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Tales of Globalization: Russia and China

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The end of 2014 marked the 23rd anniversary of the dissolution of the Soviet Union and the establishment of the Russian Federation. Like Chinese leaders in the previous decade, Russian policymakers faced the challenge of integrating their nation into the global economy. Russia’s trade openness (exports and imports scaled by GDP) grew from 26% in 1991 to 51% in 2013, very similar to the rise in China’s trade openness from 29% to 50% during these years. Russian exports increased from 13% of its GDP at the beginning of this period to 28% in 2013, while the corresponding figures for China are 16% and 26%. Both counties gradually allowed foreign capital inflows. But the similarities end there.

Russia’s exports are primarily commodities, particularly oil and natural gas. Consequently, sales of these resources account for a large part of Russia’s GDP: 16% in 2012. The plunge in world oil prices, combined with the sanctions imposed by U.S. and European Union governments following Russia’s annexation of the Crimea and its threats against the Ukraine, threaten to push the economy into a recession. The deterioration of the economic situation caused the ruble to plunge against the dollar in December, before recouping part of its value after the central bank intervened in the foreign exchange market and raised its policy rate to 17%.

Russia is particularly susceptible to a currency depreciation because of its external debt, reported to be $678 billion. Capital controls that had been imposed during the 1998 crisis were removed in the 2000s, and capital inflows, including bank loans and bond issues, increased significantly. These capital flows reversed during the global financial crisis, and there was only a modest recovery before the latest period of political tension. The Russian government’s debt includes $38 billion of bonds denominated in dollars, which is not seen as a vulnerability. But the external exposure of Russian companies is much larger. The Russian central bank claims that in 2015 Russian firms owe $120 billion of interest and repayments on their external debt. Much of this money is owed by Rosneft and Gazprom, the state oil and gas producers.

China has followed a very different path. Its main exports now include electronics and machinery. The Great Recession prompted a reevaluation of the structure of the economy by the Chinese government. Chinese leaders realize that the export- and investment-led growth of the past is no longer feasible or desirable, and have emphasized the expansion of domestic consumption. This transition is taking place while the economy slows from the torrid 10% growth rate of the past to about 7.5%.

China also has external debt, which totaled $863 billion in 2013. But China has been more deliberate in opening up its capital account, and its external liabilities primarily take the form of foreign direct investment. Moreover, its foreign exchange reserves of about $4 trillion should alleviate any concerns about its ability to fulfill its obligations to foreign lenders. Of more concern is the growth in domestic credit, which now surpasses 200% of its GDP. While a financial contraction appears inevitable, there are differences over whether this will lead to economic disruption (see also here).

China’s currency appreciated in value between 2005 and 2008, when the renminbi was “re-pegged” against the dollar. In March, the central bank announced that the renminbi would fluctuate within a band of +/- 2%. A recent study by Martin Kessler and Arvind Subramanian indicates that the renminbi is fairly valued by purchasing power estimates. The government is considering whether the renminbi will become an international currency. Its status may get a boost if the IMF decides to include the renminbi as one of the currencies on which its Special Drawing Rights is based.

China and Russia, therefore, have followed very different paths in globalizing their economies. Russia, of course, could not be expected to forsake its energy resources. But commodity exporters live and die by world prices, and the government passed up an opportunity to diversify the Russian economy. China initially used its own “natural resource” of abundant labor, but has moved up the value chain, as Japan and Korea did. Chinese firms are now expanding into foreign markets. In addition, Russia allowed short-term capital inflows that can easily cease, while China carefully controlled the external sources of finance.

Russia’s GDP per capita recorded a rise of 29% between 1991 and 2013, from $5,386 to $6,924 (constant 2005 US $). China started at a much lower base in 1991, $498, but its per capita income increased by over 7 times (719%) to $3,583. The divergence in the two countries’ fortunes shows that there are many ways to survive in the global economy, but some are more rewarding than others.

The ECB’s Daunting Task

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Mario Draghi, head of the European Central Bank, and the members of the ECB’s Governing Council are receiving praise for the initiatives they announced last week to avoid deflation (see here and here). The immediate impact of the announcement was a rise in European stock prices. But the approval of the financial sector does not mean that the ECB will be successful in its mission to rejuvenate the Eurozone’s economy.

