by Susan Lund, Toos Daruvala, Richard Dobbs, Philipp Härle, Ju-Hon Kwek, and Ricardo Falcón
For three decades, the globalization of finance appeared to be an unstoppable trend: as the world economy became more tightly integrated, new technology and access to new markets propelled cross-border capital flows to unprecedented heights. But the financial crisis brought that era of rapid growth to a halt. Drawing on our proprietary database of financial assets in 183 countries, Financial globalization: Retreat or reset? continues the McKinsey Global Institute’s ongoing series of reports on global capital markets. More than four and a half years after the financial crisis began, we find that recovery has barely started, despite a rebound in some major equity indexes. Growth in financial assets has stalled, while cross-border capital flows remain more than 60 percent below their 2007 peak. Some of the shifts under way represent a healthy correction of the excesses of the bubble years—but continued retrenchment could damage long-term economic growth.
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Response: Karl Muth poses questions to Susan Lund, author of a recent report by McKinsey Global Institute entitled ‘Financial globalization: Retreat or reset?’.
KM Q1: Does the concept of “domestic” and “foreign” investors seem an anachronistic oversimplification in the context of contemporary globalisation?
Note: Your Exhibit 31, illustrating assets held by foreign investors, is an interesting chart and something followed by analysts with more than a passing interest since the Clinton administration. But do we need to rethink who is a “foreign investor” in a world where a Russian national living in London buys shares in a FTSE firm through his holding company in the Caribbean? Doesn’t the concept of “domestic” and “foreign” investors seem an anachronistic oversimplification in the context of the contemporary globalisation you explore?
SL A1: In some ways, yes. Technology has made it possible for investors to connect with markets around the globe with the click of a mouse, and capital flows through a complex web of business and financial transactions that transcends national borders. The financial crisis certainly demonstrated that problems in one country’s markets can immediately cause ripple effects felt around the globe. But it also highlighted some important differences between foreign and domestic investors. Many countries saw lending by foreign banks drop off more sharply than lending by domestic banks—and that is especially true of cross-border "suitcase" lending and branch lending, both of which declined even more than foreign lending through established bank subsidiaries. The risk of foreign capital flows "reversing" or coming to a "sudden stop" is quite real and has been damaging in many of the financial crises of the last 20 years. And after 2008, many countries found their own taxpayers bailing out banks that failed due to foreign operations, or insuring depositors from failed foreign institutions.
But it is important to remember that foreign capital brings benefits as well as risks. The presence of foreign banks in a given country increases competition and can lower cost of capital for borrowers. Foreign direct investment by companies can bring new technologies and products, benefitting consumers. Ironically, closing national borders to foreign capital may reduce the risk of a "sudden stop" -- but it may also raise the risk of domestic financial crises, as credit risks are concentrated within the national financial system.
KM Q2: Aren’t the majority of problems we see today the result of government interventionism rather than government inaction or apathy?
Note: You suggest that governments could take action to fix market failures in the case of underserved borrowers. But aren’t the majority of problems we see today the result of government interventionism rather than government inaction or apathy? Surely the housing crisis in the U.S., driven by a bizarre regulatory framework (FHA, HUD, etc.) that encouraged housing lending to people who probably shouldn’t have ever been allowed to purchase anything on credit, was a dragon fed by the legislature rather than one slayed by heroic bureaucrats. What leads you to believe governments can competently clean up a mess – the distribution of capital in the consumer and commercial credit markets – that they were too incompetent to notice they were creating?
SL A2: The financial crisis was the result of a confluence of factors: excessive leverage, poor understanding of risks, weak supervision and incomplete regulatory frameworks, to name a few. Healthy financial globalization cannot resume without robust and consistent safeguards in place to provide confidence and stability—and the current regulatory reforms being enacted have made progress on these issues.
More broadly, governments have a clear role to play in addressing market failures and establishing conditions for healthy financial market functioning. In an era of bank deleveraging, financing for some types of borrowers and projects may be constrained. When we look ahead, we can identify enormous needs around the world for infrastructure investment, for example, both in rapidly growing emerging economies and also in some developed nations that have underinvested in infrastructure in recent decades. In many countries, new financing mechanisms will be needed to fund such projects. Governments and other public institutions can establish the conditions to enable private-sector participation -- for instance, through an infrastructure bank.
KM Q3: What barriers are most relevant in preventing the expansion of capital markets?
Note: It’s interesting that in your Exhibit A2 offers this Y-axis “depth” score, and the sample chosen is very interesting, as well. Do you believe the “room for growth” in these markets will come from foreign investment creating deeper, more sophisticated credit markets, or will come from sophistication domestically in entrepreneurs, wealthy individuals, and conglomerates/cartels/etc. seeking capital from abroad? If there is room for growth, and revenues to support additional credit, what barrier is most relevant in preventing this expansion of capital markets?
SL A3: Financial deepening -- or the development of deeper banking systems and capital markets -- can be fueled by both foreign investors and domestic investors. In emerging economies that lack insurance markets and pension funds, foreign institutional investors may provide significant demand for equities and bonds, particularly in the early stages of market development. But eventually it also becomes important to cultivate greater domestic demand for financial assets -- both from individual investors and institutional investors -- for continued market development.
Recognizing this, there are several actions that policy makers in emerging economies can take to establish conditions for financial markets to grow. First is to ensure that markets are transparent and that regulations are not only in place but enforced. Countries with weak protections for minority shareholders and creditors need to address these issues. Companies raising capital need to provide transparent financial reports, and corporate governance rules need to be in place to protect shareholders. In addition, it’s important to establish the demand side of the market – by establishing pension systems, an insurance market (particularly for life insurance), and channels like mutual funds and brokerages that enable households to invest. Finally, some countries need to remove disincentives for companies to tap capital markets -- for instance, cumbersome approval processes for issuing corporate bonds, or listing on stock exchanges.
Susan Lund is the McKinsey Global Institute's director of research and leads research on global financial markets, labor markets, and the macroeconomic outlook. Along with regularly contributing to Global Policy, Karl Muth is a commentator, consultant, economist, and legal academic.