Could US-Korea trade agreement deter enhanced regulation of financial services?
February 1, 2011 — Over the last 20 years, proponents of free trade have rested their arguments on two fundamental assumptions: first, that more liberalized trade will bring concrete benefits to most, if not all, Americans; and, second, that, because the further integration of national markets is inevitable, the U.S. essentially has no leverage to wield in influencing the direction of that process.
President Obama hasn’t explicitly been sounding the second theme, but his policy framework is built firmly on the premise that a fully globalized world economy of liberalized trade rules is the only road available to travel. Indeed, in his State of the Union Address, Obama trumpeted the idea that “the future is ours to win,” and then suggested that further liberalizing the country’s trade relationships was a vital part of keeping the U.S. competitive in the global economy.
“The world has changed,” he said, building urgency for his argument, previewed a few days earlier in a Jan. 22 radio address, that opening global markets to American goods was “one of the most important things” his Administration could do to promote American jobs and businesses.
Trade agreements are crucial to his strategy: “[L]ast month, we finalized a trade agreement with South Korea,” Obama said, boasting that the agreement “will support at least 70,000 American jobs,” an assessment that is vigorously disputed by treaty opponents. Obama was referring to the proposed Korea-U.S. Free Trade Agreement, or KORUS FTA, which he signed late last year, and for which he is now seeking Congressional approval.
He described the agreement as one that “keep[s] faith with American workers and promote[s] American jobs,” and promised more of the same “as we pursue agreements with Panama and Colombia and continue our Asia Pacific and global trade talks.”
But there are important questions about the agreement that are independent of the jobs dispute, most notably the under-explored question of whether the FTA’s chapter on the financial services sector will operate, both on a legal level and on an political level, to deter a host of potential market-regulating mechanisms — like limiting the size of financial institutions — in the U.S. and South Korea. (The implications may be broader still, since the Administration views the KORUS FTA as a model for other agreements.)
Strikingly, even though the original proposal was modified through a side agreement in the second half of 2010, it appears that no changes were made to reflect any lessons from the U.S. financial meltdown of 2008 and 2009 — this despite the fact that the U.S. possessed substantial leverage in the negotiations with South Korea.
Left off the table was the opportunity to use the FTA to shape an operational framework within which the financial services sector would be obliged — at least in respect to Korean and U.S. companies — to operate in a manner to reduce systemic risk domestically, bilaterally, and internationally.
Negotiations of the KORUS FTA began in 2006, and, in 2007, an agreement was signed by President Bush and then-President of South Korea Roh Moo-hyun. It then stalled in Congress for three years due to heavy opposition by some Democratic lawmakers, as well as united opposition from organized labor.
In June of 2010, President Obama and the new South Korean President Lee Myung-bak expressed a desire to reopen the negotiations and resolve any obstacles by November, when a G-20 summit meeting was scheduled in Seoul. The summit did not produce significant results, but in early December, the two presidents announced that they had negotiated a side agreement to the original FTA.
According to Christine Ahn of the Korea Policy Institute, the period between the G-20 summit and the successful negotiation of the agreement was pivotal, and shows that the Obama Administration had substantial leverage when re-negotiating with South Korea.
“It’s very interesting to see how Obama came back from the G-20 summit — no deal,” she said. “And then there was the escalation of the military crisis, and within a few days, we have a situation where South Korea conceded to a lot of the demands and then you have a signed deal.”
The military crisis Ahn referred to is the North Korean shelling of a South Korean island on Nov. 23. The U.S. immediately condemned the attack.
“From my perspective,” said Ahn, “it seems like South Korea got what it wanted, [which] was for the U.S. to go along with its more aggressive stance towards North Korea. [President Lee Myung-bak] came into power promising that he would take a hard-line approach to North Korea, and he needed the backing of the United States to actually see that through. He got the U.S. to side with South Korea in pursuing a more hostile, aggressive stance. And the U.S. got what it wanted, which was this trade deal.”
