IMF issues reference note on trade in financial services (June 2011)

Rethinking Bretton Woods | Tue, Jun 14, 2011

By Aldo Caliari

A Reference Note on Trade in Financial Service, authored by the IMF, seeks to provide guidance on a number of issues related to the relationship between capital controls and liberalization of trade in services.
The note was developed with the purpose of informing the advice that country teams provide on such issues in the context of surveillance, program negotiations, and technical assistance. It responds to a request formulated in the Independent Evaluation Office's evaluation of the IMF Work on Trade for "guidance on the approach to trade in financial services that stresses the links between trade in financial services, the regulatory environment, and capital account liberalization.

A briefly commented summary of the note is provided below. 

Key dimensions of legal and policy frameworks on trade in financial service:

In the note, the IMF states that General Agreement on Trade in Services (GATS) is the principal legally binding multilateral framework of rules governing the liberalization of trade in services, including trade in financial services.  Created with the intention to expand growth internationally, the GATS and Preferential Trade Agreements (PTAs) are aimed at liberalizing financial services trade through the removal of quantitative or qualitative restrictions that limit cross-border supply of services and foreign commercial presences in domestic markets. The GATS and PTAs build upon host country transparency, equal treatment of Foreign Service providers, market access, and equal treatment of domestic and Foreign Service providers.

In the GATS and PTAs, there are four modes of supply that characterize the different ways in which foreign service providers reach consumers: cross border trade, consumption abroad, commercial presence, and cross-border movement of natural persons as suppliers of services. The first two apply to the supply of services across borders, while the third is related to foreign direct investment. Depending on how commitments are made, treaties liberalizing trade in services make use of either a "positive list" or a "negative list" approach, where members can identify areas in which the national treatment obligations are to be applied.

Trade in services is usually defined by reference to modes of supply. There are distinctions made between the four modes of supply in terms of the differences by which foreign service providers can reach consumers. Financial services imports comprise banking, insurance and insurance related services, and other financial services. This brief section with the same title defines what banking is comprised of.

According to the IMF, the treaties covering trade in services do not address the liberalization of capital movements per se. The difference is characterized in that a commitment to open up its market for the cross-border supply of a particular financial service means a commensurate commitment to allow the capital flows that are an essential part of the service itself, but the host country typically does not make an across-the-board commitment to liberalize capital movements.

While openness and deregulation are often undertaken together, the IMF argues, the gains and costs of financial reform depend on the regulatory and supervisory framework.

Multilateral Framework on Trade in Financial Services and Capital Mobility: Key Features

The GATS provides the framework of multilateral rules and disciplines for trade in financial services. The GATS framework agreement establishes general obligations of WTO members including the Most Favored Nation (MFN) principle. This principle is the commitment made by a country to extend the same favorable trading treatments to all of its partners. The national schedules of commitments serve as the principal mechanism of liberalization, and members are allowed to attach certain limitations to their commitments in respect of sectors listed in their national agendas. While the GATS does not define market access, it provides six types of restrictions that a member cannot impose, unless identified in its schedule. These are restrictions on: the number of suppliers, the total value of service transactions or assets, the total number of service operations, the total number of citizens that may be employed, the types of legal entity or joint venture, and the participation of foreign capital. There are no limitations on the type of restrictions to national treatment, but it is up to members to list all potentially relevant measures in sectors where commitments are to be made.

The note then details several provisions that GATS contains to accommodate domestic policy making in the context of financial services.

These provisions include:

-- a "prudential carve out" clause. The IMF considers that the clause affords governments "considerable leeway in introducing prudential measures that fit their needs." But it goes on to quote the language that states the carve-out "cannot be used by a member to avoid its obligations or commitments," and to admit that ultimately, in the case of challenges by other WTO members on the legality of a measure adopted by a member, final determination is in the hands of the dispute settlement mechanism.
Besides this statement, the Fund's note does not spend more attention in assessing the potential for adverse interpretations of the "carve out" clause to undo the expected benefits for the regulatory space of members.

--the exclusion of services supplied in the exercise of governmental authority, which include (i) activities of central banks, monetary authorities, or other public entities in pursuit of monetary or exchange rate policies and (ii) activities forming a part of a statutory system of social security or public retirement plans and balance-of-payments safeguards.

--the balance of payment restrictions:  a member may impose, given a number of conditions and consultation with the Balance of Payments Committee, temporary restrictions that suspend its commitments (on all sectors included in its schedule, not only financial services) in the event of serious balance-of-payments and external financial difficulties.

