Financial globalisation: Whither Financialisation

McKinsey has recently released an excellent summary of global finance. The authors present a positive picture of global finance despite the significant decline in global flows and the continuation of major financial risks, not all of which are related to cross-border flows.

After a decade of aftershocks from the seismic financial crisis of 2007, the landscape of global finance is much altered. Global cross-border capital flows—including lending, purchases of equities and bonds, and foreign direct investment—have shrunk by 65 percent since 2007, from $12.4 trillion to $4.3 trillion (Exhibit 1). Half of that decline reflects a sharp reduction in cross-border lending and other banking activities. But it would be wrong to conclude that financial globalization is over. New research from the McKinsey Global Institute, The new dynamics of financial globalization, concludes that what is emerging from the rubble is a more risk-sensitive, rational, and ultimately more resilient version of global financial integration.

The most dramatic change in the postcrisis global financial system has been in cross-border lending. Large European banks—particularly those in the eurozone—are leading the retreat from foreign markets. Foreign claims of eurozone banks (including loans, other foreign assets, and lending by foreign subsidiaries) have declined by $7.3 trillion, or 45 percent, since 2007 (Exhibit 2). Nearly half has occurred in intra-eurozone borrowing, with interbank lending declining the most. The foreign claims of Swiss, UK, and other European banks have fallen by $2.1 trillion. Several of the largest US banks are shifting their portfolios away from foreign business, too. ... 

Despite the retrenchment of global banking, financial globalization continues. The global stock of foreign investment relative to GDP has changed little since 2007, standing at roughly 180 percent of world GDP. In absolute terms, total foreign investments have grown to $132 trillion in 2016, up from $103 trillion in 2007. More than one-quarter of equities around the world are owned by foreign investors, up from 17 percent in 2000. In global bond markets, 31 percent of bonds were owned by a foreign investor in 2016, up from 18 percent in 2000. Foreign lending and other investment is the only component of foreign investment assets and liabilities that has declined since the crisis.

This shows the relative stability of FDI and how destabilising short term flows can be. Reversals of short term flows into equities and property markets can add to domestic 'Minskyian' financial instabilities.

While foreign investment stocks remain highly concentrated among a handful of advanced economies, more countries are participating. MGI’s Financial Connectedness Ranking (see the short version of the ranking in this downloadable poster) shows the total stock of foreign investment assets and liabilities for 100 countries, as well as their composition and growth. Advanced economies and international financial centers are the most highly integrated into the global system. The United States, Luxembourg, the United Kingdom, the Netherlands, and Germany top the ranking. 

But developing countries are becoming more connected to global finance. Their share of total foreign investment assets has risen from 8 percent to 14 percent in the past decade. China’s rise in global finance is most notable; it rose from 16th place in 2005 to 8th in 2016. China’s total stock of foreign bank lending, foreign direct investment, and portfolio equity and bond investments reached $3.4 trillion in 2016, exceeding its $3.2 trillion of central bank foreign reserve assets—a notable shift.

Nevertheless the authors have a positive story to tell.

The new era of financial globalization promises more stability, for several reasons. 

• Foreign direct investment (FDI) and equity flows now command a much higher share of gross annual capital flows than before the crisis, from 36 percent before 2007 to 69 percent in 2016. This is good news for stability, since FDI is by far the least volatile type of capital flow and cross-border lending is the most volatile.  

• Global current-, financial-, and capital-account imbalances have shrunk, from 2.5 percent of world GDP in 2007 to 1.7 percent in 2016. This reduces one potential spark that could ignite a financial crisis. Even more dramatic has been the decline in the very large US deficit and Chinese surplus. For the first time in a decade, developing countries have become net recipients of foreign capital flows.  

• Banks around the world have larger capital and liquidity cushions to offset future losses. Most global banks have also built stronger risk-management capabilities.

