Growth in international financial flows has not been restricted to new financial derivatives: portfolio and direct investment flows, and traditional bank loans have also grown strongly. Table 1 illustrates the rapidly increasing size of these flows since the mid-1970s. Since the 1970s, portfolio capital flows have often been larger than direct investment and bank credit flows combined.
A particular feature of short-term capital flows is the speed with which such flows can reverse themselves. An obvious example is the sharp reversal of private capital inflow into the Asian region beginning in mid-1997. According to Bank of International Settlements (BIS) estimates, net private capital inflow into the Asian region fell from $US81 billion in 1996 to outflows of $US45 billion in 1997 and $US66 billion in 1998. Driving this reversal was a reduction in, largely short-term, commercial bank credits which reversed an inflow of over $US50 billion in 1996 to an outflow of $US21 billion in the following year (Eatwell and Taylor 1998).
Table 1: Global Portfolio and direct investment flows, net bank credit ($USbn)
Source: Andersen (1995), IMF, Balance of Payments Statistics Yearbook, BIS Annual Report, 1998.
Box 1 illustrates growth in capital flows in a range of other markets.
Box 1: Growth in global financial flows some examples
Foreign exchange trading
Since the abolition of controls in the early 1970s, international capital flows have grown exponentially, with growth in foreign exchange trading providing the early impetus.
Eatwell (1996), cites BIS estimates that by 1980, foreign exchange trading equaled a daily average of $80 billion with a ratio of forex trading to global trade of 10 to 1. By 1992, trading averaged $880 billion a day, a ratio of 50 to 1; and in 1995 $1,260 billion with a ratio of 70 to 1.
The bond market, Eatwell notes, began to grow considerably faster in the 1980s.
In a similar way, the stock of international bank lending has surged from $265 billion in 1975 to $4,200 billion in 1994.
All financial assets
The McKinsey Global Institute estimates that the stock of all financial assets traded in global markets rose from $5,000 billion in 1980 to $35,000 billion in 1992 ¾ twice the GDP of the OECD economies. The Institute has estimated that the stock of these assets will have reached $83,000 billion in 2000 ¾ three times OECD GDP. (Woodall, 1995).
The most extraordinary growth has been in the notional principal value of interest rate, currency, equity and commodity derivatives. By far the fastest growth has been in interest rate and currency derivatives, which constitute about 98 per cent of the total. By 1995, the notional value of outstanding contracts traded over the counter or on organised exchanges was around $US57 trillion. By 1998, this had risen to around $US86 trillion.
While these values and growth rates could reasonably be described as astronomical, it is worth noting that the notional principal values commonly cited are the face values of the contracts traded. However, with these products, typically only fractions of the face value of the contracts are the subject of margin calls, according to price movements in the underlying product covered by the contract. Thus the actual international financial flows, the credit exposure, and the money at risk in these derivative contracts, is typically only a few per cent of the notional principal value. Moreover, to the extent that the actual additional international capital flows as a result of derivatives use shift risk to those most able to bear it, such increases are likely to be stabilising rather than destabilising.
Table 2: Selected financial derivatives markets ($USbn, notional amounts outstanding at year-end)
Source: Bank of International Settlements Annual Reports, various.
Benefits from financial globalisation
Financial globalisation directs global savings to their highest returns and, through a more complete range of more liquid international financial markets, allows the better identification, pricing and trading of risk. There are great potential advantages for global and national income growth from that development, though also (paradoxically) some new types of risk may be created at the same time.
More complete and more liquid markets for equity and debt, and for derivative instruments such as futures and options, allow savers, investors, producers and traders to better manage the risks of price, interest rate or exchange rate movements. This benefit arises because risks of adverse interest rate, exchange rate and commodity price changes that might impact in a complex pattern on a project (such as a decision to finance and build a mine, and export its output) can be better identified, unbundled, and priced in liquid, specialised financial markets, separated from their underlying real activities (setting up and operating the mine), and traded to those best able to bear those risks. With the better pricing, trading and management of risks, underlying activity can be higher than if the miner had to bear all the risks.
