Several recent analyses of financial globalization offer different perspectives on whether the recent contraction in capital flows represents a cyclical decline or a long-term reversal. On the one hand, the expansion of gross financial flows in the last decade among upper-income countries will not continue at the same pace. But the development of financial markets in emerging markets will increase capital flows within that group of countries as well as draw funds from the advanced economies.
Richard Dobbs and Susan Lund of the McKinsey Global Institute note that cross-border flows are more than 60% below the pre-crisis peak. They attribute the decline to a “dramatic reversal of European financial integration” as European banks curtail their lending activities. They also draw attention to “a retrenchment of global banking” due to a reassessment by banks of their foreign activities in light of new capital requirements and regulations. Dobbs and Lund are concerned that too strong a reversal will result in a segregated global financial system.
Greg Ip of The Economist also writes about a reversal of financial integration for a similar set of reasons. Bankers are shrinking their balance sheets while regulators seek to shield their domestic financial markets from foreign shocks. In addition, Ip draws attention to the renewed interest in the use of capital controls to lower volatility. The IMF now includes controls as a tool that policymakers can use to manage the risks associated with surges of capital flows. But like Dobbs and Lund, Ip is concerned about financial fragmentation, and urges financial regulators to cooperate in order to achieve common standards.
The authors of the World Bank’s Capital for the Future: Saving and Investment in an Interdependent World, on the other hand, draw attention to developing countries and emerging markets as both a source and destination of capital flows. These countries are likely to account for an increasing share of gross capital flows, which will be driven (p. 125) “…by more rapid economic growth and lower population aging in developing countries than in advanced countries, as well as by developing countries’ relatively greater scope for increasing openness and strengthening financial sector institutions.” They see evidence of this trend prior to the global financial crisis, as the share of gross capital inflows to developing countries rose from 4 percent of the total in 2000 to 11 percent in 2007.
Foreign direct investment accounted for most of these inflows, although bank loans have also increased. While portfolio flows have constituted a relatively small share of inflows to these countries, the authors of Capital for the Future believe that in the future a larger proportion will flow through the capital markets. Ultimately, they claim (p. 131), there will be “developing-country convergence with advanced economies in terms of their composition of their capital inflows.” Policymakers can expedite the transition to more portfolio flows through the development of domestic financial markets and their regulatory structure.
China will play a major role in any increase in capital flows to emerging economies. Foreign exchange reserves have been the traditional form of asset accumulation in that country. Tamim Bayoumi and Franziska Ohnsorge of the IMF use a portfolio allocation model to speculate about the effects of the liberalization of capital regulations by the Chinese authorities on the private sector. They infer from their estimates that (p. 14) “capital account liberalization may be followed by a stock adjustment of Chinese assets abroad on the order of 15-25 percent of GDP and a smaller stock adjustment for foreign assets in China on the order of 2-10 percent of GDP.” The acquisition of foreign stocks and bonds by Chinese investors who would seek to diversify their portfolios could offset any continued increase in FDI inflows. The IMF economists contrast this forecast with one for India, which they believe would have more balanced flows following capital account deregulation because of smaller asset holdings by Indian investors and hence a more restricted scope for diversification.
These scenarios for the future of financial globalization need not contradict each other. On the one hand, bank lending in the U.S. and Europe is likely to be limited as governments enact new regulations and Europe continues to deal with its debt crisis. But investors in those countries may look to the emerging and “frontier” markets for higher returns based on their growth, while increased income in the emerging markets will drive a demand for liquid financial instruments that will spill over into foreign markets. In addition, firms in those countries will look to expand their operations in other developing economies through investments. Financial flows may follow a new course, but will not be contained for long.
