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International financial services: multinational financial companies in Australia
Journal of Multinational Financial Management 8 (1998) 365–379
International financial services: multinational financial companies in Australia Fariborz Moshirian * School of Banking and Finance, The University of New South Wales, Sydney 2052, Australia Received 1 March 1997; accepted 1 February 1998
Abstract The purpose of this paper is to analyze and measure the determinants of foreign investment in financial services in Australia over the period 1985–96. The empirical results of the flow data show that Australia’s current account balance, domestic and foreign interest rates and domestic and foreign economic activities are contributing to the expansion of the inflow of foreign investment in financial services in Australia. Furthermore, the empirical results of the stock data of investment in financial services indicate that the bank cost of capital, the size of Australia’s banking market, the real exchange rate, investment in manufacturing and banks’ foreign assets are the major determinants of foreign investment in financial services in Australia. © 1998 Elsevier Science B.V. All rights reserved. JEL classification: G15; G24 Keywords: Financial services; Foreign investment; International banking
1. Introduction In the 1960s and 1970s, the inflow of foreign capital into Australia was largely in the form of direct investment in manufacturing industries by multinational enterprises, principally from the UK. In the 1980s, particularly since deregulation of the Australian financial market and liberalization of foreign banks activities in Australia, the amount of the FDI in banking in Australia has increased over the period 1985–95, the FDI in banking has increased three-fold, while FDI in manufacturing has increased two-fold. Although FDI in banking in Australia, similar to FDI in banking in the US, form only about 7% of total FDI in Australia, however, as the banking industry is connected to other industries, in particular manufacturing, the examination of FDI in this industry is important. Interestingly, greater than 70% of * Corresponding author. Tel: 00 612 9385 5861; Fax: 00 612 9385 6347; e-mail: [email protected] 1042-444X/98/$ – see front matter © 1998 Elsevier Science B.V. All rights reserved. PII S 10 4 2 -4 4 4 X ( 9 8 ) 0 0 03 7 - 1
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the FDI in banking in Australia has been from only five countries (i.e. the United States, the United Kingdom, Japan, Singapore and New Zealand ). While the UKs share of FDI in banking in Australia declined from 25 to 15% between 1987 and 1994, that of the US and Japan increased from 14 to 25% over the same period. This means that the US and Japan are now the major investors in banking in Australia. In this study, unlike the studies of foreign banks’ activities in the US which failed to directly measure FDI in banking, unpublished quarterly data on FDI in banking in Australia will be used to measure the determinants of FDI in banking in Australia. These data provide, for the first time, an opportunity to measure Australia’s FDI, using time-series data over 1985–94, not only in general, or for manufacturing, but also for banking and allow us to establish a model which is appropriate for FDI in banking. The paper is structured as follows: Section 2 will review some of the relevant literature in FDI; Section 3 will propose various factors which determine FDI in banking in Australia; Section 4 will model FDI in banking in Australia; Section 5 will describe sources of data and the methodology used in this paper; Section 6 will report the empirical findings; and Section 7 will make some concluding remarks.
2. Literature review A number of researchers have studied the determinants of FDI. While this study does not intend to survey all these works, some of the recent studies, which are more relevant to FDI in banking, will be briefly mentioned. Some specific studies have been made in the area of foreign banks’ activities in the US. Researchers attempted to empirically find various factors which may explain foreign banking activities in the US. For instance, Gray and Gray (1981) relate the theory of multinational banking to that of manufacturing corporations. Some of these studies including Gray and Gray (1981) argue that banks follow their customers abroad so that they can provide services to them in foreign countries. The regulatory environment was also suggested as another factor [e.g. Nigh et al., (1986)]. A study by Grosse and Goldberg (1991) used FDI into the US, bilateral trade, the size of the bank market and the country’s risk as the independent variables. A study by Goldberg and Saunders (1981) used the price-earnings ratio for bank stocks, relative economic activities, FDI in the US, as the major independent variables. Furthermore, a study by Hultman and McGee (1989) used bank the price-earnings ratio, the exchange rate and FDI in the US as the major independent variables determining foreign banks activities in the US. Given the above studies, one should also note the correct definition of FDI and hence to ensure that the explanatory variables chosen to measure FDI in banking are truly reflect those factors affecting FDI in banking. According to Australian Bureau of Statistics the concept of foreign direct investments is broadly defined as ‘capital invested in an enterprise by an investor having a significant influence, either potentially or actually exercised, over key policies of
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the enterprise’. This means that any investment by a foreign private investor of 10% or more of the ordinary shares of voting stock (or an equivalent equity interest) in Australian enterprise, will be recorded as a FDI flow. Thus, the data on FDI in banking in Australia will be used to measure the determinants of foreign FDI in Australia.
3. Factors contributing to FDI in banking in Australia There are various factors contributing to the expansion of both the flow and the stock of FDI in banking. In this study, both the flow and the stock of FDI in banking in Australia will be modelled. As the factors affecting the short-term flows of capital may be different to those factors contributing to the expansion of the stock of capital in a particular industry, different sets of hypotheses are attached to flow and stock data. 3.1. The flow model of FDI in banking in Australia The starting point in the analysis of the flow model of FDI in banking is the partial stock-adjustment model adapted from Kreicher (1981). This model is as follows FB −FB =l (FB* −FB ), (1) t,i t−1,i i t,i t−1,i where: FB =actual stock of country i’s (i.e. Australia’s) FDI liabilities in banking t,i to the Rest of the World at time t; FB* =desired stock of FDI in banking at time t,i t; and l =quarterly adjustment coefficient, 0
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According to the Survey of Current Business there are three elements which form the flows of FDI in banking. These are: equity capital inflows, reinvested earnings and intercompany debt inflows. Thus, the determinants of the flow of FDI in banking should take into account those factors which in the short term affect the capital inflows in the above three forms. Thus, in this paper, five hypotheses, based on the literature on capital flows studies by Kouri and Porter (1974), Kreicher (1981), Ruffin and Russekh (1986), Haynes (1988), and Ueda (1990), will be tested. These factors are: real domestic and foreign interest rates, Australia’s economic growth, foreign countries’ economic growth and Australia’s current account balance. 3.1.1. Interest rates Capital inflows are partially determined by real domestic and foreign interest rates. The foreign investors compare their real interest rate with that of Australia. Thus, one can write Australia’s real interest rate facing the foreign private investors as: (1+i )F au f −1, r = au (1+p )E f f where i is Australia’s nominal deposit interest rate, F is the expected exchange au f rate between Australia and country f, p is expected inflation in country f and E f f is the spot exchange rate between Australia and country f. Thus, one can write R as the weighted average of the real Australia’s interest rates facing foreign au private investors in various countries. The weight given to each is based on the that country’s FDI in banking in Australia. The hypothesis to be tested is that, the higher the increase in Australia’s real interest rate, the greater should be the amount of capital inflows in banking in Australia. The real interest rate in foreign country relevant to the FDI in banking is the deposit rate corrected for expected inflation. Thus, the real domestic interest rate of foreign country whose private investors invest in Australia is as follows: i −p f, r = f f 1+p f where i is country f ’s nominal deposit rate and p is country f ’s expected inflation. f f Thus, one can write R as a weighted average of the real interest rates of those f countries which invest in banking in Australia. The weight given to each country is based on the size of that country’s FDI in banking in Australia. The hypothesis to be tested is that the higher the increase in the real foreign interest rate, the lower the inflow of FDI in banking in Australia will be. 3.1.2. Foreign economic activities Economic activities in the host and source countries could also be important determinants of the FDI inflow in banking in Australia. The hypothesis to be tested is whether foreign economic activities have some effect on the flow of FDI in banking in Australia. An increase in foreign countries’ economic activities increases the
