EU Trade in Financial Services with ASEAN, Policy Coherence for Development and Financial Crisis

EU Trade in Financial Services with ASEAN, Policy Coherencefor Development and Financial Crisis

ALFREDO C. ROBLES, JRDe La Salle University, Manila, and University of Malaya, Kuala Lupur

AbstractIn the wake of the financial crisis, negotiating free trade agreements (FTAs) with Southeast Asiahas become a priority for the European Union (EU). Paradoxically, all the indications are that theEU will demand that Indonesia, Malaysia, the Philippines and Thailand liberalize financial servicestrade with the EU. This article asks whether the EU’s policy undermines coherence between EUtrade and development policies. It argues that the EU and Association of Southeast Asian Nations(ASEAN) agree that financial services are crucial for development, but that they differ on theapproach to liberalization: the EU advocates broad-ranging liberalization, whereas ASEAN coun-tries favour a cautious approach, conditioned by their experience of the Asian financial crisis. Inview of this divergence, the EU will have to rethink its approach to financial services tradeliberalization in negotiations with ASEAN countries.

Introduction

The current financial crisis obliges the European Union to seek new markets in thedeveloping world, whether through a new World Trade Organization (WTO) agreement orthrough bilateral free trade agreements (FTAs) with developing countries (EuropeanCommission, 2012, p. 17). Between 2007 and 2009, the EU conducted FTA negotiationswith the Association of Southeast Asian Nations (ASEAN) as a group. Following thenegotiations’ failure, the EU initiated negotiations with individual members, concludingan agreement with Singapore in December 2012.1 Negotiations with Malaysia, Thailand,the Philippines and Indonesia are ongoing. In these negotiations, as at the WTO (Balibrea,2007), trade in services is a priority for the EU – and among the sectors in which the EUis lobbying vigorously for concessions are financial services. Several indicators point inthis direction. At the WTO, the EU has asserted that financial services trade was not acause of the financial crisis and reaffirmed that such trade remains beneficial to develop-ment (WTO, 2010, pp. 15–16; 2011, p. 13; 2012, p. 8). European lobbies have alreadyprepared a list of demands in the financial sector to be presented to ASEAN countries(ECCS, 2010, pp. 13–17; Kerneis, 2012). These demands were submitted to the EuropeanCommission prior to FTA negotiations with Malaysia (ESF, 2011). In the Philippines, aEuropean lobby is seeking not only the removal of limitations on the number of foreignbanks and branches allowed to operate in the country, but it is also demanding that the

1 Singapore is a developed country (per capita income of US$51,709 in 2012) and a regional financial centre. As it sharesEU interests in financial services trade, it may thus be excluded from this article. Of the other ASEAN members, Brunei isan oil-exporting country, while Cambodia, Laos, Myanmar and Vietnam are considered less developed countries by ASEANitself. These countries will not be covered in the article.

JCMS 2014 Volume 52. Number 6. pp. 1324–1341 DOI: 10.1111/jcms.12148

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© 2014 The Author(s) JCMS: Journal of Common Market Studies © 2014 John Wiley & Sons Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street,Malden, MA 02148, USA

Philippines allow 100 per cent foreign investment in lending companies, finance compa-nies and investment houses (ECCP, n.d.; Saclag, 2013). The positions of EU firms andtheir lobbies are significant because at the WTO, as Dür (2008) has demonstrated, theEU’s negotiating position was largely in line with the demands put forward by economicinterests.

If we recall the adverse effects for development that Thailand, Indonesia, Malaysia andthe Philippines suffered as the result of the 1997–8 financial crisis, the question willinevitably arise whether the EU’s demand for financial services trade liberalization under-mines EU development policy. Since the adoption of the European Consensus on Devel-opment in 2005, the ‘primary and overarching objective’ of EU development policy ispoverty eradication. To achieve this goal, the EU committed itself to promoting policycoherence for development (PCD), whereby ‘the EU shall take account of the objectivesof development cooperation in all policies that it implements which are likely to affectdeveloping countries, and that these policies support development objectives’. Among themeans for achieving PCD, the Commission listed the completion of WTO negotiations,the conclusion of economic partnership agreements (EPAs) with the African, Caribbeanand Pacific (ACP) countries and trade reform in the developing countries.2