These are significant changes and the reduction of the imbalance between the US and China is important. However, a slowing Chinese economy may encourage Chinese policy-makers to reinvigorate Chinese mercantilism. This will no doubt anger the Trump Administration in the US, creating wider problems for the world economy and the integration of the US and Chinese economies.

The authors also point out some significant risks.

But potential risks also remain and are worth watching. 

• Gross capital flows—particularly foreign lending—remain volatile. Over 60 percent of countries experience a large decline, surge, recovery, or reversal in foreign lending each year, creating volatility in exchange rates and making macroeconomic management more difficult. The median fluctuation for these countries is equivalent to 6.7 percent for developing countries and 10.8 percent for advanced economies.  

• Equity-market valuations in some markets have reached new heights, which raises questions about whether a bubble could be emerging.  

• With more countries participating in global finance, financial contagion remains a risk—especially for developing countries that lack deep, transparent, and liquid domestic financial markets.

Clearly some efforts to ease volatility must involve restrictions of some sort. Countries can make individual decisions to try to restrict flows but an international framework or agreements between states would allow states to choose lower volatility. Super low interest rates have also inflated housing and property markets making the world economy vulnerable to the potential consequences of monetary policy normalisation. Finally, while the risks of financial contagion are enhanced by greater participation, what consequences could flow from a reinvigoration of global flows?

The authors argue that banks and regulators must respond to the changing dynamics of cross-border finance.

Financial globalization is arguably healthier than it was before the crisis, but banks and regulators must remain vigilant and continue to adapt. In the future digital platforms, blockchain (PDF), and machine learning may transform financial markets and create new channels for cross-border capital flows. These technologies are enabling faster, lower-cost, and more efficient international transactions, and will further broaden participation in global finance to more firms, investors, and countries.

Banks and regulators must respond to several aspects of the new era.

• Banks. How long the ongoing retrenchment of European and US global banks persists is uncertain, but it is likely that it will continue—or at least not reverse—for the foreseeable future. Banks must continue to scrutinize their international strategies to ensure healthy long-term performance. This will entail focusing on corporate clients and countries in which they have significant market share, and shifting from subsidiary to branch structures when possible in order to optimize their capital. Banks must harness the new technologies across their global operations to increase efficiency, meet customer expectations, and capture new opportunities. Harnessing advanced analytics and machine learning algorithms to better understand risks in international markets could be a competitive edge. 

• Regulators. Given the dynamic changes in the way global finance is conducted, policy makers should continue refining regulation and supervision of financial markets. Regulators must continue to build systemic risk monitoring capabilities and ensure prompt reaction to changing market conditions. New tools for managing volatility in capital flows and in reducing capital- and financial- account imbalances are needed. In the eurozone, further development of the banking union and establishment of a capital markets union is warranted and could help promote a return to growing intraregional investments. Continued innovation in digital technologies requires favorable regulatory climate to allow experimentation, but also could create new market dynamics and risks.

Regulators must also not allow the non-bank sector to evade stabilising regulations or otherwise activity will just switch.

When considering the implications of these global changes, it is important to remember that the process of financialisation is not just related to cross-border flows, but to domestic financial systems as well. Domestic financial systems - admittedly with assistance from foreigners - have facilitated massive increases in household debt, which, in turn, have inflated property markets. While there was deleveraging in countries affected by the GFC - particularly Ireland - other countries - e.g the Netherlands have seen a reinvigoration of their housing markets, and while, household debt has fallen it is still 219.9 per cent of income.

Australia's ratio of household debt to income has increased significantly since the 1990s and after stabilizing for a period after the GFC, it has increased again to 193.7 (up from  low point of 163.1  per cent in December 2008). Housing debt to income has increased from 112.0 in December 2008 to 136.4 per cent in June 2017. The saving grace for Australia thus far is that low interest rates have stabilised the interest paid to income ratio at about 8.7 per cent. While the next move in Australian interest rates will probably be down, a return to more normal monetary policy (i.e. higher interest rates) will increase financial pressures on households.

