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Would world economy miss the financial ‘froth’?

The political backlash against profligate global banks is underway; regulators everywhere are sizing up “hot” cross-border money flows; and capital controls in developing economies are back in vogue. Financial globalisation, in short, is on the back foot.

The questions for policymakers, and for investors, is whether it is possible to skim the froth off global finance without undermining the benefits of “real” globalization in trade and direct investment.

And for many emerging economies, is slightly lower but more stable growth a price worth paying for damping volatile and destabilising financial flows?

To judge by the International Monetary Fund’s world growth projections this week, the risks to underlying growth so far appear to be modest.

The IMF boosted this year’s global growth projection by almost a full percentage point to 3.9 percent and upped next year’s to 4.3 percent — far in excess of the average 3.3 percent rate of the past decade and the fastest clip since the 5.2 percent peak of the boom in 2007.

That’s clearly not the full picture. Apart from moves by emerging giants such as Brazil to tax capital inflows flooding their local markets, most of the post-crisis proposals to rein in global banks and finance are still in gestation.

But U.S. President Barack Obama’s bombshell in proposing to ban U.S. banks from proprietary trading unrelated to customer business was the clearest sign yet that months of post-mortems and suggestion are finally gaining traction among policymakers and other proposals should be taken seriously.

The downsizing of global mega banks, previously seen too big to fail or bail, has many fans abroad and could have far-reaching implications for cross-border capital over time.

The thinking also tallies with calls for more “host country” rather than “home country” regulation, as outlined by economists writing for the UK’s Warwick Commission last November.

This would see global banks being forced to replace foreign branches with fully-capitalised subsidiaries, regulated by the host country rather than the regulator in the parent’s country — moves flagged by Bank of England governor Mervyn King as making life “a whole lot easier for the national regulators.”

What is more, one new proposal from the Basel Committee on Banking Supervision excludes the banks’ use of minority stakes in affiliates — typical of how many Western banks operate in emerging markets — from being used as capital buffers.

All the above would have the effect of raising the cost of cross-border banking and finance and could well see it retreat, but they remain looming intangibles and hard to quantify.

How far we’ve come

To benchmark how fast and big global finance has become in step with trade globalization, the IMF estimates that between 1980 and 2007, the ratio of goods and services trade to global gross domestic product — currently about $60 trillion — rose to 62 percent from about 42 percent.

But foreign direct investment rose to some 32 percent from just 6 percent. And the stock of international bank loans and other financial claims rose to 48 percent from 10 percent.

The recent credit and banking crisis clearly took a toll on cross-border capital moves, but flows to emerging economies in particular have already rebounded sharply and many estimates of the shock are already being revised higher.

Global banking association the Institute of International Finance (IIF) this week revised up its estimate of net private capital flows to emerging markets last year by almost $100 billion to $435 billion and expects the total to jump further this year to $722 billion — above 2008 levels even if still shy of 2007’s peaks of over $1 trillion.

The IIF highlighted several headwinds to these flows ahead, including capital controls in developing countries as well as banks’ higher capital requirements and reluctance to finance interest rate “carry trades” by themselves or for clients such as hedge funds.

“The prospect of this tighter regulatory environment is, of course, already being factored into current lending decisions,” it said in a report on the findings.

Significantly, the rebound in capital flows over the next two years is expected to be driven by direct investments and equity investments, with portfolio flows expected to decline again this year and next.

So, from that, it seems possible that a tightening of the regulatory screw on banks and curbing excessive “hot money” flows can be done without too much of a hit to overall growth, something borne out by many recent prominent studies.

In a paper entitled “Why did Financial Globalization Disappoint?”, Harvard economist Dani Rodrik and Peterson Institute fellow Arvind Subramanian concluded that the real economic benefits of financial globalization are hard to find.

“Countries that have grown most rapidly have been those that rely less on capital inflows. Financial globalization has not led to better smoothing of consumption or reduced volatility.”

Uneven sovereign and regulatory regimes mean international financial flows are condemned to suffer distortions far worse than domestic finance, they argue.

“The appropriate role of policy will be as often to stem the tide of capital flows as to encourage them. Policymakers who view their challenges exclusively from the latter perspective will get it badly wrong.”