Financial globalisation: Economic Policies in a New Era
Introductory remarks by Jürgen Stark,
Member of the Executive Board of the ECB
Conference on Financial Globalisation and Integration
Frankfurt am Main, 17 July 2006
Good morning Ladies and Gentlemen,
It is a pleasure to open this conference on “Financial Globalisation and Integration”. Several very eminent academics and policymakers have accepted the ECB’s invitation to this conference. I am therefore very delighted to welcome all of you to Frankfurt.
Over the past decades, financial markets have increasingly extended beyond national borders. International financial markets are an inherent feature of today’s economies. They facilitate the transmission of savings across countries. They enable agents in different countries to hedge macroeconomic and financial risks. They allow agents to diversify and optimise their international asset and liability portfolios. But they also alter significantly the framework for domestic macroeconomic policies, as they have increased the potential for international spillovers and the international transmission of shocks. Understanding the drivers, dynamics and implications of financial globalisation is crucial for policymakers. I am therefore pleased that the next one and a half days are devoted to an exchange of views among practitioners and academics on various aspects of international financial integration.
What I would like to do in these opening remarks is to briefly discuss some of the dimensions of international financial integration and share some thoughts on what we would expect to learn on each of these dimensions. What questions are we after? Where does our analysis of financial globalisation still need to be enhanced? Can we deepen our understanding of some of the remaining puzzles in international finance? And what are the implications of growing financial integration for policy conduct, including monetary policy? I will list open questions and clarify why these questions matter also from a policy-making perspective. Developing further on these questions would then be left to you, as conference participants.
To structure my remarks, I would like to start by identifying some issues that relate to what I would call the traditional view of financial globalisation. This traditional view essentially sees financial integration as the counterpart of real integration and stipulates that financial flows are essentially unidirectional and originate from capital-rich countries. Afterwards, I will identify two trends that belong to a new era of financial globalisation. The first novelty is that we see today unprecedented financial flows from developing and emerging economies to the developed world, that is in the opposite direction from what one would normally expect. The second novelty is that international financial markets are now increasingly disconnected from real developments.
Traditional view of financial globalisation
At the outset, I should clarify that financial globalisation is a multi-facetted phenomenon that cannot be captured in a single catchword, measure or index. It has various dimensions. It is visible in the increasing size and volume of financial transaction, the growing number of international financial transactions, the increased speed with which transactions are decided, implemented and settled, and the widening geographical scope of financial markets to countries and regions that until some years ago were cut off from global financial markets. Financial integration also reflects a series of driving forces, emanating partly from the private sector, partly from the public sector. The public sector has laid the foundations for growing cross-border flows by liberalising financial markets, removing international capital controls, and providing a framework of macroeconomic and financial stability. The private sector has created the momentum for deepening international integration through the development of new financial instruments, in particular in the area of risk management, the emergence of new financial institutions, and the successful use of new technologies and improved communication channels.
Traditionally, this phenomenon of deepening financial integration was mainly seen as an accompanying phenomenon to real economic integration. Financial flows were for a long time mainly triggered by the need to finance trade. International finance was mainly unidirectional, from countries with a trade surplus to those with a trade deficit. Let me give you three historical examples to illustrate this traditional view:
Under the gold standard, before the first World War, there was already a period of intensive international financial transactions. However, the bulk of the cross-border flows was at that time directed from capital-rich Europe to capital-poor regions in America or Asia and was used mainly to finance of large infrastructure projects such as railroad construction.
Under the Bretton Woods system, capital flows were very limited as the system had been designed to limit international financial transaction insofar as these were not directly linked to international transactions of goods and services.
Also in the 1980s and 1990s, when capital account liberalisation had become fairly general, a considerable part of international financial transactions still took the form of unidirectional flows to capital-poor countries. These were the decades when a growing group of countries, initially Latin American countries, later also Asian countries and transition economies, gained access to external finance from private sources.