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demand for long-term investments. Furthermore, this also increases the supply of domestic long-term assets (for example, through the accelerator mechanism). Thus, economic activity may lead to either an increase in domestic demand for foreign assets (the spillover effect) or to a decrease in domestic demand for long-term foreign assets (the Tobin effect), depending on the relative responses of total domestic demand and domestic supply to changes in domestic economic activities. Therefore, the sign of the change in foreign countries’ economic activities may be either negative or positive with respect to the inflow of FDI in banking in Australia. 3.1.3. Australia’s economic activities Another hypothesis to be examined is the effect of Australia’s economic activity on the inflow of FDI in banking. An increase in Australia’s economic activity may attract foreign investment and/or the reinvestment of existing investments in banking in Australia, provided that faster activity is associated with an increase in the rate of return. However, an increase in Australia’s economic activities may lead to a decrease in Australia’s liabilities to foreigners if the ‘spill over effect’ results in the repurchase of domestic assets from foreigners. Thus, the effect of Australia’s economic activity may either be positive or negative with respect to FDI in banking. This study will apply the use of the national income to capture the effects of economic growth on FDI in the host and source countries, similar to studies by Goldberg and Saunders (1981) and Schneider and Frey (1985). 3.1.4. Current account balance Kouri and Porter (1974), Ueda (1990) used the current account balance as one of the explanatory variables in modelling the capital flows. A deficit in the current account balance can mean one of two things. On the one hand, a large deficit may mean that the country is living beyond its means so that there is a real threat that the movement of free capital will be restricted and it will thus be more difficult to transfer profits from the host to the home country. Under such circumstances, the economic situation will be least appealing to foreign investors, in other words, the larger the current account deficit, the less FDI will be attracted (Schneider and Frey, 1985). On the other hand, it may be an indicator of an expanding economy, whereby the prospects for profitable business are good. In this scenario, private investors will be attracted to invest in the relevant country in order to take advantage of the opportunities offered by a booming economy. The hypothesis to be tested is whether Australia’s current account balance affects the inflow of FDI in banking in Australia and if so whether the causality is positive or negative. Thus, one can write the FDI inflow in banking for Australia as DFB =b +aDFB +b DR +b DR +b DGF +b DGD +b CA , t 0 t−1 1 us 2 f 3 t 4 t 5 t where: DFB =the capital inflow in banking in the US during period t; t
(5)
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DR =change in the US real interest rate facing foreign investors in various us countries during period t; DR =change in the foreign real interest rates of those countries which invest in f the banking industry in the US during period t; %DGF =weighted average percentage change in the foreign countries’ economic t growth during period t. The weight given to each country is based on that country’s inflow of FDI in banking in the US. %DGD =percentage change in the US economic growth during period t; t CA =the US current account balance during period t. t The expected signs of the above variables are a>0,b >0,b <0,b ?,b ? 1 2 3 4 and b ? 5 3.2. The model of stock of FDI in banking in Australia While in the short term, FDI flows would be affected by some short-term factors, the stock of FDI in banking is determined by those factors which have more longterm influence on the foreign banking activities in Australia. The first step in analyzing the stock data of FDI in banking will be to select the most relevant factors which appear to be the main determinants of the stock of FDI in banking in Australia. The following factors have been selected: (a) size of the market in the host country; (b) cost of capital; (c) exchange rate; (d ) labour costs (wages); (e) FDI in manufacturing; and (f ) banks’ foreign assets. Note that while some of these factors have been also identified for general FDI, the proxies used to represent these factors are appropriate for FDI in banking only, as opposed to FDI in manufacturing and/or general FDI. The remaining part of this section will discuss the above factors. 3.2.1. Size of Australia’s banking market When foreign investors (banks and non-banks) consider whether to invest in Australia, the size of Australia’s banking market could be one of the factors that they take into account. Some researchers who dealt with foreign banks activities in the US have argued that a large domestic banking market in the source country contributes to the amount of its banks activities in the US. On the other hand, Kravis and Lipsey (1982), and O’Sullivan (1985) argued that the size of the host country’s market is one of the significant determinants of FDI. In this study, as FDI in banking is made by investors from both banks and non-banks, we hypothesize that the size of Australia’s banking market is an important factor in attracting foreign investors (banks and non-banks) to this market. The larger the size of Australia’s banking market, the greater the number of potential investors (banks and non-banks) willing to invest in Australia. Therefore, a positive correlation between FDI in banking in Australia and the size of Australia’s banking market is expected. The size of Australia’s banking market, similar to the study by Grosse and Goldberg (1991), is proxied by the sum of two types of deposits held by
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Australian banks: (1) time, savings and foreign currency deposits; and (2) demand deposits. 3.2.2. Cost of capital The traditional literature on cost of capital, especially in the banking area (see for example, McCauley and Zimmer, 1989) define ‘cost of capital’ as ‘the minimum rate of return investors will require on their investment’. Furthermore, Zimmer and McCauley (1991) define a banks’ cost of capital for a financial product as ‘the spread or fee that allows the required regulatory capital to earn the rate of return demanded by the market’. Taxes are also one of the most likely variables influencing the level of FDI in banking in a country. The tax regime in use will determine whether or not it will be an attractive location for private investors to establish part of their foreign operations. Zimmer and McCauley (1991) have shown that once the bank managers have calculated the cost of equity per bank, they should work out the spread or fee that they must charge on individual financial products to cover their equity costs. In other words, assuming that the spread is set in such a way that satisfies the required equity cost, one may use the spread (measured as lending rate minus deposit rate corrected for corporate tax) as a proxy for the cost of equity for banks.1 Thus, if the Australian domestic banks require a large spread to cover their equity cost, this will place foreign banks in a better competitive position against Australian banks and hence will expand FDI in banking in Australia. In this study, the spread between lending and deposit rates of Australia compared with the ‘rest of the world’2 will be used as a proxy for cost of equity for banks. A positive correlation is expected between the FDI in banking in Australia and the relative cost of equity for banks. 3.2.3. Labor cost Studies dealing with FDI for manufacturing in developing countries such as Tsai (1991) and Jeon (1992) found wages to be statistically significant. However, most of the studies (such as Kravis and Lipsey (1982)) dealing with FDI in developed countries, where a number of factors were considered as possible explanatory variables, did not find wages to be statistically significant.3 Given the nature of the banking industry which is generally capital intensive, one would expect that for FDI in banking as compared with FDI in manufacturing, the cost of capital would be 1 Note that, according to the OECD (1994), despite the increase in non-interest related activities of banks, interest related income of banks form over 60 to 70% of the major OECD countries’ banks incomes. Furthermore, one would assume, as Zimmer and McCauley (1991) did, that a commitment to lend from the ‘off balance sheet’ of banks should also be subject to the required spread between lending and deposit rates. Thus, in this study, as we compare the bank cost of capital between countries, the spread between lending and deposit rates will be used as the proxy for bank cost of capital. 2 In this study, the ‘rest of the world’ refers to those major countries that have FDI in banking in Australia. These countries form over 70% of FDI in banking in Australia and are as follows: the US, Japan, the UK, and New Zealand. 3 Exception to these findings is the study by Cushman (1988).
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more relevant than the cost of labor. On the other hand, one may also argue that as over 70–75% of the operating cost of banks, as reported by the OECD (1994), are wages, one would expect that the relative wages between Australia and the ‘rest of the world’ would be an important factor in determining the amount of FDI in banking in Australia. 3.2.4. Exchange rate Given that foreign private investors’ operations may involve substantial flows of diverse foreign currencies, exchange rates are expected to have an impact on their FDI decisions. One possible explanation for a positive correlation between the value of the Australian dollar and FDI in Australia could be that foreign investors anticipate any investment they make in Australia to appreciate with the value of the Australian dollar. On the other hand, it can be argued that such behavior will be more likely for short-term liquid assets. The book value of long-term assets should be less prone to such fluctuations. Extending this argument, one would expect a negative correlation between the value of the Australian dollar and FDI in Australia. When the Australian dollar appreciates with respect to the foreign investors, currencies, FDI in Australia is expected to decrease because it will be more expensive for foreign investors to invest in Australia, and vice versa. In other words, a depreciated domestic currency will give foreigners an edge in acquiring control of domestic productive assets. Such a negative correlation is reported by authors such as Cushman (1988), and Froot and Stein (1991). Note also that, as the Australian dollar depreciates, private investors may reduce their repatriated income and increase their reinvestment in Australia, as they may want to avoid exchange rate losses. There are several indices available to account for exchange rates. The most appropriate one is the IMF’s Multilateral Exchange Rate Model (MERM ) index, which is superior to the other indices available for the purposes of this study.4 The way the index is constructed implies that an increase in Australian dollar,s MERM index indicates an appreciation of Australian dollar with respect to a weighted basket of the other currencies. 3.2.5. FDI in manufacturing As mentioned earlier, FDI in banking can take place by both private non-banks and banks investors. While the above five hypotheses are relevant to both banks and non-banks investors willing to invest in the Australian banking market, the
4 As Hultman and McGee (1989) argued, the manner in which the MERM is constructed makes it an explanatory variable which goes beyond simply measuring the exchange rates of currencies. The index is a combination of exchange rates and weights from the IMF’s Multilateral Exchange Rate Model. The weights take into account the size of trade flows as well as the relevant price elasticities and the feedback effects of exchange rate changes on domestic costs and prices. As a result, the value of the dollar index used in this study captures more than just changes in the exchange rates between the Australian dollar and other countries’ currencies.