The ECB is taking several expansionary steps. First, it has cut the rate paid on the deposits of banks at the ECB to a negative 0.1%, thus penalizing the banks for not using their reserves to make loans. Second, it is setting up a new lending program, called “Targeted Longer-Term Refinancing Operations (TLTROs),” to provide financing to banks that make loans to households and firms. Third, it will no longer offset the monetary impact of its purchases of government bonds, i.e., no “sterilization.” Moreover, Draghi’s announcement included a pledge that the ECB will consider further steps, including the use of “…unconventional instruments within its mandate, should it become necessary to further address risks of too prolonged a period of low inflation.”

Draghi’s promise to take further steps are reminiscent of his announcement in 2012 that the ECB was “…ready to do whatever it takes to preserve the euro.” That promise was successful in calming concerns about massive defaults and a break-up of the Eurozone. Consequently, the returns that sovereign borrowers in the Eurozone had to pay on their bonds began a decline that has continued to the present day.

But the challenges now facing the ECB are in many aspects more daunting. The current Eurozone inflation rate of 0.5% is an indicator of the anemic state of European economies.  Achieving the target inflation target of the ECB of 2% will require a significant increase in spending. The latest forecast for 2014’s GDP Eurozone growth from The Economist is 1.1%, which would be a pick-up from the 0.7% in the latest quarter, with an anticipated inflation rate for the year of 0.8%. Unemployment for the area is 11.7%, and this includes rates of 25.1% in Spain, 26.5% in Greece, and 12.6% in Italy.

More bank lending would encourage economic activity, but it is not clear that European banks are willing to make private-sector loans. Many banks are still dealing with past loans that will never be repaid as they seek to pass bank stress tests. And Draghi’s success in calming fears about sovereign default has (perhaps paradoxically) resulted in banks holding onto government bonds, which are now seen as relatively safe compared to private loans.

There is one other aspect of the European situation that can derail the ECB’s efforts: the distribution of financial wealth. The recent publication of House of Debt by Atif Mian and Amir Sufi has led to discussions of the deterioration of household balance sheets during the global financial crisis, and the economic consequences of the massive decline in household wealth. Larry Summers has praised the authors’ contribution to our understanding of the impact of the crisis on economic welfare by focusing on this channel of transmission.

Mian and Sufi have claimed that income distribution has a role in the response of households to policies that seek to boost spending. Low-income households, they point out, will spend a higher fraction of fiscal stimulus income checks than high-income households. They would most likely also spend a higher proportion of a rise in their financial worth. A concentration of such wealth in the hands of a small proportion of European households, therefore, limits the increase in spending due to higher asset prices.

The ECB, therefore, may find that the plaudits they have earned do not translate to a better policy outcome. The situation they face is not unique, and resembles in many ways the challenges that the Bank of Japan in has faced. Draghi and the ECB may have to follow their lead in devising new measures if European spending and inflation do not pick up.

The Challenges of Achieving Financial Stability

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The end of the dot.com bubble in 2000 led to a debate over whether central banks should take financial stability into account when formulating policy, in addition to the usual indicators of economic stability such as inflation and unemployment. The response from many central bankers was that they did not feel confident that they could identify price bubbles before they collapsed, but that they could always deal with the byproducts of a bout of speculation. The global financial crisis undercut that response and has led to the development of macroprudential tools to address systemic vulnerabilities. But regulators and other policymakers who seek to achieve financial stability face several challenges.

First, they have to distinguish between the signals given by financial and economic indicators, and weigh the impact of any measures they consider on anemic economic recoveries. The yields in Europe on sovereign debt for borrowers such as Spain, Portugal and Ireland are at their lowest levels since before the crisis. Foreign investors are scooping up properties in Spain, where housing prices have fallen by over 30% since their 2007 highs. But economic growth in the Eurozone for the first quarter was 0.2% and in the European Union 0.3%. Stock prices in the U.S. reached record levels while Federal Reserve Chair Janet Yellen voiced concerns about a weak labor market and inflation below the Federal Reserve’s 2% target. When asked about the stock market, Yellen admitted that investors may be taking on extra risk because of low interest rates, but said that equity market valuations were within their “historical norms.” Meanwhile, Chinese officials seek to contain the impact of a deflating housing bubble on their financial system while minimizing any economic consequences.