Household assets to income is up, but increased debt has spurred increased house prices. A fall in house prices will obviously lead to a decline in that ratio. People will feel poorer and just like everywhere else this has happened, consumption will fall. If it falls by a lot and unemployment increases, it is possible that this will lead to recession, higher unemployment, falling prices, further declines in consumption etc. Hyman Minsky provides a framework for understanding developing financial fragilities in the Australian economy and elsewhere:

The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system. In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. (Minsky 1992)

Minsky highlights the dangers of what he calls Ponzi financing, wherein ‘cash flows from operations are not sufficient to fulfil either the repayment of principal or the interest due on outstanding debts by their cash flows from operations’. The only way to pay off principal or interest is to sell assets (ideally at a profit) or borrow more (in the hope that asset prices will continue to grow). According to Minsky, a heightened emphasis on speculative and Ponzi finance increases the risk of the financial system becoming a ‘deviation amplifying system’.

It is clear that the growth of the property sector, as an outlet for investment, shares many of the characteristics of Ponzi finance. Investors utilising negative gearing provisions in the tax code – income tax deductions for property income losses – are less concerned whether their assets produce sufficient income to cover interest payments and costs and rely instead on capital gains. This enables the speculator to borrow more and more using inflated property values as collateral for further purchases. In a rising market investors and owner-occupiers can sell when necessary and utilise profits to buy another investment property or upscale, and continue the process of asset price inflation, increased indebtedness and unrealistic expectation of never-ending price increases. In Minsky’s framework, the longer the process goes on, the more likely it is that instability becomes endemic to the financial system.

Eventually, there is a point of inflection where assessments about future profits turn negative, revealing the precarious nature of the whole edifice. Minsky (1992) argues that his hypothesis:

is a model of a capitalist economy which does not rely upon exogenous shocks to generate business cycles of varying severity. The hypothesis holds that business cycles of history are compounded out of (i) the internal dynamics of capitalist economies, and (ii) the system of interventions and regulations that are designed to keep the economy operating within reasonable bounds.

Nevertheless, it seems clear also that external events can play a big role in creating inflection points, and in leading to shocks that undermine liquidity and confidence.

In a recently published paper, I argue the financialisation of the Australian economy has led to a cascading series of vulnerabilities in the Australian financial system. The vulnerabilities begin with the domination of banks in the financial system and the preponderance of the “big four” banks in the banking system. They are then exacerbated by the weight of real estate in the balance sheets of the big four. Underpinning the whole edifice is the sharp rise in household debt. Ultimately, the fate of the Australian financial sector – and the fate of the share market and the wider economy – sits precariously close to the precipice of over-inflated property markets and debt-ridden households. The debt-house-price-nexus in Australia is like a stretching rubber band. A stretched band can be relaxed gradually or it can be stretched further until, eventually, it breaks. The success of the Australian economy since the recession of the early 1990s, the profitability of the banks and the long-term rise in house prices has inevitably made investors and policy-makers complacent about these risks.

I argue that financial policy-makers have underestimated the financial vulnerabilities building up in Australia as evidenced by the slow take-up of macroprudential policies and their complacent statements about growing risks. There are three reasons for this sanguine attitude: the policy predilection for idealised economic liberal regulation of the financial sector, Australia’s overall growth performance and the profitability of the major Australian banks. Policy-makers appear to believe good fortune will continue indefinitely. Instead, “Minskyian” fragilities have built up within the property-finance nexus, which will eventually result in deleveraging, falling asset prices, a decline in consumption and recession.

***

While it pays to analyse what is happening to financial globalisation, financialisation is a wider process emergent in both domestic and global arenas and, of course, in the linkages between financial systems.

If policy-makers and polities want to avoid a cycle of financial crises and the negative impacts of increasing financialisation on consumption and production, then finance is going to need to be more effectively regulated. While this would mean that global financial flows do not return to the heights of the pre-GFC world, does this matter?