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following two factors are more relevant to foreign banks who want to establish their offices and branches in Australia. A positive correlation is expected between FDI in banking and FDI in manufacturing. The rationale for this, according to a number of researchers, is that multinational banks (MNB’s) will follow their multinational customers abroad so that they can provide services for their customers’ foreign operations. The literature suggests that due to imperfections in the factor markets, MNB’s have unique knowledge about their clients. MNB’s can access information about their multinational clients faster and at lower marginal costs. Since they are not willing to sell their unique knowledge, but use it as a comparative advantage, following a client abroad becomes an internalizing factor which drives MNB’s to set up branches in other countries. The theoretical justification of the follow-the-client hypothesis applied to banks is provided by Gray and Gray (1981). Supporting evidence for this hypothesis is reported, amongst others, by Nigh et al., (1986). In the case of foreign banks activities in the US, researchers found a positive correlation between the foreign banks’ shares of total US commercial assets and/or the number of foreign banks’ offices and general FDI in the US. However, in this study, the composite parts of FDI in Australia will be related to each other. In other words, FDI in banking as a dependent variable will be related to FDI in manufacturing, so that one can see whether FDI in banking is a complement to or a substitute for FDI in manufacturing. 3.2.6. Banks’ foreign assets Another factor which may be related to FDI in banking in Australia is banks’ foreign assets. While banks’ foreign assets (i.e. banks’ claims against foreigners) can be generated in both the domestic and the foreign markets, banks generally have easier access to the foreign market so that they can expand their assets to foreign clients.5 If a US bank in Australia lends money to a US company operating in Australia, the US banks’ lending, provided that both the US company and the US banks are not locally incorporated, will not be considered as US banks’ foreign assets. However, this relationship between a US bank and a US company is captured by the previous hypothesis (i.e. the follow-the-client hypothesis). On the other hand, if a US bank, not locally incorporated in Australia, lends money to a domestic Australian company and/or a Chinese company operating in Australia, these lendings will be considered as the US banks’ foreign assets, and the presence of the US bank in Australia may be instrumental in establishing this lending. Thus, one may argue that FDI in banking in Australia is connected to foreign countries expansion of their banks’ foreign assets. In other words, while FDI in manufacturing may be the factor accounting for banks ‘following their customer abroad’, their presence in the foreign market will also provide an opportunity for them to provide financial services to foreign customers. Thus, one can argue that foreign countries banks’ foreign assets can account for the expansion of foreign banks’ lending activities to both 5 According to the IMF definition of banks’ foreign assets provided by Landell-Mills (1986), these assets are defined as those assets of financial institutions (banks and others) held against foreign citizens, which can be generated both within domestic economy and outside domestic economy.
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Australian citizens and non-Australian residents operating in Australia,6 as well as foreign customers outside Australia who are seeking bank credit from the Australian market.
4. A model for FDI in banking in Australia Based on the previous discussion, the proposed model for FDI in banking in Australia is as follows GB=f (D, C, W, X, M, B).
(6)
GB=stock of FDI in banking in Australia measured in current US dollars. D=sum of Australia’s commercial bank deposits measured in current US dollars. C=relative cost of equity for banks between Australia and the ‘rest of the world’. The spread (measured as lending rate minus deposit rate corrected for corporate tax) is used to measure the cost of capital. The cost of equity for banks for the ‘rest of the world’ is calculated as a weighted average of those countries investing in Australia’s banking market. The weights are based on the countries’ respective share of FDI in banking in Australia. W=relative wages between Australia and the ‘rest of the world’ measured in current US dollars. Wages indices are corrected for the effect of exchange rates between the US dollars and the rest of the world. The foreign wages are weighted average wages of those countries forming the ‘rest of the world’ in this study. The weight given to each country is based on that country’s share of FDI in banking in Australia. X=Australia’s real MERM index (a measure of the real value of the Australian dollar). M=stock of FDI in manufacturing in Australia measured in current US dollars. B=weighted average of banks’ foreign assets of the ‘rest of the world’ measured in current US dollars. The weight given to each country is based on that country’s share of FDI in banking in Australia. The period covered is from 1985:I to 1996:IV. In summary, the model for FDI in banking in Australia can be expressed as: GB=a +a D+a C+a W+a X+a M+a B, 0 1 2 3 4 5 6 with the following expected signs:
(7)
a >0,a >0,a <0,a ?,a >0,a >0. 1 2 3 4 5 6
6 In the empirical reports of this study, there will be some discussion about the endogeneity problem when banks’s foreign assets are used as an independent variable.
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5. Data and methodology The model employed uses time-series data. The most crucial sets of unpublished data, i.e. capital stock in banking and in manufacturing for the period 1985–96, were obtained for the purposes of this study from the International Division of Australian Bureau of Statistics. Note that for 1994, 1996 quarterly data are constructed on the basis of estimated annual data. These data are in their current value. For instance, the current value of FDI in banking in Australia for 1993 comprises FDI in banking in Australia in 1992 corrected for capital inflows, ‘price changes’, ‘exchange rate changes’ and ‘other changes’ in 1993. For 1994–1996, quarterly data are constructed on the basis of published annual data. Data relating to the independent variables are obtained from various issues of the International Financial Statistics published by the IMF. The first step in estimating the model involved generating a measure of expected inflation. The Box–Jenkins ARIMA forecast method was used for this purpose, effecting a sample which extended from the first quarter 1970 to the first quarter 1997. Inflation is forecast as an ARIMA (1,1,0) process. That is, an autoregressive process with lag 1, and 1 degree of differencing. The forecasting horizon is four quarters ahead. The expected inflation forecast is then used to generate the real effective interest rate. First, ordinary least squares (OLS) regression is applied to the data in Eqs. (5) and (7). Due to a possible simultaneity bias problem (see Kouri and Porter (1974)), which may occur if the domestic interest rate affects the inflow of capital, the method of instrumental variable estimation is used to obtain consistent estimates for the regression model of Eq. (5). Since it is suspected that the banks’ foreign assets variable may be endogenous (in other words, this variable and FDI in banking in the US may be inter-related), the instrumental variable (IV ) procedure is also applied to account for any simultaneity bias problems in the stock model (i.e. Eq. (7)). From the results of the preliminary OLS regression coupled with diagnostic tests (columns 2 and 4 of Table 1), it is observed that there is significant heteroskedasticity associated with the data (the White measure of heteroskedasticity, WHET, is significant at the 1% level ). As a result, the final step is to use the generalized method of moments (GMM ) with a view to correct for the heteroskedasticity. Moreover, GMM will account for any residual serial correlation. The correlation matrices generated by the diagnostic tests are used to choose the instruments so that they are highly correlated with the explanatory variables they are substituting. The option NMA=m is employed in the GMM command to account for serial correlation (if any). From the diagnostic tests carried out on the residuals, the optimal lag truncation parameter, m, is found to be 5 for Eq. (7) and 11 for Eq. (5) (to the nearest integer) from Andrews (1991), Table 1. The optimal results for the GMM procedure are reported in Table 1. Considering the GMM results, it is observed that the Parzen gives a better result for Eq. (5) and the Bartlett gives a better result for Eq. (7). Therefore, given the above discussion, the following interpretation of the results is justified.
