Publications /
Opinion

Back
The Metamorphosis of Financial Globalization
Authors
September 15, 2017

After a strong rising tide starting in the 1990s, financial globalization seems to have reached a plateau since the global financial crisis. However, that apparent stability has taken place along a deep reshaping of cross-border financial flows, featuring de-banking and an increasing weight of non-banking financial cross-border transactions. Sources of potential instability and long-term funding challenges have morphed accordingly.     

Financial globalization is morphing after its recent peak

Financial globalization – as measured by the ratio of the stock of foreign assets to world GDP ¬- seems to have reached a plateau since the Global Financial Crisis (GFC) (figure 1). Post-2007 ratios seem to have been the apparent “peak” of a high wave of financial globalization rising from the mid-1990s, which likewise saw external financial assets and liabilities soaring and degrees of financial openness reaching levels triple the ones of before World War 2. 

PCNS

Along with the deceleration of the pace of rise of stocks relative to world GDP, a change of composition in flows has taken place, as also depicted in figure 1. While total cross-border lending decreased as a proportion of GDP, the stable level of global ratios of foreign liabilities to GDP occurred because of increased flows of foreign direct investment (FDI), equity portfolio and debt securities. Such aggregate figures, however, gloss over some relevant features in detail.

Financial globalization has mainly happened among advanced economies   

Rising cross-border movements of financial assets from the mid-1990s has been remarkable among advanced economies (AEs). Levels of financial openness (the sum of foreign assets and liabilities as a proportion of GDP) relative to trade openness (the sum of exports and imports as a proportion of GDP) were similar on both groups of advanced and emerging market economies (EMEs) until mid-1980s but shifted upward in the former’s case, rising rapidly particularly since mid-1990s (figure 2, left side). Cross-border financial assets and liabilities went from 135% to above 570% of GDP since mid-1990s for AEs, whereas they moved from approximately 100% to 180% of GDP on the side of EMEs (BIS, 2017).   

PCNS

In general, two major processes lead to rising cross-border financial transactions. First, there is a mutually reinforcing association with increases in foreign trade and production. Even if foreign trade corresponds simply to movements of commodities and finished goods, basic international financial links – e.g. trade finance and cross-border payments - are pulled on. Such a connection only increases with the emergence of cross-border value chains and foreign investment of corporations abroad, which lead to acquisition of assets and liabilities and corresponding management of exposures.

In addition to financial operations derived from trade and production relations, the active management of balance sheet positions may also lead to cross-border financial transactions as part of the processes of allocation and diversification of savings. As remarked by the BIS (2017), such purely financial processes bring some “decoupling between real and financial openness”. 

Financial liberalization and sophisticated banking and financial markets in AEs created conditions for a surge of foreign transactions of assets as illustrated in both figures 1 and 2 (left-side). Financial openness also rose faster than trade openness in EMEs, albeit at a much slower pace. 

It is worth highlighting the changes in the composition of EMEs gross liabilities, with declines in foreign debt being more than compensated by portfolio equity and foreign direct investments – FDI (right-side, figure 2). The global rising share of non-lending financial transactions exhibited in figure 1 was particularly accentuated in the case of EMEs. 

European banks have been at the core of both surge and pause of the wave of financial globalization since the 1990s

Figure 3 (left-side) shows the substantial piling up of European banks’ foreign claims in the run up to the GFC, followed by an also substantial retrenchment. The right side illustrates how some banks outside Europe have partially occupied the space left by their European counterparts.  

PCNS

Lending by European banks was behind two of the major contributing factors to the rising wave of financial globalization. First, the inauguration of the Euro, followed by markets initially converging their assessments of risk premiums across the zone downward toward German levels, boosted cross-border transactions. According to the BIS annual report released last July:

Between 2001 and 2007, 23 percentage points of the increase of the ratio of advanced economies’ external liabilities to GDP was due to intra-euro area financial transactions and another 14 percentage points to non-euro area countries’ financial claims on the area (p.102).

Furthermore, European banks also played an active role in the asset bubble-blowing process in the U.S. financial system. As tackled in studies by Hyun Song ShinClaudio Borio and others, European banks used U.S. wholesale funding markets to sustain exposures to U.S. borrowers through the shadow banking system. Despite their small presence in the domestic U.S. commercial banking sector, their weight on overall credit conditions was magnified through the shadow banking system in the United States that relies on capital market-based financial intermediaries which intermediate funds through securitization of claims. 

From the standpoint of the balance-of-payments between the U.S. and Europe, those transactions netted out. Nonetheless, from an accounting sense they represented short-term borrowing combined with long-term lending by European banks, with a corresponding double counting as cross-border financial transactions. 

The retrenchment of European banks’ foreign claims followed both the U.S. asset-bubble burst starting in 2007 and the Euro-zone crisis 2009 onward. Besides business-driven reasons – losses, decisions to deleverage balance sheets – tighter banking regulation and the orientation toward domestic assets assumed by post-crisis unconventional monetary policies also weighed. These factors have also led to deleveraging, balance-sheet shrinking, and domestic reorientation by banks in the other crisis-affected AEs. Although some banks from outside the latter have expanded their foreign lending, levels of global financial openness have been maintained thanks to growing flows of non-lending instruments (debt securities, portfolio equity and FDI).

