Exploring the Global Financial Information Superhighway

Vol. 12: Construction Period of Offshoring and Outsourcing in the Investment Banking Industry (part five)

Consulting Fellow, RIETI

On January 1, 1995, the World Trade Organization (WTO) was established to continue and further the framework of the General Agreement on Tariffs and Trade (GATT). The scope of the WTO expanded to include trade in services, including financial and telecommunications services, intellectual property rights, dispute settlement between member nations, and those nations' trading policies, in addition to trade in goods which had been discussed under GATT. This volume analyzes the course of developments that led to the establishment of the WTO, the organization's framework, the position the WTO gives to the General Agreement on Trade in Services (GATS), and the impact of GATS on the investment banking industry.

World Trade Organization

The Great Depression began in 1929 with the crash of the New York Stock Exchange. To overcome the resultant economic slump, Britain and France, both Allied states owning vast colonies, advanced their efforts to form bloc economies. Another member of the Allies, the United States, enforced the New Deal program centered on public investments within its territories. In contrast, Germany, Italy, and Japan, Axis nations with limited colonies and natural resources, faced economic difficulties. Based on the reflection that this division created in the global economy was a main cause of World War II, the GATT framework was established in 1948, three years after enactment of the Bretton Woods System in 1945, and discussions on trade system liberalization began with the aim of ending discriminatory treatment in international trade.

The GATT framework achieved gradual scale expansion by opening its doors not only to advanced nations but also to developing countries. The number of GATT participants varied from year to year: 23 nations were represented at the inaugural round in Geneva, Switzerland, in 1947; 13 at the second round in Annecy, France, in 1949; 38 at the third round in Torquay, Britain, in 1951; 26 at the fourth round (rounds four to eight were all held in Geneva) in 1956 and fifth Dillon Round held from 1960 to 1961; 62 at the sixth Kennedy Round from 1964 to 1967; 102 at the seventh Tokyo Round from 1973 to 1979; and 123 at the eighth Uruguay Round from 1986 to 1994. Discussions at the first to fifth rounds of GATT negotiations focused on tariff reduction. Anti-dumping measures and non-tariff measures joined the agenda in the sixth and seventh rounds, respectively. Discussions outgrew only trade in goods to cover trade in services and intellectual property rights in the eighth Uruguay round. The long series of discussions under GATT bore fruit in the form of the WTO's establishment as an international organization on January 1, 1995, exactly 50 years after the end of World War II (Note 1,2).

The WTO is defined by the Marrakesh Agreement Establishing the World Trade Organization (hereinafter the "WTO Agreement"), which came into effect on January 1, 1995. A total of 16 articles comprise the framework of the WTO Agreement, which also includes Annexes thereto, regulating matters including establishment of the WTO as an international organization (Article I), scope (Article II), functions (Article III), structure (Article IV), relations with other organizations (Article V), the secretariat (Article VI), budget and contributions (Article VII), status (Article VIII), and decision-making (Article IX) (Note 1,2).

Annex 1 of the WTO Agreement consists of Multilateral Agreements on Trade in Goods (Annex 1A), General Agreement on Trade in Services (Annex 1B), and Trade-Related Aspects of Intellectual Property Rights (TRIPS; Annex 1C). In addition to these provisions, the WTO Agreement defines Dispute Settlement Understanding in Annex 2, Trade Policy Review Mechanism in Annex 3, and Plurilateral Trade Agreements in Annex 4. (Note 1,2) The dispute settlement procedures prescribed in Annex 2 strongly bind agreements made by WTO member nations. The WTO differs from traditional multilateral treaty organizations in this respect (Note 3).

Article IX inherits from GATT the practice of decision-making by consensus, with the process occurring in four levels. On the first level is the Ministerial Conference, held at least once every two years. The General Council, held regularly at WTO headquarters in Geneva, is on the second level, acting as a substitute organization for the Ministerial Conference while at the same time functioning as an organization for trading policy review and dispute settlement. The Council for Trade in Goods, the Council for Trade in Services, and the Council for Trade-Related Aspects of Intellectual Property Rights, all prescribed in Annex 1, are on the third level. Committees and working groups for specialized discussion in respective fields occupy the fourth level. The WTO Secretariat prescribed in Article VI of the WTO Agreement, with a staff of approximately 600, is defined not as a decision-making body but as an organ engaging in research on international trade, and in public relations activities aimed at mass media and other parties, in addition to performing its main mission of providing member countries with a forum for discussion (Note 1,2).