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Table 1 Regression results for flow and stock data of FDI in banking in Australia, 1985:I–1996:IV Eq. (5)
OLS
GMM NMA=11 (Bartlett)
Eq. (7)
OLS
GMM, NMA=5 (Bartlett)
b 0 DFB t−1 DR us DR f %DGF t−1 %DGD t−1 CA t−1 R 92 DW WHETa JBb J-statistics
0.16(0.67) −0.05(−0.42) −0.06(−1.8) −0.02(−1.9) −9.1(1.0) 14.1*(2.6) −0.09(−1.2) 0.079 2.1 30.3** 0.45(0.79)
0.70(4.7) 0.75**(12.9) 0.10*(2.5) −0.06**(10.4) 24.1*(2.5) −22.1**(−6.6) 0.19**(4.4)
a 0 D C W X M B R 92 DW WHETa JBb J-statistics
1.55(0.20) 0.03(0.30) 2.2(0.16) 1.1*(2.5) −1.73*(−2.5) 0.25*(2.8) 0.43(0.75) 0.89 0.37 38.6** 0.20(0.30)
3.93(1.6) 0.33**(3.5) 0.24**(3.8) −0.51*(1.9) −1.62**(−3.5) 0.75*(11.1) 0.32**(6.2)
4.7
2.1
2.5
* and ** indicate that an estimate is significantly different from zero at the 5% level and 1% level, respectively. Student’s t statistics are shown in parenthesis. OLS=ordinary least square. GMM=generalised methods of moments. aWhite test for heteroscedasticity. bJacque–Bera test statistic for normality; p-value in parenthesis.
6. Empirical results for FDI in banking in Australia As can be seen, columns 2 and 3 of Table 1 report the empirical results of Eq. (5). As can be seen the adjusted R2 for Eq. (5) is very low and hence one should be cautious about the empirical results of this equation. In column 3, the lag value of capital inflow in banking (DFB ) has the expected positive sign and is statistically t−1 significant. Australia’s domestic interest rate variable has the expected positive sign and is statistically significant. The foreign real deposit rate is statistically significant with a negative sign indicating that the change in the interest rates of foreign countries can affect the inflow of FDI in banking in Australia. The foreign economic growth variable (GF ) is statistically significant with a positive sign indicating that as foreign countries’ economic activities expand, foreign investors tend to invest more in Australia. The negative sign for Australia’s economic growth variable indicates that foreigners, in the wake of an increase in Australia’s economic activities, tend to decrease their new investment and repatriate part of the profit generated from their existing assets from Australia. Australia’s current account balance variable is statistically significant with a positive sign indicating that a high current account deficit in Australia is interpreted by foreign investors as a sign of market expansion and investment opportunities. Australia’s current account deficit is perceived by foreign investors as a positive factor for further economic growth and investment in Australia. The overall statistical results of Eq. (5) are consistent with the majority of studies in the area of capital flow such as Kouri and Porter (1974), Ruffin and
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Russekh (1986) who found that some of the short-term economic variables influence the flow of capital. As can be seen, columns 5 and 6 of Table 1 report the empirical results of Eq. (7). In column 6, Australian banks’ commercial deposit variable (D) is statistically significant with a positive sign. This result is consistent with the expectation that foreign investors are attracted to invest in a host country whose banking market is large. FDI in banking in Australia is found to be positively correlated with the relative cost of equity for banks (C ) between Australia and the ‘rest of the world’. The positive sign of this variable implies that foreign banks will find themselves in a better competitive position to enter Australia’s market and compete with Australian domestic banks and hence increase their market share in Australia. Furthermore, this result indicates, indirectly, that foreign non-bank investors consider the relative cost of equity for banks as an important factor in deciding whether to invest in Australian banking market. The empirical result of this variable is also consistent with the price-earnings ratio variable used by Goldberg and Saunders (1981) and Hultman and McGee (1989) in measuring the determinants of factors contributing to the expansion of foreign banks in the US. The relative wage variable (W ) is statistically significant with a negative sign. This result indicates that as Australia’s wages increase relative to the source countries, the level of FDI in banking declines. The index used to proxy the exchange rate of the Australian dollar, X, is positively correlated with FDI in banking. This means that foreign investors anticipate that any investment they make in Australia will appreciate with the value of the Australian dollar. This result is consistent with the findings of Hultman and McGee (1989) where they found a positive relationship between the exchange rate variable and foreign banks’ activities in the US. For Australia, FDI in banking appears to be a complement to FDI in manufacturing and hence this result does support the theoretical argument that FDI in banking and manufacturing are complementary to each other. Banks’ foreign assets belonging to foreign countries (B) are statistically significant with a positive sign. This result indicates that, as the international lending activities of foreign banks increase, there is an accompanying increase in their FDI in banking. Therefore, an increase in a foreign bank’s FDI in Australia can be interpreted as a greater capacity for it to engage in international lending activities from Australian market. Thus, one can argue that banks’ foreign assets can account for the expansion of foreign banks’ lending activities to both Australian citizens and non-Australian residents operating in Australia, as well as foreign customers outside Australia who are seeking bank credit from the Australian market.
7. Conclusion This paper has distinguished between the activities of foreign banks in Australia and FDI in banking in Australia. It has argued that the number of offices of foreign
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banks and/or the share of their assets in Australia’s commercial bank assets do not fully reflect the magnitude of FDI in banking in Australia. A model for the flow of FDI in banking has been proposed which comprises certain explanatory variables (i.e. domestic and foreign interest rates, domestic and foreign economic activities and the current account balance) similar to other models developed to measure international portfolio investment and general FDI. Furthermore, a model for the stock of FDI in banking has been proposed which comprises certain explanatory variables (i.e. the size of Australia’s banking industry, the cost of capital in banking, wages, foreign exchange rates, FDI in manufacturing and banks’ foreign assets), peculiar to FDI in banking as compared with FDI in general and/or FDI in manufacturing. The empirical results of the stock model of FDI in banking in Australia indicate that the bank cost of capital, the size of Australia’s banking market, current account deficit in Australia, the exchange rate, and banks’ foreign assets are the major determinants of FDI in banking in Australia. Furthermore, the empirical results in this study do support that FDI in manufacturing is a complement to FDI in banking. Given some of the above factors which can be generalised as those factors that private investors would consider as universally important factors determining their level of FDI in banking, one would expect that, with better foreign market access for trade in financial services in the Post Uruguay Era, private investors (banks and non-banks) may increase their investment in Australia, as the Australian financial institutions may increase their operation in the Asia–Pacific region.
Acknowledgements The author is grateful to the editor, Ike Mathur, and an anonymous referee for helpful comments.
References Andrews, D., 1991. Heteroskedasticity and autocorrelation consistent covariance matrix estimation. Econometrica 59, 817–858. Cushman, D.O., 1988. Exchange-rate uncertainty and foreign direct investment in the United States. Weltwirtschaftliches Archiv 124, 322–336. Froot, K.A., Stein, J.C., 1991. Exchange rates and foreign direct investment: an imperfect capital markets approach. The Quarterly Journal of Economics 106, 1191–1217. Goldberg, L.G., Saunders, A., 1981. The Determinants of foreign banking activity in the United States. Journal of Banking and Finance 5, 17–32. Gray, J., Gray, P., 1981. The multinational bank: a financial MNC? Journal of Banking and Finance 5, 33–63. Grosse, R., Goldberg, L.G., 1991. Foreign bank activity in the United States: an analysis by country of origin. Journal of Banking and Finance 15, 1093–1112. Haynes, S., 1988. Identification of interest rates and international capital flows. Review of Economics and Statistics 74, 103–111.
