Danae Kyriakopoulou: Global Capital Movements Change Shape

2017-10-09 IMI

This article appeared in The Bulletin September 2017 published by OMFIF. Danae Kyriakopoulou is Chief Economist and Head of Research at OMFIF. Almost a decade after the 2008 financial crisis, the global economy is finally experiencing a period of synchronous recovery with both emerging and advanced markets expected to post robust economic growth this year and next. However, the difficult economic conditions following the crisis continue to affect the longer-term aftermath. A notable trend in politics, economics and regulation has been the rise in anti-globalisation sentiment. The political focus has been mostly on trade and immigration; the support of protectionism and stricter control of borders were decisive factors both in the UK’s June 2016 referendum to leave the European Union and in the election of Donald Trump to the US presidency. While anti-globalisation and anti-establishment parties haven’t prevailed in key European elections in France and the Netherlands, their popularity is higher than before the crisis. The effect on global capital flows has been less visible. The years building up to the crisis were a period of intense financial globalisation. Deregulation and financial innovation provided new opportunities for investors to diversify their portfolios and attempt to manage risk, and capital flows soared as banks and corporations expanded globally. Global liquidity was further supported by a surge in savings in China and other emerging markets, notably commodity exporters. This, in turn, financed huge deficits in developed economies, while the introduction of the euro in 1999 supported a rapid increase in cross-border transactions in the currency union. These conditions have been reversing since the financial crisis, impacting the way capital flows around the world. Global banks retreat The most pronounced changes have been in global banking. Statistics compiled by the Bank for International Settlements show that banks’ foreign claims have fallen to $25.8tn in the first quarter of 2017, almost $6tn down from the peak in the first quarter of 2008 – an 18% decline. A large share of that can be explained by the weak macroeconomic environment in Europe, one of the world’s most financially open regions. Economic theory and evidence suggest movements in cross-border lending represent the most volatile form of capital flows and the most likely to change during crises. Foreign claims of euro area banks have almost halved to $9.4tn from $17.4tn in the first quarter of 2008. The global reduction in cross-border lending can be attributed to a variety of factors. Importantly, it reflects a desire by banks to reduce risk in the light of the painful consequences of hazardous decisions that led to large losses during the crisis. Regulation designed to tighten financial conditions, too, has encouraged such desires. Globally, this has taken the form of stricter capital and liquidity standards as part of the Basel III measures, and regular stress testing. These measures have created disincentives for banks to maintain some foreign operations. Central bank policies have played a role as well. Research by the Bank of England shows that stricter microprudential capital requirements tend to reduce cross-border bank lending, and that some forms of unconventional monetary policy can amplify this effect. For example, both the Bank of England’s funding for lending scheme and the European Central Bank’s targeted longer-term refinancing operations were designed to encourage banks to focus on domestic lending. Rebutting deglobalisation It would be tempting to conclude from this that the world has reached ‘peak finance’ and that we are now in a phase of financial deglobalisation. This might not appear undesirable, given the role played by cross-border bank loans in the build-up of the unsustainable expansionary phase before the crisis. The reality is more nuanced. A rise in other forms of capital flows has partly offset the contraction in cross-border lending. Foreign direct investment and portfolio debt and equity have continued to grow. According to analysis from the United Nations conference on trade and development, global FDI flows continued to rise in the aftermath of the 2008 upsets and have recovered to near pre-crisis levels. These higher flows have contributed to a rise in the stock of global FDI to $27tn in 2016 from $18tn in 2007. FDI statistics show emerging markets are now more active players in the globalisation of capital, removing the concentration of risk and exposure to volatility. OMFIF research into countries’ net international investment positions published as part of Global Public Investor 2017 in June further shows that creditor and debtor positions have been consistently widening over the past decade and that the ratio of external liabilities to GDP has continued to grow in both advanced and emerging economies. Risks remain, however. FDI is a more stable form of financial globalisation that reflects countries’ and companies’ long-term interests and that tends to be more difficult to reverse suddenly. Yet an increasing share of FDI income is now concentrated in low-tax, often offshore, jurisdictions. This has created a disconnect between FDI and the expected rise in productive capacity across countries, instead boosting the profits of multinational enterprises in a way that is out of proportion with the economic fundamentals of the recipient economies. New uncertainties are emerging from the impact of technological developments on monetary policy, credit providers, and the nature of cross-border financial transactions and capital flows. These will challenge both regulators and banks to re-evaluate old models and develop new ones.

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Danae Kyriakopoulou: Global Capital Movements Change Shape

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