General Agreement on Trade in Services

Agriculture, forestry, and fisheries comprise the center of primary industries. Manufacturing forms the core of secondary industries. Telecommunications, financial, transportation, sales, and consulting, among other services, are the center of tertiary industries. According to the Petty-Clark's Law on structural industrial changes, as economies modernize, industries from the viewpoints of profitability and workforce, the center of the industrial structure shifts from primary to secondary industries, and then from secondary to tertiary. Consistent with this law, a shift to a service economy occurred in advanced nations in the 1970s and the ratio of tertiary industries centering on services rose via this phenomenon (Note 4).

In the early 1980s the United States experienced a decline in trade balance and a concurrent domestic business slump. At that time, products made in primary and secondary industries comprised a large majority of U.S. exports. However, U.S. companies had already prepared systems for globalizing their services that belonged to tertiary industries. Taking note of the situation, the U.S. decided to advance initiatives for expanding trade in services, and focused its attention on GATT, which had served not only advanced nations but also developing countries as a forum for discussing trade in goods. Meanwhile, developing countries, including India and Brazil, opposed liberalizing trade in services. Countries in Europe also took a passive stand on the issue. Arguing against those positions, the U.S. strongly insisted that trade in services should be added to the agenda as a "new realm" at a round following the Tokyo Round of GATT negotiations (Note 4). Trade in services was taken up as an item on the agenda of the eighth Uruguay Round of GATT negotiations that began in 1986. With its establishment in 1995, the WTO adopted the General Agreement on Trade in Services (GATS) as Annex 1B (Note 5).

In GATS, services are defined as services in all sectors "except services supplied in the exercise of governmental authority." The WTO needed to clearly define the scope of covered service transactions when it established the GATS framework. This definition was necessary because tracking actual cross-border transactions was easy for goods, which are tangible, but difficult for services, which are intangible (Note 6). To deal with the problem, GATS defined four modes from the perspective of how service users and suppliers relocate themselves and engage in trade in services (Note 3,4,6,7,8).

1) The first mode is service transactions across national borders (cross-border trade), wherein services themselves relocate across national borders with their users and suppliers remaining in their original locations. This transaction mode also exists for trade in goods.

2) The second mode is service consumption overseas (consumption abroad), wherein service users relocate across national borders and consume services in countries where service providers are located.

3) The third mode is service provision through operational bases (commercial presence), wherein service providers relocate across national borders, set up bases in countries where service users are located, and provide services.

4) The fourth mode is service provision through movement of natural persons (presence of natural persons). As in the third mode, service providers relocate across national borders to countries where service users are located, and provide services. This mode differs from the third mode in that service providers are natural persons.

Keeping an inventory for trade in services is difficult because production and consumption take place almost simultaneously. Services are also produced and consumed in geographically close locations. Transactions in services and transactions in goods differ on these points. To address these characteristics, GATS, the agreement on trade in services, instituted the third mode and brought service provision through the establishment of operational bases under its framework. Coverage of services offered by foreign-capital bases characterizes GATS (Note 3,4). According to Takazawa's trading forecasts by mode, transactions in the third mode will occupy the highest ratio of transactions, at about 50% (Note 6). Transactions in the first and second modes will account for approximately 35% and 10%-15%, respectively. The remaining few percentage points of transactions will be in the fourth mode.

Investment banking industry and GATS

Basic principles for GATS are most-favored-nation treatment (Article II: the principle of member nations treating all other member nations fairly, without discrimination), transparency (Article III: the principle of member nations publishing measures generally applied to domestic parties to all other member nations), national treatment (Article XVII: the principle of member nations guaranteeing the same rights as those enjoyed by their own citizens to the citizens of partner countries), and market access (Article XVI: the principle of member nations imposing no restrictions on service providers from other countries) (Note 3,7). In GATS, obligations are defined in three levels: obligations with which all member nations must comply unconditionally and uniformly are on the first level; obligations with which member nations must comply in the fields of their commitment are on the second level; and obligations with which member nations must comply in committed fields according to contents are on the third level. In GATS, most-favored-nation treatment and transparency are categorized as first-level obligations, and national treatment and market access as third-level obligations (Note 4).