The idea of ‘policy coherence for development’, first introduced in the MaastrichtTreaty, was incorporated in Article 208 of the Lisbon Treaty. ‘Incoherence’ is exemplifiedby the common agricultural policy, but other glaring cases of incoherence involve fisheriesand environmental policies (Barry et al., 2010; Carbone, 2009; Hertog and Stroß, 2011;Hoebink, 2004; Keijzer, 2010; Koulaimah-Gabriel and Oomen, 1997; OECD, 2009;Picciotto, 2005). The Commission asserts that the EU’s PCD agenda is ‘more ambitiousthan ever’, pointing out that since 2005, the EU ‘has gradually strengthened PCD proce-dures, instruments and mechanisms at all levels’ (European Commission, 2011, pp. 9, 11).Between 2000 and 2010, the EU established mechanisms designed to ensure greatercoherence within the Commission; defined ‘coherence commitments’; identified 12 policyareas where it would track progress in PCD; selected five global development challengesfor PCD; and prepared a list of targets and indicators (Commission, 2007, pp. 33–6;European Commission, 2009, p. 7; 2011, pp. 11, 24, 25). For the next decade, theCommission affirms that the EU must tackle two challenges: first, it must engage indialogue on PCD issues with developing countries, whose role in the PCD process has sofar been limited; and second, the EU must measure the impacts of EU policies, bygathering information and evidence that take into account PCD and the perspectives ofdeveloping countries (European Commission, 2009, p. 8; 2011, p. 24).

The Commission believes, however, that it is too early to assess the developmentimpact of its services trade policy since WTO and bilateral negotiations are ongoing.Services trade has not yet attracted attention in the PCD debate (Commission, 2005).Services are quite heterogeneous, covering such sectors as telecommunications, energy,electricity, water, computer services, construction, tourism, business services and trans-port. The EU advocates wide-ranging liberalization of services trade – mainly throughauthorization of foreign direct investment (FDI), but also through cross-border supply ofservices. Evaluating the development impact of the EU’s services trade policy would

2 European Council et al. (2006); Commission (2007). On EU development policy, see Carbone (2007); Holland andDoidge (2012); Hout (2007); Mold (2007).

EU trade in financial services with ASEAN 1325

© 2014 The Author(s) JCMS: Journal of Common Market Studies © 2014 John Wiley & Sons Ltd

require knowledge of each service sector and case studies of EU policy towards developingcountries, which would exceed the scope of a single article. Instead, this article focuses onone particular set of services and evaluates EU policy there from a PCD perspective.

The EU’s continual assertion of the benefits of financial services trade liberalizationcreates the impression that ASEAN is blind to them. It is argued here that the EU and fourASEAN members with whom it is negotiating FTAs (Malaysia, Thailand, Indonesia andthe Philippines) agree that financial services and financial services trade liberalization arecrucial for economic development. The difference lies in their approach: the EU favourswide-ranging liberalization of FDI in, and cross-border supply of, services, while ASEANcountries have adopted a cautious approach that seeks to prevent and mitigate financialcrises. It is further argued in this article that the goal of financial stability is conditionedby the experience of the Asian financial crisis, which demonstrated that wide-rangingliberalization of financial services trade heightens vulnerability to crisis and that theability to restrict such trade may be crucial in order to mitigate the effects of crisis.

For the EU’s PCD work, the argument presented in this article has several implications.It casts doubt on the fruitfulness of dialogue with developing countries when they havealready expressed unambiguously their preferences. It raises the question of whetherfurther evidence of the impact of financial services trade liberalization is necessary whenthe Asian financial crisis arguably provides such evidence. It suggests that for dialogue(and by extension, negotiations) to succeed, the EU may have to incorporate ASEANperspectives into its trade policy.

This article proceeds as follows. It will begin by demonstrating that Europeans andSoutheast Asians agree on the crucial role of financial services and their liberalization foreconomic development, but that they differ on the pace and scope of liberalization. Thearticle will then explain the ASEAN countries’ approach by re-interpreting the Asianfinancial crisis as a crisis triggered by financial services trade liberalization and bypresenting Malaysia’s successful use of capital controls as an argument against bindingfinancial services trade liberalization.

I. EU and ASEAN Perspectives on Financial Services Trade Liberalization

For FTA negotiations to have any chance of success, the areas of agreement and disa-greement between the parties must be specified. In financial services trade, EU andASEAN agreement on the key role of the financial sector in development should not maskdisagreement on the appropriate approach to trade liberalization.

Financial Services and Trade Liberalization for Development

The EU constantly stresses the strategic role of financial services in development and theneed for trade liberalization in order to ensure that the sector does play this role. Malaysia,Thailand, the Philippines and Indonesia to a large extent share that vision. The reasons forEU interest in financial services trade with ASEAN are logical: EU members are theworld’s largest exporters and importers of financial services. In 2011, EU exports totalledUS$134,302 million, of which US$61,063 million went to non-EU members; importsamounted to US$61,601 million, of which US$24,759 million were from non-EUmembers. The EU thus enjoyed a surplus with non-members of US$36,304 million. Yet in

1326 Alfredo C. Robles, Jr


Southeast Asia, the EU’s only major market was Singapore, to which it exportedUS$1,115 million in 2011 (WTO, 2013, pp. 170–1). The other ASEAN members did noteven appear among the top 20 EU markets. As a group composed of rapidly growingcountries, ASEAN thus offers considerable market potential.

