I
use the terms transition economy and modern sector interchangeably. In line with the
dichotomy defined by Sachs, this can also be thought of in terms of the commercialised sector
of an emerging market economy.

Economy 3: rest of the world RoW the modern global economy, which I also refer to as the
international economy or sector, or more specifically I sometimes refer to the international
financial market.

The local economies and the transition economy coexist in a common political space, i.e. as
two halves of a dual economy. However, I do not mean to imply as the term dual economy
may suggest - that there are necessarily any a priori restrictions on the nature of the
production function in the local economies or type(s) of goods that they can produce. Of
course for modelling purposes I make some such assumptions namely identical technology
but they should not be taken as key. Instead, the crucial assumptions which motivate this
framework concern the (1) role of standards and conventions as part of the institutional
environment and crucially as trade barriers (2) permitted trade access who can trade with
whom; (3) the relative endowments of the two factors of production: labour (L) and financial
capital (K). The dual framework also benefits from a simplification, namely that both halves
share in principle the same currency and political risks. This allows us to focus more easily on
the institutional issues of concern, linking analysis to empirical evidence with less need to
account for these factors.

The Rest of the World represents the international economy and in particular the international
financial markets. I make no unusual assumptions about it; But of course it is larger than the
other two economies in all important respects endowments, population, production capacity.
25
A definition of this term could animate an extensive discussion in itself. I think of this expression in terms of
the structures we consistently find in companies that enable them to divide labour, specialise and create services
that are integrated in a complex impersonal network of suppliers, distributors and market institutions.

18
Institutional differences:
Standards and conventions in each economy differ and have a direct impact on the production
technology for financial services. I assume that these differences exist without explicitly
being concerned with their origins. For the given circumstances of each economy there is a set
of standards and conventions that can be considered as near optimal. To achieve an increase
in the overall efficiency of the financial sector, economic structure as well as standards and
conventions must be modified. The important principle is that efficiency increases cannot be
achievable simply through changes in institutions they must also be adapted to the economic
structure. New or foreign institutions, however effective they may be at home always require
some adjustment in order to become operational in a new legal, political and economic
environment. However I do not want to imply that a countrys existing institutions are by
definition optimal for their situation this would imply that all institutional structures are
always by definition optimal. But room for improvement must logically always exist, even if
we are at a loss to see how. Hence in the model I think in terms of near optimal institutions
which leave room for improvement but are not automatically less efficient than those from
more advanced economies with which financial sector trade is conducted.

Trade access
To simplify the initial analysis26, I restrict the possible trade patterns between the three
economies. Firstly I exclude the possibility of direct trade between the local economies and
RoW; the local economies and RoW trade with the transition economy but not with each
other; I also assume no trade takes place between the local economies this could be
formalised if necessary by introducing prohibitive transport costs for example. Of course in
certain important respects, empirical evidence would show that this restriction is unjustified,
namely that many projects in developing countries have succeeded in developing distribution
structures for select agricultural products or handicrafts, linking less formal enterprises
directly with developed export markets. Whether this implies in itself a migration to the
transition economy by either buyers or sellers or whether the intermediaries that facilitate this
trade should be considered part of the transition economy is open for debate.

Relative endowments:
By imposing assumptions about relative endowments of the two primary factors of production
and imposing a model of type Heckscher-Ohlin, I predetermine relative prices and certain
trade patterns. Each economy starts out with very different ratios of the two factors of
production, labour (L) and capital (K). Relative endowments of labour and capital in each
zone are such that:
K1i/L1i< K2/L2< K3/L3

where subscripts indicate the economy to which they apply.

This implies, with competitive factor markets, that the prices of labour (w) and financial
services (r) are such that
w1i/r1i<w2/r2<w3/r3=w*/r*

26
This simplification would also seem justified in terms of what is observed. Although individual cases of trade
between the informal economies in developing countries and advanced economies takes place such as through
fair trade or micro-finance funds, these are exceptions. By definition almost, informal economies do not trade
much at all, and even less so directly with advanced economies.

19
where again, the subscripts indicate the economy to which the price applies, and * indicates
the prevailing world price.

In absolute terms it is also worth noting that K1i< K2<K3 , and L3> L2, L1i, but that the
relationship between L1i and L2 is not specified. This means that the local economies can in
aggregate provide a very elastic supply of labour to the transition economy and that there is
scope for the issues of concern to the local economies to be of great importance in the country
as a whole. This is coherent with reality in a number of emerging market countries such as
South Africa, Brazil, India.

Cost minimisation under perfect competition in each economy would imply that
wj/rj = dak1/daL1 = daK2/daL2

Relative factor prices are equated to the technical rate of substitution. Preferences are normal
and so relative prices are also equated to the marginal rate of substitution between the two
goods a labour intensive good X1 and a more financial services intensive good X2 - if
perfect markets operate.

Trade of primary interest is in financial services, but as this represents a factor of production,
the analysis is also concerned with the relationship between finance and tradable goods for
consumption. Financial services are for simplicity sake in the model represented by K
(capital) and its cost being the return to it (r). Trade in this service can in principle take place
through each of the four standard modes27. In the first section I concentrate mostly on mode 3
trade. In the second section, in which I extend the model, I consider trade in modes 1, 2 and 3.

Mode 3 corresponds to foreign banks establishing a presence in another country through

green field investment or acquisition of an existing bank. For the sake of simplicity, all capital
disbursed is assumed to be of foreign origin, where the costs of funds is lower due to
endowments. But this is a minor assumption in the short run because it is precisely a decline
in institutional barriers which will enable foreign financial institutions to be more effective at
raising funds locally.

Given the immaterial nature of most financial services, mode 1 and mode 2 trade could in
principle be grouped together. What really matters is the terms on which business is done
rather than the question of who goes to see whom (if indeed anyone does). In both cases a
common interface in terms of standards and conventions is required; In terms of the model
using institutional barriers, I consider mode 2 implies a borrower upgrading standards,
governance, to comply with those set by a foreign lender; Mode 1 would imply the reverse
that a foreign lender accommodates local conditions in the country to which it is exporting /
lending to a borrower in a less developed jurisdiction. Although regulatory constraints may
place some limits on adjustment, other means of accommodating client demands or even
circumventing regulations are often possible. However, I specify this structure in order to
associate modes 1 and 2 with cases of particular interest to the analysis. Hence:

Mode2: implies that an enterprise seeking funding migrates or complies with foreign
standards and conventions in order to benefit from lower costs of financial services in that
jurisdiction.

27
Modes of trade to which I refer are those defined consistent with WTO terminology

20
Mode 1: implies that a foreign bank offers financial services abroad under its own terms and
conditions to local banks and other financial institutions, but not local enterprises; Hence it is
local banks that adjust to foreign institutions. If lending to local enterprises is to be conducted
by foreign banks, I assume that the financial institutions concerned prefer to engage in mode 3
trade.28 Mode 1 is therefore most important when considering the role of local intermediaries
that exercise a degree of market power29, especially with regard to access to imports of
financial services.

Potential trade patterns of relevance are outlined below

dual economy
goods
local fin. mode1&2
Rest
fin. mode3 transition
fin. mode1&2 of
economy
World
fin. mode3
economies goods

figure 1: model trade configurations

To create a benchmark, I begin with all three economies operating in a basic Heckscher-Ohlin
type framework, using the production functions of type Cobb-Douglas for two goods (X1 and
X2), both of which I consider to be tradable. As there are only two goods but three countries
- I assume that they are only imperfect substitutes for each other. Perfect competition implies
that all firms in each economy can be considered identical this is an important simplification
which I later relax.

I also suppose that X1 is always more labour intensive than X2 and hence, barring perfect
factor mobility or fundamental changes to endowments, the local economies export X1 and
import X2; the transition economy exports their version of X1 to the RoW and X2 to the local
economies, importing the foreign version of X2 from RoW.

4.2 IMPORTANT SIMPLIFICATIONS

28
A profit maximising financial institution is assumed to prefer to cut out intermediaries from their business
model if they themselves can perform this task as or more efficiently; an exception to this could be made if we
take into account the short term and uncertainty related benefits of being able to trade fixed costs for variable.
29
I refer to market power strictly in the sense of a imperfect competition and the ability for an enterprise to set
prices above marginal cost.

21
Absence of foreign exchange and political risk premiums
Given the analysis focuses largely on the determinants of the price of financial services,
notably the interest rate, it is worth commenting on the absence of any discussion of
premiums for foreign exchange or country risk. These risk types would normally play a
prominent role in pricing of international financial services. As I wish to concentrate analysis
primarily on the role of standards and conventions, I have consciously chosen a dual economy
structure in which these two features are in principle of little formal relevance: a dual
economy is defined as a single political entity (hence political risk is the same for both halves)
and generally operates a single currency (hence the issue of exchange rates is irrelevant).
Regarding interaction between the transition economy and the RoW, I simplify them away as
constant30.

Single period model

Another important simplification is the absence of time. Realistically speaking, to analyse the
dynamics of trade in financial claims we should consider not only geographical but also inter-
temporal trade using a multi period model in which trade in financial services in one period,
accumulating assets, is compensated by trade flows or dividends in later periods, as would be
the case for example in a repayments schedule. However, to begin with, I work only on the
basis of a one period static model. I believe this does not have a qualitative impact on the
analysis. Restructuring the model using only present values through the consistent
application of a discount factor to all flows would show this to be the case.

