The Retreat of Financial Globalization?
I left this in draft since Nov 3 and am publishing this now….
by Joseph Joyce
The Retreat of Financial Globalization?
Eight years after the global crisis of 2008-09, its reverberations are still being felt. These include a slowdown in world trade and a reassessment of the advantages of globalization. Several recent papers deal with a decline in international capital flows, and suggest some reasons for why this may be occurring.
Matthieu Bussière and Julia Schmidt of the Banque de France and Natacha Valla of CEPII (Centre d’Etudes Prospectives et d’Informations Internationales) compare the record of the period since 2012 with the pre-crisis period and highlight four conclusions. First, the retrenchment of global capital flows that began during the crisis has persisted, with gross financial flows falling from about 10-15% of global GDP to approximately 5%. Second, this retrenchment has occurred primarily in the advanced economies. particularly in Europe. Third, net flows have fallen significantly, which is consistent with the fall in “global imbalances.” Fourth, there are striking differences in the adjustment of the various types of capital flows. Foreign direct investment has been very resilient, while capital flows in the category of “other investment”—mainly bank loans—have contracted substantially. Portfolio flows fall in between these two extremes, with portfolio equity recovering much more quickly than portfolio debt.
Similarly, Peter McQuade and Martin Schmitz of the European Central Bank investigate the decline in capital flows between the pre-crisis period of 2005-06 and the post-crisis period of 2013-14. They report that total inflows in the post-crisis period reached about 50% of their pre-crisis levels in the advanced economies and about 80% in emerging market economies. The decline is particularly notable in the EU countries, where inflows fell to only about 25% of their previous level. The steepest declines occurred in the capital flows gathered in the “other investment” category.
McQuade and Schmitz also investigate the characteristics of the countries that experienced larger contractions in capital flows in the post-crisis period. They report that inflows fell more in those countries with higher initial levels of private sector credit, public debt and net foreign liabilities. On the other hand, countries with lower GDP per capita experienced smaller declines, consistent with the observation that inflows have been curtailed more in the advanced economies. In the case of outflows, countries with higher GDP growth during the crisis and greater capital account openness were more likely to increase their holdings of foreign assets.
Both studies see an improvement in financial stability due to the larger role of FDI in capital flows. Changes in bank regulation may have contributed to the smaller role of bank loans in capital flows, as has the diminished economic performance of many advanced economies, particularly in the Eurozone. On the other hand, smaller capital flows may restrain economic growth.
While capital flows to emerging markets rebounded more quickly after the crisis than those to advanced economies, a closer examination by the IMF in its April 2016 World Economic Outlookof the period of 2010-2015 indicate signs of a slowdown towards the end of that period. Net flows in a sample of 45 emerging market economies fell from a weighted mean inflow of 3.7% of GDP in 2010 to an outflow of 1.2% during the period of 2014:IV – 2015:III. Net inflows were particularly weak in the third quarter of 2015. The slowdown reflected a combination of a decline in inflows and a rise in outflows across all categories of capital, with the decline in inflows more pronounced for debt-generating inflows than equity-like inflows. However, there was an increase in portfolio debt inflows in 2010-2012, which then declined.
The IMF’s economists sought to identify the drivers of the slowdown in capital flows to these countries. They identified a shrinking differential in real GDP growth between the emerging market economies and advanced economies as an important contributory factor to the decline. Country-specific factors influenced the change in inflows for individual countries, as economies with more flexible exchange rates recorded smaller declines.
In retrospect, the period of 1990-2007 represented an extraordinarily rapid rise in financial globalization, particularly in the advanced economies. The capital flows led to increased credit flows and asset bubbles in many countries, and culminated in an economic collapse of historic dimensions. The subsequent retrenchment of capital flows may be seen as a return to normalcy, and the financial and banking regulations–including capital account controls–enacted since the crisis as an attempt to provide stronger defenses against a recurrence of financial volatility. But the history of finance shows that new financial innovations are always on the horizon, and their risks only become apparent in hindsight.
The following is from a 2011 article from ‘Financial Times’:
“Mr Bernanke has previously argued that a “global savings glut” led emerging markets to send large amounts of capital to the US in the 2000s, pushing down US interest rates. His new paper says that those emerging markets wanted safe assets – and US regulators failed to keep the financial system from creating them.”
“In analogy to the Asian crisis, the primary cause of the breakdown was the poor performance of the financial system and financial regulation in the country receiving the capital inflows, not the inflows themselves,” Mr Bernanke said, adding that the US crisis had given him new sympathy for developing countries that have to manage large capital inflows.”
Or, put another way:
“In the wake of the financial crisis of 2007–2008, the governor of the People’s Bank of China explicitly named the reserve currency status of the US dollar as a contributing factor to global savings and investment imbalances that led to the crisis. As such the Triffin Dilemma is related to the Global Savings Glut hypothesis because the dollar’s reserve currency role exacerbates the U.S. current account deficit due to heightened demand for dollars” (wiki)
Or, for yet another piece of the puzzle:
“In the wake of the financial crisis of 2007–2008, the governor of the People’s Bank of China explicitly named the Triffin Dilemma as the root cause of the economic disorder, in a speech titled Reform the International Monetary System. Zhou Xiaochuan’s speech of 29 March 2009 proposed strengthening existing global currency controls, through the IMF” (wiki)
So, the suggestion from the article that “the retrenchment of capital flows may be seen as a return to normalcy”, is almost certainly correct. But, ‘normalcy’ is not a good thing. Much needed capital is accumulating in too few hands and these concentrations are then invested too conservatively in efforts to balance portfolios that have become too large. Thus, global growth, or ‘normalcy’ is not what it needs to be if progress is to be… what it must be, to maintain a sustainable pace of growth.
But “new financial innovations” are now less a threat in part due to lessons learned, but more-so because of the slowing capital flows. The ‘normalcy’ problem then being that there is too little development, and too much hedging. The solution then being to make investment safer where it is needed most, and this is of course what ISDS provisions are intended to do.