Global trade in goods is contracting, manufacturing investment is weak across the world and global supply chains are unravelling. Yet finance seems relatively untouched by the US-China trade tensions — immune, even, from the overwhelming pressures of deglobalisation. This counter-intuitive development cries out for explanation.
To say there has been no deglobalisation in financial markets risks oversimplification. According to a study by McKinsey Global Institute, global cross-border capital flows shrank from a peak before the financial crisis of $12.4tn in 2007 to $4.3tn in 2016. Yet the decline was almost exclusively in bank lending, notably in the interbank market. Eurozone banks alone account for half of the contraction.
These banks’ response to the crisis was to scale back often unprofitable and risky foreign operations, reduce lending and shed assets in their efforts to restore their capital ratios. But this was more a case of cyclical deleveraging than a broad-based deglobalisation, argue economists at the Bank for International Settlements.
There were also big flows in the other direction. Japan’s banks have looked overseas in pursuit of lending opportunities, encouraged by sluggish demand and low rates in their domestic market. The McKinsey study shows that Japanese banks’ foreign assets rose from $2.3tn in 2007 to $3.9tn in 2016.
The securities markets remain thoroughly globalised. A recent study of global equity ownership by the OECD shows that foreign ownership of public equity in the UK stood at 54 per cent in the UK in 2017, up from 4 per cent in 1981. This is mirrored in other developed economies. Foreign ownership of equities in Japan rose from 3 per cent to 30 per cent over roughly the same period, while the same proportion for the much larger US market tripled from 5 per cent to 15 per cent.
If these foreign ownership stakes remain high and cross-border flows continue to be vibrant, it is not always for the healthiest of reasons. After years of ultra-loose monetary policy from the major central banks, extremely low or negative interest rates have wreaked havoc on investment portfolios. Institutions such as insurers that have given historic high-return guarantees have felt obliged to take on currency risk and increased credit risk in pursuit of yield.
The volume of cross-border “carry trading” has increased phenomenally as investors borrow in weak, low-interest funding currencies to invest in higher yielding paper elsewhere. As the financial crisis recedes further into the memory, the chief impact of the central banks’ asset purchasing programmes has been to push investors into taking more risk in markets where valuations look increasingly stretched.
The picture on cross-border flows is changing. Foreign direct investment, hitherto robust, weakened conspicuously in the first half of this year, reflecting the worsening of trade war uncertainties. After a record year for international mergers and acquisitions in 2018, when the value of cross-border deals increased by 45 per cent, deals have slowed palpably in 2019, according to a report by the Boston Consulting Group.
But there are reasons for thinking that cross-border flows in banking and securities markets will remain strong — not least because of what is happening in China. China’s four largest banks increased foreign lending more than tenfold from $86bn in 2007 to over $1tn in 2016. The authors of the McKinsey study think growth could continue because foreign assets are just 9 per cent of total bank assets in China, compared with the 20 per cent or more that is common for banks in developed economies.
Meantime, portfolio flows will be pumped up as the world’s index providers keep raising the Chinese share of their emerging market indices. The authorities in Beijing have also taken measures to open up China’s markets to foreign portfolio capital. Indeed, the People’s Bank of China is now proposing to give international investors unfettered access to mainland stocks and bonds.
Western investors in passive funds should be cautious. As Beijing tries to deleverage the Chinese financial system after the credit binge of recent years, its financial companies are under pressure to raise fresh capital. Index funds will be obliged to absorb their proportionate share to maintain the issuers’ correct index weightings.
Moreover, investors should recognise that the longer the search for yield goes on, the greater the accumulation of risk in the global financial system and the bigger the probability of another financial crisis.
A final question is whether portfolio capital’s immunity from trade friction will last. Two seasoned China watchers, Fraser Howie and Roger Garside, pointed out in an article in July for the Nikkei Asian Review that the Trump administration has the power to restrict US institutions from investing in Chinese companies and might even consider denying Chinese banks’ right of access to the dollar clearing market. That would open up a new front in the war. Finance may yet be dragged into the mud.
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