Second, regulators need to consider the international dimensions of financial vulnerability. Capital flows can increase financial fragility, and the rapid transmission of financial volatility across borders has been recognized since the 1990s. Graciela L. Kaminsky, Carmen M. Reinhart and Carlos A. Végh analyzed the factors that led to what they called “fast and furious” contagion. Such contagion occurred, they found, when there had been previous surges of capital inflows and when the crisis was unanticipated. The presence of common creditors, such as international banks, was a third factor. U.S. banks had been involved in Latin America before the debt crisis of the 1980s, while European and Japanese banks had lent to Asia in the 1990s before the East Asian crisis.

The global financial crisis revealed that financial integration across borders exacerbated the downturn.  The rise of international financial networks that transmit risk across frontiers was the subject of a recent IMF conference. Joseph Stiglitz of Columbia University gave the opening talk on interconnectedness and financial stability, and claimed that banks can be not only too big to fail, and can also be “too interconnected, too central, and too correlated to fail.” But dealing with interconnected financial networks is difficult for policymakers whose authority ends at their national borders.

Finally, officials have to overcome the opposition of those who are profiting from the current environment. IMF Managing Director Christine Lagarde has attributed insufficient progress on banking reform to “fierce industry pushback” from that sector. Similarly, Bank of England head Mark Carney has told bankers that they must develop a sense of their responsibilities to society. Adam J. Levitin, in a Harvard Law Review essay that summarizes the contents of several recent books on the financial crisis, writes that “regulatory capture” by financial institutions has undercut financial regulation that was supposed to restrain them, and requires a political response. James Kwak has emphasized the role of ideology in slowing financial reform.

Markets for financial and other assets exhibit little sign of stress. The Chicago Board Options Exchange Volatility index (VIX), which measures expectations of U.S. stock price swings, fell to a 14-month low that matched pre-crisis levels. Such placidity, however, can mask the buildup of systemic stresses in financial systems. Regulators and other policy officials who seek to forestall another crisis by acting peremptorily will need to possess political courage as well as economic insight.

Too Much of a Good Thing?

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Global banks do not have much to cheer about these days. Earnings are falling, and the banks are responding by cutting jobs. The Federal Deposit Insurance Corporation has charged 16 banks of colluding to rig the London Interbank Offer rate (LIBOR). And the Federal Reserve has approved a rule that requires foreign banks with $50 billion of assets in the U.S. to establish holding companies for their American units that meet the same capital adequacy standards as do their U.S. peers. The latter move has been interpreted as a sign of the fragmentation of global finance that will hinder the global allocation of credit.

The Federal Reserve supported the foreign banks in the fall of 2008 when the it lent to distressed institutions. The U.S. units of European banks accounted for $538 billion of the Federal Reserve’s emergency loans, over half of the total. Federal Reserve Chair Ben Bernanke had to answer criticism from U.S. lawmakers that the loans did not benefit U.S. taxpayers. At the same time, the Federal Reserve was establishing swap lines with central banks in 14 countries. The dollars those monetary authorities acquired were used to prop up their banks that needed to finance their holding of U.S. debt.

Banks have various ways to meet the new capital adequacy standards. They can hold back on dividend payouts from their earnings, although that may not be popular with their stockholders. They can raise funds in the capital markets. And some banks, such as Deutsche Bank, will shrink their balance sheets in order to comply with the regulations. This has led to fears of cutbacks in lending.

The announcement of the new standard came as the Bank of International Settlements (BIS) was publishing its quarterly report on the international banking markets. The BIS data showed that the cross-border claims of BIS reporting banks fell by $500 billion in the their quarter of 2013, the biggest contraction since the second quarter of 2012. Most of this decline occurred in Europe, as lending between parents banks and their subsidiaries in the Eurozone and the United Kingdom declined.