Services inherently tend to reject radical changes because they are rooted in the history, traditions, cultures, and customs of each country, and closely linked to citizens' everyday life (Note 7). In view of this tendency, GATS advocates step-by-step liberalization of trade in services. To facilitate such liberalization, GATS adopts a "positive list system" obliging member nations to liberalize items stated in the commitment list, instead of a "negative list system" obliging them to deregulate all items other than those stated against liberalization in the commitment list. The WTO adopted the positive list system supported by developing countries, instead of the negative list system advocated by advanced nations, in order to encourage developing countries to participate in GATS (Note 8).

Discussion on liberalizing trade in financial services grew tangled over the course of the eighth Uruguay Round on increasing free trade in services. Thus no agreement on the issue resulted at the point of WTO establishment on January 1, 1995 (Note 8). European countries and Japan reached a provisional compromise in the form of the second protocol to the General Agreement on Trade in Services (Note 9) in July 1995. Seventy countries, including the U.S., finally reached an agreement and produced the fifth protocol to the General Agreement on Trade in Services (Note 10) in December 1997.

The Annex on Financial Services included in GATS prescribes in Paragraph (a), chapter 5 definitions that "A financial services is any service of a financial nature offered by a financial service supplier of a Member," adding, "Financial services include all insurance and insurance-related services, and all banking and other financial services (excluding insurance) (Note 5)."

Tangible financial services (i) through (xvi) enumerated in the paragraph show that financial services defined therein cover all operations performed by the front office, middle office, and back office of investment banks, which we analyzed in the first volume (Note 12) of this series.

Theoretically, the GATS framework advocates equal treatment of domestic financial institutions and their foreign counterparts advancing into concerned countries. In my opinion, the investment banking business undertaken by wholesale divisions of financial institutions and the commercial banking business carried out by their retail divisions should be treated as separate operations, as there is a huge discrepancy in the levels of international standardization achieved in wholesale and retail financial services.

Like other services, retail financial services have mechanisms peculiar to each country rooted in its history, traditions, cultures, and customs. In particular, retail financial services in the banking and securities sectors have a long history of service consumption mostly within national borders. In many ways, these services are closely linked to citizens' everyday lives. (The history of the Japanese securities industry and that of the banking industry were analyzed respectively in volumes 4 (Note 11) and 8 (Note 12).) Meanwhile, wholesale financial services by operators of investment banks focus on transactions between so-called professionals. Unlike the abovementioned retail financial services, the trading and settlement markets have been established for wholesale financial services in compliance with standardized international rules over the course of financial market globalization that has been going on since the 1980s.

In addition, characteristics not found in retail financial services surface when investment banking operations are analyzed within the framework of the four-mode classification of GATS. First, in front office operations, numbers of direct transactions between domestic institutional investors and overseas investment banks (cross-border trade in the first mode), and transactions with domestic branches of overseas investment banks (operational base establishment in the third mode) began growing at an accelerated pace in the mid-1990s. This trend has not been witnessed in retail financial services. Second, in the back office, operations that offer both cross-border trade in services in the first mode and service base establishment in the third mode started to appear. Examples include the development of a large intra-group offshoring base that performs all paperwork for Asia-Pacific operations, as explained in volume 9 (Note 13). This phenomenon is also not found in retail financial services.

Japan's financial market strategies in the era of financial services export competition

Trade liberalization in financial services, a course that GATS promotes, agrees with the course of reducing inequality in competition through international efforts to harmonize financial regulations (Note 7), which is promoted by the Basel Committee on Banking Supervision explained in volume 11 (Note 14). In other words, the framework of international finance began to move in the direction of weaker domestic regulation and stronger international regulation in the mid-1990s with the establishment of the Bank for International Settlements (BIS) and the WTO as forums for international discussion. In addition to financial services, the 69 member nations reached an agreement in February 1997 to liberalize telecommunications markets under the GATS framework, agreeing to deregulate basic telecommunications services, including long distance communications services, by 1998.