Other examples might include an Asian agricultural importer hedging commodity price risks on a Chicago commodities exchange and interest rate and exchange rate risks on a London financial exchange, or a Canadian fuel importer hedging on New York energy and financial exchanges. The counterparties to such hedging might be other traders or processors in third countries facing opposite risks, or speculators simply prepared to act on their belief that prices are more likely to move in one direction than the other. Transactions of this type have contributed to the widely observed explosion in the volume of gross international financial flows, to many multiples of the annual value of global trade, or of net global capital flows, or of GDP. A single trade flow of $100 of goods might give rise to gross trade financing, futures hedging, and other secondary financial market flows of many times that amount. But those excess transactions are not economically meaningless, or casino entertainment for the traders involved: they serve a real economic (and social) purpose of allowing real production to be higher than it otherwise could be.
One lesson from the Asian crisis is that businesses in many regio
nal economies would have been better served by participating more in the explicit pricing and trading of risks of exchange rate and interest rate changes, than in believing government assurances that those risks did not exist.
More complete and more liquid international markets for equity and debt achieve better allocation of world savings to the highest-yielding investments. At the microeconomic level, more globalised financial markets could achieve internationally what a developed domestic financial sector can achieve nationally: participants could borrow and lend in the face of negative or positive shocks to their income, smooth their consumption over time, and thus improve their welfare.
In fact, individuals or regions consumption and income is only weakly correlated within nations because of relatively efficient national financial sectors. But national consumption is strongly correlated with national income, because of relatively incomplete global financial sectors.
More complete and more liquid international financial markets would finance international arbitrage in goods and services to reduce international price differences (after transport and other transaction costs).
That would also enhance welfare, by shifting market supplies, at the margin, from national markets in which they are lowly valued, to markets in which they are more highly valued.
This example again reminds us that the liberalisation and globalisation of goods markets and financial markets go hand in hand. As one commentator notes: . both goods market and financial market integration are necessary for full economic integration, as any desired current account position entails the simultaneous exchange of financial assets. Consequently, if local people prefer to exchange financial instruments with other local people rather than with outsiders, goods market flows will be impeded.
More complete and more liquid international financial markets would better perform their role in price discovery, by which market prices for a financial asset (eg a share) adjust promptly and smoothly to new information about the value of the underlying asset (the company).
Large, liquid markets ensure that a seller of an asset receives its highest current price. Conversely, segmented smaller markets reduce the chance that a seller will receive the best price. The best price discovery results arise when all offers to buy and sell at a given time are crossed in the one market. These considerations help explain why, with the fall in trading costs within the US in the 1800s and early 1900s permitted by the spread of the telegraph, the stock ticker and the telephone, the New York Stock Exchange steadily increased in prominence and liquidity at the expense of the many smaller regional stock exchanges, but to the advantage of efficient capital raising. We would expect similar forces to be at work today with the fall in international financial trading costs as a result of cheaper IT.
Finally, more competitive and specialised international financial markets reduce the spreads between borrowing and lending rates and the fees for providing financial intermediation. As with any competition-driven reduction in costs of a factor of production, such developments are to the ultimate advantage of a wide range of businesses and consumers.
The risks of increased financial globalisation
Of course, to argue that more financial globalisation is potentially welfare enhancing is not to suggest it will automatically occur in the way that will maximise the net benefits.
One key area of risk, now receiving much attention, is the potential for excessive volatility in short-term gross capital flows. Even where net annual capital flows summarised in the capital account of the balance of payments are not large, shorter-term gross flows are much larger and can reverse very rapidly if there is a change of sentiment in capital markets. Such reversals may occur either rationally with the emergence of pertinent new information on the creditworthiness or likely prospects of industries or economies, or in a sense irrationally, through herd-like changes in prevailing market opinion. The nature of these risks has been clarified in recent studies of the likely linkages behind so-called financial contagion.
Contrary perhaps to current impressions, the evidence is that over the last 25 years, financial crises were more frequent in the period 1975 to 1986 than more recently, while banking crises were at their peak in the early 1980s. Not surprisingly, crises have been more frequent in emerging markets than in industrial economies. There is some evidence that contagion has become more prevalent, leading to a greater clustering of crises. The tentative findings from these studies confirm the value of sound domestic policy settings and robust commercial institutions, especially in the banking sector and the prudential supervision thereof.