Distinguishing between financial services trade and capital flows

In principle it is important to distinguish between capital flows and trade in financial services.
Trade in services is most obvious in mode 3, in which it can be seen as a foreign production
process installed for local raising of capital and lending of funds. Mode 1 trade might in
contrast appear first and foremost to be an example of foreign capital flow. Although both
necessarily involve an element of services export, there are no binding implications about the
source of funds and hence the extent to which they require an international flow of capital, if
any. In the following analysis I do not make any formal assumptions to deal with this
problem. Source of funds is relevant in this study only in so far as relative endowments in
each economy establish an equilibrium price for financial services. Hence exporters implicitly
export capital whenever they export services if they are to benefit from their entire
production cost advantages.

The price of these financial services is equated to the return to capital. As a benchmark it is
the relative cost of capital with respect to labour (w/r) that is important and which determines
the patterns of trade. But I also relax this assumption when discussing the potential role of
differences in market structure and trade barriers. In the second section I introduce operational
costs per financial institution that account for the cost of production of financial services and
allow for profits.

Finally, I interpret the demand (supply of) for capital as the demand (supply) for borrowing
(lending) and equate this with a demand (supply of) for financial services. Of course this is an
over-simplification as well, which needs to be explored further. Differences between various
types of lending products project finance, factoring, equity, debt, etc. are overlooked and
services such as credit rating, transaction services or asset management are all simplified
away. But with a focus on the effects of the least developed economies in the model, the

30
Unfortunately, this is would not be justified by reference to empirical evidence.

22
diversity of financial services that we can consider is likely in reality to be fairly restricted.
Also, more sophisticated product differentiation is a key feature of informal transaction
barriers.

4.3 THE BARRIERS TO TRADE

Institutional barriers applied to financial services trade

Institutional differences act like a tariff on imports of financial services putting a wedge
between the price prevailing in the trading partner economy and the local price determined by
relative endowments. A free trade scenario would imply that all trading partners use
identical standards and conventions and hence and transaction costs tend to zero. By contrast,
once we assume that different standards and conventions are used, transaction costs for
trading in financial services with another economy become non-zero simply because extra
effort must be made to adapt to foreign practices. These tariff like barriers are denoted by the
coefficient ; where subscripts are given, they are indicated as either 12 referring to the tariff
equivalent on trade between the local and the transition economies; or 23 indicating the tariff
equivalent applicable to trade between RoW and the transition economy. The coefficient not
only raises the relative price r/w above what it would be without barriers to trade of any kind,
but also limits the extent to which financial services providers are likely to import capital. The
factor is directly related to the differences in standards and conventions discussed above
that lead foreign providers to be less efficient abroad than at home and hence when exporting
their services are unable to supply them at quite the same price that prevails in their domestic
market.

Changes in will have two key effects. Firstly a change in will move the production
frontier up and down along the axis of goods X2 (financial services intensive) in accordance
with the amount of financial services that are imported and hence change the quantity K in the
economy. If decreases for example, more trade in financial services will take place. This
trade will engender an increase in capital circulating in the economy because trade in the
service entails, by assumption, a corresponding influx of capital.

Secondly, a change in will modify the ratio w/r to w/r(1+) and shift the optimal production
choice (X1, X2). If increases, the cost of financial services will, relative to perfect free trade,
increase and production will shift in favour of X1.

X2

K 23
 Figure 2: classic gains from trade barrier reductions

Transaction inefficiency applied to trade in the goods sector

A transaction inefficiency (tg)applied to exports of goods operates similarly to an export tax
(from now on referred to as such) and is equivalent to an import tariff on the other good in the
model31. It reduces the purchasing power of exports in terms of imports. We can think of this
export tax structure as a cost which local producers may incur in searching for distributors
and purchasers abroad, conforming with foreign regulations or simply as loss of income to
distributors exercising market power. It is also possible to think of these barriers in terms of
transport costs. In general the concept corresponds to that used by Sachs et al. in their paper
regarding the role of transaction efficiency in a dual economy.

A change in export tax tg applied to X1 will have the usual tariff effects but applied inversely
to the good X2 in our model. An increase in this tax will diminish gains from trade in X1 as
the difference between local and the foreign market price declines. Relative prices faced by
producers will encourage a shift of production towards X2 and the relative price ratio faced by
consumers will change such that their real purchasing power declines

31
From Lerners theorem of symmetry

24
5 ANALYSIS I: EXOGENOUS CHANGES TO INTEGRATION, TRADE
BARRIERS

In the first analysis I consider changes in institutions to be exogenous. The cost of financial
services is initially determined by equilibrium in each market relative to the local wage rate.
In the context of international trade, transaction inefficiencies on trade in financial services
and goods are modelled as tariff equivalents (,tg). As a first step, I wish simply to illustrate
the effect of changes in ,tg on production, consumption and relative prices. Institutional
barriers in this section are considered to be symmetrical with respect to modes of trade; hence
I do not explicitly differentiate between modes 2 and 3. (For the analysis in chapter 6, this
will change)

5.1 TRADE BETWEEN THE LOCAL AND THE TRANSITION ECONOMIES

By construction due to size trade at this stage in the analysis has an impact on prices and
resource allocation in the local economies but not on the transition economy. It is a classic
case of a small and a big economy, in which additional demand and supply from trade with
the small economy has no effect on the marginal prices in the big economy. Declining
transaction barriers in financial services between the two stylised economies within the
duality have two direct effects and numerous indirect consequences. Firstly, the equilibrium
price of financial services in the local economies (r3) declines. Secondly, with an expansion of
financial sector trade, I assume total capital (K) in the local economies increases. With a
decrease in r, relative wages (w/r) increase. An expansion of K stimulates an increase in
overall economic activity.

Numerous indirect effects can be identified. Many are coherent with the analysis presented by
Jones and Dei (1983), to which one may refer for further discussion. I briefly consider some
of the more important ones. Following a decrease in r, consistent with the Stolper-Samuelson
theorem, for constant levels of profits and given competitive factor markets, the relative price
of X1 and X2 changes such that P2, the price of the more capital intensive product, declines.
production shifts in favour greater production of X2. And by extrapolation from the
Rybczinski theorem, an increase in capital will also favour an expansion of production in X2
and a decrease in the production level of X1. Economic activity overall will increase in the
local economies. But as they have an inherent disadvantage in the production of capital
intensive goods, they will not to start export X2; Instead, the substitution effect means that
imports of this good are likely to decline unless the income effect from increases in K
outweigh it. The corresponding rise in the relative price of X1 in the local economy simply
decreases the gains from trade that accrue to the local economies because their cost advantage
compared to producers in the transition economy diminishes.

Upward pressure on wages in the local economies may be counterbalanced by the existence of
high levels of underemployment or disguised unemployment. So any upward pressure may be
negated by increased supply of labour, leaving real wages relatively stable. Of course if
increased financial services trade and capital bring with them important increases in
productivity, some increases in real wages may be possible. So although the welfare effects
for the local economies are positive and generally important, net changes in welfare may
depend on the level of upward pressure on wages.

25
Increased economic activity will also allow an expansion in trade with the transition
economy. Depending on preferences, more of X1 will be exported in exchange for X2.
Transaction inefficiencies tg will however limit the gains from this expansion of output and
trade. A decline in tg will shift relative prices between X1 and X2 such that production shifts
towards X1.

5.2 TRADE BETWEEN THE TRANSITION ECONOMY AND THE REST OF THE WORLD

The dynamics of trade between the transition economy and RoW are in essence the same as
those applied to the case of trade between the transition economy at its local economies.
Declining barriers in have a positive effect on the transition economy in terms of the cost of
financial services and this leads again to an expansion of K in the country, an expansion of the
production possibility frontier and a shift towards greater production of X2, the product more
intensive in the use of financial services.

The main differences, abstracting from the formal analysis, between this case and that within
the duality derive from the nature of their respective labour markets and the assumption that
productivity in the transition economy is likely to be higher than in the local economies. Dual
economies, particularly the informal sectors within them, are notorious in the literature for
having high levels of unemployment. Some of this work force may migrate to the modern
sector if economic activity there expands. As for productivity, I assume that the modern sector
is qualitatively much closer to that in the RoW than productivity levels in the local
economies.

The effect of transaction inefficiencies applied to trade in goods also mirrors the relationship
within the dual economy. As in the case of tariff barriers (tg), a reduction in these informal
barriers will alter the relative price between these two goods, stimulating a shift of resources
towards greater production of X1 (on which the equivalent export tax is levied). Prices in
RoW are considered to be exogenous and hence all gains in transaction efficiency go to the
transition economy.

5.3 INDIRECT EFFECTS ON THE LOCAL ECONOMIES OF DIMINISHING BARRIERS

BETWEEN THE TRANSITION ECONOMY AND THE REST OF THE WORLD

Now I consider the impact on the local economies in the duality of greater institutional
integration between the transition economy and the rest of the world. Although integration in
terms of our transaction efficiency coefficients only requires net convergence in a two
economy model, with three economies it is necessary to indicate which economys
institutions have shifted in which direction. Coherent with what is generally observed, I
assume that all convergence between the transition economy and RoW is undertaken by the
transition economy in the direction of the standards and conventions of the international
financial sector (RoW). At this initial stage of analysis I assume that institutions in the local
economies do not change.