The apparently higher stability of global finance may conceal other fragilities

As highlighted by a recent report from McKinsey Global Institute (2017), some features of “the new dynamics of financial globalization” may embed in it higher stability. Higher capital buffers and minimum amounts of liquid assets have reduced the weight of bank lending and the intrinsic features of mismatch and volatility of banks’ balance sheets. The higher share of equity and FDI, in turn, may carry longer-term return horizons and closer alignment of risks between asset purchasers and originators. The unwinding of debt-financed huge current-account imbalances characteristic of the global economy in the run-up to the GFC has also contributed to such a view of global finance entering a less unstable phase.

However, flows of FDI partially correspond to disguised debt flows and/or transfers motivated by tax arbitrage or regulatory evasion (Blanchard & Acalin, 2016). Cross-border debt flows – including securities - in turn, are also sensitive to global factors, besides carrying a high sensitivity to and procyclicality with respect to monetary-financial conditions in either source and/or destination countries. 

There are also “blind spots” left by de-banking hitherto not preempted by non-banking financial transactions. For instance, cross-border de-risking by global banks has entailed closure of correspondent banking relations in many countries in which the paucity of alternatives has led to negative consequences to the local financial dynamics (Canuto & Ramcharan, 2015). By the same token, the arms-length distance between asset holders and liability issuers intrinsic to debt securities and portfolio equity, in the absence of the project-finance role played in the past by international investment banks, often constrains the cross-border financing of greenfield investment projects to FDI possibilities (Canuto, 2014) (Canuto & Liaplina, 2017)

It is also worth referring to the potential transformative impact – and corresponding need for regulatory adaptation – on cross-border finance brought by digital technologies. We may well be on the brink of an additional metamorphosis of global finance and the instability that may come with it. 

Bottom line

The transformation of global finance has not suppressed the need for policies to monitor and cope with risks. On the side of recipients of net capital inflows, domestic agendas of institutional strengthening to reinforce alignment of risks between investors and countries, together with regulatory vigilance against excess financial euphoria or depression remain necessary. The bar in terms of domestic institutional quality – corporate governance standards, business environment – has been raised in the new phase of global finance. 

RELATED CONTENT

  • Authors
    October 4, 2016
    Brazil has been suffering from anemic productivity growth. This is a major challenge because in the long run, sustained productivity increases are necessary to underpin inclusive economic growth. Without them, increases in real labor earnings tend to conflict with global competitiveness; collecting taxes in order to fund government expenditures on infrastructure and social policies becomes a heavy burden; returns to private investment becomes harder to achieve; and ultimately citize ...
  • Authors
    Samuel George
    September 27, 2016
    On July 15, Turkey’s tumultuous 2016 took a shocking twist as elements within the country’s military attempted a coup against the government of President Recep Tayyip Erdogan. The putsch rapidly snapped at the seams, and a night that began with soldiers blocking bridges yielded a morning with those same soldiers flogged by civilians in the street. In the days following the attempt, Erdogan declared a three-month state of emergency and began purges of depth and breadth that extended ...
  • September 07, 2016
    Ce podcast est délivré par Moubarack Lo. Cette présentation a pour objet de définir une théorie de l’émergence économique, qui constitue une étape vers la convergence avec les pays dévelo ...
  • Authors
    Aleksandr V. Gevorkyan
    August 15, 2016
    Emerging market economies (EM) as a special class of financial assets have recently been subject to two competing tales. On the one hand, there is evidence of continued financial deepening and further integration within the global financial system, while the offer of higher yields remains hard to find elsewhere. On the other hand, there are frequent bouts of fear of systemic unwinding of positions triggered by investors “exiting” EM that exhibit signs of weak or unclear macroeconomi ...
  • Authors
    Volume 69, Issue 3
    Introduction by Rabah Arezki
    Yaw Nyarko
    July 14, 2016
    OCP Policy Center and its partners, the International Monetary Fund (IMF), and the Center for Technology and Economic Development (CTED) at the New York University are pleased to announce the publication of a Special Issue on "Food Price Volatility and its Consequences" in Oxford Economic Papers. The papers selected in this special issue were first presented in February 2014 at an international conference organized in Rabat in collaboration with the IMF's Research Department and  t ...
  • July 13, 2016
    Housing is part of the United Nations 11th Sustainable Development Goal, which is to “make cities inclusive, safe, resilient and sustainable”. One of the most important targets of such a goal is to “ensure access for all to adequate, safe and affordable housing1 and basic services and upgrade slums”. Since 2007, the world has faced rising inequality, insecurity and climate change impact. According to UN Habitat, 54% of the world´s population currently live in cities. By 2050, this n ...
  • Authors
    July 11, 2016
    The Chinese economy is rebalancing while softening its growth pace. China’s spillovers on the global economy have operated through trade, commodity prices, and financial channels. The global reach of the effects from China’s transition have recently been illustrated in risk scenarios simulated for Latin American and the Caribbean economies.  The Chinese economy is rebalancing while softening its growth pace… The weight of the Chinese economy in the global economy rose on its way t ...
  • June 30, 2016
    Latin American economies are facing two historically defining challenges. First, how to cope with the end of the commodities “super-cycle” and the prospect of a long period of low prices for basic natural resources. After all, raw materials production and semi-industrialized goods encompass most of their comparative advantages. Second, and even more exacting, how to adjust to the present disruptive transition from an old to a new global economic and social model. The 20th century in ...