According to Martin Hart-Landsberg, director of the Political Economy Program at Lewis and Clark College, the dominant position of the U.S. is evidenced by that fact that, even prior to opening trade negotiations, the U.S. set several demands and pre-conditions, including a requirement that South Korea open up its media market to U.S. films.
“The fact that the Koreans capitulated on all these terms, essentially giving up a lot of things in order to even start negotiations, shows the relative strength of the governments,” said Hart-Landsberg. “The South Korean government has acknowledged the very dominant political and military role the U.S. has in the Korean peninsula, and that has definitely weakened its ability to negotiate.”
So, with leverage to exert, the U.S. had to decide where, how, and on whose behalf to exercise that leverage.
Limitations on more robust regulation of the financial services sector?
The Office of the U.S. Trade Representative has called the “Financial Services” chapter (Chapter 13) of the agreement “a groundbreaking achievement, providing more extensive provisions related to financial services than ever before included in a U.S. FTA.”
Chapter 13, article 4
A Party shall not adopt or maintain, with respect to financial institutions of the other Party or investors of the other Party seeking to establish such institutions, either on the basis of a regional subdivision or on the basis of its entire territory, measures that:
(a) Impose limitations on:
(i) The number of financial institutions whether in form of numerical quotas, monopolies, exclusive service suppliers, or the requirements of an economic needs test;
(ii) the total value of financial service interactions or assets in the form of numerical quotas or the requirement of an economic needs test;
(iii) the total number of financial service operations or on the total quality of financial services output expressed in terms of designated numerical units in the form of quotas or the requirements of an economic needs test; or
(iv) the total number of natural persons that may be employed in a particular financial service sector or that a financial institution may employ and who are necessary for, and directly related to, the supply of a specific financial service in the form of numerical quotas or the requirement of an economic needs test; or
(b) Restrict or require specific types of legal entity or joint venture through which a financial institution may supply a service.
Christine Ahn says that the financial services industry was deeply involved in the negotiation of the agreement and, in fact, “was one of the main drivers” of that negotiation. Ahn asserts that comments from the financial services industry show that the industry is “salivating” over the prospect of the FTA’s ratification and implementation.
According to John Dearie, the Executive Vice-President for Policy at the Financial Services Forum — a coalition of the 20 largest financial services institutions in the U.S. — “The agreement has been referred to as a ‘gold standard agreement’, meaning that South Korea went far beyond its WTO obligations, permitting market access across virtually all service sectors.”
Article 13.4 of the agreement (see sidebar for full text of the Article) prohibits either country from adopting or maintaining a variety of limitations on the “financial institutions of the other Party or investors of the other Party seeking to establish such institutions.” That means that the U.S. would not be able to enforce such limitations on Korean companies, and visa versa. But, as a practical matter, the provisions would also effectively discourage the impositions of such limitations on domestic institutions operating in each country as well, since neither country would want to put its own companies at a disadvantage relative to the other country’s financial institutions.
One provision of Article 13.4 prohibits limitations on the “total value of financial service interactions or assets” in respect to the other party. Todd Tucker, the research director of Public Citizen’s Global Trade Watch, claims that, if U.S. regulators or Congress were to decide to limit the size of a bank’s assets or market share in order to avoid situations where banks become too big to fail, the Korean government could challenge that law under the FTA.
An official at the Office of the U.S. Trade Representative, who was not authorized to speak on the record, vigorously disputes this contention, and asserts that such regulation would not be prohibited. That official argues that the “obligations” of Chapter 13 refer to sector-wide limitations (that is, all institutions in a country), not limitations on individual institutions.
But at least one provision of Article 13.4 — paragraph (a)(4) — does appear to refer to both restrictions applicable to either the entire financial sector or an individual financial institution, and the other provisions do not specify “financial sector” only.
Ian Fletcher, a research fellow at the Business and Industry Council, argues that the FTA restricts one country from applying “provisions against financial firewalls between financial activities [or] regulation on derivatives” on the financial institutions of the other country. He cites the the provision of the FTA that prohibits either the U.S. or Korea from restricting or requiring “specific types of legal entity or joint venture through which a financial institution may supply a service.”