In the EU’s view, liberalizing financial services trade also promises benefits toASEAN. The EU always stresses that provision of finance, risk transfer and investmentmanagement tools to consumers and firms will help countries grow, diversify and export(WTO, 2005, pp. 1–2). According to an EU-funded study, the range of financial servicesprovided to consumers and firms in Southeast Asia needs to be expanded; to achieve this,securities and corporate bond markets have to be developed (Ecorys et al., 2009, p. 150).

For the EU, promoting the developing countries’ financial sector requires liberalizationof financial services trade by allowing foreign institutions to invest or to provide cross-border services. Foreign competition would reduce poverty by increasing competition,promoting innovation and reducing costs (WTO, 2005, pp. 1–2; 2011, p. 19). The EU’sviews are backed by studies carried out by international organizations – notably the WorldBank and the UNCTAD (Dobson, 2007; UNCTAD, 2007).

Malaysia, Thailand, the Philippines and Indonesia do recognize the central role of thefinancial sector in economic development and the need for financial sector liberalization.Malaysia sees the financial sector as a catalyst in its transition to a high-value, high-income economy by 2020 (BNM, 2011, p. 22). Thailand believes that a strong andefficient financial system would effectively allocate resources and support economicdevelopment even in a crisis (BOT, 2009, p. 2). For the Philippines, the financial system’sfunction is to mobilize and intermediate funds, while promoting financial inclusion(NEDA, 2011, p. 192). Indonesia recognizes that in order to enhance welfare, funding forinvestment in food, agriculture and rural industries must be secured (PRI, 2010, p. 43). Allfour states attach high priority to the financing of economic activity and enterprises,particularly small and medium-sized enterprises (SMEs) (BNM, 2011, p. 18; BOT, 2009,p. 7; PRI, 2010, p. 43; NEDA, 2011, p 191).

Perhaps most importantly for the EU, all four nations acknowledge the benefits ofincreased foreign investment. In 1998, following the crisis, Indonesia permitted foreignbanks and non-bank institutions to take over Indonesian banks and invest in listed andunlisted banks; it also allowed joint venture banks to increase their branches (Gopalan andRajan, 2009, p. 5). Malaysia issued two new licences for foreign commercial banks in2009, authorized existing foreign commercial banks to establish four new branches and 10microfinance branches in 2010, and announced three new licences for world-class com-mercial banks that could support high value-added economic activities in 2011 (Kerneis,2012). In Thailand, existing foreign bank branches have been given a choice betweenopening two additional branches or incorporating locally, with up to 20 branches. In 2013,Thailand sought applications for five licences for new foreign commercial banks (BOT,2013). The Philippines, while not specifying any quantitative targets, has announcedreforms suggesting willingness to permit more FDI: liberalization of financial productsand services, liberalization of the capital account and support for the development of aSoutheast Asian capital market (NEDA, 2011, p. 197).

As ASEAN members, these countries are committed to financial services liberaliza-tion, which is negotiated under the 1995 ASEAN Framework Agreement on Services(AFAS) and the 2007 ASEAN Economic Community Blueprint. Financial services



liberalization is one of the three pillars (the others being capital market development andcapital account liberalization) of the ASEAN Roadmap for Monetary and FinancialIntegration (RIA-Fin).3

Having established that the EU and ASEAN agree in principle on the significance offinancial services and their liberalization, we must now examine the true source of theirdisagreement: the approach to implementing liberalization.

Approaches to Financial Services Trade Liberalization

The EU approach requires that ASEAN liberalize financial services trade practicallyacross-the-board. In contrast, the policies actually implemented by Southeast Asian coun-tries demonstrate that they prefer a cautious approach for the sake of the overriding goalof financial stability. EU demands addressed to ASEAN countries in FTA negotiations areconfidential, but leaked WTO documents and European lobbies’ publications give us aclear idea of their nature. At the WTO in 2003, the EU demanded that each countryeliminate a long list of regulations, and that all make concessions in accordance with the‘Understanding on Commitments in Financial Services’, which so far binds only devel-oped countries (Commission 2003a, 2003b, 2003c, 2003d). This second demand maskeda demand for sweeping liberalization of financial services trade. Under the Understanding,the developed countries made the most sweeping concessions to each other in Mode 3 ofservice supply (commercial presence or FDI). Each country granted foreign financialinstitutions the right to invest in its territory or to acquire existing enterprises, withoutlimitation in number, scope or scale of operations, in the entire spectrum of financialservices. Developed countries also authorized their financial institutions to introduce newfinancial services in each other’s territories. Concessions under Mode 1 of service supply(cross-border supply – neither the service supplier nor the consumer moves physically)were limited to insurance and re-insurance; and under Mode 2 (consumption abroad – theconsumer moves to the supplier’s country) to two types of insurance, although thedeveloped countries allowed residents to purchase abroad all other financial services.Finally, they agreed to eliminate any obstacles to entry or operation of foreign financialinstitutions that may have been overlooked (WTO, 1995, paragraphs 3, 4, 5, 6 and 10; Vander Stichele, 2005).