There are several consequences of this scenario that are worth noting:

26
Firstly, a decrease in the coefficient 23 implies an increase in 12. Although it is certainly
possible that changes to standards and conventions in the two halves of the dual economy
evolve at the same rate in terms of their impact on the cost of financial services trade, there is
no evidence, either empirical or theoretical, to suggest that this would have to be the case. In
principle this means that the cost of financial services in the local economies would, in the
absence of other factors, rise and overall capital (K) circulating in the local economies may
even decline.

Lower costs of capital in the transition economy imply upward pressure on real wages in that
economy. An increase in capital may also (although I have not explicitly modelled this)
expand the overall production potential of the economy by rendering more efficient
technology more affordable. Both of these effects will draw further labour in from the local
economies, helping to dampen any increase in real wages in the transition economy. Further
migration from the local economies may produce an increase in remittances back to the local
economies32.

There will also be pressure on relative prices in the transition economy that favours greater
production of goods intensive in capital. The relative prices in the transition economy will, as
noted above, shift such that labour intensive goods become more expensive relative to capital
intensive goods, although this is unlikely to go as far as becoming a real case of Dutch
Disease33. The increase in the price of labour intensive goods in the transition economy will
attract greater exports from the local economies as they have a cost advantage in this sector.
This in turn will tend to decrease demand for capital in that economy,. So although the
interest rate may fall. But if demand from the transition economy is strong and remittances
help raise local consumption, total activity in the production of X1 may nevertheless augment
demand for capital. The net change to the total value of the local financial services is unclear.
Yet with constant demand, the dominant force would be downward pressure on prices in the
financial sector. This is coherent with what we would expect applying the Stolper Samuelson
theorem to a rise in the price of X1:
w>p1>p2>r

Of course it is possible that in a less than perfectly competitive economy, as is likely to be the
case, not all of the increase in wages is captured by labour. It is conceivable that market
structures are such that some of this rise is captured by landowners or other capital owners.
This will not however imply that the rate of return to financial services and capital in the local
economies will attract more attention.

Although in principal the overall effect of a decrease in 23 on the local economies remains
ambiguous, it seems likely that the net effect on financial services lending to the local
economies will be negative. It should be noted however that, as in the model by Banerjee and
Newman, this may in fact be the optimal outcome in terms of maximising welfare in the dual
economy as a whole. Two effects dominate. Firstly, there should be a reduction in financial
services trade, partly due to higher relative informal barriers and partly due to a shift in the

32
Remittances have recently become a more important subject of research. As a proportion of total GDP of
certain countries and in absolute terms, remittances can be very important. Links between this trade analysis and
remittance flows would also be an interesting avenue for further empirical research.
33
For Dutch Disease to occur, the level of capital flowing into the country would have to be unusually high;
upward pressure on the price of local labour would gradually discourage inflows of finance as investment
opportunities become less profitable.

27
local economies towards less capital intensive products. As far as financial capital and
services are required to achieve higher productivity in the local economies, these forces will
tend to reduce the overall output of the economy. Secondly however, growth in the transition
economy will as the local economies sole trading partner have a positive effect on output
through an increase in demand for labour intensive exports from the local economies. There
will also be a tendency to draw in further migrant labour directly to the transition economy.
And this may increase the flow of remittances. Although output in the local economies may
be reduced, this may assuming higher productivity in the transition economy - be the best
outcome for welfare if measured for the duality together as one entity.

Importantly for innovation in financial services, this implies that public sector policies aimed
at increasing the seemingly low level of financial services and credit available in local
economies may stand a greater risk of flooding local markets when in the absence of other
reforms the transition economy is achieving greater integration with the world economy.
Yet it is precisely in such countries that the income gap inside the country becomes more
extreme 34and often stimulates political pressure to increase funding to disadvantaged and
rural populations. Using public policy to expand lending in local economies may be desirable
to alleviate poverty, even if funds could earn a higher financial return in a more efficient
modern sector.

Although, as mentioned, greater integration with the RoW may be a welfare maximizing
outcome, in the absence of appropriate redistribution policies, it may not be a Pareto optimum
in the sense that the situation of all individuals across the dual economy unambiguously
improves. Political measures may be desired or explicitly called for to help compensate for
adverse effects during the transition phase (which can be very long)35.

Changes in transaction barriers to goods trade between the transition economy and the rest of
the world will also have an indirect effect on the local economies. Even in a very simplified
model with only two products, much depends on the income elasticity of demand in the
transition economy for imports from RoW relative to those exported by the local economies.
Intuitively it would seem that beyond the simple model with two products - the demand for
products from developed countries will rise with income somewhat faster than the demand for
basic commodities or goods from the local economies36. On balance again, we may expect
that greater integration between the transition economy and the rest of the world in terms of
trade in goods will be to the detriment of the local economies.

Crucially this brings us to the importance of balanced policies to promote integration between
the local economies and the transition economy, or indeed the RoW. Consistent with results
found by Sachs et al. with regard to the importance for dual economies in a transition stage, it
is important in the long run to improve internal transaction efficiency if emerging markets are
to gain the most from expanding growth and trade.

34
This situation also conforms with the predicted phenomena of Kuznets in which inequality first increases
during growth and then later decreases as emerging markets catch up with developed markets.
35
This sort of political situation recalls the recent election results in India where it is claimed that rural voters
moved against the incumbent party because they have not benefited from the recent period of growth.
36
Need to seek references to back up this proposition

28
6 ANALYSIS II: ENDOGENOUS CHOICE OF STANDARDS AND
CONVENTIONS

6.1 ADDITIONS AND AMENDMENTS TO THE MODELLING FRAMEWORK

I now amend the model to consider circumstances in which the cost of efficiency barriers
presented by differences in standards and conventions are specific to individual firms
(borrowers) and financial services providers instead of being the same for a whole economy.
Although firms and institutions cannot unilaterally change the standards under which their
home market (or a foreign market) operates, they can change their own structure and
behaviour in order to comply with those prevailing in other markets. By doing so they avoid
paying the tariff equivalent on traded financial services.

Financial institutions continue to be able to export under modes 1 and 3, but some have
greater cost advantages for doing business abroad than others. Firms (borrowers) can now
engage in mode 2 trade by effectively migrating to a different institutional environment.
But these adjustments imply a cost. From a modelling perspective, the situation is not unlike
that of a quota: all firms and banking institutions are in principal subject to a tariff, but those
with lower costs of adjustment find it cost effective to purchase exemptions.

Important additional assumptions are also made concerning the externalities associated with
the trade decisions of individual firms and banks. Traditional and pro-competitive effects of
trade continue to have an impact on the price of financial services, putting downward pressure
on local interest rates r towards that of their trading partner r*. But crucially I now assume
that the cost of financial services is dependent not only on relative endowments and the level
of institutional barriers but also upon the level of local market liquidity and the scope for
portfolio diversification. Net inflows of financial services imply an augmentation of liquidity
and in general an expansion of opportunities for portfolio diversification. Each financial
institution and borrowing firm can have an incremental impact on these two new factors.

These sets of assumptions introduce a structure in which small innovations or exogenous

differences in the institutional character of banks and borrowers can trigger an important
evolution of standards and conventions simply through profit maximising / cost minimising
behaviour. The institutional character of financial markets becomes partially endogenous.

The benchmark cases remain the same. Aggregate trade in financial services is still subject to
an institutional transaction barrier such that factor prices do not equalise; instead the
relationship is maintained in which r1>r2>r3=r*.

I refer to the investment that trading parties must make to change standards and conventions
to adjust to a foreign market as an adjustment fee that a firm or bank j incurs in order to
become exempt from the institutional barrier :
j = j where the expected value of , E()=0.

The different forces interacting to determine the equilibrium rate of financial services are now
more complex. The cost of financial services providers are now either primarily a function of
the foreign cost of funds for financial services I plus the informal barrier or, for individual

29
lenders that have a low cost of adjustment j, they are ri=(C) of the local cost of funds (i)
defined as a percentage rate, adjustment or operational costs as a function of total lending
activity (L), that cover project evaluation and monitoring of borrowers; and costs to cover
expected losses from defaults.
ri = C(i, L, (L), )

Where '(L)>0 and ''(L)<0

Marginal costs are also rising in , which in turn is dependent on the aggregate risk profile of
the banks portfolio. As such it is a function of the credit risk for each client, market and
liquidity risk and the correlation between risks hence there is an economic benefit to
portfolio diversification and a more liquid market37. These advantages translate into lower
expected losses and therefore lower reserve requirements.

In principle we should also consider that there is a fixed start up investment required for
financial institutions that choose to engage in trade, especially mode 3; Banks that decide to
trade through commercial presence (mode 3) pay I3. For what follows, we can also think in
terms of an annuity which is necessary to pay off these debts. If we assume that investments
are proportional to the level of lending undertaken (L), this has the practical advantage of
being stated in percentage terms that we can easily add to interest rates.

The quota-like structure of trade and barriers can be seen more clearly in the following
graphical representation:

S'

ea
pa
e>0
p >0 e=0
S*
b c
p* mode 3
a d

quota equiv. L

Figure 3:quota like structure of firm specific costs of adjustment

37
Bekaert and Harvey (2003) note that liquidity effects in emerging markets can be particularly acute. They site
a study by Chuhan listing liquidity as one of the main reasons for foreign institutional investors not investing in
emerging markets.