This view of financial flows as a tool to assist capital-poor countries is of course still highly relevant today. And despite several decades of experience, a number of questions are still debated in the academic and policy community:
A first question concerns the benefits of such financial flows to capital-poor countries. One can easily outline a list of benefits that come with the opening of a country to international financial markets. It allows consumption smoothing through intertemporal asset trade. It promotes international risk diversification. And it ensures a more efficient allocation of resources to their most productive uses. Through these channels, financial integration would be expected to enhance economic growth. Yet, these gains that are so obvious in theory are not always easy to find in empirical data. A large body of econometric studies has tried to quantify the impact of external finance on economic growth and found that the impact is usually positive, but small. Therefore, the nexus between external finance and growth is an area where work will undoubtedly have to continue in the years ahead.
A second question concerns the conditions to benefit from financial integration. Econometric analysis tends to confirm that the empirical link between external finance and growth is conditional on a country’s fundamentals. Economic literature has typically identified two such conditions, namely a stable macroeconomic framework and a strong institutional framework. Deepening further our understanding of these conditions – especially in terms of institutional stability, which is a relatively new element in the international policy debate – will be key to make sure that all countries can reap the full benefits of global financial integration.
A third question relates to the potential costs of financial globalisation. An excessively rapid opening of the capital account, especially if stability-oriented macroeconomic policies and strong institutional fundamentals are not yet in place, may magnify a country’s vulnerability to external shocks. The series of capital account crises in the late-1990s and early-2000s provided an illustration of the potential exposure of countries with balance sheet weaknesses to shocks in the international financial system.
To sum up, the balance of benefits and costs of financial integration is clearly tilted to the positive side, conditional on the presence of the right institutional and macroeconomic fundamentals. I look forward to hear what conference participants would like to add on this aspect of what I have called the traditional view of financial globalisation.
These traditional policy discussions typically focus mainly on financial flows to emerging market and developing economies. More recently, however, there has been some reversal in the established logic that capital flows uphill, if you like, from “rich” to “poor” countries. Over the past five years, we have in particular witnessed increasing financial flows from emerging market economies to industrial countries. This trend is linked to the widening current account deficit of the largest industrial country in the world, the United States. In other words, this trend is part of today’s constellation of global imbalances, which will be the subject of this second part of my remarks.
Over the past years, we have become accustomed to think of global imbalances as the manifestation of external trade or current account balances. In 2005, the current account deficit of the US amounted to around USD 800 bn, mirrored in current account surpluses across other countries and regions, in particular the oil-exporting countries (surplus of USD 400 bn) and Japan, China and other Asian countries (also around USD 400 bn).
An alternative reading of global imbalances is to understand them as a reflection of domestic saving-imbalances. Indeed, the external current account imbalances are nothing else than the reflection of low saving compared to investment in the deficit country and excess saving in the surplus countries. This saving-investment dimension is important to understand the internationally agreed policy recommendations to address global imbalances, in particular the need to enhance public and private saving in the United States and to spur domestic absorption in emerging Asia and in oil exporting countries.
But global imbalances can also be approached from a financial perspective, complementing the current account perspective and the saving-investment perspective. This financial perspective is visible in the size of net financial inflows into the United States, which has climbed to a level of around USD 800 billion in 2005, i.e. by definition precisely the amount that was needed to finance the current account deficit. This financial dimension of global imbalances has led to the build-up of an increasing negative net US international investment position that is now around one-fourth of US GDP.
The financial side of global imbalances has triggered a new set of policy questions on financial globalisation:
A first main question is whether financial globalisation has made large current account imbalances more sustainable. Probably, the deepening of global financial markets has made it possible for the US economy to run a larger current account deficit than would otherwise have been possible. At the same time, one may argue that this does not change fundamental considerations about sustainability of the underlying imbalances in the US public and private sector, in particular low savings and strong consumption growth in the US government and household sector, which ultimately cannot be sustained at their present level.
A second main question is whether financial globalisation implies that the adjustment of global imbalances will be spread among the global economy? For example, it remains an open question to which degree economies that are in external balance, like the euro area, can ultimately contribute to the adjustment of global imbalances? Another question is whether the unwinding of global imbalances could ultimately be more disruptive and generate larger spillovers than in a world with less international financial linkages. There is indeed reason to believe that, in the event of a disorderly unwinding of global imbalances, few countries would be shielded from the knock-on effects in today’s globally integrated financial markets. At the same time, there are reasons to believe that a gradual and orderly adjustment remains the most likely outcome. In particular, a combination of a gradual rebalancing of global growth and the determined implementation of the internationally agreed set of policy strategy should help minimise the downside risk of global imbalances.