The 2008 financial crisis exposed the risks inherent in such sweeping liberalization. Thelatter enabled a German regional bank to set up easily a commercial presence (Mode 3) inthe United Kingdom and the United States; to engage in cross-border borrowing from theUnited Kingdom (Mode 1) and in the United States (Mode 3) without any restrictions on thenature or scale of its operations; and to invest in new, risky financial products backed bysubprime mortgages. In the end, the subsidiary accumulated debts that were more than fivetimes the value of the mother company’s stock market value and had to be bailed out by theBundesbank (Gumbel, 2007; Mollenkamp et al., 2007; Kirchfeld and Simmons, 2008).

Recent demands of the European Chamber of Commerce in Singapore (ECCS) are notremarkably different from the 2003 EU demands. ECCS demands that ASEAN countriesremove restrictions on European institutions’ cross-border lending to Southeast Asia(Mode 1), on borrowing by Southeast Asians who travel abroad (Mode 2), and on

3 ASEAN (2007); Park and Takagi (2012); Wihardja (2013). For a cautionary note, see Volz (2013).



European institutions’ freedom to invest in Southeast Asia and to engage in operationsonce established there (Mode 3). For example, under Mode 1, the ECCS objected to theIndonesian regulation limiting the amount that domestic and foreign companies couldborrow abroad. The ECCS wanted the Philippines to stop preventing Filipinos frompurchasing financial services while abroad (Mode 2). On Mode 3, the ECCS targeted theMalaysian, Philippine and Thai requirements that new foreign banks should show thattheir activity would yield economic benefits for the host country. The ECCS demandedthat all four countries remove limits on foreign shareholding in domestic financial insti-tutions, set at 30 per cent in Malaysia, 40 per cent in Indonesia, 60 per cent in thePhilippines and 75 per cent in Thailand (ECCS, 2010, pp. 13–41). Similar demands weretransmitted by the European Services Forum to the European Commission shortly beforethe latter started FTA negotiations with Malaysia (ESF, 2011).

The more cautious attitude of the Southeast Asian states is reflected in their obligationsunder the WTO General Agreement on Trade in Services (GATS) and under their EPAswith Japan. Under GATS, they made the most concessions in Mode 2 (consumptionabroad), since they had already removed most capital controls. For instance, Indonesiaallowed residents to purchase abroad 10 insurance services and six banking services whileMalaysia liberalized two insurance and 11 banking services. The Philippines, Thailandand Malaysia were cautious with respect to Mode 1(cross-border supply). The Philippinesexcluded 19 insurance and nine banking services; Thailand excluded insurance servicesaltogether. Malaysia agreed to liberalize 11 types of cross-border services, but in factrequired a commercial presence for them (Mode 3). All four states made concessions onMode 3, but all set conditions in effect prohibiting unrestricted FDI. The number oflicenses for new banks was set at 10 in the Philippines and for new insurance companies,at seven in Malaysia. Thailand did not offer licenses for new foreign banks. All set limitsto operations of foreign banks by specifying the number of branches that these couldestablish (for example, two additional branches in Thailand). All set limits on foreignequity participation in domestic banks (WTO, 2003a, 2003b, 2003c, 2003d).

Further evidence of the four countries’ caution may be found in the EPAs concludedwith Japan between 2001 and 2007. What is remarkable is that Thailand and Malaysiasimply reproduced the concessions that they had made at the WTO. Only Indonesia andthe Philippines made one or two additional concessions – for example, higher limits forJapanese companies’ participation in domestic institutions (80 per cent in insurance forIndonesia and 60 per cent for commercial banks in the Philippines). Otherwise theyspecifically incorporated their GATS concessions into their respective agreements. It isnoteworthy that at the WTO, Japan had supported EU demands addressed to SoutheastAsia for across-the-board liberalization of financial services trade. Yet in the EPAs, Japanaccepted the WTO status quo. This acceptance was coupled with the possibility, agreed toby the Southeast Asian countries, of further liberalization of services trade and/or theintroduction of new financial services (JIEPA, 2007, pp. 77, 899–904; JPEPA, 2006, pp.72, 655, 814–15; JTEPA, 2007, pp. 88, 904–15; JMEPA, 2005, pp. 110, 719, 820–51).Hence Japanese financial institutions may expect negotiation of further liberalization.Insisting on immediate liberalization would have jeopardized the successful conclusion ofEPAs, which covered very many other issues of importance to Japan. On the other hand,Southeast Asian countries can expect to exercise a degree of control over the liberalizationof financial services trade.