30
This diagram considers the impact of mode 3 trade. In autarchy in the given economy, the
price of financial services is at pa and the volume of lending and other financial services is at
the point on the horizontal axis that corresponds to equilibrium point ea. Without any
institutional barriers, but assuming still that operational costs impose a slightly upward
sloping supply curve by foreign banks, volume rises and pricing declines in accordance with
an equilibrium at e =0. Integrating assumptions about the existence of differences in standards

and conventions restrains supply. For a given proportion of financial institutions with
adjustment costs j lower than the cost of informal barriers , a quota equivalent volume of
trade will take place. Those financial institutions will sell at the new price p >0 and make

profits of j. Hence the area abcd will be divided inversely between profits to banks
engaged in mode 3 trade and their respective spending on costs of adjustment.

Defining the Demand function for financial services:

Firms demand for financial services is a function of the absolute size of their business
projects and expected return on them. They minimize their cost of funding by considering
their choice between the cost of domestic and foreign financial services. Domestic services
impose no supplementary costs of adjustment. Accessing foreign financial services will
impose an internal cost of adjustment j.. In the model given, equilibrium cost of financial
services in the less developed country will be higher than in the more advanced trading
partner economy. Borrowers follow the rule:

Minimize C(r, j) s.t. to a specified level of borrowing (L) where the choice is
between (1) ri= C(i, L, , ), = 0 and (2) r = C(, L, (L), ), ij > 0;
where i = economy 1,2,3, * refers to the cost of funds in the next economy up
and j refers to the costs of adjustment for firm j in home economy i.

The adjustment cost is considered to be an annual percentage charge of funds borrowed that
is spent on compliance with standards and conventions. This can easily be thought of in real
terms as, for example, higher expenditure to comply with accounting standards and corporate
governance or to hire staff with experience and qualifications in the other more advanced
economy. Although less likely, we can also think of this as a potential cost savings that can
be realised if a borrower chooses to go down-market in terms of standards.

Therefore, to minimize costs, the borrower simply has to discern the lower of
ri() and r*(j)
When ri() < r*(j), borrowers will purchase financial services locally, from domestic or
foreign banks, both of whom offer the same rates.

When ri() > r*(j) borrowers will choose to migrate to other standards and conventions
and purchase financial services under mode 2 trade.

Firms will migrate to the institutional space of their larger trading partner up to the point
where their costs of adjustment are equal to or slightly lower than the savings they anticipate
making on their cost of funding. Extra benefits accrue vis--vis competitors to all borrowers
with costs of adjustment lower than this cut off level because they benefit from lower
effective costs of funding.

Shape of the demand function and rudimentary mechanics

31
The demand for financial services is drawn for a given level of economic activity and
expected returns on borrowers business projects. Changes in aggregate expected returns on
projects will cause shifts in the demand function. These depend in principle on numerous
exogenous factors such as technology and macroeconomic stability. Holding these factors
constant, I only explicitly address the role of endowments (K,L) and the effect of changes in
trade barriers, specifically the transaction inefficiencies considered in the previous section
applying to the export of goods. In the absence of comparative changes in technology or
internal market size, the expected revenue from business projects will increase with
reductions in trade barriers simply through expansion of exports and a reduction of losses
attributable to transaction inefficiencies. As mentioned above in reference to historical
studies, this contribution to growth should not be underestimated.

Defining the supply function for financial services

The supply of financial services is still largely determined by relative endowments in each
economy. But the conditions under which banks and other financial institutions will find it
profitable to export their services and capital down market become more complex.
Previously the decision to export was based on the difference between the price of financial
services in the targeted export market (r) and the prevailing price in the home market of the
exporter (r*) plus the tariff equivalent barrier (). As long as
r r* +
it would still be profitable to export financial services to the target market. Now banks can
invest / pay a cost of adjustment specific to them (j) which exempts them from this barrier
. This can be thought of as the necessary change in their ongoing cost of operations. But they
also must account for the cost of reserves to be put aside for expected losses and their
incremental impact on (i) liquidity and (ii) the scope for portfolio diversification in each
market.

For simplicity I assume that all banks have to raise funds through deposit taking. This could
be done in a home market, foreign market or a combination of both. To avoid over-
complication, I do not explicitly model this dynamic but use as if it were exogenous for
each market.

Shape of the supply curve and rudimentary mechanics

The shape of the supply curve and the dynamics of shifts in it require clarification. Firstly I
consider the possibility that the supply curve is backward bending at some level of interest
rates, conform with the structure most recently presented by Stiglitz38. This means that at
relatively high levels of interest rates, expected losses through default are sufficiently high to
not merely deter further lending but to reduce it overall. The consequence for the analysis of
trade is that in cases where interest rates in the financial sector are already high and credit
rationing operates, reductions in the interest rate through trade may produce even greater
gains than those one might otherwise expect with a classic upward sloping supply;
Alternatively, if the risk of default remains stable, but credit becomes more easily available,
aggregate losses may rise and the economy may become over-indebted with a rising level of
non-performing loans.

38
Stiglitz and Greenwald (2003)

32
 Supply of loanable funds
Expected r
return

r* r L
figure 4: credit market supply and the relationship between expected return and pricing

Secondly, the supply curve shifts in accordance with changes in . Expected losses may also
change for a given interest rate, rising if for example the macroeconomic climate worsens or
trade barriers rise. Conversely, they may fall if trade barriers fall or if technology
improvements increase productivity. It is also important to keep in mind that expected losses
are valid for a given set of potential clients, i.e. borrowers, and that any material change in the
overall composition of this set will also be reflected in changes in average expected losses.

Changes in operational costs will also cause shifts in the supply curve. In terms of trade in
financial services, a firm proposing financial services in another economy and employing the
same production technology (mix of K, L and conventions and standards) will be subject to
higher relative operational costs (L) than in their home market. There are two principle
reasons for this.

Firstly, it should be relatively clear from the model that if for example, relative factor prices
are not the same as in the home market, the optimum mix of K and L will change in addition
to changes in standards and conventions. Financial institutions that do not respond to these
differences will be less efficient than in their home market, even if they remain competitive
vis--vis local suppliers of financial services due to the benefit of endowments.

Secondly, the institutional environment of the foreign economy and financial sector may
imply (i) that not only standards and conventions but also the character of factors of
production such as labour are not perfect substitutes across markets; and (ii) that even if they
were perfect substitutes, the institutional environment renders certain technology less
efficient due to reasons explained in previous sections of this paper. Hence there are
significant learning and adjustment costs associated with export activities, some of which may
over time be decreased; others may require coordinated action with other agents in the
economy and financial sector in order to be lowered.

In the short run this supplementary cost for operations causes the supply curve of foreign
operators (compared to its home market offer) to pivot upwards and for its intercept with the
vertical axis to jump in accordance with the fixed costs that the firm must cover for entering
the new market. In the long run, learning effects may allow the supply curve to pivot
downwards. Supply increases with convergence of standards and learning of conventions but

33
at a declining rate. An important effect of this structure is that in spite of the larger size of the
foreign market, borrowers in smaller markets do not suddenly face a horizontal supply curve
for credit and financial services at a fixed price when foreign banks arrive. Of course with a
sufficiently large number of new entrants, a horizontal supply curve may even in this structure
may be possible; But one does not generally observe in reality that large number of banks
enter a market simultaneously capturing the whole market.

Lastly of relevance to our analysis, in the context of trade among three or more inter-related
economies, changes in profit margins in one market may have an impact on supply in others.
When financial institutions have to optimise the allocation of their limited resources between
competing markets, not all export opportunities will necessarily be exploited. Greater
competition in a banks home market may put downward pressure on margins and hence
render other foreign markets more attractive. But it is equally likely that continued growth in
a home market creates opportunities for expansion that are more attractive financially than
those available in export markets.

To summarise, the decision to export by financial services providers under mode 3 is based on
a similar calculation to that made by borrowers. After accounting for fixed investment and
costs of adjusting to local market standards and conventions, the competitive price offered by
the exporting bank still must be lower than or equal to the prevailing price level in the
importing market (market i), i.e.
r*(*, , j, + i3) ri

where i3 stands for the annuity equivalent required to cover initial up-front investments I3. Not
all financial institutions face the same cost of adjustment.

For export under mode 1, I assume that there is no adjustment by the exporting firm and
hence all if any adjustment undertaken to circumvent barriers are borne by local banks
acting as wholesale intermediaries importing the financial services for local distribution.

Proceeding with the analysis, in the three economy model, again I first discuss the impact of
choice of standards in a 2x2 structure for each of the two combinations of trading partners and
subsequently draw together the indirect impact of integration between the transition economy
and RoW on the local economies. In each case I first look at the decision for borrowers to
migrate up defined as mode 2 trade, then the decision by banks to export down market
through trade in modes 1 and 3. Finally I make a preliminary attempt to assess the impact of
different combinations of modes of trade.