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Hultman, C.W., McGee, L., 1989. Factors affecting the foreign banking presence in the US. Journal of Banking and Finance 13, 383–396. Kouri, P., Porter, M., 1974. International capital flows and portfolio equilibrium. Journal of Political Economy 82, 443–467. Kravis, I.B., Lipsey, R., 1982. The location of overseas production and production for export by US multinational firms. Journal of International Economics 12, 201–223. Kreicher, L.L., 1981. International portfolio capital flows and real rates of interest. Review of Economics and Statistics 67, 20–28. Jeon, Y., 1992. The determinants of Korean foreign direct investment in manufacturing industries. Weltwirtschaftliches Archiv 128, 527–545. Landell-Mills, J., 1986. The fund’s international banking statistics. IMF, Washington, DC. McCauley, R.N., Zimmer, S.A., 1989. Bank cost of capital and international competition. Federal Reserve Bank of New York Quarterly Review 15, 33–59. Nigh, D., Cho, R., Krishnan, S., 1986. The role of location-related factors in US banking investment abroad: an empirical examination, Journal of International Business Studies, Fall, 59–72. OECD 1994. Bank Profitability. OECD, Paris. O’Sullivan, P., 1985. Determinants and impact of private foreign direct investment in host countries. Management International Review 25, 28–35. Ruffin, R., Russekh, F., 1986. The Role of foreign direct investment in US capital flows. American Economic Review 76, 1127–1130. Schneider, F., Frey, B.S., 1985. Economic and political determinants of foreign direct investment. World Development 13, 161–175. Tsai, P., 1991. Determinants of foreign direct investment in Taiwan. World Development 19, 275–285. Ueda, K., 1990. Japanese capital outflows. Journal of Banking and Finance 14, 1079–1101. Zimmer, S., McCauley, R.N., 1991. Bank cost of capital and international competition. Federal Reserve Bank of New York Quarterly Review 15, 33–59.
International financial services: multinational financial companies in Australia Fariborz Moshirian * School of Banking and Finance, The University of New South Wales, Sydney 2052, Australia Received 1 March 1997; accepted 1 February 1998
Abstract The purpose of this paper is to analyze and measure the determinants of foreign investment in financial services in Australia over the period 1985–96. The empirical results of the flow data show that Australia’s current account balance, domestic and foreign interest rates and domestic and foreign economic activities are contributing to the expansion of the inflow of foreign investment in financial services in Australia. Furthermore, the empirical results of the stock data of investment in financial services indicate that the bank cost of capital, the size of Australia’s banking market, the real exchange rate, investment in manufacturing and banks’ foreign assets are the major determinants of foreign investment in financial services in Australia. © 1998 Elsevier Science B.V. All rights reserved. JEL classification: G15; G24 Keywords: Financial services; Foreign investment; International banking
1. Introduction In the 1960s and 1970s, the inflow of foreign capital into Australia was largely in the form of direct investment in manufacturing industries by multinational enterprises, principally from the UK. In the 1980s, particularly since deregulation of the Australian financial market and liberalization of foreign banks activities in Australia, the amount of the FDI in banking in Australia has increased over the period 1985–95, the FDI in banking has increased three-fold, while FDI in manufacturing has increased two-fold. Although FDI in banking in Australia, similar to FDI in banking in the US, form only about 7% of total FDI in Australia, however, as the banking industry is connected to other industries, in particular manufacturing, the examination of FDI in this industry is important. Interestingly, greater than 70% of * Corresponding author. Tel: 00 612 9385 5861; Fax: 00 612 9385 6347; e-mail: [email protected] 1042-444X/98/$ – see front matter © 1998 Elsevier Science B.V. All rights reserved. PII S 10 4 2 -4 4 4 X ( 9 8 ) 0 0 03 7 - 1
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the FDI in banking in Australia has been from only five countries (i.e. the United States, the United Kingdom, Japan, Singapore and New Zealand ). While the UKs share of FDI in banking in Australia declined from 25 to 15% between 1987 and 1994, that of the US and Japan increased from 14 to 25% over the same period. This means that the US and Japan are now the major investors in banking in Australia. In this study, unlike the studies of foreign banks’ activities in the US which failed to directly measure FDI in banking, unpublished quarterly data on FDI in banking in Australia will be used to measure the determinants of FDI in banking in Australia. These data provide, for the first time, an opportunity to measure Australia’s FDI, using time-series data over 1985–94, not only in general, or for manufacturing, but also for banking and allow us to establish a model which is appropriate for FDI in banking. The paper is structured as follows: Section 2 will review some of the relevant literature in FDI; Section 3 will propose various factors which determine FDI in banking in Australia; Section 4 will model FDI in banking in Australia; Section 5 will describe sources of data and the methodology used in this paper; Section 6 will report the empirical findings; and Section 7 will make some concluding remarks.
2. Literature review A number of researchers have studied the determinants of FDI. While this study does not intend to survey all these works, some of the recent studies, which are more relevant to FDI in banking, will be briefly mentioned. Some specific studies have been made in the area of foreign banks’ activities in the US. Researchers attempted to empirically find various factors which may explain foreign banking activities in the US. For instance, Gray and Gray (1981) relate the theory of multinational banking to that of manufacturing corporations. Some of these studies including Gray and Gray (1981) argue that banks follow their customers abroad so that they can provide services to them in foreign countries. The regulatory environment was also suggested as another factor [e.g. Nigh et al., (1986)]. A study by Grosse and Goldberg (1991) used FDI into the US, bilateral trade, the size of the bank market and the country’s risk as the independent variables. A study by Goldberg and Saunders (1981) used the price-earnings ratio for bank stocks, relative economic activities, FDI in the US, as the major independent variables. Furthermore, a study by Hultman and McGee (1989) used bank the price-earnings ratio, the exchange rate and FDI in the US as the major independent variables determining foreign banks activities in the US. Given the above studies, one should also note the correct definition of FDI and hence to ensure that the explanatory variables chosen to measure FDI in banking are truly reflect those factors affecting FDI in banking. According to Australian Bureau of Statistics the concept of foreign direct investments is broadly defined as ‘capital invested in an enterprise by an investor having a significant influence, either potentially or actually exercised, over key policies of
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the enterprise’. This means that any investment by a foreign private investor of 10% or more of the ordinary shares of voting stock (or an equivalent equity interest) in Australian enterprise, will be recorded as a FDI flow. Thus, the data on FDI in banking in Australia will be used to measure the determinants of foreign FDI in Australia.