The GATS recognizes that for many areas of financial services, international capital transactions are typically associated closely with the provision of services. WTO members must allow cross-border capital movements "if these are an essential part of a service for which they have made liberalization commitments," although the exact relationship between one and the other will depend on the mode of provision. For instance free capital movements may be required under mode 1, as international capital transactions are an integral part of accepting deposits from or making loans to nonresidents, or securities trading on behalf of a client residing in another country. Mode 3 requires that, In permitting the establishment of a commercial presence, the WTO allows inward capital flows related to that establishment.

While capital controls may be considered a legitimate part of the toolkit to manage capital inflows in certain circumstances, the IMF says they may, in some cases, be inconsistent with GATS obligations. These controls could range from price-based measures, to a prohibition against the sale of short-term securities to non-residents.

According to the note, the GATS safeguard the rights and obligations of common WTO/Fund members under the Fund's articles. The Fund explains that Article XI of GATS "prohibits WTO members from applying restrictions on payments and transfers for current international transactions relating to their specific commitments." But members are allowed to apply exchange actions which are "in conformity" with the Fund's Articles.

Article XII of GATS sets forth a number of conditions under which a WTO Member can impose restrictions in the "event of serious balance-of-payments and external financial difficulties or threat thereof." One of the conditions set forth in Article XII of the GATS is that the restrictions be "consistent with" the Fund's Articles.

However, the IMF is less convincing in its explanation of how the rights of common WTO/IMF members are safeguarded with regards to capital movements. The IMF note claims that "these restrictions will only be permitted if they meet all of the conditions set forth in Article XII of the GATS," except for restrictions imposed at the request of the Fund. Indeed, Article VI of the Fund's articles provides for the right of members to "exercise such controls as are necessary to regulate international capital movements." The only limitation is that they should not be capital transfers necessary for the payment of current transactions. So, while there is a difference in the right to impose capital movement restrictions in both regimes, the Fund's note does not explain how it arrives to the conclusion that one (GATS in this case) should be preferred above the other (Fund's articles) and not viceversa.

In analyzing coverage of sector specific commitments under the GATS, the note judges that it is modest overall. While the more developed countries made the most commitments of substance, many WTO member countries have less restrictive policies than those implied by the legal framework in GATS. But, the note acknowledges, 25 emerging market and low income countries that are latecomers into the WTO have been forced to make larger concessions. Similarly, there are 29 countries negotiating entry that might be in the same situation.

Banking is a special case where most countries have made more restrictive commitments than they are legally obliged to under their GATS commitments. Another interesting fact the note highlights is that the developed countries as a whole have taken more open stances than developing countries. But because developed countries tend to not go beyond their commitments whereas developing countries do, the difference of stances is, in practice, less wide.

Various attempts have been made to estimate service trade restrictiveness, but there is no consensus on methodology while lack of comprehensive data limits such investigations. Alternative methods include surveying market restrictions and challenges among governments, although measuring such challenges are difficult and analogous to other problems in national policy.

Also alluded in this section of the IMF note is the Cooperation Agreement between the WTO and the Fund, which "sets out a detailed framework for cooperation between the institutions."

Key Aspects of Preferential Trade Agreements and Bilateral Investment Treaties Relevant for Trade in Financial Services

What typically motivates PTAs is the desire to remove or reduce trade barriers and ultimately establish a free trade area or a customs union among the parties. PTAs generally build on the key principles established under GATS, while the former are recognized under the latter as a vehicle for economic integration. But, the Fund cautions, they do not always follow the GATS model for scheduling of commitments and many PTAs and BITs do not contain the GATS' safeguards and exceptions that provide governments with both short term and long term policy space.Of particular concern for the Fund are "special provisions that accommodate monetary and exchange rate policies, balance-of-payments measures, and prudential measures."

The note also refers to Bilateral Investment Treaties, which afford protection that usually extends to international transfers of funds pertaining to an investment.

The note then focuses on provisions that restrict capital controls in both PTAs and BITs. It says some PTAs and BITs restrict the use of capital controls during macroeconomic and financial distress and do not provide for a "safeguard" clause, or a provision that allows a government to change the capital controls during times of crisis. This absence could cause problems for the Fund in a number of instances.

First, PTAs and BITs overlap with Fund jurisdiction to the extent that they cover certain transfers that are defined under the Fund's Articles as payments for current international transactions. So, if there is a financial crisis, discrimination among Fund members could arise if a party were to impose controls on nonparties to the PTA or BIT only. Such measure would discriminate among the Fund's universal membership. The Fund 's note states the restriction could not be approved, as inconsistent with the Fund member's obligation. The Fund stops short here of explaining why the outcome is that the restriction would not be approved altogether, rather than opting for considering that the measure should extend to all members equally.

Second, the Fund's Articles prescribe that the Fund might request a member to impose capital controls to avoid that Fund's resources are used to meet a "large and sustained" outflow of funds. PTAs or BITs provisions could preclude the member from complying with the Fund's request.