6.2 TRADE ANALYSIS: INTERACTION BETWEEN THE LOCAL ECONOMIES AND THE
TRANSITION ECONOMY

Trade in Mode 2 Borrowers from the local economies migrate to the transition economy

Firms will migrate up market if their costs of adjustment are smaller than the savings on
financing that can be obtained in the transition economy. Adopting a formal business structure
with all that it entails in terms of internal procedures, official paper work, patience and in the
worst case perhaps undisclosed fees to government workers can be very costly in both time

34
and money. Firms must have a regular banking relationship and sufficient internal controls
and accounting standards to comply with formal sector lending criteria. Even then, they must
be able to present convincing business prospects on a scale sufficient to allow lenders to cover
their marginal costs of monitoring. It must be recognised that for the majority of firms in the
local informal economies, the costs of adjustment are absolutely prohibitive. For those few
that can migrate we can consider that it is a permanent migration (barring corporate failure)
and is in fact an indication of successful grass roots economic development.

The additional demand for funds and financial services in the transition economy associated
with each additional borrower will by definition be negligible. In the individual local
economy i, the primary effect will be a reduction in the demand for financial services. In
theory the equilibrium price for these services should decline. But several potential secondary
effects and modifying influences may in practice play a role in the actual outcome.

Firstly, given that each local economy is very small and assumed to be isolated from lenders
in other local markets, there is likely to be a high degree of market power exercised by
financial services providers. This means that although a decrease in demand will put
downward pressure on the price of financial services, benefits will not all go to borrowers.

Secondary effects may act to shift the remaining demand function. There are two
counteracting forces that should be considered. On the on hand, a successful grass roots
enterprise that migrates to the modern sector in the transition economy may pull local
suppliers and other business associates with it, leaving them still dependent on financial
services in the informal local economy but with greater market opportunities. This would
have the effect of increasing demand for financial services in the local economy.
Alternatively, if the migrating borrowers played a dominant role in their local economy, their
exit could reduce the overall quality of assets that remain in the local economy. Crucially the
outcome the net effect on the equilibrium price of financial services - depends on the ways
in which the activities of the migrating firm are integrated with the local economy before and
after. To pursue this question through empirical analysis, micro-level flow of funds analysis
may be appropriate.

Trade in Mode 3 Banks engage in down-scaling

Banks that open activities through down-scaling of operations to serve rural and under-
developed markets will anticipate costs of adjustment that are smaller than the prevailing
difference in the cost of financial services between the local economies and the transition
market. In practice these new entrants must also consider their own downward impact on the
equilibrium interest rate in these local markets. Although in a restricted dual economy model
banks may find profitable opportunities in this sort of trade, in reality cost that must be
incurred to overcome information asymmetries are prohibitive and those opportunities that do
exist are often outweighed by more attractive returns to either further investment in a
booming transition economy (i.e. the home market) or in the economy of the RoW. Capital
flight from developing economies is consistent with these propositions and is a well known
phenomena, one that is often dearly lamented.39

39
See comments in a study from 2003 by Adams, Brunner and Raymond; Commentary also comes from
participants at the 2002 Commonwealth Business Council symposium on Financial Markets

35
Some mode 3 trade of this type has occurred in emerging markets, but often it has been
stimulated or subsided by public sector organisations on a national or international level. In
South Africa, banks have been pushed through national legislation to achieve target levels of
service to under-banked communities40. In Sri Lanka, bilateral donor programmes have
assisted local state owned banks in the development of profitable operational strategies and
structures for increased rural banking41.

The effect of this direction of trade should be to reduce costs of financial services in the target
local markets. At a certain level of activity, some banks may also find that increasing
activities in these markets follow prudent lending policies expands portfolio
diversification and decreases aggregate expected losses across the bank. This would imply a
lower value of and hence for other factors remaining equal, an expansion of supply42.

Although this form of trade expansion would seem to be beneficial, a strong expansion of
credit has been known to stimulate extra demand by unsophisticated borrowers. Combined
with a lack of institutions through which to share information on aggregate debts of individual
clients, credit quality can plunge, default levels can rise and people go too far into debt. Short
term mistakes or miscalculations can in this way quickly turn a healthy market into a bad one
for all participants43. With reference to the reasoning behind the existence of a backward
bending supply and credit rationing, if financial services and credit expands in the economy
but no change is experienced in the expected return as a function of the interest rates (the
curve presented in figure 4 remains stable), a flood of new credit and downward pressure on
the interest rate may reduce rationing but eventually lead to a higher level of default and non-
performing loans.

A final point regarding an expansion of trade in mode 3 in local economies: it may help to
relieve what is often termed absolute poverty, as many programmes have shown44; But from
the perspective of maximising aggregate welfare across the whole dual economy, it may be
better to invest further in the transition economy if it can provide greater growth and
productivity.

Trade in Mode 1 Banks sell wholesale services to local institutions

Under my assumptions, the export of financial services in mode 1 implies the provision of
whole sale financial services to intermediaries in the local economies, for example lending by
international banks to local banks, or financing by transition economy banks of rural credit
agencies. This sort of trade is characteristic of structures in which cooperative or local
banking organisations are supplied with funding and other services by an umbrella
organisation integrated in the transition economy. In order for this trade pattern to arise, there
must exist a set of institutions active in the local economies with adjustment costs low enough
for them to purchase services upmarket at a rate which is still lower than the prevailing retail
40
See references for example on World Bank Findings (May 1999) regarding Standard Bank of South Africas
E-Plan.
41
GTZ project work with Peoples Bank in Sri Lanka through their programme on Rural Banking Innovation
42
Portfolio diversification advantages from micro-finance lending have been cited by ICICI in India in recent
press reports and in informal discussion with the author of this paper with Schroders.
43
This has most notably been the case for micro-finance in Bolivia, where initial success attracted excessive
imprudent lending and the market collapsed when individual became over-indebted.
44
Micro-finance programmes such as the Grameen Bank and many others have demonstrated their capacity tor
relieve poverty

36
rate in the local economies. This sort of institution can be thought of as a translating
intermediary that is able to evaluate and monitor projects in its local economies much more
efficiently than the foreign bank but is also adept enough at managing its relationship with the
transition economy bank, the exporter of wholesale services, to benefit from near transition
economy rates. The intermediary can in essence engage in both markets with a high degree of
efficiency, reconciling differences in standards and conventions internally.

Although an expansion of this sort of trade will increase supply in the local economies,
benefits are likely to be captured largely by the intermediary unless they themselves are
subject to competition with many other actors. In reality, there is usually little competition
due to the restricted size of local markets and the informal political structures in local
economies which are able to discourage new entrants. Liquidity and portfolio diversification
risk are likely to play a minor role because benefits of this nature are generally an
exponentially increasing function; diversification into a very small market relative to a banks
total assets is of little value in terms of risk spreading45. Mode 1 trade may produce marginal
benefits to local economies, but much depends upon local market structure. It may be
important to consider complementary policies to improve market structure at the same time as
fostering greater down market trade in order to ensure that the benefits of greater integration
are not overwhelmingly captured by local vested interests

6.3 TRADE ANALYSIS: INTERACTION BETWEEN THE TRANSITION ECONOMY AND

THE REST OF THE WORLD

As with the initial analysis, the determinants and qualitative effects of different trade flows
between the transition economy and the RoW are, with certain exceptions, qualitatively very
similar to those for trade between the two halves of the dual economy. I concentrate in this
section on some important differences one may anticipate in reality and comment on trade
with respect to anecdotal empirical observations.

Trade in Mode 2 - Borrowers migrate to the RoW economy

Migration by firms in the transition economy to RoW standards and conventions will be
undertaken if the associated costs of adjustment are outweighed by the benefits in lower costs
of funds and higher liquidity. The marginal impact on demand in the international financial
market is by definition insignificant. The reduction of demand in the transition economy may
put downward pressure on prices; but it may also reduce liquidity and diminish incentives for
other foreign financial providers to enter or maintain existing trade levels.

The impact on conditions for borrowers remaining in the transition market is controversial
and ambiguous. Demand for financial services is reduced, but so may be liquidity,
opportunities for portfolio diversification by financial institutions and the incentive for
foreign investors to service the market.46

45
fund managers have expressed interest for example in portfolios of micro-credit loans primarily due to their
lack of any correlation with other earnings ; but scale and administration hamper a wide scale development of
this
46
see Bekaert and Harvey 2003

37
This sort of migration is an important trend in todays financial markets47. Many stocks are
listed on multiple exchanges, traded as ADRs or GDRs or are even listed exclusively on a
foreign exchange48. Firms that migrate do tend to benefit not only from direct cost advantages
but may also benefit from a virtuous cycle of increasing integration with international
business in other terms contacts, reputation, etc.

Trade in Mode 3 Foreign bank entry in emerging markets

This form of trade is what has dominated the 1990s, especially in central Europe and Latin
America but also to a certain extent in Asia and Africa; Largely triggered by privatisations,
reductions in legal entry barriers and asset sales, financial sector liberalisation and macro-
economic reform and growth prospects have attracted foreign banks49; For some banks, the
need to expand their scope and size, faced with larger competitors in developed markets and
fewer opportunities for growth has also stimulated this sort of trade.

A RoW financial institution will undertake mode 3 trade in the transition economy if the costs
of adjustment and investment are lower than the difference in pricing between financial
services at home and among competitors in the transition economy. Put more simply, if the
RoW competitor can adjust to the transition economy market and still be more competitive
than existing offers, expected profits are positive. The RoW bank must then simply assess the
opportunity cost of this investment, which in our model is the expected profits from further
expansion in the RoW economy that can be bought for investment I3.

