Monday, October 20, 2014

Financial Globalization in Reverse?

WASHINGTON, DC – For three decades, financial globalization had seemed inevitable. New information technologies made it possible to conduct transactions halfway around the world in the blink of an eye. Savers gained the ability to diversify, while the largest borrowers could tap global pools of capital. As national financial markets grew more intertwined, cross-border capital flows rose from $0.5 trillion in 1980 to a peak of $11.8 trillion in 2007.

But the 2008 crisis exposed the dangers, with the globalized financial system’s intricate web of connections becoming a conduit for contagion. Cross-border capital flows abruptly collapsed. Almost five years later, they remain 60% below their pre-crisis peak.

This pullback in cross-border activity has been accompanied by muted growth in global financial assets (despite the recent rallies in stock markets around the world). Global financial assets have grown by just 1.9% annually since the crisis, down from 7.9% average annual growth from 1990 to 2007.

Should the world be worried by this decline in cross-border capital flows and slowdown in financing? Yes and no.

After the outsize risks of the bubble years, these trends could be a sign that the system is reverting to historical norms. As we now know, much of the growth in financial assets prior to the crisis reflected leverage of the financial sector itself, and some of the growth in cross-border flows reflected governments tapping global capital pools to fund chronic budget deficits. Retrenchment of these sources of financial globalization is to be welcomed.

But not all of the current retreat is healthy. Surprisingly, emerging economies are also experiencing a slowdown; the development of their financial markets is barely keeping pace with GDP growth. Most of these countries have very small financial systems relative to the size of their economies, and, with small and medium-size enterprises (SMEs), households, and infrastructure projects facing credit constraints, they certainly have ample room for sustainable market deepening.

A powerful factor underlying the drop in cross-border capital flows is the dramatic reversal of European financial integration. Once in the vanguard of financial globalization, European countries are now turning inward.

After expanding across national borders with the creation of the euro, eurozone banks have now reduced cross-border lending and other claims within the eurozone by $2.8 trillion since the end of 2007. Other types of cross-border investment in Europe have fallen by more than half. The rationale for the euro’s creation – the financial and economic integration of Europe – is now being undermined.

Current trends seem to be leading toward a more fragmented global financial system in which countries rely primarily on domestic capital formation. Sharper regional disparities in the availability and cost of capital could emerge, particularly for smaller businesses and consumers, constraining investment and growth in some countries. And, while a more balkanized financial system does reduce the likelihood of global shocks creating volatility in far-flung markets, it may also concentrate risks within local banking systems and increase the chance of domestic financial crises.

So, is it possible to “reset” financial globalization while avoiding the excesses of the past?

Successfully concluding the regulatory reform initiatives currently under way is the first imperative. That means working out the final details of the Basel III banking standards, creating clear processes for cross-border bank resolution and recovery, and building macro-prudential supervisory capabilities. These steps would go a long way toward erecting safeguards that create a more stable system.

But additional measures are needed. The spring meetings of the World Bank and the International Monetary Fund represent a pivotal moment for shifting the debate toward a second phase of post-crisis reform efforts – one that focuses on ensuring a healthy flow of financing to the real economy.

A crucial part of this agenda is the removal of constraints on foreign direct investment and foreign investor purchases of equities and bonds, which are far more stable types of capital flows than bank lending. Many countries continue to limit foreign investment and ownership in specific sectors, restrict their pension funds’ foreign-investment positions, and limit foreign investors’ access to local stock markets. Eliminating these barriers would increase the availability of long-term financing for business expansion.

More broadly, officials in emerging economies should restart reforms that enable further domestic financial-market development. Most countries have the basic market infrastructure and regulations, but enforcement and supervision is often weak. Progress on this front would enable equity and bond markets to provide an important alternative to bank lending for the largest companies – and free up capital for banks to lend to SMEs and consumers. Deepening capital markets would also benefit local savers and open new channels for foreign investors to diversify.

Given that Europe led the recent rise and fall of financial globalization, any effort to reset the system should focus on measures to restore confidence and put European financial integration back on track. The recent crisis in Cyprus underscores the urgency of establishing a banking union that includes not only common supervision, but also resolution mechanisms and deposit insurance.

Determining the right degree of openness is a thorny and complex issue for every country. Policymakers must weigh the risks of volatility, exchange-rate pressures, and vulnerability to sudden reversals in capital flows against the benefits of wider access to credit and enhanced competition. The right balance may vary depending on the size of the economy, the efficiency of domestic funding sources, and the strength of regulation and supervision.

