A Guide to the (Financial) Universe: Part 1
A decade after the global financial crisis, the contours of the financial system that has emerged from the wreckage are becoming clearer. While the capital flows that preceded the crisis have diminished in size, most of the assets and liabilities they created remain. But there are significant differences between advanced economies and emerging markets in their size and composition, and those nations that are financial centers hold large amounts of international investments. Moreover, the predominance of the U.S. dollar for official and private use seems undiminished, if not strengthened, despite the widespread predictions of its decline. A guide to this new financial universe reveals a number of features that were not anticipated ten years ago.
2. External Assets and Liabilities
Financial globalization is the result of the flow of capital across borders and the integration of domestic financial markets. Financial flows like trade flows increased during the first wave of globalization during the 19th century, which ended with the outbreak of World War I. After World War II, trade and capital flows started up again and grew rapidly. In the mid-1990s financial flows accelerated more rapidly than trade, particularly in the advanced economies, and peaked on the eve of the global financial crisis.
Philp R. Lane of the Central Bank of Ireland and Gian Milesi-Ferretti of the IMF in their latest survey of international financial integration (see also here) provide an update of their data on the size and composition of the external balance sheets. Financial openness, as measured by the sum of gross assets and liabilities, for most countries has remained approximately the same since the crisis. But its magnitude differs greatly amongst countries. Financial openness in the advanced economies excluding the financial centers, as measured by the sum of external assets and liabilities scaled by GDP, is over 300%, which is approximately three times as large as the corresponding figure in the emerging and developing economies. This is consistent with the large gross flows among the advanced economies that preceded the crisis. However, the same measure in the financial centers is over 2,000%. These centers include small countries with large financial sectors, such as Ireland, Luxembourg, and the Netherlands, as well as those with larger economies, such as Switzerland and the United Kingdom.
Some advanced economies, such as Germany and Japan, are net creditors, while others including the U.S. and France are net debtors. The emerging market nations excluding China are usually debtors, while major oil exporters are creditors. These net positions reflect not only the acquisition/issuance of assets and liabilities, but also changes in their values through price movements and exchange rate fluctuations. Changes in these net positions can influence domestic expenditures through wealth effects. They affect net investment income investment flows, although these are also determined by the composition of the assets and liabilities (see below). In many countries, such as Japan and the United Kingdom, international investment income flows have come to play a large role in the determination of the current account, and can lead to a divergence of Gross Domestic Product and Gross National Income.
The external balance sheets of the advanced economies are often characterized by holdings of equity and debt liabilities—“long equity, short debt’’—while the emerging market economies hold large amounts of debt and foreign exchange reserves and are net issuers of equity, particularly FDI—“long debt and foreign reserves, short equity.” The acquisition of foreign reserve holdings by emerging Asian economies is responsible for much of the “Lucas paradox,” i.e., the “uphill” flow of capital from emerging markets to advanced economies. However, there has also been a rise in recent years n the issuance of bonds by non-financial corporations in emerging markets, in some cases through offshore foreign affiliates.
As FDI has increased, the amount of investment income accounted for by FDI-related payments has risen. In the case of the emerging markets, these payments now are responsible for most of their investment income deficit, while the amounts due to banks and other lenders have diminished. FDI payments for the advanced economies, on the other hand, show a surplus, reflecting in part their holdings of the emerging market economies’ FDI.
The balance sheets of the international financial centers also include large amounts of FDI assets and liabilities. These holdings reflect these countries’ status as financial intermediaries, and funds are often channeled through them for tax purposes. The double-counting of investment that this entails overstates the actual value of foreign investment. The McKinsey Global Institute in its latest report on financial globalization has estimated that if such double-counting was excluded, the value of global foreign investment would fall from 185 percent of GDP to 140 percent.
The composition of assets and liabilities has consequences for economic performance. First, equity and debt have different effects on recipient economies. Portfolio equity inflows lower the cost of capital in domestic markets, and can enhance the liquidity of domestic stock markets and the transparency of firms that issue stock. In addition, M. Ayhan Kose of the World Bank, Eswar Prasad of Cornell University and Marco E. Terrones of the IMF have shown that equity, and in particular FDI, increases total factor productivity growth. Philip R. Lane of the Central Bank of Ireland and Peter McQuade of the European Central Bank, on the other hand, reported that debt inflows are associated with the growth of domestic credit, which can lead to asset bubbles and financial crises. Second, the differences in the returns on equity and debt affect the investment income flows that correspond to the assets and liabilities. Equity usually carries a premium as an incentive for the risk it carries. The U.S. registers a surplus on its investment income despite its status as a net debtor because of its net positive holdings of equity.
Third, the mix of assets and liabilities influences a country’s response to external shocks. FDI is relatively stable, but its return is state-contingent. Debt, on the other hand, is more volatile and in many cases can be withdrawn, but its return represents a contractual commitment. As a result, the mix of equity and debt on a country’s external balance sheet affects its net position during a crisis as well as its net investment income balance.
The change in the value of equity, for example, can depress or raise a country’s balance sheet during a crisis. Pierre Gourinchas of UC-Berkeley, Hélène Rey of the London Business School and Govillot of Ecole des Mines (see also here) have characterized the U.S. with its extensive holdings of foreign equity as the world’s “venture capitalist.” Gourinchas, Rey and Kai Truempler of the London Business School showed that the loss of value in its equity holdings during the global crisis provided a transfer of wealth to those countries that had issued the equity. Those nations that had issued equity, on the other hand, avoided some of the worst consequences of the crisis.
This analysis of external balance sheets, however, assumes that the assets and liabilities are pooled. Stefan Avdjiev, Robert N. McCauley and Hyun Song Shin of the Bank for International Settlements (see also here) have pointed out that public assets, such as the foreign exchange reserves of the central bank, may not be available to the private sector. South Korea, for example, had a positive net international investment position that included foreign currency assets, which appreciated in value when the global crisis struck. Nonetheless, corporations and banks had issued dollar-denominated liabilities, and their value also rose. The country was one of those that entered into a currency swap arrangement with the Federal Reserve.
Eduardo A. Cavallo and Eduardo Fernández-Arias of the Inter-American Development Bank and and Matías Marzani of Washington University in St. Louis also investigate whether foreign assets provide protection in the case of a shock. They report that portfolio equity assets as well as reserves lower the probability of a banking crisis. Portfolio equity, like reserves, are relatively liquid and therefore residents can draw upon them during periods of volatility.
The difference between private and public assets liabilities has been investigated by Andreas Steiner of Grongien University and Torsten Saadma of the University of Mannheim. They calculate a measure of private financial openness that excludes the reserve assets of central banks as well as loans based on development aid. In the case of emerging markets and developing economies, their measure differs significantly from the standard measure, and results in different findings for the linkage of financial openness and growth.
Avdjiev, McCauley and Shin of the BIS also point out that balance sheets are measured on a national basis. But assets and liabilities may be held through foreign affiliates. International banks, for example, have foreign units with claims and liabilities. If these are consolidated on their parents’ balance sheet, then a very different assessment of the banks’ international creditworthiness may emerge. Similarly, non-financial firms may obtain credit through their foreign branches that borrow in the offshore debt markets. The credit inflow could hamper the ability of domestic authorities to stabilize the financial system. External balance sheets measured on a national basis may give a misleading picture of domestic institutions’ foreign linkages.
(to be continued)