Trade in Mode 1 Banks sell whole sale services to local institutions

At low levels of convergence of standards and conventions between economies and high costs
of adjustment, trade is most likely to be conducted by this mode. Exporters from the RoW
economy do not have to incur up-front investment costs or struggle with the costs and
operational challenges of adjustment. Their price advantage continues however to provide
them with sufficient market power to attract business from wholesale intermediaries in the
transition economy. The benefits of trade will be split between RoW lenders and transition
economy intermediaries, unless both markets are subject to high levels of competition. The
distribution of gains will depend on the relative market power of each and their relative
efficiency at adapting to the others standards and conventions for conduction business in
financial services. High realised margins are often observed in developing countries for
example in Africa50. Yet they are often achieved in countries in which the overall growth rate
is not outstanding. Market power operating in the way described above may be part of the
explanation51.

47
see Claessens et al.(2003) on the future of stock exchanges in emerging economies and a World Exchange
Federation study by Carol Frost of Tuck Business School on costs of funding and cross border listings
48
ADR : American Depository Receipt ; GDR : Global Depository Receipt ; Both enable foreign stocks to be
traded indirectly on US exchanges; Direct listings abroad are also important features of trade; During the 1990s
many South African companies chose to establish a principal listing in London.
49
Refer to a paper by Clarke et al. (October 2001) on what stimulates foreign bank entry
50
See presentation by Liquid Africa for the UNDP conference on developing capital markets in Africa
51
Neue Zrcher Zeitung, Fokus der Wirtschaft, July 24/25 2004 article on Entwicklungshilfe oder
Kolonisierung? Der Bankensektor der neuen EU-Lnder fes in auslndischer Hand

38
This is a well developed model of trade which saw rapid expansion in the 1980s as lending
increased to emerging markets. Many banks established operations in markets in Latin
America and east Asia at that time to service local banks and corporate borrowers. But in
spite of a physical presence, it is arguable that little institutional convergence was undertaken
by international banks. Lending practices were, through market power exercised by big
international banks, more or less imposed on emerging market borrowers. Hence in the terms
of this paper, trade was in mode 1 in spite of the physical presence of international banks in
the relevant countries. This form of trade was also very prominent in the more recent financial
crises in East Asia in which foreign banks provided short term hard currency loans to local
banks, which in turn funded local enterprises. The resulting currency and term mismatches
played an important role in the now well known disastrous results.

6.4 INDIRECT EFFECTS ON THE LOCAL ECONOMIES OF GREATER INTEGRATION

BETWEEN THE TRANSITION ECONOMY AND RoW

In this section I draw together comments and analysis from the previous two sections to
explain graphically the direct and indirect effects of individual decisions by borrowers and
lenders in both the two and three economy models. In contrast to the analysis of chapter 5, it
is important to remember that trade barriers are considered to be firm specific. Each firm can
choose to invest in compliance with foreign standards and conventions, and each bank may
for historical or other reasons be able to achieve this compliance with varying levels of
expense and operational difficulty. Integration can be initiated by small innovations that
increase the incentives for other individual firms to make similar decisions because trade
decisions produce externalities in the form of changes to liquidity and portfolio diversification
opportunities.

Although the analysis can be extended, I focus only on three specific cases of policy interest
involving modes 2 and 3 trade. Firstly I present the case in which expanding mode 2 trade
initiates an unstable equilibrium52 in which the transition market gradually diminishes in size.
Secondly I look at the virtuous cycle of development of the transition economy that can be
initiated by innovation that renders mode 3 trade more attractive. Lastly I look at the
conditions under which balanced growth in both modes of trade create a stable transition
economy financial market.

The mode 2 trade vicious circle: Borrower Migration and diminishing liquidity in the
transition economy

For each firm that decides to migrate up from the transition market to RoW, liquidity is
reduced in their original home market and hence the factor increases. Total cost above the
given level of to a borrower may therefore rise in the transition economy if the liquidity
2

effect outweighs the decline in demand. As this overall cost rises for remaining borrowers, the
level of costs of adjustment j at which migration upmarket becomes profitable rises because
savings from migration are greater. This can alternatively be conceptualised as a shift to the
right of the line 23 at which migration becomes financially attractive (see figure 5). The

52
One could also speak in terms of a polarisation of standards involving a gradual disappearance of the middle
ground

39
function r(C) for remaining borrowers shifts to r(C)' which moves to the right and up in the
manner displayed. I do not claim to determine the exact shape of this function, but it will
clearly depend on the rate at which changes in liquidity augment the cost factor .

The result of one large borrower migrating up is that the borrowers with the next lowest costs
of adjustment will find it increasingly attractive to upgrade to RoW standards and
conventions too. As the number of firms that perform this switch augments, the transition
economy effectively experiences institutional evolution on a micro-level. The extent of this
evolution will depend upon the structure of borrowers in the economy. We can imagine on the
one hand a small transition economy dominated by two large successful companies that
decide to migrate. The gap between these companies and those just below in terms of
development and size may be so large that the gap in adjustment costs is also of similar
magnitude; Even if migration by the top two companies has a big effect on liquidity, the cost
of adjustment for remain firms are prohibitively high and migration is not profitable.
Alternatively, in an economy with a broader and more equal distribution of borrowers in
terms of size and capacity to develop, assuming other factors remain equal and mode 3 does
not develop, a small increase in innovation or reduction in adjustment costs may trigger an
increasing flow of migration by borrowers to RoW standards and conventions, effectively
helping to develop production in the transition economy through greater dependence directly
on the RoW financial sector.

r(C)

r(C)'

2 r(C)

23
RoW transition economy
standards and conventions standards and conventions

Figure 5: mode 2 trade between the transition economy and the Rest of the World

Indirect effects may also be experienced by the local economies. If the equilibrium price of
financial services rises in the transition economy but 2 remains constant, less migration from
the local economies to transition economy standards may occur. The potential savings from
investing in adjustment decline. Recall also that firms at the lower end of the risk profile can
trade down to the local markets to benefit from a negative adjustment cost. They now lose
less by migrating down in terms of the difference in interest rates (other factors constant of
course). This is equivalent to saying that borrowers from the transition economy who are near

40
the border between being part of the transition versus local economies may have more to gain
in the short run (financially) by migrating downmarket and realising costs savings related to
reductions in compliance, reporting etc. So it is possible that liquidity will increase in the
local economies if we hold 3 exogenous and constant. Total cost r(C) may therefore decline
and further incentives will exist for borrowers to remain in the local financial sector. This
creates a shift of the total cost function, raising costs of firms borrowing on transition
standards and conventions and lower those borrowing on local economy standards. The point
at which migration from the local economies to the transition economy becomes profitable
shifts to the left due to a diminished differential between r(C) in each economy. As a
consequence, with other factors remaining constant, financial sector activity in the transition
economy declines in favour of an expansion in local economies. This potential trend towards
down market migration will eventually be stopped when firms are no longer able to reduce
costs by complying with informal lender standards instead of with transition economy
standards and conventions.

r(C)

r(C)
r(C)'
3

21
transition economy local econo mies
standards and conventions standards and conventions

Figure 6: mode 2 trade between the transition economy and its local economies

Combining effects and the two preceding diagrams, note that integration in the form of
innovation by borrowers from the transition economy that stimulates mode 2 trade can lead to
higher costs in the transition market. Lower incentives to migrate up to the transition
economy and lower relative costs in the local economies may improve liquidity there. At the
extreme, integration in mode 2 between RoW and the transition economy leads to an unstable
equilibrium in terms of choice of standards and conventions. It incites a continued gradual
migration away from transition economy standards and conventions either down or
upmarket53. At some point, enough firms may have migrated that borrowers originally form

53
There is clear evidence that many companies based in emerging markets have found it attractive to list their
shares on world exchanges such as London or New York and to comply with international or US GAAP
accounting standards in spite of those demanded in their home market. In terms of moving down market it
seems relatively clear that the extensive efforts to develop micro-finance in developing and transition countries

41
the transition market have by force of numbers integrated their original home market with the
international financial sector. Those companies that have been unable to keep up will have
found themselves as a consequence forced down into the local economies.

r(C)
r(C)
1
r(C)'
2

RoW 23 21
transition economy
standards and conventions Local economy
standards and conventions
standards and conventions

Figure 7: indirect effects of increasing mode 2 trade by transition economy borrowers

The virtuous circle: Expanding mode 3 trade and increasing liquidity

Focusing solely on mode 3 trade now, the relationship reverses such that the transition
economy gains liquidity and local borrowers have greater incentives to stay. The expansion of
activity by foreign banks (mode 3 entry) increases liquidity and competition, hence lowering
the total cost of funding to local borrowers. Mode 3 entry will slowly dry up as the gradual
reduction in the local total cost of funding means that other potential mode 3 exporters from
the RoW economy have less and less incentive to enter the market (unless their cost of
adjustment declines). Financial services providers will engage in trade in mode 3 up until
their cost advantage in their target export market is equal to their costs of adjustment. Beyond
the simplifications of the model, it is also important to consider that in imperfect market
structures where supernormal profits are earned, banks may continue to be attracted by mode
3 trade even after this point if they think they can capture an important part of the market and
similarly exercise such power.

has in some cases been an implicit recognition that the practices of formal sector banks are not sufficiently
adapted to local circumstances to be of practical application to the poorest sections of society

42
 mode 3 effects on the transition economy
r(C)

r(C)
r(C)'
2

23
RoW transition economy
standards and conventions standards and conventions

Figure 8: mode 3 trade between the transition economy and the Rest of the World

Between RoW and the transition economy, mode 3 trade shifts the curve down and to the
right. Total cost under transition economy standards and conventions declines due to higher
liquidity in the market. And with a lower differential between the cost of financial services in
the RoW and transition economy, the adjustment cost must be lower to attract financial
services providers to make this investment and change their standards and conventions to
serve the transition economy.

