Parts I and II of this Guide appear here and here.
4. Stability and Growth
Is the global financial system safer a decade after the last crisis? The response to the crisis by central banks, regulatory agencies and international financial institutions has increased the resiliency of the system and lowered the chances of a repetition. Banks have deleveraged and possess larger capital bases. The replacement of debt by equity financing should provide a more stable source of finance.
Indicators of financial volatility, such as the St. Louis Fed Financial Stress Index, currently show no signs of sudden shifts in market conditions. The credit-to-GDP gap, developed by the Bank of International Settlements (BIS) as an early warning indicator of systemic banking crises, exhibits little evidence of excessive credit booms. One exception is China, although its gap has come down.
But increases in U.S. interest rates combined with an appreciating dollar could change these conditions. Since the financial crisis, financial flows have appeared to be driven in part by a global financial cycle that is governed by U.S. interest rates as well as asset market volatility. This has led Hélène Rey of the London Business School to claim that the Mundell-Fleming trilemma has been replaced by a dilemma, where the only choice policymakers face is whether or not they should use capital controls to preserve monetary control. Eugenio Cerutti of the IMF, Stijn Claessens of the BIS and Andrew Rose of UC-Berkeley, on the other hand ,have offered evidence that the empirical importance of any such cycle is limited. Moreover, Michael W. Klein of Tufts University and Jay C. Shambaugh of George Washington University in one study and Joshua Aizenman of the University of Southern California, Menzie Chinn of the University of Wisconsin and Hiro Ito of Portland State University in another have found that flexible exchange rates can affect the sensitivity of an economy to foreign policy changes and afford some degree of policy autonomy.
A rise in U.S. rates, however, will increase the cost of borrowing in dollars. The volume of credit flows denominated in dollars reflects the continuing predominance of the dollar in international financial markets. Dollar-denominated credit to emerging market economies, for example, rose by 10% in 2017, driven primarily by a rise in the issuance of debt securities. Higher interest rates, a depreciating currency and a deteriorating international trade environment can quickly downgrade the creditworthiness of emerging market borrowers.
Other potential sources of stress remain. One of these is the lack of adequate “safe assets,” which serve as collateral for lending. U.S. Treasury bonds are utilized for this purpose, but in the run-up to the global crisis mortgage-based securities (MBS) with the highest ratings also served that function. Their disappearance leaves a need for other privately-provided safe assets, or alternatives issued by the international public agencies. Moreover, doubts about U.S. fiscal solvency could lead to doubts about the creditworthiness of the U.S. government securities.
Claudio Borio of the BIS perceives another flaw in the international monetary system: “excess financial elasticity” that contributes to financial imbalances. The procyclicality of finance is heightened during boom periods by capital inflows, and the spread of easy monetary conditions in core countries to the rest of the world is facilitated through monetary regimes. The impact of the regimes includes the decision of policymakers to resist currency appreciation which affects their interest rates, and the role of dominant currencies such as the dollar. Borio calls for greater international cooperation to mitigate the volatility of the financial cycle.
Dirk Schoenmaker of the Duisenberg School of Finance and VU University Amsterdam has drawn attention to a fundamental tension within the international system. He suggests that there is a financial trilemma, with only two of these three characteristics of a financial system as feasible: International financial integration, national financial policies and financial stability. A nation that wants to enjoy the benefits of cross-border capital flows needs to coordinate its regulatory activities with those of other countries. Otherwise, banks and other institutions will take advantage of discrepancies across borders in the rules governing their activities to find the least onerous regulations and greatest room for expansion.
These concerns about stability could be accepted if financial development had a positive impact on economic growth. But Boris Cournède, Oliver Denk and Peter Hoeller of the OECD, in a review of the literature on the relationship of the financial sector and economic growth, report that above a threshold of financial development the linkage with growth is negative (see also here). Their results indicate that this reversal occurs when the financial expansion is based on credit rather than equity markets. Similarly, Stephen G. Cecchetti and Enisse Kharroubi of the BIS (see also here) report that financial development can lower productivity growth.
In addition, it has long been acknowledged that there is little evidence linking international financial flows to growth (see, for example, the summary of this work by Maurice Obstfeld of the IMF (and formerly of UC-Berkeley)). More recently, Joshua Aizenman of the University of Southern California, Yothin Jinjarik of the University of Wellington and Donghyun Park of the Asian Development Bank have shown that the relationship of capital flows and growth depends on the form of capital. FDI flows possess a robust relationship with growth, while the linkage with other equity is smaller and less stable. The impact of FDI may depend on the development of the domestic financial sector. Debt flows in normal times do not reinforce growth, but can contribute to the probability of a financial crisis.
The impact of international financial flows on income inequality is also a subject of concern. Davide Furceri and Prakash Loungani of the IMF found that capital account liberalization reforms increase inequality and reduce the labor share of income. Furceri, Loungani and Jonathan Ostry also report that policies to promote financial globalization have led on average to limited output gains while contributing to significant increases in inequality. Distributional effects are more pronounced in those countries with low financial depth and inclusion, and where liberalization is followed by a crisis. A similar result was reported by Silke Bumann of the Max Planck Institute for Evolutionary Biology and Robert Lensink of the University of Groningen.
The change in the international financial system that may be the least understood is the evolution of FDI, which has grown in recent decades while the use of bank credit has fallen. FDI flows are increasingly routed thought countries such as Luxembourg and Ireland for the purpose of tax minimization. Moreover, the profits generated by foreign subsidiaries can be reinvested and form the basis of further FDI. Quyen T. K. Nguyen of the University of Reading asserts that such financing may be particularly important for operations in emerging market economies where domestic finance is limited. FDI flows also include intra-firm financing, a form of debt, and therefore FDI may be more risky than commonly understood.
5. Conclusions
As a result of the substantial capital flows of the 1990s and early 2000s, the scope of financial markets and institutions now transcends national borders, and this expansion is likely to continue. While financial openness as measured by external assets and liabilities has not risen since the global crisis, this measurement is misleading. Emerging market economies with growing GDPs but less financial openness are becoming a larger component of the global aggregate. But financial openness and GDP per capita are correlated, and the populations of those countries will engage in more financial activity as their incomes increase.
A stable international financial system that promotes inclusive growth is a global public good. Global public goods face the same challenge as domestic public goods, i.e., a failure of markets to provide them. In the case of a global public good, the failure is compounded by the lack of an incentive for any one government to supply it.
The central banks of the advanced economies did coordinate their activities during the crisis, and since then international financial regulation has responded to the growth of global systematically important banks. But the growth of multinational firms that manage global supply chains and international financial institutions that move funds across borders poses a continuing challenge to stability. In addition, while the United Kingdom and the U.S. served as a financial hegemons in the past, today we have nations with small economies but extremely large financial sectors that reroute financial flows across border, and their activities are often opaque.
The global financial crisis demonstrates how little was understood of the fragility of the financial system that had built up around mortgage-backed securities. Regulators need to understand and monitor the assets and liabilities that have replaced them if they are not to be caught by surprise by the outcome of the next round of financial engineering. If “eternal vigilance is the price of liberty,” it is also a necessary condition for a stable financial universe.