But the objective of building a competitive, diverse, and open financial sector deserves to be a central part of the policy agenda. The ties that bind global markets together have frayed, but it is not too late to mend them.

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  1. CommentedC. Jayant Praharaj

    Equities and bonds can constitute very unstable cross-border capital flows, unlike what the author seems to be implying.

  2. CommentedRobert Pringle

    The authors identify the central issue facing the world today and some of their policy recommendations are well taken. However, it is a mistake to look to the current Basel process/bank resolution/macro-prudential measures to deliver sufficient reform of banking - a major step towards market discipline is essential to protect public budgets. Nothing less that an integrated reform of both the banking and the official monetary system will create a framework robust enough to accommodate the strains resulting from necessary financial globalisation. For what the IMF and G20 should do this week, here is a draft Communique

  3. CommentedZsolt Hermann

    There are lots of important points in this article:

    1. Globalization is not man made, we are not controlling it. Globalization is part of our evolutionary process as the whole of nature is progressing towards more evolved, more interconnected systems in order to maintain life, general balance and homeostasis.
    What we do is we use these inevitable interconnections, but at the moment we use them in a negative way. We are like cells in a healthy body, which cells although understanding they are interconnected and that they fully depend on each other, still want to use the connections for self benefit, exploiting everything and everyone for ourselves. This is the behavior of a cancer, and the results if we continue this way are the same, the destruction of the whole system with the harmful cell within.

    2. Retreating from globalization, from increasing integration is impossible, since as mentioned above the process is evolutionary, it is going based on unbreakable natural laws, and since humanity, despite popular belief is part of this natural system we have no choice. Our only choice as mentioned above is a conscious adaptation to the system, accepting to its laws.

    3. The present financial system is not really a concern, since it is not going to last. The present financial system is just an artificial construct that has grown on top of the equally artificial, unnatural and thus unsustainable constant quantitative growth economic model. This model is now falling apart, taking it financial system with it.

    Our present concern should be squarely on how to adapt to the fully matured, global, interconnected and interdependent human network within the equally fully interconnected natural system that is guarding its general balance and homeostasis with all of its tools. Either we adapt or will be forced to adapt, the only question is if we do this adaptation willingly with full awareness, or in darkness by the blows from behind.

  4. CommentedEtienne Schneider

    I think these suggestions are onesided and too simplified. What happened in the 90's to Asian and Sout American eonomies who followed the suggestions of freeing up their markets?
    It led to large inflows of hot money (capital flow bonanzas like Kenneth Rogoff calls it) which in the end led to very miserable effects for these economies when the money was drawn-off again.

  5. CommentedEtienne Schneider

    Just one! rational for the euro's creation is the economic and financial integration.

    The other rational, which is considered even more important from old-fashioned european politicians but also from other citizens, is the political intergration.
    And this rational is certainly not undermined.

    Please be aware of the fact that the EU was created in order to maintain a stable and peaceful! Europe, which was by no means standard for the last couple of hundred years. The creation financial integration of Europe and the EU currency is just one step more step of making the Eurozone more intervowen.

  6. CommentedProcyon Mukherjee

    McKinsey’s data is an eye opener as is evident in the Exhibit-1 of the report that global equities have plummeted at a CAGR of -5.5% ($64 Trillion in 2007 to $50 Trillion in 2012), which is the largest drop among the basket of financial assets and it is only the growth of government bonds and non-securitized loans that could balance the fall. The most notable observation of the report is that financial deepening in the run-up to the crisis stemming from leverage led to financing for households and corporations but accounted for just over one-fourth of the rise in global financial depth from 1995 to 2007—an astonishingly small share, since providing credit to these sectors is the fundamental purpose of finance. The second striking observation (as in exhibit-2) is that capital flows have reversed from emerging markets to developed markets in the period 2007 to 2012, which is the fundamental reason for the cross-border flows to be limited and drawn down as the rise in the prior period came from the emerging market needs of cross-border flows.

  7. CommentedEtienne Schneider

    Speaking of "Global financial assets" sounds very vague for me and I think there is no standard textbook definition for it. I would appreciate if authors either avoid these terms or refer to a proper definition.

    Moreover, thinking of global financial assets roughly as stocks and bonds, I do not see why an asset grow of "just" 1.9% should be a sign "financial globalization in reverse". Obviously, assets grew to unsystainably high levers before, so it moderate growth in understandable.

  8. CommentedRoss Clem

    Financial market deepening of emerging economies may not benefit from globalization of finance.

  9. CommentedFrancisco Coelho

    Cross-border capital flows rose from $0.5 trillion in 1980 to a peak of $11.8 trillion in 2007.