Would a contraction in bank credit have negative consequences? It certainly will for those firms in Europe that are unable to obtain credit. But there are also grounds for believing that a reduction in banking activity may under some circumstances be advantageous for an economy. The same issue of the BIS Quarterly Review that reported the international banking data also carried an article by BIS economists Leonardo Gambacorta, Jung Yang and Kostas Tsataronis. They compared the impact of bank and capital market activity on economic growth, and found that increases in both contributed to higher growth, but only up to threshold levels of GDP. After those thresholds are reached, further expansion in banking or capital markets had negative impacts on growth. Similar results have been reported by Jean-Louis Arcand, Enrico Berkes and Ugo Panizza of the IMF, Stephen G. Cecchetti and Enisse Kharroubi also at the BIS, and Sioong Hook Law of Universiti Putra Malaysia and Nirvikar Sinth of UC-Santa Cruz in the Journal of Banking & Finance (working paper version here).

These studies deal with the domestic impacts of financial activity. How about bank lending across borders? The record there also demonstrates that bank lending can have adverse consequences. Martin Feldkircher of Oesterreichische Nationalbank (the National Bank of Austria) has a paper in the Journal of International Money and Finance (working paper version here) that examines the determinants of the severity of the global financial crisis in 63 countries, using 97 candidate variables. He reports that the change in domestic credit provided by the banking sector is a robust determinant of crisis severity. When he further investigated by interacting the bank credit variable with measures of risk, including macro, external, fiscal, financial and contagion and spillover risk, he found that the interaction of bank credit with foreign claims from banks in advanced countries robustly explained crisis severity. He concludes: “Countries with high credit growth and considerable exposure to external funding saw their economies more severely affected during times of financial distress.”

There is a line between financing new economic activities and bankrolling speculation. The former promotes welfare, the latter ends in volatility and distress. Unfortunately, that line shifts as new opportunities appear. Trying to find it is a constant challenge for regulators.

Riding the Waves

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The volatility in emerging markets has abated a bit, but may resume in the fallout of the Russian takeover of the Crimea. The capital outflows and currency depreciations experienced in some emerging market nations have been attributed to their choice of policies. But their economic situations reflect the domestic impact of capital inflows as well as their macroeconomic policies.

 Fernanda Nechio of the Federal Reserve Bank of San Francisco, for example, shows that exchange rate depreciations of emerging markets are linked to their fiscal and current account balances, with larger depreciations occurring in those countries such as Brazil and India with deficits in both balances. Kristin Forbes of MIT’s Sloan School also draws attention to the connection between the extent of the currency depreciations and the corresponding current account deficits. Nechio and Forbes both advise policymakers in emerging markets to make sound policy choices to avoid further volatility.

Good advice! But Stijn Claessens of the IMF and Swati Ghosh of the World Bank have pointed out in the World Bank’s Dealing with the Challenges of Macro Financial Linkages in Emerging Markets that capital flows can exacerbate prevailing economic trends. Relatively large capital inflows to emerging markets (“surges”) tend to take the form of bank and portfolio debt, which contribute to increased domestic bank lending and domestic credit. Claessens and Ghosh write (p.108) that “…large inflows in net terms are the financial counterpart to the savings and investment decisions in the country and affect the exchange rate, inflation, and current account positions.” They also endanger the stability of the financial system as bank balance sheets expand and lending standards deteriorate. These financial flows contribute to increases in asset prices and further credit extension until some domestic or foreign shock leads to an economic and financial downturn.

Are the authorities helpless to do anything? Claessens and Ghosh list policies that may reduce macro vulnerability, which include exchange rate appreciation, monetary and fiscal policy tightening, and the use of capital controls. They also mention, as do the authors of the other chapters of the World Bank volume, the use of macro prudential policies (MaPPs) aimed at financial institutions and borrowers. But they admit that the evidence on the effectiveness of the MaPPs is limited.

Moreover, the macroeconomic policies they enumerate may not be sufficient to deal with the impact of capital inflows. Tightening monetary policy can draw more foreign capital. Fiscal policy is not a nimble policy lever, and usually operates with a lag

What about the use of flexible exchange rates as a buffer against foreign shocks? Emerging market policymakers have been reluctant to fully embrace flexible rates. More importantly, as pointed out here, it is not clear that flexible rates provide the protection that the theory of the “trilemma” suggests it does. Hélène Rey of the London Business School claimed last summer that there fluctuating exchange rates cannot insulate economics from global financial cycles in capital flows and credit growth. Macroprudential measures such as higher leverage ratios are needed, and the use of capital controls should be considered.

