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Thursday, 4 December 2014

Financial globalization—where next?

Alexandra Zeitz (Global Economic Governance Programme, University of Oxford)

PEFM hosts Charles Collyns, Managing Director and Chief Economist, Institute of International Finance

Could financial globalization be heading into reverse? Before the 2008 financial crisis, financial integration was steadily and rapidly advancing, drawing emerging markets more tightly into a network of cross-border financial flows. In the aftermath of the crisis, flows have reduced and dramatically changed their composition.

How much is a natural reaction to the crisis? And how much an unintended consequence of increasing financial regulation? What are the consequences for emerging markets? In a PEFM seminar on Monday, November 17 Charles Collyns, Managing Director and Chief Economist at the Institute of International Finance (IIF), offered his views from within the financial industry on the prospects for financial globalization.

The striking cutback in cross-border financial flows (from approximately $9 trillion in 2007 to about $2.5 trillion in 2013) mostly reflects the steep decline in international bank flows. Much of this is due to a collapse in short-term inter-bank lending, which had built up excessively in the lead-up to the crisis. By contrast, foreign direct investment and portfolio flows have remained largely steady globally.
Emerging markets have not been spared in this shifting composition of international finance. While the amount of foreign capital flowing into emerging markets has remained constant over the last few years, Collyns pointed to data showing that commercial bank flows retreated substantially, compensated for by a significant increase in portfolio equity.

It is difficult to solely attribute the steep decline in cross-border bank activity to the anticipation of tighter regulation, Collyns conceded. Some of this is simply the roll back of a process that had clearly gotten ahead of itself—and indeed contributed to the crisis. Yet he argued that new standards will reduce the role of banks, by increasing the cost of maturity transformation with capital adequacy requirements and liquidity ratios and making it harder for commercial banks to use their own balance sheets for market-making because of new structural rules (e.g. Dodd-Frank in the US or Vickers ring-fencing in the UK).

At the same time, no doubt reflecting in part the effects of QE in the USA and elsewhere, emerging markets have had to deal with a flood of relatively short term and volatile capital inflows, mainly into equity and bond markets. Policy-makers’ responses have diverged: while Brazil and Turkey opted for measures to restrict short-term flows, including imposing taxes, Chile and Mexico have left inflows (and outflows after the ‘taper tantrum’) unimpeded. Collyns cautioned against over reliance on the former approach, stressing the benefits of financial integration over the longer term.

The argument in favour of financial globalization is based mainly on the claim that integration deepens and strengthens financial markets. While it is true that deep domestic financial markets can be beneficial to development, the causal link between financial globalization and domestic financial development was not entirely proven. Collyns suggested, for instance, that the inflow of foreign capital could encourage the development of domestic financial institutions, though not everyone in the audience was convinced that short-term portfolio flows—which have become increasingly significant in emerging markets—would have this effect.

Well-established financial markets are critical for growth and stability, providing capital for investment and allowing for maturity transformation. Collyns also argued that deep financial markets can act as shock absorbers for international volatility, protecting economies from the rapid outflows, for instance, of the ‘taper tantrum’. He provided evidence from Chile, where domestic capital seemingly compensated for foreign outflows by returning to the country, although it was not entirely clear why this should be so. Why would domestic capital be counter-cyclical? Wouldn't it respond to the same pressures and stimuli as foreign capital?

The picture painted on Monday evening was not necessarily of financial globalization in retreat, but was indisputably of financial globalization changing shape. The optimal policy responses to this new terrain have not yet been fully determined. Collyns called for emerging markets to ensure they have sound macroeconomic environments for these volatile flows and then to continue the process of integration. Internationally, he argued that a global safety net will still be required for when countries are exposed to runs and currency crises. IMF reform (currently held up by the US Congress) and/or the establishment of a viable international network of swap arrangements is urgently needed to provide such a lender of last resort on the required scale to deal with the (inevitable) financial crises of the future.

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