As these developments suggest, the fields of finance and telecommunications started to move in the direction of trade liberalization. With their movement, the global economy's era of service export competition can be assumed to have begun. Ahead of other countries, Singapore adjusted its national strategies in response to this paradigm shift from commodity export competition to service export competition in a case introduced in volume 10 (Note 15). According to research conducted by the International Monetary Fund (IMF), Singapore's per-capita gross domestic product (GDP) exceeded 35,000 U.S. dollars in 2007, overtaking Japan's per-capita GDP of approximately 34,300 U.S. dollars (Note 16). In addition, in view of active commodity markets in recent years, Singapore announced its plan to set up the Singapore Mercantile Exchange (SMX) and commence trading on the exchange during the first quarter of 2009 to establish its position as a center of commodity futures markets in Asia (Note 17). This news suggests the Singaporean government's strong intention to aggressively pursue its policy of attracting foreign investment to the country's financial services sector.

Japan had meanwhile built a foreign currency acquisition-based industrial structure through processing trade after the end of World War II. The country grew into a major economic power and won the "Japan as No. 1" moniker in the 1980s. However, Japan's industrial structure focused on secondary industries remains unchanged today. There is an impression that Japan is failing to follow the paradigm shift from commodity export competition to service export competition that began in the mid-1990s. From 1995 to 2002, not only the United States, but also European countries, including Britain, France, and Germany, and all major developing nations, including India, China, and Brazil, increased their service exports. In the same period, Japan experienced a service export decline (Note 6).

Even without reconsidering the abovementioned Petty-Clark's Law, service industries, including the finance business, are increasing their weight in both domestic and global economies. In view of this trend, I theorized that the Japanese economy had sufficient potential for redevelopment by enforcing economic and industrial policies focusing on the export of services, including financial services. Based on the view, I shared my idea for reviving the Japanese economy in the September 25, 2007 column (Note 18), "Japanese Financial Market's Strategy in the Globalization Era." I proposed that Tokyo as a metropolis constitute part of international financial markets in Asia, and that regional cities attract back office operations centers for international financial services providers. To find concrete policy measures regarding these points, I continue to perform analysis through this series by positioning global information system strategies with investment banks in the center, and interweaving topics including related developments in the global economy, changes in financial markets and financial administration, and the establishment of new management approaches.

The next volume will look at Asia, which in 1997 hit an air pocket in the course of global finance expansion when GATT member nations agreed on frameworks for liberalizing trade in financial and telecommunications services.

July 30, 2008
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  10. WTO (1997), " Fifth protocol to the General Agreement on Trade in Services "
  11. Matsumoto, H. (2007), " Dawn Period of Offshoring and Outsourcing in the Investment Banking Industry (part two) ," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 4, December 18, 2007.
  12. Matsumoto, H. (2008), " Construction Period for Offshoring and Outsourcing in the Investment Banking Industry (part one) ," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 8, April 16, 2008
  13. Matsumoto, H. (2008), " Construction Period for Offshoring and Outsourcing in the Investment Banking Industry (part two) ," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 9, May 8, 2008
  14. Matsumoto, H. (2008), " Construction Period for Offshoring and Outsourcing in the Investment Banking Industry (part four) ," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 11, July 1, 2008.
  15. Matsumoto, H. (2008), " Construction Period for Offshoring and Outsourcing in the Investment Banking Industry (part three) ," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 10, June 3, 2008.
  16. Nihon Keizai Shimbun (2008), "Singapore Exceeds Japan in terms of per capita GDP," (in Japanese), July 3, 2008.
  17. Nihon Keizai Shimbun (2008), "Singapore Plans to Set up a New International Commodity Derivatives Exchange to Establish its Position as a Key Trading Hub in East Asia," (in Japanese), July 9, 2008.
  18. Matsumoto, H. (2007), " Japanese Financial Market's Strategy in the Globalization Era ," RIETI Column no. 171, September 25, 2007

July 30, 2008

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