3. Factors contributing to FDI in banking in Australia There are various factors contributing to the expansion of both the flow and the stock of FDI in banking. In this study, both the flow and the stock of FDI in banking in Australia will be modelled. As the factors affecting the short-term flows of capital may be different to those factors contributing to the expansion of the stock of capital in a particular industry, different sets of hypotheses are attached to flow and stock data. 3.1. The flow model of FDI in banking in Australia The starting point in the analysis of the flow model of FDI in banking is the partial stock-adjustment model adapted from Kreicher (1981). This model is as follows FB −FB =l (FB* −FB ), (1) t,i t−1,i i t,i t−1,i where: FB =actual stock of country i’s (i.e. Australia’s) FDI liabilities in banking t,i to the Rest of the World at time t; FB* =desired stock of FDI in banking at time t,i t; and l =quarterly adjustment coefficient, 0
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According to the Survey of Current Business there are three elements which form the flows of FDI in banking. These are: equity capital inflows, reinvested earnings and intercompany debt inflows. Thus, the determinants of the flow of FDI in banking should take into account those factors which in the short term affect the capital inflows in the above three forms. Thus, in this paper, five hypotheses, based on the literature on capital flows studies by Kouri and Porter (1974), Kreicher (1981), Ruffin and Russekh (1986), Haynes (1988), and Ueda (1990), will be tested. These factors are: real domestic and foreign interest rates, Australia’s economic growth, foreign countries’ economic growth and Australia’s current account balance. 3.1.1. Interest rates Capital inflows are partially determined by real domestic and foreign interest rates. The foreign investors compare their real interest rate with that of Australia. Thus, one can write Australia’s real interest rate facing the foreign private investors as: (1+i )F au f −1, r = au (1+p )E f f where i is Australia’s nominal deposit interest rate, F is the expected exchange au f rate between Australia and country f, p is expected inflation in country f and E f f is the spot exchange rate between Australia and country f. Thus, one can write R as the weighted average of the real Australia’s interest rates facing foreign au private investors in various countries. The weight given to each is based on the that country’s FDI in banking in Australia. The hypothesis to be tested is that, the higher the increase in Australia’s real interest rate, the greater should be the amount of capital inflows in banking in Australia. The real interest rate in foreign country relevant to the FDI in banking is the deposit rate corrected for expected inflation. Thus, the real domestic interest rate of foreign country whose private investors invest in Australia is as follows: i −p f, r = f f 1+p f where i is country f ’s nominal deposit rate and p is country f ’s expected inflation. f f Thus, one can write R as a weighted average of the real interest rates of those f countries which invest in banking in Australia. The weight given to each country is based on the size of that country’s FDI in banking in Australia. The hypothesis to be tested is that the higher the increase in the real foreign interest rate, the lower the inflow of FDI in banking in Australia will be. 3.1.2. Foreign economic activities Economic activities in the host and source countries could also be important determinants of the FDI inflow in banking in Australia. The hypothesis to be tested is whether foreign economic activities have some effect on the flow of FDI in banking in Australia. An increase in foreign countries’ economic activities increases the
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demand for long-term investments. Furthermore, this also increases the supply of domestic long-term assets (for example, through the accelerator mechanism). Thus, economic activity may lead to either an increase in domestic demand for foreign assets (the spillover effect) or to a decrease in domestic demand for long-term foreign assets (the Tobin effect), depending on the relative responses of total domestic demand and domestic supply to changes in domestic economic activities. Therefore, the sign of the change in foreign countries’ economic activities may be either negative or positive with respect to the inflow of FDI in banking in Australia. 3.1.3. Australia’s economic activities Another hypothesis to be examined is the effect of Australia’s economic activity on the inflow of FDI in banking. An increase in Australia’s economic activity may attract foreign investment and/or the reinvestment of existing investments in banking in Australia, provided that faster activity is associated with an increase in the rate of return. However, an increase in Australia’s economic activities may lead to a decrease in Australia’s liabilities to foreigners if the ‘spill over effect’ results in the repurchase of domestic assets from foreigners. Thus, the effect of Australia’s economic activity may either be positive or negative with respect to FDI in banking. This study will apply the use of the national income to capture the effects of economic growth on FDI in the host and source countries, similar to studies by Goldberg and Saunders (1981) and Schneider and Frey (1985). 3.1.4. Current account balance Kouri and Porter (1974), Ueda (1990) used the current account balance as one of the explanatory variables in modelling the capital flows. A deficit in the current account balance can mean one of two things. On the one hand, a large deficit may mean that the country is living beyond its means so that there is a real threat that the movement of free capital will be restricted and it will thus be more difficult to transfer profits from the host to the home country. Under such circumstances, the economic situation will be least appealing to foreign investors, in other words, the larger the current account deficit, the less FDI will be attracted (Schneider and Frey, 1985). On the other hand, it may be an indicator of an expanding economy, whereby the prospects for profitable business are good. In this scenario, private investors will be attracted to invest in the relevant country in order to take advantage of the opportunities offered by a booming economy. The hypothesis to be tested is whether Australia’s current account balance affects the inflow of FDI in banking in Australia and if so whether the causality is positive or negative. Thus, one can write the FDI inflow in banking for Australia as DFB =b +aDFB +b DR +b DR +b DGF +b DGD +b CA , t 0 t−1 1 us 2 f 3 t 4 t 5 t where: DFB =the capital inflow in banking in the US during period t; t
(5)
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DR =change in the US real interest rate facing foreign investors in various us countries during period t; DR =change in the foreign real interest rates of those countries which invest in f the banking industry in the US during period t; %DGF =weighted average percentage change in the foreign countries’ economic t growth during period t. The weight given to each country is based on that country’s inflow of FDI in banking in the US. %DGD =percentage change in the US economic growth during period t; t CA =the US current account balance during period t. t The expected signs of the above variables are a>0,b >0,b <0,b ?,b ? 1 2 3 4 and b ? 5 3.2. The model of stock of FDI in banking in Australia While in the short term, FDI flows would be affected by some short-term factors, the stock of FDI in banking is determined by those factors which have more longterm influence on the foreign banking activities in Australia. The first step in analyzing the stock data of FDI in banking will be to select the most relevant factors which appear to be the main determinants of the stock of FDI in banking in Australia. The following factors have been selected: (a) size of the market in the host country; (b) cost of capital; (c) exchange rate; (d ) labour costs (wages); (e) FDI in manufacturing; and (f ) banks’ foreign assets. Note that while some of these factors have been also identified for general FDI, the proxies used to represent these factors are appropriate for FDI in banking only, as opposed to FDI in manufacturing and/or general FDI. The remaining part of this section will discuss the above factors. 3.2.1. Size of Australia’s banking market When foreign investors (banks and non-banks) consider whether to invest in Australia, the size of Australia’s banking market could be one of the factors that they take into account. Some researchers who dealt with foreign banks activities in the US have argued that a large domestic banking market in the source country contributes to the amount of its banks activities in the US. On the other hand, Kravis and Lipsey (1982), and O’Sullivan (1985) argued that the size of the host country’s market is one of the significant determinants of FDI. In this study, as FDI in banking is made by investors from both banks and non-banks, we hypothesize that the size of Australia’s banking market is an important factor in attracting foreign investors (banks and non-banks) to this market. The larger the size of Australia’s banking market, the greater the number of potential investors (banks and non-banks) willing to invest in Australia. Therefore, a positive correlation between FDI in banking in Australia and the size of Australia’s banking market is expected. The size of Australia’s banking market, similar to the study by Grosse and Goldberg (1991), is proxied by the sum of two types of deposits held by
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Australian banks: (1) time, savings and foreign currency deposits; and (2) demand deposits. 3.2.2. Cost of capital The traditional literature on cost of capital, especially in the banking area (see for example, McCauley and Zimmer, 1989) define ‘cost of capital’ as ‘the minimum rate of return investors will require on their investment’. Furthermore, Zimmer and McCauley (1991) define a banks’ cost of capital for a financial product as ‘the spread or fee that allows the required regulatory capital to earn the rate of return demanded by the market’. Taxes are also one of the most likely variables influencing the level of FDI in banking in a country. The tax regime in use will determine whether or not it will be an attractive location for private investors to establish part of their foreign operations. Zimmer and McCauley (1991) have shown that once the bank managers have calculated the cost of equity per bank, they should work out the spread or fee that they must charge on individual financial products to cover their equity costs. In other words, assuming that the spread is set in such a way that satisfies the required equity cost, one may use the spread (measured as lending rate minus deposit rate corrected for corporate tax) as a proxy for the cost of equity for banks.1 Thus, if the Australian domestic banks require a large spread to cover their equity cost, this will place foreign banks in a better competitive position against Australian banks and hence will expand FDI in banking in Australia. In this study, the spread between lending and deposit rates of Australia compared with the ‘rest of the world’2 will be used as a proxy for cost of equity for banks. A positive correlation is expected between the FDI in banking in Australia and the relative cost of equity for banks. 3.2.3. Labor cost Studies dealing with FDI for manufacturing in developing countries such as Tsai (1991) and Jeon (1992) found wages to be statistically significant. However, most of the studies (such as Kravis and Lipsey (1982)) dealing with FDI in developed countries, where a number of factors were considered as possible explanatory variables, did not find wages to be statistically significant.3 Given the nature of the banking industry which is generally capital intensive, one would expect that for FDI in banking as compared with FDI in manufacturing, the cost of capital would be 1 Note that, according to the OECD (1994), despite the increase in non-interest related activities of banks, interest related income of banks form over 60 to 70% of the major OECD countries’ banks incomes. Furthermore, one would assume, as Zimmer and McCauley (1991) did, that a commitment to lend from the ‘off balance sheet’ of banks should also be subject to the required spread between lending and deposit rates. Thus, in this study, as we compare the bank cost of capital between countries, the spread between lending and deposit rates will be used as the proxy for bank cost of capital. 2 In this study, the ‘rest of the world’ refers to those major countries that have FDI in banking in Australia. These countries form over 70% of FDI in banking in Australia and are as follows: the US, Japan, the UK, and New Zealand. 3 Exception to these findings is the study by Cushman (1988).
