Financial Globalization in Reverse?

Martin N. Baily, Susan Lund

12 April 2013

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WASHINGTON, DC – For three decades, financial globalization had seemed inevitable. New information technologies made it possible to conduct transactions halfway around the world in the blink of an eye. Savers gained the ability to diversify, while the largest borrowers could tap global pools of capital. As national financial markets grew more intertwined, cross-border capital flows rose from $0.5 trillion in 1980 to a peak of $11.8 trillion in 2007.
But the 2008 crisis exposed the dangers, with the globalized financial system’s intricate web of connections becoming a conduit for contagion. Cross-border capital flows abruptly collapsed. Almost five years later, they remain 60% below their pre-crisis peak.
This pullback in cross-border activity has been accompanied by muted growth in global financial assets (despite the recent rallies in stock markets around the world). Global financial assets have grown by just 1.9% annually since the crisis, down from 7.9% average annual growth from 1990 to 2007.
Should the world be worried by this decline in cross-border capital flows and slowdown in financing? Yes and no.
After the outsize risks of the bubble years, these trends could be a sign that the system is reverting to historical norms. As we now know, much of the growth in financial assets prior to the crisis reflected leverage of the financial sector itself, and some of the growth in cross-border flows reflected governments tapping global capital pools to fund chronic budget deficits. Retrenchment of these sources of financial globalization is to be welcomed.
But not all of the current retreat is healthy. Surprisingly, emerging economies are also experiencing a slowdown; the development of their financial markets is barely keeping pace with GDP growth. Most of these countries have very small financial systems relative to the size of their economies, and, with small and medium-size enterprises (SMEs), households, and infrastructure projects facing credit constraints, they certainly have ample room for sustainable market deepening.
A powerful factor underlying the drop in cross-border capital flows is the dramatic reversal of European financial integration. Once in the vanguard of financial globalization, European countries are now turning inward.
After expanding across national borders with the creation of the euro, eurozone banks have now reduced cross-border lending and other claims within the eurozone by $2.8 trillion since the end of 2007. Other types of cross-border investment in Europe have fallen by more than half. The rationale for the euro’s creation – the financial and economic integration of Europe – is now being undermined.
Current trends seem to be leading toward a more fragmented global financial system in which countries rely primarily on domestic capital formation. Sharper regional disparities in the availability and cost of capital could emerge, particularly for smaller businesses and consumers, constraining investment and growth in some countries. And, while a more balkanized financial system does reduce the likelihood of global shocks creating volatility in far-flung markets, it may also concentrate risks within local banking systems and increase the chance of domestic financial crises.
So, is it possible to “resetfinancial globalization while avoiding the excesses of the past? Successfully concluding the regulatory reform initiatives currently under way is the first imperative. That means working out the final details of the Basel III banking standards, creating clear processes for cross-border bank resolution and recovery, and building macro-prudential supervisory capabilities. These steps would go a long way toward erecting safeguards that create a more stable system.
But additional measures are needed. The spring meetings of the World Bank and the International Monetary Fund represent a pivotal moment for shifting the debate toward a second phase of post-crisis reform effortsone that focuses on ensuring a healthy flow of financing to the real economy.
A crucial part of this agenda is the removal of constraints on foreign direct investment and foreign investor purchases of equities and bonds, which are far more stable types of capital flows than bank lending. Many countries continue to limit foreign investment and ownership in specific sectors, restrict their pension funds’ foreign-investment positions, and limit foreign investors’ access to local stock markets. Eliminating these barriers would increase the availability of long-term financing for business expansion.
More broadly, officials in emerging economies should restart reforms that enable further domestic financial-market development. Most countries have the basic market infrastructure and regulations, but enforcement and supervision is often weak.

Progress on this front would enable equity and bond markets to provide an important alternative to bank lending for the largest companies – and free up capital for banks to lend to SMEs and consumers. Deepening capital markets would also benefit local savers and open new channels for foreign investors to diversify.
Given that Europe led the recent rise and fall of financial globalization, any effort to reset the system should focus on measures to restore confidence and put European financial integration back on track. The recent crisis in Cyprus underscores the urgency of establishing a banking union that includes not only common supervision, but also resolution mechanisms and deposit insurance.
Determining the right degree of openness is a thorny and complex issue for every country. Policymakers must weigh the risks of volatility, exchange-rate pressures, and vulnerability to sudden reversals in capital flows against the benefits of wider access to credit and enhanced competition. The right balance may vary depending on the size of the economy, the efficiency of domestic funding sources, and the strength of regulation and supervision.
But the objective of building a competitive, diverse, and open financial sector deserves to be a central part of the policy agenda. The ties that bind global markets together have frayed, but it is not too late to mend them.