The firewall that existed under the Glass-Steagall Act, for example, prohibited depository banks from offering investment banking services, until it was repealed in 1999. (The repeal of the law has been criticized on the grounds that it allowed some banks to become too big to fail.)
A proposal to regulate derivatives by limiting what kinds of institutions could trade in them would also raise issues of how to interpret the FTA’s provision precluding requirements on the “specific types of legal entity” that could provide the service.
Tucker also claims that the agreement would prohibit any regulatory bans — such as on credit default swaps or flash trading — because they could be interpreted as a “quota of zero” (see bottom box), and therefore violate paragraph (a)(iii) by limiting the total quantity of financial services output.
Though the U.S. would not be barred from imposing such regulations on its own institutions, it is difficult to imagine that it would decide to enact a limitation that could only be applied only to U.S. banks and not to Korean-registered banks operating in the U.S., of which there are currently several.
In an email response to further inquiry, a USTR official insisted to Remapping Debate that “the obligations in the financial services chapter do not prevent government actions to address systemically important financial institutions, create ‘firewalls’ among sector-specific financial services suppliers, or otherwise regulate financial products.”
So if the FTA is not intended to block regulations addressing systemic risk, why not add language to the agreement to make that clear? (Nothing would prevent, for example, the inclusion of an illustration of the type of regulation the parties intend to permit under the FTA.)
“We don’t need to clarify this part of the agreement,” the official said. “We understand, and our trading partners understand, how the agreement operates as a whole. We don’t think it’s necessary to do anything different here.”
What’s a quota in the context of a trade agreement?
Each of the provisions in Article 13.4 is qualified by the phrase “in the form of numerical quotas.” The agreement does not define what constitutes a “numerical quota,” however, and Public Citizen's Tucker points out that, in the past, regulatory bans have in fact been interpreted as quotas.
In 2003, the government of Antigua and Barbuda challenged a U.S. regulatory ban against internet gambling, claiming that it violated market-access provisions in the General Agreement on Trade in Services (GATS) that are very similar in language to those in the KORUS FTA. The Office of the U.S. Trade Representative argued that bans are not quotas.
The WTO Appellate Body ruled in 2005 that regulatory bans are considered a “quota of zero,” and found in favor of Antigua and Barbuda and against the U.S.
Although the WTO jurisprudence is not binding on the KORUS FTA, Tucker said that if a similar case came up based on Article 13.4, the panel deciding the case would be likely to consult it.
Giving with one hand and taking with the other?
Despite the disagreements about the implications of Article 13.4, the FTA framework provided another opportunity through which to create clarity. Most free trade agreements contain a so-called “prudential carve-out” section that is designed to protect a country’s right to regulate its economy. The “Financial Services” Chapter of the FTA contains such a provision (see sidebar for full text).
Notwithstanding any other provision of this Chapter or Chapter Eleven (Investment), Fourteen (Telecommunications), including specifically Article 14.23 (Relation to Other Chapters), or Fifteen (Electronic Commerce), and, in addition, Article 12.1.3 (Scope and Coverage) with respect to the supply of financial services in the territory of a Party by a covered investment,
a Party shall not be prevented from adopting or maintaining measures for prudential reasons, including for the protection of investors, depositors, policy holders, or persons to whom a fiduciary duty is owed by a financial institution or cross-border financial service supplier, or to ensure the integrity and stability of the financial system.
Where such measures do not conform with the provisions of this Agreement referred to in this paragraph, they shall not be used as a means of avoiding the Party’s commitments or obligations under such provisions.
The first sentence of the provision says that, despite the limitations imposed by the FTA, both the U.S. and South Korea will still be able to adopt any regulations they need to for prudential reasons, “including for the protection of investors, depositors, policy holders, or persons to whom a fiduciary duty is owed by a financial institution or cross-border financial service supplier, or to ensure the integrity and stability of the financial system.”
So, if the U.S. wanted to, say, ban certain kinds of derivatives, or limit the size of banks because they were too-big-to-fail, then, despite the provisions in Article 13.4, this sentence in Article 13.10 would seem to protect the right to impose those regulations if they were seen as necessary to “ensure the integrity and stability of the financial system.”