Is globalisation near its limits?
In an imaginary world where national markets were seamlessly integrated with one another, goods, services and capital would flow as easily, and prices would adjust as quickly, among nations as within them, after allowing for transport cost and transaction cost differences. In such a world, it would be impossible to make anyone better off by trading a good, a service or finance from a lower valued use in one market to a higher valued use in another.
Against that hypothetical benchmark, there is abundant recent evidence that profitable and socially beneficial globalisation potentially has much further to run.
Since the mid-1990s, a number of studies have been published comparing the trade flows, capital flows and price differences among the Canadian provinces and between them and the US, and similar studies have also been performed among some other members of the OECD. While the detailed estimates differ, all studies show that even among closely integrated economies and after allowing for distance, market size and transactions costs, there remains a very large home bias: markets distribute goods, services and capital much more efficiently within national boundaries than across them. Recent globalisation trends have somewhat lowered home bias, but there are likely to be many profitable opportunities to reduce it much further. For example, we have barely begun to see the practical impact of the internet on international trade in goods and services, or in retailing, banking or stockbroking.
14 Cited in Edey and Hviding (1995).
15 In principle, global inflows should equal global outflows, just as global aggregates for exports should equal global aggregates for imports. However, for various reasons, countries generally do not correctly record all transactions, or corresponding transactions are classified differently. This leads to errors and omissions in national data that cause discrepancies in global aggregates.
16 China, India, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand.
17 Bank for International Settlements Annual Report, various.
18 IMF, International Capital Markets: Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, September 1998, p. 97 fn 14.
19 Ibid., Annex V pp 180-196.
20 Note that in the examples given, the trade flow may be between country A and country B, but the financial hedging flows might be between country A and country C, and country D and country C. Many of these complex gross flows net out in the trade and capital account data.
21 Coleman, A. Economic Integration and Monetary Union, NZ Treasury Working Paper 99/6, p. 9.
22 The somewhat arcane issue of financial market efficiency in price discovery is outlined in Yakov Amihud and Mendelson, H., Trading Mechanisms and Value-Discovery: Cross-National Evidence and Policy Implications, Carnegie-Rochester Conference Series on Public Policy, Volume 34 Spring 1991, North Holland, pp. 105-130.
23 Smith, opcit, pp. 80-81.
24 'Funds that might once have gone into banks or life insurance companies are now as likely to wind up in mutual funds or pension (ie superannuation) funds. Here technology plays an important role. Many of these new savings institutions are more cost efficient than traditional intermediaries. In the US a $10 billion bank has between 5000 and 7000 employees. In contrast, a $10 billion mutual fund can be managed by 20 professionals and a computer.' Smith, C. W. Globalization of Financial Markets, Carnegie-Rochester Conference Series on Public Policy, Volume 34 Spring 1991, North Holland, p. 81.
25 Concepts of rationality and irrationality need to be treated cautiously in discussing market sentiment. Information for fund managers to make fully informed individual decisions is expensive, and national de jure (and international de facto) lender of last resort facilities can make it 'rational' (if not socially optimal) for a fund manager to 'hide in the herd'. If all goes well, fund performance is no worse than average, and if the worst comes to the worst, bad performance is still no worse than average and is underpinned by 'lender of last resort' intervention by national or international authorities. This type of constrained 'rationality' is a reminder of the importance of 'moral hazard' in altering the nature of financial behaviour.
26 A summary of this family of 'contagion' research, and new empirical evidence on the role of 'contagion' in currency crises is in the IMF's World Economic Outlook May 1999, Chapter III, pp. 69 - 87.
27 IMF World Economic Outlook, May 1998, chapter IV pp. 74-97.
28 IMF World Economic Outlook, May 1999, chapter III pp. 66-87.
29 A comprehensive summary of such evidence is in Helliwell, J F. (1998), Do National Borders Matter?, Washington DC, Brookings Institution, Chapter 4.