A new era of financial globalisation?
Let me now turn to what one may call a “new era of financial globalisation”. This relates to the emergence of what has been called “diversification finance” as opposed to the more traditional “development finance”. As I had briefly outlined before, capital flows traditionally could be understood as the flipside of trade flows. Today, however, we are observing large gross – bidirectional – flows that are decoupled from the trade in goods. For example, in 2005 net flows of equity and bond capital to the US were around USD 800 bn. Gross cross-border flows to and from the US, however, surpassed an impressive USD 40 trillion, i.e. they were 50 times about the size of the net flow.
These gross capital flows do not result from trade patterns but rather from investment decisions that reflect the desire of investors to diversify their portfolios. As a result, countries have build up large foreign asset positions which amount to more than 100 percent of world GDP. But still these numbers are relatively “small” when compared to the total stock of foreign and domestic investment. In fact, despite the trend towards international portfolio diversification, international investors continue to have a strong preference for domestic financial assets. This phenomenon has been identified in the literature as the home bias puzzle. Home bias has been – steadily but slowly – declining over recent years, especially in euro area economies as these tend to be relatively highly integrated with each other. However, most economies in the world invest only around 10 percent of their portfolio wealth in foreign securities although simple benchmarks would suggest a much higher share of foreign investment to be optimal. This would suggest that we are only at the start of this new era of financial globalisation.
While the rising stocks of cross-border financial assets and liabilities lead to a number of interesting analytical and policy questions I now want to refer to only one of them, namely the increasing potential for valuation gains and losses. Valuation effects have had a particularly large effect on the international investment position (IIP) of the US in recent years. In fact, they have mitigated the effect of the continued accumulation of net liabilities to an unprecedented degree. Without these valuation effects the US IIP – which has been fairly stable around 20 percent of GDP since 2002 – would have worsened to around 40 percent of GDP. But valuation gains are likely to be one-off, and may even reverse, and hence over the long-run they cannot be expected to change the trajectory of the international investment position. Still, in the short-run, valuation gains could potentially alter the dynamics of the adjustment of global imbalances. Understanding these valuations gains and their potential implications is therefore still an important challenge.
To sum up, there are a large number of still unresolved analytical and policy issues here. If we indeed enter into a new era of financial globalisation, we may need to address a whole set of analytical and policy questions:
First of all, what explains the fact that home bias is still so large despite our perception of a very integrated global economy? What explains the asymmetries in “home bias” across countries and across instruments? Will home bias continue to decline? And finally, a question that is extremely relevant for policymakers is whether a further decline in home bias will have an impact on the functioning of financial markets on financial prices, capital flows and foreign asset positions?
Larger gross positions imply that valuation gains and losses on those positions may become more relevant. A policy question is whether such valuation effects can play a role in current account adjustment? Can valuation effects – through wealth effects – have a significant impact on the real economy?
Finally, increasing gross positions imply a potential for more intensive transmission of economic and financial shocks. For policy makers, this has important implications as it may alter over time the degree of business cycle synchronisation across the world.
Outlook for the conference
To conclude, it is useful to wrap up the different analytical and policy questions that this conference may help address.
In session 1 on global imbalances, the main challenge is to understand the financial counterpart of the current constellation of current account positions. Perhaps the central question here is whether global financial integration facilitates the sustainability of global current account imbalances, or whether on the contrary it just leads to a delay in the adjustment that could eventually turn out to be more disruptive?
In session 2 on home bias and risk sharing, the main challenge is to see whether we can enhance our understanding of the home bias puzzle and asses what would be the implications of a further decline in home bias. In particular, could we expect the functioning and dynamics of financial markets to significantly change?
Session 3 on international financial integration may offer an occasion to deepen our understanding of the policy implications of a world of ever-closer financial integration. The central question, especially also for central bankers, is to understand how financial integration alters the transmission channels of transmission of international shocks, and whether such transmission of shocks facilitates or complicates stability-oriented macroeconomic policies, including of course in particular monetary policy.
With so many open questions, you will understand our many motivations for having organised this conference. I wish you a very fruitful 1½ days of deliberation.
 Data based on IMF World Economic Outlook, April 2006.