The indirect consequences for the local economies are ambiguous. As the equilibrium cost of
financial services in the transition economy falls, migration by borrowers up from the local
economies will become more attractive (mode 2). But as domestic banks in the transition
economy increasingly are forced to compete with new entrants, the attraction of potential
opportunities for mode 3 trade with the local economies may increase, even if today this form
of trade is observed very infrequently.

Another important force will be the expansion of overall economic activity in the transition
economy due to increased financing through RoW bank mode 3 trade. This may create
sufficient expansion in the economy to create new opportunities for domestic transition
economy banks. This expansion of activity will have a tendency to draw in more labour from
the local economies. If this leads to a decline in demand in the local economies for financial
services, or an increase in supply of finance through remittances of migrant labourers,
downward pressure on local economy costs of financing may result.

43
 Mode 3 indirect effects on local economies
r(C)
r(C)'
1
r(C)

RoW 23 21
transition economy
standards and conventions Local economy
standards and conventions
standards and conventions

Figure 9: indirect effects of increasing mode 3 trade between the transition economy and the
Rest of the World

The overall effect, looking at the three economies together suggests that the transition
economy will expand. The local economies may experience some contraction. But as
discussed previously, rapid expansion of the transition economy may be more likely to
maximize welfare for the duality as a whole, provided income can be redistributed and as
Sachs et al. emphasise, that transaction efficiency within the duality can be steadily improved.

Balanced integration with the World Economy: Mode 2 and mode 3 expansion

Having illustrated the way in which expansions in mode 3 and mode 2 trade in financial
services can have contrasting effects, it is worth looking at the conditions under which these
two forces might counterbalance each other. But I do not mean to suggest that there should be
any preference in terms of welfare or otherwise for a balanced growth in modes of trade. I
simply mean to illustrate in the confines of the current model, factors that lead to greater trade
in modes 2 and 3; Subsequently, we can make some assumptions about conditions that could
prevent either mode from generating extreme, unfavourable shifts in the costs of financial
services.

Recall firstly that it is the costs represented by that are inversely impacted by mode 3 and
mode 2 trade in any given market. Mode 3 trade reduces liquidity risk and expands portfolio
diversification opportunities in the target market and hence generates a decline in ; Mode 2
acts through the same mechanisms to increase the value and relevance of for the given
market away from which borrowers are migrating. If a balance between these two tendencies

44
is to be achieved54, clearly some balance must be found between level of mode 3 and mode 2
trade. What are the conditions then that will incite financial services providers and borrowers
to engage in these forms of trade?

Within the narrow confines of the modelling structure, the relationship between j and for
the given market that determines whether a given firm or financial services provider decides
to incur costs of adjustment in order to trade or not. [Remember that trade can still take place
even if no migration in standards and conventions takes place. But it is subject to the
transaction inefficiency tariff .] The impact on the remaining agents in an economy is the
level of the externality produced by each individual firms or banks decision to migrate or
trade. Hence we should think in terms of the total change in due to the exit from (in the
case of mode 2) or entry into (in the case of mode 3) the economy of a borrower or
financial services provider, of which there are j=1 to n. Whether or not the decision by the
first firm or bank will also incite the next firm or bank in this series (ordered in terms of costs
j) to migrate or trade will depend on the relationship between the marginal increase or
decrease in caused by firm 1 and the difference between j=1 and j+1. A stable equilibrium
will be reached when j > and |j| < |j-j+1|. An economy with very few firms and
financial services providers of vastly different character and adjustment costs will find it more
difficult to initiate a self-reinforcing evolution towards new standards. By contrast, an
economy with a larger number of firms and financial services providers that tend towards a
normal distribution in terms of adjustment costs j around the value would have a greater
chance of being able to initiate a gradual self-reinforcing evolution towards new standards
and conventions.

Balancing modes 2 and 3

For both modes 2 and 3 trade to develop in unison there must be a certain degree of symmetry
in the distribution of abilities (and hence cost of adjustment) of individual firms to migrate
upmarket to advanced economy standards and conventions and for financial institutions from
the more advanced economy to successfully adapt services to the transition economy. It is not
clear whether such symmetry should exist, although in the long run learning effects may
certainly encourage it. In the short run it is conceivable that political, institutional or historical
factors may result in greater abilities to migrate for firms or for lowers costs for financial
services providers to adjust to other markets. Alternatively, even if there is a relative degree
of symmetry in this regards, market structure and power may have an impact, putting more
pressure on either borrowers or lenders to incur adjustment costs.

54
This may be a desirable policy objective, especially if an overall value is placed on avoiding extremes of
wealth the emergence of a pronounced Kuznets curve and minimising the challenges presented by rapid rural
immmigration and urbanisation.

45
7 CONCLUSION

The primary question posed by this paper has concerned the impact of integration between the
international financial sector and a dual economy. Although the conclusions derive from a
simplified modelling framework, incite can nevertheless be gained into forces influencing
trade and institutional convergence in the financial sector as well as the potentially diverging
impact of different modes of trade. Caution is most important with regard to the conceptual
dimensions of standards and conventions and the divisions that help to define the dual
economy. These dimensions do not correspond to distinct differences that we may easily
observe; their boundaries are in reality more fluid.

The framework presented has illustrated that differences in factor endowments, specifically
capital, can be sufficient not only to explain convergence by emerging markets towards
advanced economies standards and conventions, but also to provide a strong argument in
favour of this tendency. Even if greater efficiency in the financial sector of such an emerging
market may be achieved by further development of local standards and conventions, adoption
of advanced economy institutions may be more attractive if it significantly reduces the
transaction costs associated with this trade. This is because, by assumption, advanced
economies are more generously endowed with capital relative to other resources than
emerging market economies. Hence through differences in relative prices, there are gains
from trade.

This conclusion provides an interesting contrast with policy that advocates international
adoption of best practice in the financial sector. Best practice is often a mixture of standards
and conventions followed in the most advanced market oriented economies. Studies try to
support the position that such best practices are best because they most efficiently support
financial sector development. Analysis from this paper imply that although it may be
warranted to continue to support adoption and local adaptation of best practice, this is not for
the reasons commonly cited. Adherence to developed country standards by emerging markets
can be beneficial simply due to the reduction in informal trade barriers that it provides.

The analysis also demonstrates that incremental differences in the operational profile of
financial services providers or innovations undertaken by them, in order to more efficiently
serve foreign markets, can have an amplified effect on the overall evolution of standards and
conventions in an export market. This process varies however, according the modes of trades
as defined in with regards to standards and conventions. Mode 3 form of trade for instance
expands the level of activity in the export market conducted under local standards and
conventions. It may create a marginal increase in liquidity which lowers the costs of
borrowing in that market. It may also create a deeper or more diverse market which provides
greater opportunities for banks to diversify their portfolios. These positive developments will
incite other banks and borrowers to adapt to foreign standards in order to enter the market.
This process can continue until a portion of firms having developed the capacity to adhere to
foreign standards and conventions is large enough to have effectively stimulated institutional
convergence between these two economies.

Although the effects of international financial sector integration on local under-developed

economies remain ambiguous, the analysis has drawn attention to some of the potential
consequences for stability and growth and hence the relevance of further investigation. Not
least the challenge for policy makers remains awkward because, although it is often assumed

46
that resources employed in the modern sector are more productive that in the local economies,
welfare maximisation may not necessarily derive from directing funds overwhelmingly to the
modern economy. It is important to improve transaction efficiency between the two halves of
a dual economy in order to stimulate further specialisation and commercialisation. Unequal
distribution of the gains from trade (and growth) may be problematic. A relative neglect of the
local economy may have political implications if redistribution policies are not forthcoming.
Even if the dual economy as a whole is displaying a healthy rate of growth, this may be led by
a booming modern sector which obscures the consequences for the local economies and hence
the dual economy as a whole.

Finally, the paper has also provided an initial incite into a structure for identifying types of
institutions or mixed market structure and trade patterns that could be useful to policy makers.
Certain standards and conventions or trade constellations could be more powerful at
stimulating a self-sustaining process of institutional evolution. If this is a public policy
objective, the ability to identify certain private sector developments that should be selectively
encouraged over others is likely to be very valuable.

7.1 POSSIBLE EXTENSIONS

This paper makes numerous assumptions that could in principle be tested empirically. For
some issues, availability of data may be a serious handicap or construction of indices may
prove to be fraught with problems of subjective assessments. It may be difficult to collect data
and in some cases this may also be because the prerequisite conceptual framework is
insufficient. In particular the complex inter-relationships between individual elements of the
institutional environment make it difficult to apply a positivistic methodology and isolate the
value or impact of specific components while assuming that other features remains
constant. For other empirical questions, such as the extent to which mode 3 trade stimulates
local financial market deepening, it is possible that the time frame in which companies
respond to changes, learn and adapt is too long to be able to make conclusive evaluations yet
on the interaction of financial services trade on the one hand and standards and conventions
on the other.

