Capital flows: Powered down

After Lehman Brothers investment bank collapsed in late 2008, the lights almost went out in the global financial system. Power has been only partly restored.

Cross-border global capital inflows remain almost 70 per cent lower than their pre-crisis peak in mid-2007, according to calculations for the Financial Times by the McKinsey Global Institute, the research arm of the consultancy firm. Relative to global economic output, flows are lower than levels seen more than a decade ago, when the world was recovering from the collapse of the dotcom bubble.

Even the modest improvement this year in growth across advanced economies has failed to revive the pace of financial globalisation.

Whether the contraction is such bad news is contentious among economists. The role flows play in promoting economic growth and job creation is not clear. After the events of the past six years, a fall might come as a relief. Excessive inflows fuelled crises in countries such as Spain, which was then hit by a collapsing house price bubble.

But the expansion in capital flows up until 2007 went hand-in-hand with the integration of the world’s economies; the reversal of that globalisation could explain the lacklustre post-crisis performance of advanced countries. “Part of it is a healthy correction but with a 70 per cent fall, there are legitimate borrowers who are not getting funding. If this continues, it will affect economic growth,” warns Susan Lund, a McKinsey partner.

Lawrence Summers, the former US Treasury secretary, has pointed out that when connections are lost in power cuts, economic output falls rapidly – and that the effects of financial crises are analogous. “There would be a set of economists who would sit around explaining that electricity was only 4 per cent of the economy and so if you lost 80 per cent of electricity you couldn’t possibly have lost more than 3 per cent of the economy,” he joked in a speech at an International Monetary Fund conference last November. But “we would understand . . . that when there wasn’t any electricity, there wasn’t really going to be much economy”.

Nonetheless, the financial events of recent years have highlighted risks created by at least some flows. “I’m not saying that you should not have any capital flows across countries. But if you look at what happened during this crisis, and what has happened before other crises, you find that too many short-term capital flows – too much hot money – fuel asset price bubbles and are very destabilising,” says Professor Hélène Rey of the London Business School.

As flows have contracted, their composition has shifted significantly, reflecting changes in the global economic world order. Much of the contraction has been the result of weakened European banks scaling back cross-border lending – within Europe and to other parts of the world.

The impact on emerging markets of this has been “relatively painless”, argues Claudio Borio, of the Bank for International Settlements in Basel. Where European banks retreated, others have stepped in. Emerging markets companies have also raised more money in capital markets. “The fact that European banks have pulled back from international lending in order to repair balance sheets is healthy,” says Mr Borio.

Still, the expansion of emerging debt markets has brought disadvantages. Emerging economies registered steep falls in bonds, currencies and equities after Ben Bernanke, US Federal Reserve chairman, first hinted in May last year at plans to scale back the Fed’s programme of quantitative easing or asset purchases.

Among the most important factors determining the extent of the sell-off was the size of the relevant countries’ financial markets, according to a paper last month by Barry Eichengreen of the University of California, Berkeley, and Poonam Gupta of the World Bank. “Success at growing the financial sector can be a mixed blessing,” they concluded. “Among other things, it can accentuate the impact on an economy of financial shocks emanating from outside.”

Yet a striking feature of the past few years has been how little impact the QE programmes of the Fed and other central banks have had in boosting global flows. A revival to pre-crisis levels in cross-border flows may require a further shift in global economic power.

“Given the amount of saving in China and the opportunities for investors that China represents, it is going to be a major source of capital inflows and outflows in the medium term,” says Prof Rey. “But we will have to carefully manage those flows. Imagine if China had had inflows on a similar scale as Spain had into real estate: what the impact would have been on financial stability in China?”