At least two reasons may explain the Southeast Asian countries’ more cautiousapproach to financial services trade liberalization. One is the desire to ensure nationalcontrol of the financial system. Malaysia aims to ensure that a ‘core group of strong andcompetitive domestically-owned financial institutions’ must mobilize more than half ofresident deposits (BNM, 2011, pp. 39, 95). This concern is related to the sensitive issue ofdistribution of wealth between the Malay majority and the Chinese minority; allowing thebanking sector to become predominantly foreign-owned would upset the balance and thusbe politically costly for the government (Hamilton-Hart, 2008, p. 66; Gopalan and Rajan,2009, p. 8). Without making programmatic statements, the Philippines, neverthelessrequires that 70 per cent of the assets of the banking sector must be controlled by Filipinos(WTO, 2003c, p. 8). In Indonesia and Thailand, public opinion became suspicious offoreign economic interests as a result of the Asian financial crisis, even if it could beargued that in Thailand, a ‘nationalist’ policy was also a way of accommodating localbusiness interests (Hamilton-Hart, 2008, p. 66; Hicken, 2008, p. 211).

In fact, it is the desire to maintain financial stability and prevent financial crises that iscommon to all four countries’ approach. Since the 1997–8 Asian financial crisis, govern-ments and regulators have attached priority to combating the sources of vulnerability thatled to the crisis (MacIntyre et al., 2008, p. 14). Malaysia is aware that capital flows acrosseconomies and regions will increase in magnitude and frequency, increasing volatility infinancial markets. Thus the overarching objective of its regulatory and supervisory regimeis the financial system’s stability (BNM, 2011, pp. 10, 41). For Thailand, the financialsystem should be sufficiently strong and resilient to enable it to withstand volatility andprevent it from becoming a burden to Thailand (BOT, 2009, p. 3). The Philippines seeksto establish a framework for financial stability, which can be achieved by strengtheningoversight by the country’s three supervisory bodies (NEDA, 2011, pp. 199–200). InIndonesia, the central bank launched in 2012 a programme that would create ‘a robuststructure for the domestic banking system capable of meeting the needs of the public andpromoting sustainable economic development’ (BI, 2012).

At the regional level, these countries, with their ASEAN partners, agree that ‘liberali-sation of the financial services sector should allow member states to ensure orderlyfinancial sector development and the maintenance of financial and economic stability’(ASEAN, 2007, pp. 11–12). Liberalization would be guided by the principle of duerespect for national policy objectives and the individual country’s level of economic andfinancial sector development. The European Commission and European lobbies consist-ently respond to concerns over financial stability that liberalization is not equivalent toderegulation and may even imply reregulation (Commission, 2003). They fail to acknowl-edge that Southeast Asian countries have already experienced the adverse consequences offinancial services trade liberalization.

II. The ASEAN Experience of Financial Services Trade Liberalization andFinancial Crisis

Even proponents of financial liberalization admit that information asymmetry makes thefinancial sector inherently unstable, and thus crisis-prone (Dobson, 2007, pp. 290–307).Consumers cannot assess beforehand the quality of a service offered by one institution andcompare it to services offered by others. Unlike physical goods, financial products lack



visibility; and unlike many services, their outcomes only become evident sometime afterthe purchase. Financial institutions may not disclose risks to potential consumers clearlyor engage in financial speculation that adversely affects the returns to a financial product(Rai et al., 2011, p. 274). Creditors and depositors have imperfect information on theactual position of financial institutions. In developing countries, low-income groups areparticularly plagued by information asymmetries (Hanning and Jensen, 2011, pp. 297,300).

The risks associated with financial services trade liberalization are also widely recog-nized. Foreign financial institutions may engage in activities that aggravate overbankingand over-insuring, concentrate on the most profitable market segments, increase capitalinflows that heighten the country’s vulnerability to shocks, move funds abruptly from onemarket to another, facilitate capital flight and, in a crisis, ‘cut and run’. All of these effectswill be magnified if foreign institutions dominate the domestic market (Dobson, 2007, p.298; UNCTAD, 2007, pp. 3–4; Williamson, 1999, p. 13; Yokoi-Arai, 2008, p. 615). Iffinancial services trade liberalization is achieved through capital account liberalization,then one should keep in mind the cautionary note sounded in recent studies. These suggestthat there are certain ‘threshold’ levels of financial and institutional development that aneconomy needs to attain before it can benefit from, and reduce the risks of, capital accountliberalization (Kose et al., 2009).

By the time Southeast Asian countries made their WTO concessions on financialservices, they were already experiencing the adverse impact of financial services tradeliberalization. In the 1980s, they had liberalized Mode 1 (by liberalizing their capitalaccount) and Mode 3 (by authorizing FDI in banking). These two policies created thestructural conditions for the Asian financial crisis, which thus revealed the risk of financialservices trade liberalization. The Malaysian experience with capital controls made it clearthat the ability to restrict financial services trade, without being hampered by internationalagreements, is crucial in efforts to mitigate the effects of crisis.

