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Three steps to stop financial collapse
Currency wars dominated the policy conversation when the finance ministers of the Group of 20 leading nations gathered last month in Moscow. This crowded out talk of another threat to recovery and growth: the Balkanisation of the global financial system.
For three decades, there was a seemingly unstoppable increase in capital mobility and integration. But the 2008 crisis halted that abruptly. Cross-border flows collapsed and remain 60 per cent below their peak.
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A large factor in this drop is the dramatic reversal of European financial integration. Nations once in the vanguard are turning inward. Having expanded across borders with the creation of the single currency, eurozone banks have reduced cross-border lending within the eurozone by $2.8tn since the end of 2007. Other types of cross-border investment in Europe have fallen by more than half. Capital flows have declined sharply in other advanced economies, too.
This has been accompanied by muted growth in global financial assets (which holds true despite recent rallies in stock markets worldwide). The value of global financial assets has grown by just 1.9 per cent annually since the crisis from 7.9 per cent average annual growth from 1990 to 2007.
After our experiences of asset bubbles and volatility, should we not welcome these changes? The answer is yes and no. Some of the shifts no doubt represent a healthy correction of the excesses of the bubble years. Growth and leverage of the financial sector itself accounted for 37 per cent of financial deepening between 1995 and 2007, a trend now reversed. But, surprisingly, the slowdown in the growth of financial assets also extends to emerging economies, where the development of financial markets is barely keeping pace with gross domestic product growth.
If the world maintains its current trajectory, we are headed for a system in which nations rely on domestic capital formation (and, in consequence, concentrate risks in local banking systems). Sharp regional differences could emerge in the availability of, and returns on, capital. Countries with high savings rates such as China and Japan would find themselves with plenty of capital, though it would be mostly locked up in deposit accounts – but lower returns on it as a result of ultra-low interest rates would punish savers and investors. Others (including some advanced markets, and emerging economies such as Brazil, India and much of Africa) would find capital in short supply and at a higher price, constraining investment and growth.
This is not to advocate relaunching the trends that led to the last crisis. Much is riding on regulatory reforms such as finalising Basel III global banking rules; developing clear processes for cross-border bank resolution and recovery; and creating a eurozone banking union. But in fighting the last war, it is easy to lose sight of new hazards. Sluggish growth may become the new reality unless there is equal emphasis on ensuring a healthy flow of financing to the real economy.
There are three actions for G20 nations to take. First, remove barriers to healthy financial globalisation. Openness to foreign investment and capital flows entails risks but also clear benefits. The degree of openness and pace of movement will depend on the size and sophistication of a country’s financial sector, and the strength of its regulation and supervision. But the relative weight of risks and benefits can be shifted by removing barriers – such as limits on foreign investment and ownership in different sectors – to the more stable, long-term types of flow.
Second, develop equity and bond capital markets, particularly in emerging markets. Capital markets provide a crucial alternative to bank loans and enable foreign investors to participate in local markets. Most countries have basic market infrastructure and regulations, but enforcement and market supervision are often weak. Improving this would benefit local borrowers, too.
Third, quickly establish a eurozone banking union to restore confidence and put financial integration back on track. A banking union – including supervision, resolution and deposit insurance – can help restore confidence in the eurozone’s future and the healthy flow of financing.
These three moves would help put financial globalisation on a more sustainable basis and, ultimately, reignite growth.
The writers are a professor at Sciences Po in Paris and a former director of the London School of Economics and partner at the McKinsey Global Institute