Last week we learned that capital flows to developing countries fell in February, with syndicated bank lending falling to its lowest level since 2005. This was followed by the news that domestic credit growth is falling in many emerging markets, including Brazil and Indonesia. The ensuing changes in fundamentals in these countries may or may not alleviate further depreciation pressures. But they will reflect the procyclical linkage of capital flows and domestic credit growth as much as wise policy choices. And there is no guarantee that the reversals will not overshoot and bring about a new set of troubles. The waves of capital can be as tricky to ride as are ocean waves.

Speaking Truth to Power

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When the full history of the European debt crisis is related, one important part of the story will be the uneasy relationship of the International Monetary Fund with its European partners in the “Troika,” the European Commission and the European Central Bank. The Fund and the Europeans came to hold different views on the nature of the crisis and how it should be handled soon after its outbreak in 2010. Their disagreements reflect the split in the Fund’s membership between creditors and debtors, and the inherent ambiguity of the position of an intergovernmental organization that serves principals with different interests.

Greece obtained $145 billion from the Troika in May 2010. Of that amount, $40 billion was provided by the IMF in the form of a three-year Stand-by Arrangement. This represented 3,200% of the Greek quota at the IMF, far above the usual access limits. Susan Schadler has drawn attention to the modification of IMF policy that was made in order to allow the agreement to go forward.

The IMF has criteria to be met in deciding whether to allow a member “exceptional access” to its resources. One of these of these is a high probability that the borrowing member’s public debt will be sustainable in the medium-term. At the time of the arrangement, the IMF’s economists realized that there was little probability that Greek sovereign debt would be sustainable within any reasonable timeframe. The IMF, therefore, amended the criteria so that exceptional access could also be provided if there were a “high risk of international systemic spillover effects.” There was little doubt that such effects would occur in the event of a default, but whether this justified lending such large amounts was questionable.

It soon became clear that the two of the other four criteria would not be met. Greece would not regain access to private capital markets while it participated in the Fund program (criterion #3). Moreover, there was little prospect of a successful implementation of the policies contained in the original agreement (criterion #4). By 2011, it was evident that the program with Greece was not viable. Talks began on a new program and a restructuring of the debt, which eventually occurred in 2012. Moreover, Ireland received assistance from the Troika in December 2010, as did Portugal in February 2011.

This was the background when newly-appointed Fund Managing Director Christine Lagarde, a former French finance minister, appeared at the annual gathering of central bankers and financiers at Jackson Hole, Wyoming, in August 2011. Ms. Lagarde voiced her concerns that her fellow Europeans were responding too slowly to the dangers posed by the sovereign debt crisis. (Lagarde also called upon U.S. policymakers to undertake steps to resolve the housing crisis.) But her recommendations for more vigorous actions went unheeded. Her call for a more accommodative monetary policy was ignored by outgoing ECB President Jean-Claude Trichet. And European bankers were displeased by her assessment of their capital base as inadequate and her proposal of public injections of capital if private sources were inadequate.

In retrospect, Lagarde’s judgments look prescient. Trichet’s successor at the ECB, Mario Draghi, came to a very different view of what that institution needed to do to maintain financial stability. The ECB lowered its key interest rate in November 2011, and the following month instituted a longer-term refinancing operation for European banks. European banks, however, are still seen as relatively frail.

The IMF subsequently reassessed the response to sovereign debt crises and reviewed the framework for debt restructuring. Its review found that “debt restructurings have often been too little and too late, thus failing to re-establish debt sustainability and market access in a durable way.” The report’s authors claimed that: “Allowing an unsustainable debt situation to fester is costly to the debtor, creditors and the international monetary system.” The policy review raised the possibility of more involvement of the official sector in debt restructuring.

But the development at the IMF of a proposal to write down unsustainable debt at an earlier stage of a crisis has aroused resistance from German and other policy officials. They see the suggestion of a standstill on debt repayments as an assault on the rights of bondholders. Any mention of delay or reduction of payments is viewed as the first step towards the evasion of borrowers’ responsibilities.

Such a position in the wake of the restructuring of the Greek debt is alarming. Other borrowers will suffer financing problems, and relying on exhortations to repay in full will not improve their circumstances. Moreover, ignoring the costs to the debtor of a (attempted) repayment is self-defeating. The Greek economy may have touched bottom, but even under the most optimistic scenario its debt/GDP ratio will not decline for years.