Financial Services Trade Liberalization and Crisis

The literature on the Asian financial crisis is voluminous and cannot be surveyed here(Bello, 1998; Chang, et al., 2001; Corsetti, et al., 1998; Desai, 2003; Haggard, 2000;Haggard and MacIntyre, 1998; Jomo, 1998a; MacIntyre, et al., 2008; Michie and Smith,1999; Pempel, 1999; Prakash, 2001; Sheng, 2009). There is now little doubt that onesystemic component of the crisis was the liberalization of the capital account by thesecountries in the 1980s. What is not realized is that this liberalization in effect liberalizedMode 1 and to a certain extent Mode 3 of services trade. This section does not aim topresent an original or exhaustive analysis of the crisis; rather it uses GATS categories todescribe capital account liberalization measures in the 1980s in the four countries, andsketches the links between liberalization through Modes 1 and 3 and the build-up to thecrisis. It thus challenges the EU’s claim made at the WTO that services trade is not a causeof financial crisis.

A state that authorizes FDI in banking obviously liberalizes financial services tradethrough Mode 3. But if it liberalizes the capital account (which involves capital transfers,direct investment, portfolio investment, other investment and reserve assets), it is in effectauthorizing cross-border trade (Mode 1). A country that removes exchange controls



enables its residents to purchase, without travelling abroad, financial services from aforeign bank lacking a commercial presence in their country (Dobson, 2007, p. 294);permits domestic banks to lend to, or accept deposits from, foreign residents; and allowsforeign banks established in the country to accept deposits from, make loans to, or tradein securities for residents (Bongini, 2003, p. 17; Gallagher, 2010, p. 6).

In the 1980s and early 1990s, capital account liberalization in Thailand, Indonesia, thePhilippines and Malaysia effectively liberalized Mode 1. In 1987, Thailand authorizedMode 1 by allowing both cross-border borrowing by Thai residents and inbound portfolioinvestment. In 1990, foreigners were authorized to hold baht deposits and residents to holdforeign currency deposits in commercial banks. Conditions for purchase and transferabroad of foreign currency by residents for remittance abroad of interest and principal andfor inward remittance for securities investment were also eliminated (Jittrapanum andPrasartset, 2009, p. 3; Sutham, 1998, p. 1892).

In 1988, Malaysia permitted residents to borrow abroad up to US$5 million in foreigncurrency, and foreign companies operating in Malaysia could borrow up to US$10 million(Njie, 2007, p. 61). The government gave further impetus to Mode 1 by promoting theKuala Lumpur Stock Exchange, in which one-quarter of the stock was soon held byforeigners (Jomo, 1998b, p. 182). In 1989, Indonesia gave foreigners the right to buysecurities of companies listed on the stock exchange. Banks were allowed to operate moreactively in foreign exchange and to open branch offices abroad (Chant and Pangestu,1996, pp. 249, 252, 270, 271). In the Philippines, all obstacles to the inflow or outflow offoreign exchange were removed in 1991. Exporters could now retain 100 per cent of theirforeign exchange earnings. Limits on foreign exchange purchases were removed. Full andimmediate repatriation of investments without central bank approval was authorized (Intaland Llanto, 1998, p. 13).

Liberalization of Mode 3, while less extensive, did occur. In 1988, Indonesiaremoved most restrictions on the entry of new banks, thereby permitting new jointventures, new branches of general banks and the expanded branching of foreign banksto seven cities. Wholly-owned Indonesian companies and joint ventures with up to 85per cent foreign ownership were allowed to operate securities companies. In 1992,foreigners were allowed to purchase up to 49 per cent of shares of commercial banks(Chant and Pangestu, 1996, pp. 232–3). In 1993, Thailand established the BangkokInternational Banking Facility, with the aim of attracting more foreign banks. Thesewere authorized to borrow in foreign exchange from non-residents (Mode 1) and lendmoney in Thailand (Mode 3) and abroad (Mode 1) (Sutham, 1998, pp. 1893, 1896). In1994 the Philippines issued ten licenses for foreign bank branches, established throughequity purchase in an existing bank or a joint venture (Intal and Llanto, 1998, p. 11).Malaysia did not issue new banking licences, but it did establish in October 1990 anInternational Offshore Financial Centre (IOFC) on Labuan Island that was authorized tooperate in offshore banking, offshore insurance, trust fund management and tax plan-ning. In three years, Labuan was able to attract a dozen foreign banks (Skully, 1995, pp.339–40).