Susan Lund is a principal with the McKinsey Global Institute.

Martin N. Baily, Chairman of the US President’s Council of Economic Advisers under Bill Clinton, is Bernard L. Schwartz Chair in Economic Policy Development at the Brookings Institution. 

April 11, 2013 7:14 pm
Markets Insight: Japan should heed lessons of Volcker’s war
The former Federal Reserve chairman knows well the limits of central bank powers
When Haruhiko Kuroda, the new governor of the Bank of Japan, announced a radical new form of quantitative easing this month, some pundits dubbed it his “Volckermomento. No wonder.

Just over three decades ago, Paul Volcker, then the US Federal Reserve chairman, leapt into the history books with a bold gamble to squeeze inflation out of the American economy by jacking up interest rates to a peak of 21.5 per cent. Now Mr Kuroda is engaged in another dramatic move – albeit this time to banish deflation. And, as before, it is a move that carries economic and political risks of the sort that central banks usually hate; hence that “Volckertag.

But as investors reel in surprise, there is a certain irony here: Mr Volcker himself is far from thrilled about this month’s policy shift. Of course, he does not want to criticise Mr Kuroda or any of his colleagues directly; that would breach central bank etiquette. But this week I chaired a debate at New York University with the former Fed chairman, and he could not hide his profound unease. “Central banks are no longer [acting like] central banks,” he warned, amid a discussion about Japanese and American monetary policy. “I think it gets dangerous when they lose sight of the basic function of the central bank.”

The key issue concerns what this “function” should be. In recent years, it has generally been assumed that a central bank’s core mandate is to keep inflation low and growth on track (and, in the case of the US, to deliver low unemployment too). Mr Volcker disagrees. “The basic function of a central bank is to defend the value of the currency,” he insists, arguing that central banks function most effectively when they focus primarily, if not exclusively, on that aim.

In theory, that “valuefunction is not at odds with other goals, such as hitting an inflation target or boosting growth. But in the current world, since central banks are now unleashing unorthodox measures to achieve those alternative growth and inflation mandates, they are increasingly losing sight of the “value function.

When central banks start gobbling up equities, long-term bonds or mortgage debt, for example, they risk damaging themselves and markets, Mr Volcker argues. “There are going to be big losses in central bank portfolios – you cannot assume that interest rates will remain low for ever ... the Federal Reserve [has now become] the world’s largest financial intermediary.”

Then there is political risk: the more central banks embrace unorthodox measures, the more politicians, investors and voters alike expect them to deliver magic tricks. In particular, Mr Volcker hates the idea now current in Japan – that central banks should deliberately stoke up inflation to boost growth. “The central bank is not an all-powerful tool,” Mr Volcker says. “Once you have the idea that a little bit of inflation is a good thing, it is very hard to get rid of it.”

Most investors – and some central bankers – will probably just shrug their shoulders; in today’s world, Mr Volcker is apt to sound like a cranky general obsessed with trying to fight the last war.

After all, there is little sign of increased price pressure in the US, let alone Japan, or any dramatic loss of currency credibility. Inflation expectations in the 10-year US Treasuries market tumbled to 2.4 percentage points this week, the lowest level for three months, and roughly in line with their levels in the past three years.

And while a survey this week showed three-quarters of households in Japan now expect prices to rise, this follows several years of deflation. Indeed, the sense of stagnation is so ingrained in Japan that it is widely assumed nothing short of “shock and awe” will shift the mood. It is also assumed that if – or whenprices pick up again, the BoJ will be able to reverse course with relative ease. So, too, in the US, where this week’s release of the Fed minutes showed the Fed governors were actively discussing future exit strategies, and were hoping this would be smooth.

But even if this backdrop makes it politically easy for policy makers to brush off Mr Volcker’s words, sometimes it is useful to at least reflect on the last economicwar”. After all, the battle that Mr Volcker fought three decades ago has left him keenly aware of just how fragile confidence in central banks can be. It has also taught him how limited a central banker’s powers really are.

Ironically, that is not a lesson Mr Kuroda himself needs to relearn; in private, the new BoJ governor is keenly aware of those two points (not least because of the structural impediments in Japan, of the sort that my colleague Martin Wolf described this week). But those investors snapping up Japanese and US assets today with such glee should note Mr Volcker’s words, even – or especially – if they are too young to have witnessed that original Volcker moment” with their own eyes.

Copyright The Financial Times Limited 2013.

Outlook 2013 - The Irreversible Trends Driving Gold to $10,000

Nick Barisheff, president and CEO of Bullion Management Group Inc.,

Part 1 of 3

Part 2 of 3

Part 3 of 3

Commodities daily

Friday, April 12 2013

Note from the editor

The chatter from Chile’s Cesco week

By Jack Farchy in Santiago

Even the horses seemed to have read the script at this year's Cesco week.