With the development of cryptocurrencies, the time is ripe for a reconsideration of international international financial and monetary relations, with the aim of developing new international agreements to regulate global financial flows, imbalances and currencies.

Not likely, however.

Charts of the Week

The two booming components of the Australian economy. House and holes as one commentator calls himself. (from MacroBusiness)

The following are a series of graphs on Chinese agricultural trade. Important because so many policy-makers and business people believe that Australia's next boom will centre around agricultural exports to China. If China continues to become wealthier, then opportunities for exports will grow. Other countries, of course, are keen to take advantage of this possibility. From the US Department of Agriculture. 

Finally a graphic on food spending at home and away. (from Max Roser)

Financialisation and Globalisation: Permament Reverse or Cyclical Downturn?

Introduction

One of the major markers of globalisation since the 1970s has been the incredible expansion of the financial sector - a phenomenon known as financialisation. The financial sector expanded in virtually every country in the world. Since this time the process of financialisation (defined as the expansion of both domestic and global finance) has been been in retreat as has financial globalisation (defined by cross-border financial flows only).

The global crisis, not surprisingly, has been primarily responsible and it will take quite some time for capital flows to recover, especially if the European financial crisis deepens. The expansion of credit/debt has stalled and the excesses of pre-crisis finance continue to be worked out of the system, Over the medium-term, even in the absence of another systemic financial crisis, it is likely that financialisation will be restricted by global deleveraging as excessive indebtedness is worked out of the world economy.

Nevertheless, wariness about financial instability will continue to be challenged by financial innovation and the possibilities for profits in new financial products. Despite arguments that the global financial crisis showed the need for better regulation of financial markets, it is not clear that this view has overcome the arguments of financial interests for few substantial changes to regulation. Financialisation continues to progress in developing countries and financial globalisation will recover as the world economy recovers.

The issue for the future is whether a financialised world political economy is inherently prone to a cycle of crisis, retreat, recovery, stability, excesses, crisis. While it is possible to argue that financialisation has reached a high point in many developed economies, it is likely that developing countries will become even more important global financial players in coming years - both as recipients and investors.

In Australia, the financial sector has grown rapidly since financial liberalisation in the 1980s. The cyclical downturn in the financial sector has not been as extreme and Australian banks are in rude health compared to banks in other developed economies. The solid performance of the Australian financial system has been helped by the government's willingness to support the financial system during the crisis and the avoidance of recession. The household sector remains highly indebted and foreign debt remains at highest ever levels. Any renewed expansion of credit will increase Australia's medium-term financial vulnerability.  Policy-makers should be aiming to foster a period of consolidation in the Australian financial markets and the property sector.

Financialisation and Financial Globalisation

According to McKinsey, global financial assets increased from about US$12 trillion in 1980 to US$206 trillion in 2007. Financial depth (defined as financial assets as a percentage of GDP) increased from 120 per cent to 355 per cent over the same period. By 2012, financial assets had increased to $225 trillion, but compared to world GDP they had declined by 43 per cent (54 per cent if government debt is excluded). Declines have occurred in both developed and developing countries. Developing countries are significantly less financialised than developed countries with financial depth of 157 per cent compared to 408 per cent. China's financial depth (226 per cent) is considerably lower than that of the United States (463 per cent - down 37 per cent from 2007 up to mid 2012), Japan (453 per cent) and Western Europe (369 per cent) , with India (148 per cent) lower still.

Finance progressively detached itself from the 'real' economy with just over a quarter of the rise in financial depth between 1995 and 2007 related to households and non-financial corporations. This is astounding given the extensive growth of mortgage markets in virtually all developed economies.

These figure above relate to the growth of finance generally, but if we consider cross-border movements of capital (an integral component of globalisation alongside trade) it is clear that the process has gone backwards since the crisis, declining substantially since 2007 from $11.8 trillion to around $4.6 trillion in 2012.