The events of 1997–8 revealed that liberalization of Mode 1 and Mode 3 createdthe structural conditions for a financial crisis. In Thailand, Mode 1 liberalization gave theprivate sector access to foreign credit and enabled it to borrow excessively. By 1997, theprivate sector owed US$50.1 billion out of Thailand’s total debt of US$108.7 billion, with



a third of the debt being short-term (Sheng, 2009, p. 141). Much of the private sectorborrowing went to finance real estate and generated a bubble (Lauridsen, 1998, pp. 138,144). In Indonesia, foreign banks arranged more private sector loans to the governmentand to Indonesian companies. Foreign capital flowed into short-term instruments, whileIndonesian companies borrowed abroad. Thus, the share of short-term debt in totalIndonesian debt rose from 17.7 per cent in 1994 to 20.9 per cent in 1995 and 24.8 per centin 1996. The lending boom also fuelled a real estate bubble (Montes and Abdusalamov,1998, pp. 168–71). In the Philippines, portfolio investment initially shifted from T-billsinto the stock market. Capital inflows caused the peso to appreciate and encouragedcapital to invest in real property and finance (Lim, 1998, pp. 205, 211). Meanwhile, manycommercial banks and large and medium companies borrowed heavily abroad to takeadvantage of lower interest rates. For all these reasons, the debt of the banking and privatenon-banking sectors rose significantly in 1996 and 1997 (Intal and Llanto, 1998, pp.25–7). In Malaysia, banks and big companies also borrowed heavily from abroad. Com-mercial banks’ net foreign liabilities increased from RM10.38 billion (end 1995) toRM25.2 billion (June 1997). Malaysia’s largest companies borrowed RM35 billion(Jomo, 1998b, pp. 182–3).

The novelty of the notion of services trade at the time of the Asian financial crisisprobably explains why analyses of the crisis make no reference at all to financial servicestrade; instead they cite premature liberalization of the capital account as the decisive factorin creating vulnerability to external shock. Nevertheless, the build-up to the crisis providessubstantial evidence of the negative consequences of wide-ranging liberalization of Mode1 and Mode 3. Malaysia’s experience with capital controls in 1998–9 further suggests thatstates wishing to mitigate the effects of a crisis should retain the ability to restrict financialservices trade, without any obstacle created by international agreements.

Capital Controls and Crisis Mitigation

Malaysia resorted to capital controls and effectively restricted financial services tradewhen conventional remedies for the crisis proved to be ineffective. Its capital controls didnot appear to violate GATS because Malaysia had not assumed Mode 1 obligations;however, they did seem to contravene Malaysia’s Mode 3 obligations. In the latter case,the question arises whether Malaysia’s imposition of capital controls implies that liber-alization of financial services trade in an FTA following the GATS model would allowstates to impose capital controls in a crisis, or whether a strict interpretation of GATS-likeprovisions would have prohibited Malaysian controls.

Between 1997 and 1998, in response to the crisis, Malaysia adopted an orthodoxapproach by cutting interest rates and government spending (Jomo, 1998b, p. 191). Thesefailed to stimulate the economy due to speculation against the Malaysian ringgit inoffshore markets, mainly in Singapore. Obviously speculation was only possible throughtrade in financial services. In order to attract ringgit held by Malaysian residents, financialinstitutions in Singapore offered interest rates of 20–40 per cent, compared to the 11 percent rate offered by banks in Malaysia. The institutions in Singapore then lent the ringgitto offshore banks, hedge funds and portfolio institutions; the ringgit was used to purchaseUS dollars, in the expectation that it would be sharply devalued (Kaplan and Rodrik, 2001pp. 9–10, 20).



To end the speculation, Malaysia imposed controls on capital outflows from 1 Sep-tember 1998 to 1 September 1999. These inevitably restricted cross-border financialservices trade (Mode 1) and the activity of foreign institutions established in Malaysia(Mode 3). Malaysians borrowing in ringgit from foreigners or remitting more thanRM10,000 for overseas investment were required to obtain central bank approval. For-eigners holding Malaysian stocks were prohibited from selling them for a year. Foreignbanks and stock-broking companies were no longer allowed access to domestic credit.Foreigners who held a ringgit account with a financial institution in Malaysia wererequired to obtain approval if they wished to make transfers between those accounts orfrom those accounts to resident accounts. Foreigners were allowed to use their foreigncurrency deposits in Malaysia only for certain purposes, such as payment for goods andservices for use in Malaysia (Khor, 2009, pp. 6–7, 22–3).

Though the IMF initially condemned the capital controls, subsequently it admitted thatthe Malaysian economy was growing, thereby acknowledging that Malaysia had elimi-nated the offshore ringgit market and provided a breathing space in which to implementreforms (Ariyoshi et al., 2000, p. 54). Kaplan and Rodrik argue that the capital controlsenabled the government to revive demand and restore stability to financial markets(Kaplan and Rodrik, 2001, p. 27; Sheng, 2009, p. 215).