Focusing on more specific types of institutions or forms of financial services could yield
interesting policy results. For example, there may be forms of financing, such as factoring,
that can be subject to lower costs of adjustment yet through learning effects and
innovation - have a positive effect in the medium term on stimulating other forms of trade in
financial services. Understanding which forms of financing are most likely to have this sort of
effect would assist policy makers in focusing efforts on more efficient development
programmes.

Similarly, there may be some forms of standards and conventions which are
disproportionately important in terms of facilitating or hindering financial services trade yet
are not subject to symmetrical costs of adjustment. This would mean that public sponsorship
of certain standards and conventions could be more cost effective than others in terms of
reducing the overall cost of financial services in a given market through expanded trade.
Payment systems standards harmonisation might be one such example. All economies require
structures for making payments. Sharing electronic or card standards can facilitate commerce
and minimise the length of time during which funds are unavailable. Of course, it is open to
debate, how much this form of convergence helps financial sector integration overall.

47
Empirically it may be also difficult to distinguish between the advantages banks entering new
markets enjoy due to home market endowments and those they enjoy due to other factors that
bestow upon them lower cost of adjustment and greater ability to enter certain new markets.

One final extension of interest pertains to the demarcation between standards and
conventions. If conventions are more easily changed by individual banks than standards, and
yet changes in conventions by dominant financial services providers may incite other banks to
copy their actions, it may be warranted for the public sector to support changes by specific
market leading banks in order to achieve policy objectives on institutional evolution. Such a
study could start from a now well-known structure set out by Williamson (2000) in which he
defines levels of institutions according to the time frame in which they change. But it may
also be useful to supplement this view by an appreciation of the extent to which institutions
can be changed unilaterally by individual participants or require coordination.

I have attempted in this paper to integrate this view on the mechanisms of institutional change
by distinguishing between standards and conventions, the former being part of the market
framework which requires coordination for change and the latter being focused on internal
behaviour of an institution. In a conceptual sense, for each set of standards there is a limited
set of efficient conventions. But critically in a trade environment, agents may choose to invest
in changes in conventions if it allows them to participate in other markets where different
and perhaps more efficient standards prevail. This in turn has an impact on the relative
benefits of participating in other markets and incites gradual innovation in both institutions
and standards. In this manner the analysis looks on mechanisms of change in systems which
are often from the outset described in such a way that they find it difficult to account for
change.

48
8 ANNEX I work in progress on informal export barriers in the goods sector

This section represents work in progress dealing with the relationship between informal
barriers on goods trade, acting as export tax equivalents, and the informal barriers on financial
services imports represented by differences in standards and conventions. The purpose of this
separate study is to clarify the extent to which trade facilitation needs to be balanced across
various sectors in order to maximise the potential benefits of public policy investment in this
area.

Transaction inefficiency applied to trade in the goods sector

A transaction inefficiency (tg) applied to exports of goods operates similarly to an export tax
(from now on referred to as such) and is equivalent to an import tariff on the other good in the
model55. It reduces the purchasing power of exports in terms of imports. We can think of this
export tax structure as a cost which local producers may incur in searching for distributors
and purchasers abroad, conforming with foreign regulations or simply as loss of income to
distributors exercising market power. It is also possible to think of these barriers in terms of
transport costs. In general the concept corresponds to that used by Sachs et al. in their paper
regarding the role of transaction efficiency in a dual economy.

A change in export tax tg applied to X1 will have the usual tariff effects but applied inversely
to the good X2 in our model. An increase in this tax will diminish gains from trade in X1 as
the difference between local and the foreign market price declines. Relative prices faced by
producers will encourage a shift of production towards X2 and the relative price ratio faced by
consumers will change such that their real purchasing power declines.

Relation between informal barriers on financial services imports and goods exports
Abstracting from the model used so far, we can intuitively see that in a long term equilibrium
for financial services, anything that increases the business opportunities, in the form of future
expected profits, will also lead to an increase in the demand for (among others) financial
services. Hence a reduction in export barriers for example, is bound to give rise to a greater
level of demand for financial services.

It follows that the benefit from reducing institutional barriers to trade in financial services will
be even greater if in parallel export opportunities for local producers are expanded, for
example through an increase in export transaction efficiency. The question remains whether
the benefits to reducing one barrier are subject to diminishing returns. If this is the case, there
would be a strong argument for coordinating structural policy in both areas to gain maximum
benefit from reductions in these types of trade barriers.

This result becomes even more clear if we think more about the inter-relationship between the
interest rate and the degree of openness of an economy. Growth can be stimulated by both
productivity increases and through trade. The latter has arguably played a much greater part in
rising world income levels than is commonly thought especially during the beginning of the
industrial revolution56. Financial services trade and investment is attracted ultimately by
anticipated profits, which in turn rely on the profits of clients. Reductions in trade barriers, be

55
From Lerners theorem of symmetry
56
see ORourke and Williamson on the integration of commodity markets

49
they formal or informal, will, in the absence of a large internal market, positively correlate
with expected profits and hence attract greater interest from financial sector intermediaries. A
balanced approach to reducing informal barriers for both financial services and goods is
therefore essential if public and private resources are to be deployed efficiently.

50
BIBLIOGRAPHY

Adams, John, Brunner, Hans-Peter and Raymond, Frank. Interaction of Informal and Formal
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Allen, Franklin and Gale, Douglas. Financial Contagion. The Journal of Political Economy,
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Anant, T.C.A.. International Financial Standards and Codes: an Indian Perspective.

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 TABLE OF CONTENTS

1 1 INTRODUCTION ........................................................................................................... 2
1.1 PURPOSE AND CORE QUESTION ........................................................................ 2
1.2 METHOD ................................................................................................................... 3
1.3 MAIN CONCLUSIONS ............................................................................................ 4
2 KEY CONCEPTS .............................................................................................................. 6
2.1 INSTITUTIONS......................................................................................................... 6
2.2 DUALISM .................................................................................................................. 7
2.3 FINANCIAL SECTOR INTEGRATION .................................................................. 9
3 BACKGROUND AND JUSTIFICATION ...................................................................... 10
3.1 STANDARDS AND BEST PRACTICE ................................................................. 11
3.2 FOREIGN BANK ENTRY ...................................................................................... 13
3.3 FINANCIAL SECTOR DEVELOPMENT ............................................................. 14
3.4 BACKGROUND TO METHOD AND APPROACH ............................................. 14
TRADE: DYNAMICS AND BARRIERS ....................................................................... 16
FINANCIAL INTERMEDIATION ................................................................................. 16
4 BASIC MODEL OUTLINE............................................................................................. 18
4.1 THE MODEL STRUCTURE................................................................................... 18
4.2 IMPORTANT SIMPLIFICATIONS........................................................................ 21
4.3 THE BARRIERS TO TRADE ................................................................................. 23
5 ANALYSIS I: EXOGENOUS CHANGES TO INTEGRATION, TRADE BARRIERS25
5.1 TRADE BETWEEN THE LOCAL AND THE TRANSITION ECONOMIES...... 25
5.2 TRADE BETWEEN THE TRANSITION ECONOMY AND THE REST OF THE
WORLD ............................................................................................................................... 26
5.3 INDIRECT EFFECTS ON THE LOCAL ECONOMIES OF DIMINISHING
BARRIERS BETWEEN THE TRANSITION ECONOMY AND THE REST OF THE
WORLD ............................................................................................................................... 26
6 ANALYSIS II: ENDOGENOUS CHOICE OF STANDARDS AND CONVENTIONS29
6.1 ADDITIONS AND AMENDMENTS TO THE MODELLING FRAMEWORK .. 29
6.2 TRADE ANALYSIS: INTERACTION BETWEEN THE LOCAL ECONOMIES
AND THE TRANSITION ECONOMY .............................................................................. 34
6.3 TRADE ANALYSIS: INTERACTION BETWEEN THE TRANSITION
ECONOMY AND THE REST OF THE WORLD .............................................................. 37
6.4 INDIRECT EFFECTS ON THE LOCAL ECONOMIES OF GREATER
INTEGRATION BETWEEN THE TRANSITION ECONOMY AND RoW..................... 39
7 CONCLUSION ................................................................................................................ 46
7.1 POSSIBLE EXTENSIONS ...................................................................................... 47
8 ANNEX I work in progress on informal export barriers in the goods sector ............... 49

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 DIAGRAMS AND CHARTS

Figure 1: page 21
model trade configurations

Figure 2: page 24
classic gains from trade barrier reductions

Figure 3: page 30
quota-like structure of firm specific costs of adjustment

Figure 4: page 33
credit market supply and the relationship between expected return and pricing

Figure 5: page 40
mode 2 trade between the transition economy and the Rest of the World

Figure 6: page 41
mode 2 trade between the transition economy and its local economies

Figure 7: page 42
indirect effects of increasing mode 2 trade by transition economy borrowers

Figure 8: page 43
mode 3 trade between the transition economy and the Rest of the World

Figure 9: page 44
indirect effects of increasing mode 3 trade between the transition economy and the Rest of the
World

57