The USTR official made this argument explicitly: "Even if we wanted to impose a measure that would be inconsistent” with provisions of Article 13.4, the official told Remapping Debate, “if we believed that we needed to impose such a measure, we have the right to do that under the prudential exceptions."
But the story is complicated significantly by the very next (and last) sentence of Article 13.10, which turns around and limits the availability of the prudential carve-out. When a financial regulation, it says, is inconsistent with the provisions of the financial services chapter — including Article 13.4 on market access — that regulation is not protected by the carve-out if it is being “used as a means of avoiding the Party’s commitments or obligations under such provisions.”
Public Citizen’s Tucker wrote in an email that the net effect was the prudential carve-out section was “self-cancelling.” True exceptions to trade agreements would, in contrast, “clearly allow countries reprieve from their obligations under the agreement if the exception’s requirements are met.”
The KORUS FTA’s limitation on the carve-out language would require in each case the resolution of the potentially difficult question of what is motivating a provision that does have the effect of contradicting one of the regulation-limiting provisions of Article 13.4. Is the provision designed to curtail systemic risk, avoid an FTA obligation, or both?
According to Joshua Meltzer, a Global Economy and Development fellow at the Brookings Institution, who has written in support of the FTA, the limiting sentence of Article 13.10 is merely designed to “make sure that you basically don’t use prudential regulation as a disguise to get out of your commitment.”
“[The first sentence] says that each country’s need to regulate their financial systems is more important than all the other provisions in the Agreement,” Meltzer said. “I’m not concerned that [the second sentence] is some kind of loophole.”
“It’s pretty clear that [the provision] is designed not to be clear, and that the dispute panel will have to make up a meaning. That’s a very strange way to set the most important international economic policy.” — Robert K. Strumberg, Professor of Law at Georgetown University Law School.
But how would a panel decide whether a prudential measures defense was a disguise, rather than a justifiable desire to ensure the stability of the system?
“It’s reasonable to say it’s a complex issue,” Meltzer said. “There’s a certain amount of what’s called ‘constructive ambiguity,’ because it’s nearly impossible to specify in detail exactly when a regulation starts becoming a trade restriction rather than generally aimed at a legitimate purpose.”
Ed Gerwin, a trade lawyer and senior fellow for trade and global economic policy at the think tank Third Way, has also written in favor of the agreement. When asked about the prudential carve-out language, he said that he was not able to explain it. For a detailed interpretation, he suggested asking someone at the Financial Services Forum.
When I put the question to John Dearie at the Forum, he said, “A trade attorney would be able to answer that question better than me.”
According to Robert K. Strumberg, Professor of Law at Georgetown University Law School focusing on international and trade law, the language in the second sentence is probably intentionally imprecise.
“It’s confusing as hell,” Strumberg said. “It’s incredibly vague. And this isn’t a trifling matter — these are some of the most important regulations that there are in terms of how our economy works.”
Strumberg added that it would be up to the dispute panel that heard the first case to decide what the meaning of the carve-out is.
“It’s pretty clear that [the provision] is designed not to be clear, and that the dispute panel will have to make up a meaning,” he said. “That’s a very strange way to set the most important international economic policy.”
A missed opportunity?
The disputes as to interpretation of the agreement may give the impression that the only policy possibilities in a trade agreement are to limit the ability of the signatories to impose regulatory controls, or to leave the parties free to impose such controls. There is actually a third possibility — use the agreement affirmatively to encourage the parties to adopt more robust regulatory controls — but that route was not taken.
The KORUS FTA was modeled on past FTAs, especially the North American Free Trade Agreement (NAFTA), and largely uses the same framework, albeit with different language. Some opponents of the agreement, however, believe that the U.S. financial crisis provided lessons about the perils of under-regulation that that Administration should have heeded when it renegotiated the deal.