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more relevant than the cost of labor. On the other hand, one may also argue that as over 70–75% of the operating cost of banks, as reported by the OECD (1994), are wages, one would expect that the relative wages between Australia and the ‘rest of the world’ would be an important factor in determining the amount of FDI in banking in Australia. 3.2.4. Exchange rate Given that foreign private investors’ operations may involve substantial flows of diverse foreign currencies, exchange rates are expected to have an impact on their FDI decisions. One possible explanation for a positive correlation between the value of the Australian dollar and FDI in Australia could be that foreign investors anticipate any investment they make in Australia to appreciate with the value of the Australian dollar. On the other hand, it can be argued that such behavior will be more likely for short-term liquid assets. The book value of long-term assets should be less prone to such fluctuations. Extending this argument, one would expect a negative correlation between the value of the Australian dollar and FDI in Australia. When the Australian dollar appreciates with respect to the foreign investors, currencies, FDI in Australia is expected to decrease because it will be more expensive for foreign investors to invest in Australia, and vice versa. In other words, a depreciated domestic currency will give foreigners an edge in acquiring control of domestic productive assets. Such a negative correlation is reported by authors such as Cushman (1988), and Froot and Stein (1991). Note also that, as the Australian dollar depreciates, private investors may reduce their repatriated income and increase their reinvestment in Australia, as they may want to avoid exchange rate losses. There are several indices available to account for exchange rates. The most appropriate one is the IMF’s Multilateral Exchange Rate Model (MERM ) index, which is superior to the other indices available for the purposes of this study.4 The way the index is constructed implies that an increase in Australian dollar,s MERM index indicates an appreciation of Australian dollar with respect to a weighted basket of the other currencies. 3.2.5. FDI in manufacturing As mentioned earlier, FDI in banking can take place by both private non-banks and banks investors. While the above five hypotheses are relevant to both banks and non-banks investors willing to invest in the Australian banking market, the
4 As Hultman and McGee (1989) argued, the manner in which the MERM is constructed makes it an explanatory variable which goes beyond simply measuring the exchange rates of currencies. The index is a combination of exchange rates and weights from the IMF’s Multilateral Exchange Rate Model. The weights take into account the size of trade flows as well as the relevant price elasticities and the feedback effects of exchange rate changes on domestic costs and prices. As a result, the value of the dollar index used in this study captures more than just changes in the exchange rates between the Australian dollar and other countries’ currencies.
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following two factors are more relevant to foreign banks who want to establish their offices and branches in Australia. A positive correlation is expected between FDI in banking and FDI in manufacturing. The rationale for this, according to a number of researchers, is that multinational banks (MNB’s) will follow their multinational customers abroad so that they can provide services for their customers’ foreign operations. The literature suggests that due to imperfections in the factor markets, MNB’s have unique knowledge about their clients. MNB’s can access information about their multinational clients faster and at lower marginal costs. Since they are not willing to sell their unique knowledge, but use it as a comparative advantage, following a client abroad becomes an internalizing factor which drives MNB’s to set up branches in other countries. The theoretical justification of the follow-the-client hypothesis applied to banks is provided by Gray and Gray (1981). Supporting evidence for this hypothesis is reported, amongst others, by Nigh et al., (1986). In the case of foreign banks activities in the US, researchers found a positive correlation between the foreign banks’ shares of total US commercial assets and/or the number of foreign banks’ offices and general FDI in the US. However, in this study, the composite parts of FDI in Australia will be related to each other. In other words, FDI in banking as a dependent variable will be related to FDI in manufacturing, so that one can see whether FDI in banking is a complement to or a substitute for FDI in manufacturing. 3.2.6. Banks’ foreign assets Another factor which may be related to FDI in banking in Australia is banks’ foreign assets. While banks’ foreign assets (i.e. banks’ claims against foreigners) can be generated in both the domestic and the foreign markets, banks generally have easier access to the foreign market so that they can expand their assets to foreign clients.5 If a US bank in Australia lends money to a US company operating in Australia, the US banks’ lending, provided that both the US company and the US banks are not locally incorporated, will not be considered as US banks’ foreign assets. However, this relationship between a US bank and a US company is captured by the previous hypothesis (i.e. the follow-the-client hypothesis). On the other hand, if a US bank, not locally incorporated in Australia, lends money to a domestic Australian company and/or a Chinese company operating in Australia, these lendings will be considered as the US banks’ foreign assets, and the presence of the US bank in Australia may be instrumental in establishing this lending. Thus, one may argue that FDI in banking in Australia is connected to foreign countries expansion of their banks’ foreign assets. In other words, while FDI in manufacturing may be the factor accounting for banks ‘following their customer abroad’, their presence in the foreign market will also provide an opportunity for them to provide financial services to foreign customers. Thus, one can argue that foreign countries banks’ foreign assets can account for the expansion of foreign banks’ lending activities to both 5 According to the IMF definition of banks’ foreign assets provided by Landell-Mills (1986), these assets are defined as those assets of financial institutions (banks and others) held against foreign citizens, which can be generated both within domestic economy and outside domestic economy.
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Australian citizens and non-Australian residents operating in Australia,6 as well as foreign customers outside Australia who are seeking bank credit from the Australian market.
4. A model for FDI in banking in Australia Based on the previous discussion, the proposed model for FDI in banking in Australia is as follows GB=f (D, C, W, X, M, B).
(6)
GB=stock of FDI in banking in Australia measured in current US dollars. D=sum of Australia’s commercial bank deposits measured in current US dollars. C=relative cost of equity for banks between Australia and the ‘rest of the world’. The spread (measured as lending rate minus deposit rate corrected for corporate tax) is used to measure the cost of capital. The cost of equity for banks for the ‘rest of the world’ is calculated as a weighted average of those countries investing in Australia’s banking market. The weights are based on the countries’ respective share of FDI in banking in Australia. W=relative wages between Australia and the ‘rest of the world’ measured in current US dollars. Wages indices are corrected for the effect of exchange rates between the US dollars and the rest of the world. The foreign wages are weighted average wages of those countries forming the ‘rest of the world’ in this study. The weight given to each country is based on that country’s share of FDI in banking in Australia. X=Australia’s real MERM index (a measure of the real value of the Australian dollar). M=stock of FDI in manufacturing in Australia measured in current US dollars. B=weighted average of banks’ foreign assets of the ‘rest of the world’ measured in current US dollars. The weight given to each country is based on that country’s share of FDI in banking in Australia. The period covered is from 1985:I to 1996:IV. In summary, the model for FDI in banking in Australia can be expressed as: GB=a +a D+a C+a W+a X+a M+a B, 0 1 2 3 4 5 6 with the following expected signs:
(7)
a >0,a >0,a <0,a ?,a >0,a >0. 1 2 3 4 5 6
6 In the empirical reports of this study, there will be some discussion about the endogeneity problem when banks’s foreign assets are used as an independent variable.