In 1998 Malaysia’s obligations in financial services trade were derived from GATS andnot from any bilateral or regional FTAs. As the GATS offers the model for services tradeliberalization under bilateral or regional FTAs, it is worthwhile examining if Malaysia’scapital controls were compatible with its GATS obligations. Several financial sectorslisted by Malaysia under GATS may been affected by capital controls – notably accept-ance of deposits from the public; lending of all types, including financing of commercialtransactions; money and foreign exchange broking services; trading for own account orfor customers in negotiable instruments (including exchange rate and interest rate instru-ments and foreign exchange); services related to issues of securities; and asset manage-ment. In these and other financial subsectors, Malaysia excluded concessions under Mode1. For this reason, no objection could have been raised against the capital controls limitingMode 1, such as the requirement of central bank approval for borrowing in ringgit fromforeigners and for overseas remittances. As for Mode 3, Malaysia, which had not issuedany new licences for commercial banks (Mode 3), did not restrict the activity of foreignbanks already established in the country. The only conditions declared to the WTO wererelated to foreign ownership limits and the introduction of new products and activities inLabuan. Apparently Malaysia did not declare to the WTO restrictions resembling thecapital controls (WTO, 2003b, pp. 21–40). One must therefore ask if, under GATS rules,Malaysia could have been accused of introducing restrictions on financial services tradethat it had not declared to the WTO.

GATS experts might contend that financial services trade liberalization does notprevent states from implementing policies designed to limit systemic risk (Dobson, 2007,p. 292).They can point to the model offered by the ‘prudential carve-out’ in the GATSAnnex on Financial Services, which authorizes a state to take measures for prudentialreasons, ‘including for the protection of investors, depositors, policyholders or persons towhom a fiduciary duty is owed by a financial service supplier, or to ensure the integrityand stability of the financial system’. To prevent or mitigate risks that financial activitiespose to the economy, a WTO member may restrict or curtail trade in financial services and



the related capital flows, despite its GATS obligations (Kern, 2003, p. 3). The ‘prudentialcarve-out’ is said to be flexible as it does not list all reasons justifying prudential measures,nor does it even define the term ‘prudential’ (Yokoi-Arai, 2008, pp. 639–40). The impli-cation is that states that liberalize financial services trade would still be free to imposecapital controls in times of crisis.

Unfortunately the carve-out also stipulates that a state may not use it in order to avoidits GATS obligations. For critics, this provision nullifies the authorization given to statesto take prudential measures, which by definition will permit a state to avoid its GATSobligations (Gallagher, 2010, p. 8; 2012, p. 121). If another WTO member objects to aprudential measure, it may resort to WTO dispute settlement (GATS Article XXIII), whichinvolves consultations among the parties, to be followed by submission to a panel andeventually an appeal to an appellate body, with the entire process taking years (Hoekmanand Kostecki, 2009, pp. 84–130). In a financial crisis, the mere threat of resort to WTOmechanisms would severely circumscribe a country’s ability to restrict financial servicestrade. Assuming the dispute makes it to the panel stage, a narrow interpretation of thecarve-out that opposes capital controls may not be automatically ruled out, given that tradeliberalization and expansion of services trade are the main GATS goals (Krajewski, 2003,p. 57).

In view of the uncertainty surrounding the carve-out, it seems that the prudent courseof action for a state that wishes to maintain the ability to mitigate (and prevent) a financialcrisis by restricting financial services trade is to refrain from liberalizing Mode 1 andMode 3 of financial services trade under bilateral FTAs.

Conclusions

ASEAN countries share the EU view that promotion of financial services and financialservices trade liberalization are worthwhile policy goals. Nevertheless, the differencesregarding the approach to implementation are such that the EU and European lobbiesimplicitly deny that the cautious method of liberalization amounts to liberalization at all.These differences pose a serious challenge to the EU’s agenda on policy coherence fordevelopment and raise the question as to how the EU should proceed. On the one hand, EUeconomic interests seem to dictate across-the-board liberalization of financial servicestrade in Southeast Asia. On the other hand, a PCD agenda requires that the EU take intoaccount the views of developing countries in a dialogue and, by extension, in negotiations.The risks involved in ignoring such views cannot be underestimated: negotiations couldstall, and the EU could become the target of public criticism from its negotiating partnersas well as from civil societies in Europe and Southeast Asia.

Faced with this dilemma, it may perhaps be useful for the EU to recall that whileASEAN policies may run counter to EU trade interests at least in the short term, theydo not exclude further liberalization in Indonesia, Malaysia, the Philippines and Thai-land. Such liberalization is taking place, albeit at a pace determined by these countriesrather than by the EU. Yet Southeast Asian countries might become more receptive inthe future to EU demands if the EU demonstrated sensitivity to their developmentconcerns. Perhaps the EU’s own experience of financial crisis will convince it and itsmember states of the merits of a more cautious approach to financial services tradeliberalization.



Correspondence:Alfredo C. Robles, JrInternational Studies DepartmentDe La Salle University2401 Taft Avenue, Manila 1004Philippinesemail: [email protected]

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