Aldo Caliari, director of the Rethinking Bretton Woods Project at the Center of Concern, a faith-based advocacy organization for economic justice, says the KORUS FTA reflects “a model that was developed before the financial crisis” that “assumes that deregulation is going to lead to benign results.” But, he continued, “It does not really take on board what we are learning right now about the problems embedded in that model, [the assumption] that financial actors are going to self-regulate and that they will do it in the best interests of society.”
Kevin P. Gallagher, Associate Professor of International Relations at Boston University, who has written in opposition to the agreement, agrees, and describes the re-negotiation as a “missed opportunity” to reform the NAFTA-style model.
The only way to draft it?
The North American Free Trade Agreeement (NAFTA), which came into force in 1994, includes language identical to the first sentence of the KORUS FTA's prudential carve-out, but does not include the second sentence.
That second sentence is, however, included in the prudential carve-out provisions of financial services chapters of many other FTAs that were negotiated before the financial crisis, including, as the USTR official pointed out, the General Agreement on Trade in Services (GATS), which entered into force in 1997.
The second sentence is included United States-Chile FTA, which went into force in 2004, but that agreement includes a footnote that states: “The Parties understand that a Party may take measures for prudential reasons through regulatory or administrative authorities, in addition to those who have regulatory responsibilities with respect to financial institutions, such as ministries or departments of labor.”
The KORUS FTA does not contain the footnote.
According to the Financial Services Forum’s John Dearie, though, the financial crisis has actually enhanced the value of the agreement. “One of the lessons of the recent crisis is the tremendous need for greater cross-border communication and cooperation among financial authorities,” he said in an email.
The KORUS would do that, he said, by establishing regular dialogues between the two countries’ regulators. “The agreement should be ratified, not renegotiated," he added.
And the lesson that the USTR official said had been taken from the financial crisis was that, “Trade commitments did not cause the financial crisis nor inhibit in any way our ability to respond appropriately to it.” As such, no changes in the approach or language of the FTA’s financial services chapter were made when the 2010 negotiations gave the parties the opportunity to take account of the financial meltdown.
What might another path look like?
Manuel Pérez-Rocha, associate fellow at the Institute for Policy Studies, said that the U.S. should have used its leverage to push for greater international regulation of some aspects of the financial services sector.
Prospects for ratification
Proponents and opponents alike agreed that the agreement has a good chance of being ratified this year.
Currently, the U.S. also has FTAs pending with Columbia and Panama, both of which follow the same model as the KORUS FTA, and both of which include very similar language regarding market access for financial institutions and prudential exceptions.
Indeed, the prudential carve-out in the Columbia FTA is almost identical to the one in the KORUS FTA.
President Obama has expressed interest in reviving these other Bush-era FTAs, as well.
“There is no current [international] framework for the regulation of financial products,” said Pérez-Rocha. “Obama could have used the re-negotiations to establish one, at least for Korea and the U.S., with this agreement.”
Pérez-Rocha’s candidates for such regulation in the context of an FTA include greater oversight of the derivatives market, and measures that lessen the risk of world economies being saddled with financial institutions that are “too big to fail.”
Pérez-Rocha did not specify the particulars of the regulations he would incorporate, but domestic efforts to tighten regulation of the derivatives market have focused on moving "over the counter" trading to regulated exchanges and central clearing houses, where it would be easier to monitor. Domestic proposals to reduce “too big to fail” risk have included measures that would cap bank size by asset and market share, and others that would re-enact the Glass-Steagall firewall between depository and investment banking.
Martin Hart-Landsberg had a different perspective. Rather than perpetuating the current FTA model, or moving immediately to incorporate provisions that enhance financial sector regulation into trade agreements, the U.S., he said, would do well first to take a long, hard look at its overall economic goals and priorities.
“It’s hard to say ‘Well, what would a good free trade agreement look like?’ because [the question] abstracts from all the problems in the U.S. economy,” Hart-Landsberg said. “You have to start and say ‘What would a healthy industrial policy look like? How would we want to rethink transportation? How would we want to rebuild an infrastructure? How would we want to ensure adequate investment in economic activities that would connect to new growth poles?’”
“Only then,” he added, “can you ask, ‘what would a trade strategy look like that would flow from that?’”