Not falling apart
The global financial system isn’t dead. But it might be shrinking. For the past four years, bankers have fretted that finance is retreating behind national borders, with dire consequences for trade and economic growth. The reality is that a diminution of the financial sector was overdue. And outside the euro zone, cross-border flows are still reasonably healthy.
The expansion of the financial system before the crisis was undeniably rapid: a new report by the McKinsey Global Institute shows that the combined value of equity markets, corporate and government bonds, and bank loans expanded by 7.9 percent a year between 1990 and 2007. However, this breakneck growth relied more on bad elements than good ones.
McKinsey applies the concept of “financial deepening”: the overall value of financial assets as a proportion of GDP. In 1995, this was 256 percent of global economic output. By 2007, it had reached 355 percent. Yet most of the expansion was due to rising share prices and higher leverage in the financial system. Barely a quarter of the world’s financial growth over the period went to consumers and companies. As the McKinsey authors put it: “This is an astonishingly small share, given that this is the fundamental purpose of finance.”
Such rapid, reckless expansion had to come to an end. Increased financial leverage had boosted earnings, which supported equity prices, which in turn helped justify even higher levels of debt. Deleveraging was sure to follow. Since the crisis, the overall stock of financial assets has continued to expand at a lower rate of 1.9 percent a year. But as a share of global GDP it has fallen to 312 percent. Without the expansion in government borrowing, it would have been even lower.
The crunch hasn’t been felt equally around the world. True, international capital flows have slumped: an estimated $4.6 trillion flowed across borders last year, compared with $11.8 trillion in 2007. Yet much of the change can be explained by Europe’s recent woes. According to McKinsey, the nations of Western Europe generated 56 percent of the growth in global capital flows between 1980 and 2007. The same countries are responsible for 72 percent of the subsequent collapse.
The rest of the world’s financial system looks less sickly. Capital flows to emerging markets were $1.5 trillion last year, close to the pre-crisis peak. In 2012, emerging markets actually exported $1.8 trillion in capital – more than they received in inflows – as many stuffed their current account surpluses into Western currencies and capital markets. So-called “south-south” flows are a tiny proportion of the total but growing quickly.
It would also be a mistake to gauge the health of the financial system from the troubles faced by global banks. European lenders in particular have trimmed cross-border lending both inside and outside the euro zone. And regulatory demands that banks hold more capital and liquidity in local subsidiaries make it harder to quickly move money around the globe.
Yet while banks feel the pain, the broader financial system is not suffering as much. For example, companies are increasingly turning to corporate bonds rather than loans. This has further to go: McKinsey calculates that if companies with revenue of more than $500 million shifted 60 percent of their total debt to bonds, they would collectively issue $1 trillion in fresh paper.
The question McKinsey’s study doesn’t answer is how much finance the world actually needs. Much of the West’s expansion over the last two decades was powered by a rapid and unsustainable expansion in debt. In the United States, Japan and western Europe, financial assets are still equivalent to more than four times GDP. In the developing world, the ratio is less than half that amount: only in China does it exceed 200 percent.
As these countries develop, some further financial deepening seems likely – as does a continued role for cross-border capital flows. The challenge will be ensuring that, in their urge to keep economic growth on track, developing nations concentrate on stimulating the good aspects of financial development, and focusing on the kind of finance that benefits the productive economy, while avoiding the West’s mistakes.