Financial Sector Openness: Foreign Loans vs. FDI

We construct the first general equilibrium model of foreign direct investment (FDI) in the banking sector to compare the welfare consequences of two types of liberalization. We find that liberalizing by lifting restrictions on inflows of foreign loans is more likely to reduce the average interest rate spread (markup) than liberalizing by allowing FDI in the banking sector. Using heterogeneous, imperfectly competitive lenders, the model explains why endogenous markups can increase with FDI while lending rates actually fall, especially in less developed countries where it can be harder to implement the parent’s technology or where there are more limitations on entry by domestic banks. We show that borrowing costs fall under both types of liberalization due to improved efficiency among lenders and that allowing FDI can generate permanent trade imbalances while still increasing consumption and welfare in both countries. JEL Classifications: F1, F2, F4, E44