The IMF is the agent of 188 principals. To be credible, it must  serve the interests of all its members, not just its partners in a lending arrangement. Moreover, the IMF has established more credibility in this crisis than those who have consistently refused to acknowledge its extent. In seeking to improve the process of dealing with debt restructuring,  the IMF is fulfilling its mission to provide “…the machinery for consultation and collaboration on international monetary problems.” (IMF Article of Agreement I(i).) Its members should allow it to meet that mandate.

Assigned Readings: November 14, 2013

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Taking a historical perspective of economic changes, this paper argues that muddling through crises-induced reforms characterizes well the evolutionary process of forming currency unions. The economic distortions facing the euro include structural challenges in the labor and product markets, and financial distortions. While both structural and financial distortions are costly and prevalent, they differ in fundamental ways. Financial distortions are moving at the speed of the Internet, and their welfare costs are determined more by the access to credit lines and leverage, than by the GDP of each country. In contrast, the structural distortions are moving at a slow pace relative to the financial distortions, and their effects are determined by inter-generational dynamics. These considerations suggest that the priority should be given to dealing with the financial distortions. A more perfect Eurozone is not assured without successfully muddling through painful periodic crises.

International financial linkages, particularly through global bank flows, generate important questions about the consequences for economic and financial stability, including the ability of countries to conduct autonomous monetary policy. I address the monetary autonomy issue in the context of the international policy trilemma: countries seek three typically desirable but jointly unattainable objectives: stable exchange rates, free international capital mobility, and monetary policy autonomy oriented toward and effective at achieving domestic goals. I argue that global banking entails some features that are distinct from broad issues of capital market openness captured in existing studies. In principal, if global banks with affiliates established in foreign markets can reduce frictions in international capital flows then the macroeconomic policy trilemma could bind tighter and interest rates will exhibit more co-movement across countries. However, if the information content and stickiness of the claims and services provided are enhanced relative to a benchmark alternative, then global banks can weaken the trilemma rather than enhance it. The result is a prediction of heterogeneous effects on monetary autonomy, tied to the business models of the global banks and whether countries are investment or funding locations for those banks. Empirical tests of the trilemma support this view that global bank effects are heterogeneous, and also that the primary drivers of monetary autonomy are exchange rate regimes.

We analyse global and euro area imbalances by focusing on China and Germany as large surplus and creditor countries. In the 2000s, domestic reforms in both countries expanded the effective labour force, restrained wages, shifted income towards profits and increased corporate saving. As a result, both economies’ current account surpluses widened before the global financial crisis, and that of Germany has proven more persistent as domestic investment has remained subdued.

In contrast to earlier recessions, the monetary regimes of many small economies have not changed in the aftermath of the global financial crisis. This is due in part to the fact that many small economies continue to use hard exchange rate fixes, a reasonably durable regime. However, most of the new stability is due to countries that float with an inflation target. Though a few have left to join the Eurozone, no country has yet abandoned an inflation targeting regime under duress. Inflation targeting now represents a serious alternative to a hard exchange rate fix for small economies seeking monetary stability. Are there important differences between the economic outcomes of the two stable regimes? I examine a panel of annual data from more than 170 countries from 2007 through 2012 and find that the macroeconomic and financial consequences of regime‐choice are surprisingly small. Consistent with the literature, business cycles, capital flows, and other phenomena for hard fixers have been similar to those for inflation targeters during the Global Financial Crisis and its aftermath.

  • Much has been done since 2010 to reduce macroeconomic imbalances in the Euro Area periphery and to bolster economic and financial integration at the EU level
  • Stronger exports may now be stabilizing output after two years of contraction, but headwinds remain with fiscal adjustment continuing and bank lending constrained
  • Market sentiment, underpinned by OMT, has improved with better economic news
  • Challenges remain, however, including the need to restore full bond market access for Portugal as well as Ireland and agree further financing and relief for Greece
  • Italy remains at risk over the longer term, with a return to durable growth requiring deeper structural reforms that political divisions are likely to impede
  • Progress mutualizing sovereign and bank liabilities looks likely to remain limited, leaving Euro Area members vulnerable to renewed weakness in market sentiment

Strategic Retreat or Tactical Pause?

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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.