Most of the fall (70 percent) is accounted for by Western Europe - a substantial reversal of financial integration as European banks have retreated from cross-border lending. Central banks have become more important in cross border flows in Europe, accounting for over 50 percent of capital flows. Cross-border flows have fallen from 20 per cent of global GDP in 2007 to 6 per cent in 2012, a remarkable decline.

Capital flows involving developing countries have rallied since the debacle of 2008-09. Developing countries have increased their share of cross-border flows from 5 per cent in 2000 to 32 per cent in 2012. More capital flowed out of developing countries than flowed in - US$1.8 trillion compared to US$1.5 trillion.

Financial globalisation (i.e. cross-border financialisation) is still extensive with around 30 per cent of global equities and bonds owned by foreigners (54 percent for Europe, 23 per cent for North America and 9.4 per cent for China).

Australia

Australia, of course, has been a willing participant in the process of financialisation. A recent speech by Malcolm Edey, Assistant Governor (Financial System) at the Reserve Bank of Australia, reveals the extent of the financialisation of the Australian economy up to 2007 and its retreat after the crisis.

Edey points out that credit to GDP "increased from around 50 per cent in the mid 1980s to around 160 per cent in 2007". Total banking system assets "rose from around 50 to around 200 per cent of GDP" and "foreign exchange turnover increased by a factor of more than 30 in nominal dollar terms over that quarter-century, when the nominal economy itself expanded only by a factor of 4½.

The process of financial liberalisation began in Australia in the late 1970s and accelerated through the mid-1980s. Although many people seem to have forgotten Australia had a serious financial crisis in the late 1980s to early 1990s, which ironically may have helped us in the global financial crisis as banks remained more cautious through the 1990s and early 2000s.

The graph below shows just how much Australian financial sector assets have increased over the past 25 years.

The Australian banking sector avoided the excesses of some banking systems such as Ireland, Iceland, the United Kingdom and France among others. US problems lay outside of an extensive build up in banking assets.

The wealth management sector has also expanded since the 1980s, although much of that has to do with a new 'regulation' of enforcing superannuation payments for all Australians in work - hardly de-regulation. As Edey points out: 

Funds under management (principally in superannuation and life offices) expanded from around 30 to around 130 per cent of GDP between 1985 and 2007, broadly matching the growth rate seen in the deposit and loan sector. And, of course, there has been a huge growth in services related to asset and risk management, including securities and derivatives trading.

Both managed funds and securitisation took a big hit from the financial crisis, but all sectors have been affected, reversing the process of financialisation. Continuing woes in Europe are likely to see many investors less amenable to risk. Although this can change rapidly as investors often seem to have short memories. The recent rise of the share market would be worrying many of those who sold out of equities and encouraging many to get back in, which will further inflate the share market, possibly setting it up for a large correction down the line.

Another impact of liberalisation has been the decline in interest rate margins. This is despite the fact that the Australian banking sector is dominated by the big 4 banks. While it is easy to point to the costs of liberalisation in terms of the tendency towards crisis, it is important to remember that easier access to credit has benefits as well.

As Edey points out the post-liberalisation financial system

changed profoundly in other ways than just size. One was in its degree of openness to competition and in the nature of that competition. The post-Campbell reforms allowed market forces to work, and opened up the system to new competitors. ...  Deregulation ended the artificial rationing of bank loans, making credit much more widely available ... the cost of financial intermediation came down very substantially. ...

The rationing that existed in the old regulated environment had encouraged banks to compete on a ‘whole of institution’ basis, rather than at the level of individual product lines. ... In this situation, wide interest margins were used to cross-subsidise payment services, and customer mobility was limited because loyalty to a bank was one of the critical factors in obtaining access to scarce loans.   

Deregulation changed that model by allowing innovators to compete separately for the most profitable lines of business. Cross-subsidies in the banking system were competed down, and this helped to drive the reduction in net interest margins.