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5. Data and methodology The model employed uses time-series data. The most crucial sets of unpublished data, i.e. capital stock in banking and in manufacturing for the period 1985–96, were obtained for the purposes of this study from the International Division of Australian Bureau of Statistics. Note that for 1994, 1996 quarterly data are constructed on the basis of estimated annual data. These data are in their current value. For instance, the current value of FDI in banking in Australia for 1993 comprises FDI in banking in Australia in 1992 corrected for capital inflows, ‘price changes’, ‘exchange rate changes’ and ‘other changes’ in 1993. For 1994–1996, quarterly data are constructed on the basis of published annual data. Data relating to the independent variables are obtained from various issues of the International Financial Statistics published by the IMF. The first step in estimating the model involved generating a measure of expected inflation. The Box–Jenkins ARIMA forecast method was used for this purpose, effecting a sample which extended from the first quarter 1970 to the first quarter 1997. Inflation is forecast as an ARIMA (1,1,0) process. That is, an autoregressive process with lag 1, and 1 degree of differencing. The forecasting horizon is four quarters ahead. The expected inflation forecast is then used to generate the real effective interest rate. First, ordinary least squares (OLS) regression is applied to the data in Eqs. (5) and (7). Due to a possible simultaneity bias problem (see Kouri and Porter (1974)), which may occur if the domestic interest rate affects the inflow of capital, the method of instrumental variable estimation is used to obtain consistent estimates for the regression model of Eq. (5). Since it is suspected that the banks’ foreign assets variable may be endogenous (in other words, this variable and FDI in banking in the US may be inter-related), the instrumental variable (IV ) procedure is also applied to account for any simultaneity bias problems in the stock model (i.e. Eq. (7)). From the results of the preliminary OLS regression coupled with diagnostic tests (columns 2 and 4 of Table 1), it is observed that there is significant heteroskedasticity associated with the data (the White measure of heteroskedasticity, WHET, is significant at the 1% level ). As a result, the final step is to use the generalized method of moments (GMM ) with a view to correct for the heteroskedasticity. Moreover, GMM will account for any residual serial correlation. The correlation matrices generated by the diagnostic tests are used to choose the instruments so that they are highly correlated with the explanatory variables they are substituting. The option NMA=m is employed in the GMM command to account for serial correlation (if any). From the diagnostic tests carried out on the residuals, the optimal lag truncation parameter, m, is found to be 5 for Eq. (7) and 11 for Eq. (5) (to the nearest integer) from Andrews (1991), Table 1. The optimal results for the GMM procedure are reported in Table 1. Considering the GMM results, it is observed that the Parzen gives a better result for Eq. (5) and the Bartlett gives a better result for Eq. (7). Therefore, given the above discussion, the following interpretation of the results is justified.
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Table 1 Regression results for flow and stock data of FDI in banking in Australia, 1985:I–1996:IV Eq. (5)
OLS
GMM NMA=11 (Bartlett)
Eq. (7)
OLS
GMM, NMA=5 (Bartlett)
b 0 DFB t−1 DR us DR f %DGF t−1 %DGD t−1 CA t−1 R 92 DW WHETa JBb J-statistics
0.16(0.67) −0.05(−0.42) −0.06(−1.8) −0.02(−1.9) −9.1(1.0) 14.1*(2.6) −0.09(−1.2) 0.079 2.1 30.3** 0.45(0.79)
0.70(4.7) 0.75**(12.9) 0.10*(2.5) −0.06**(10.4) 24.1*(2.5) −22.1**(−6.6) 0.19**(4.4)
a 0 D C W X M B R 92 DW WHETa JBb J-statistics
1.55(0.20) 0.03(0.30) 2.2(0.16) 1.1*(2.5) −1.73*(−2.5) 0.25*(2.8) 0.43(0.75) 0.89 0.37 38.6** 0.20(0.30)
3.93(1.6) 0.33**(3.5) 0.24**(3.8) −0.51*(1.9) −1.62**(−3.5) 0.75*(11.1) 0.32**(6.2)
4.7
2.1
2.5
* and ** indicate that an estimate is significantly different from zero at the 5% level and 1% level, respectively. Student’s t statistics are shown in parenthesis. OLS=ordinary least square. GMM=generalised methods of moments. aWhite test for heteroscedasticity. bJacque–Bera test statistic for normality; p-value in parenthesis.
6. Empirical results for FDI in banking in Australia As can be seen, columns 2 and 3 of Table 1 report the empirical results of Eq. (5). As can be seen the adjusted R2 for Eq. (5) is very low and hence one should be cautious about the empirical results of this equation. In column 3, the lag value of capital inflow in banking (DFB ) has the expected positive sign and is statistically t−1 significant. Australia’s domestic interest rate variable has the expected positive sign and is statistically significant. The foreign real deposit rate is statistically significant with a negative sign indicating that the change in the interest rates of foreign countries can affect the inflow of FDI in banking in Australia. The foreign economic growth variable (GF ) is statistically significant with a positive sign indicating that as foreign countries’ economic activities expand, foreign investors tend to invest more in Australia. The negative sign for Australia’s economic growth variable indicates that foreigners, in the wake of an increase in Australia’s economic activities, tend to decrease their new investment and repatriate part of the profit generated from their existing assets from Australia. Australia’s current account balance variable is statistically significant with a positive sign indicating that a high current account deficit in Australia is interpreted by foreign investors as a sign of market expansion and investment opportunities. Australia’s current account deficit is perceived by foreign investors as a positive factor for further economic growth and investment in Australia. The overall statistical results of Eq. (5) are consistent with the majority of studies in the area of capital flow such as Kouri and Porter (1974), Ruffin and
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Russekh (1986) who found that some of the short-term economic variables influence the flow of capital. As can be seen, columns 5 and 6 of Table 1 report the empirical results of Eq. (7). In column 6, Australian banks’ commercial deposit variable (D) is statistically significant with a positive sign. This result is consistent with the expectation that foreign investors are attracted to invest in a host country whose banking market is large. FDI in banking in Australia is found to be positively correlated with the relative cost of equity for banks (C ) between Australia and the ‘rest of the world’. The positive sign of this variable implies that foreign banks will find themselves in a better competitive position to enter Australia’s market and compete with Australian domestic banks and hence increase their market share in Australia. Furthermore, this result indicates, indirectly, that foreign non-bank investors consider the relative cost of equity for banks as an important factor in deciding whether to invest in Australian banking market. The empirical result of this variable is also consistent with the price-earnings ratio variable used by Goldberg and Saunders (1981) and Hultman and McGee (1989) in measuring the determinants of factors contributing to the expansion of foreign banks in the US. The relative wage variable (W ) is statistically significant with a negative sign. This result indicates that as Australia’s wages increase relative to the source countries, the level of FDI in banking declines. The index used to proxy the exchange rate of the Australian dollar, X, is positively correlated with FDI in banking. This means that foreign investors anticipate that any investment they make in Australia will appreciate with the value of the Australian dollar. This result is consistent with the findings of Hultman and McGee (1989) where they found a positive relationship between the exchange rate variable and foreign banks’ activities in the US. For Australia, FDI in banking appears to be a complement to FDI in manufacturing and hence this result does support the theoretical argument that FDI in banking and manufacturing are complementary to each other. Banks’ foreign assets belonging to foreign countries (B) are statistically significant with a positive sign. This result indicates that, as the international lending activities of foreign banks increase, there is an accompanying increase in their FDI in banking. Therefore, an increase in a foreign bank’s FDI in Australia can be interpreted as a greater capacity for it to engage in international lending activities from Australian market. Thus, one can argue that banks’ foreign assets can account for the expansion of foreign banks’ lending activities to both Australian citizens and non-Australian residents operating in Australia, as well as foreign customers outside Australia who are seeking bank credit from the Australian market.
7. Conclusion This paper has distinguished between the activities of foreign banks in Australia and FDI in banking in Australia. It has argued that the number of offices of foreign
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banks and/or the share of their assets in Australia’s commercial bank assets do not fully reflect the magnitude of FDI in banking in Australia. A model for the flow of FDI in banking has been proposed which comprises certain explanatory variables (i.e. domestic and foreign interest rates, domestic and foreign economic activities and the current account balance) similar to other models developed to measure international portfolio investment and general FDI. Furthermore, a model for the stock of FDI in banking has been proposed which comprises certain explanatory variables (i.e. the size of Australia’s banking industry, the cost of capital in banking, wages, foreign exchange rates, FDI in manufacturing and banks’ foreign assets), peculiar to FDI in banking as compared with FDI in general and/or FDI in manufacturing. The empirical results of the stock model of FDI in banking in Australia indicate that the bank cost of capital, the size of Australia’s banking market, current account deficit in Australia, the exchange rate, and banks’ foreign assets are the major determinants of FDI in banking in Australia. Furthermore, the empirical results in this study do support that FDI in manufacturing is a complement to FDI in banking. Given some of the above factors which can be generalised as those factors that private investors would consider as universally important factors determining their level of FDI in banking, one would expect that, with better foreign market access for trade in financial services in the Post Uruguay Era, private investors (banks and non-banks) may increase their investment in Australia, as the Australian financial institutions may increase their operation in the Asia–Pacific region.
Acknowledgements The author is grateful to the editor, Ike Mathur, and an anonymous referee for helpful comments.
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