If given a choice between going back to the old system of regulated banks and credit or staying with the current system with all its problems, most would choose the latter, especially if it were explained that it would mean less access to credit. But this is obviously part of the problem too, greater willingness to extend credit during periods of asset price ebullience can lead to deteriorating lending standards increasing the possibilities of non-performing loans down the line. Thus far this has not occurred in Australia, with the excellent growth performance of the Australian economy providing a sound macroeconomic environment (low unemployment) and a cautious household sector increasing saving.

Banks have also remained extremely profitable, which has been reflected in their share prices.

 

Still household indebtedness remains close to pre-crisis highs, which makes households and the wider economy vulnerable to changing macroeconomic conditions and a decline in international financial supply. Housing-related debt accounts for 81.6 per cent of household interest payments to income and 90 per cent of debt to income. Interest payments as a percentage of disposable income have come down from their pre-crisis peak, but are still higher than they were in the late 1980s when mortgage rates reached 17 per cent! (see Table B21)

Competition in the banking sector until recently was mainly on the lending side of the equation, but as banks have sought alternative sources of funding, competition for deposits has increased. Banks have reduced their reliance on short-term debt and securitisation has also declined from a lower base.

The wholesale funding mix for banks has also shifted away slightly from overseas sources, but clearly the major change is away from short-term funding.

The high level of debt build-up from the 1990s to 2007 has stabilised in the post-crisis years. Australians have returned to saving. The share market has recovered and property continues to tread water.

Not surprisingly, credit growth in all sectors has been flat in recent years.

 

A renewed property boom runs the risk of reversing this trend, leading to a bigger adjustment down the track. Having built up their debt share so high households can only increase their leverage at the cost of higher vulnerability. This is one of the reasons the RBA needs to take care when regulating new lending products and lowering interest rates further, without compensating policies from the government to discourage housing speculation.

Australian households are now more connected to the financial sector, through higher levels of debt and forced saving through Australia's superannuation system.  The Australian economy is also more connected to the global financial system. Banks and other corporates have increasingly turned to offshore sources for funding.

Currently, according to the RBA's Deputy Governor Guy Debelle, "domestic markets have benefited from strong international demand for Australian dollar assets. Local issuers continue to be viewed favourably by offshore investors looking to diversify credit exposures."

Extensive foreign liabilities mean that Australia will continue to remain vulnerable to changes in international financial sentiment, although it needs to be noted that Australia has recently passed a very severe test during the GFC. Many other countries have not been so lucky with stagnant growth and continuing financial trials.

Financialisation affects us all and it is policy that must determine the balance between the individual benefits of increased access to credit and the possibilities of financial instability. Australia's financial sector remains sound but an eventual recession will test the financial sector and its growth in Australia, especially if lending standards deteriorate over the next few years.

Conclusion

Financial globalisation has ebbed and flowed over the past couple of hundred years. The period before World War One is often called the golden age of capitalism but it ended in war and economic depression. It took a long time for financial flows to recover, but recover they did.

 

 

 

Despite some setbacks in recent years, the world economy remains highly globalised and financialised. In considering whether the current period is a permanent reversal or just a pause in the two distinct but related processes, requires detailed analysis of political processes in the major economies of the world. It seems unlikely that United States policy-makers will change their mind on the benefits of financial liberalisation and financialisation, but a prolonged period of economic stagnation could have an impact on this predilection.

Virtually the entire world adheres to a form of capitalism and while not all policy-makers in all countries are equally sanguine about globalisation, very few currently believe that the solution to development requires a full scale retreat into isolation.

This could change, however, if globalisation is blamed for growing inequality and political chaos. It may be the turn of developed countries to support alternatives to globalisation if economic crisis continues to affect growth and the distribution of wealth and income across societies. Democratic polities cannot necessarily be blamed for looking to more insular alternatives if increasing globalisation is associated with rising inequality and instability.