A horse race at the 2,000-strong gala dinner for the great and good of the copper industry in which each runner was named for one of the world’s largest copper mines, was won by “Esperanza” (in turquoise). The mine is one of a clutch of Chilean production sites whose 2013 output growth numbers contributed to a decidedly bearish tone at the gathering.

The miners, traders and hedge funds I spoke to were almost unanimous in expecting the copper market to be in surplus this year, next year and probably the year after.

But there the agreement stopped, with some expecting prices to be forced down to $6,000 a tonne (vs current prices of $7,500 and a high of $10,190 in 2011) while others believe that prices will stay at today’s levels.

Here is what I took away from the week:

Both Chinese demand and the Chinese stocking cycle are now positive for the market. Chinese end demand is recovering from a terrible 2012 in which copper demand saw zero growth or perhaps even contraction, although it is not growing at the dramatic pace it saw in the last decade. Copper consumption for the power grid is going strong; some other areas less so.

At the same time, last year’s destocking by consumers appears to have ended. And, as prices have fallen in the past month or so, bonded stocks in Shanghai are being drawn down. CRU, the consultancy, estimates the stocks stand at 700,000-720,000 tonnes, from a peak of more than 800,000. Some traders say the draw could be as much as 150,000. Chinese smelters have stopped exporting metal wherever possible – a flow that traders estimate will account for some 40,000 tonnes a month this year.

Premiums for copper in bond and CIF have leapt to about $100-$110 a tonne, the highest since early 2012, with CIF Shanghai heard to have traded as high as $120. Combine the improvement in China with the near-record bearish positioning of hedge funds in the market, and most people in Santiago this week were expecting a near-term short-covering rally.

But where were the Chinese? There was a noticeable dearth of Chinese delegates at Cesco week this year. In part that is likely to be because of the creation of new Asian copper conferences – “Asia Cesco week” in Shanghai in November and an Asian LME week in Hong Kong in June. It was also suggested that some Chinese traders had struggled to get visas. But without doubt the lack of Chinese participants added to the sense that they were unlikely to chase the market higher. And while most funds and traders are expecting a short-covering bounce, they are all planning to use it as an opportunity to get short. Targets on the downside are in the $6,200-$6,800 range by the end of the year.

Copper joins in the warehouse games. The rise in LME stocks to a 10-year high has been a major driver of the bearish thesis. This is largely reflective of the poor demand in China and Europe at the end of last year, as well as the improvement in supply. But it is also a result of the fact that warehouse companies – particularly Pacorini, owned by Glencore – have been offering incentives of more than $100 to deliver copper to their warehouses. In this sense, copper has become caught up in the game of stock accumulation behind long queues in the same way as aluminium and zinc have.

The response from the copper industry this week was less than delighted: Thomas Keller, chief executive of Codelco, the world’s largest copper producer, told me the situation was “prehistoric”. “It distorts the market. If the LME can do something about it, it would be welcome,” he said. Several of the world’s largest copper consumers were also vocally unhappy.

The warehousing incentives make the LME stocks more difficult to interpret, since they are likely to have drawn out inventory from other less visible locations.No consumer has any stocks of anything. All the stocks are visible,” said one large trader.

Woes of the mining industry part 1: what is the marginal cost? If there was one constant of Cesco week this year it was listening to mining executives bemoaning their lot. Costs – both operating and capex – are still rising rapidly because of falling grades, higher energy, water and labour costs, and strong producer currencies. CRU estimates that copper mining costs in Chile have increased 60 per cent since 2007, compared with 30 per cent globally. Nowhere is the trend clearer than Codelco, which saw a 57 per cent increase in cash costs between 2010 and 2012.

Nonetheless, those costs remain low relative to current prices, with Codelco’s overall cash costs at $1.635 a pound ($3,604 a tonne) – leading some investors to argue that prices have much further to fall. But references to cash costs are increasingly falling out of favour among mining executives, as they recognise that there is a significant additional cost involved in simply keeping production constant from one year to the next. Several miners’ internal models now predict “long-term” prices of more tan $3 a pound ($6,600 a tonne); Wood Mackenzie sees long-term prices at $3.50 ($7,716 a tonne).

Woes of the mining industry part 2: will no one rid me of this troublesome asset? Pinto Valley (BHP Billiton), Northparkes (Rio Tinto), Frieda River (Xstrata) . . . for an industry that professes itself to be bullish copper, the miners are certainly trying to sell a lot of assets. One trader described the sell-off of assets (which spreads well beyond copper to coal, aluminium, nickel and other commodities) among the major miners as a “firesale”. But many suspect that, as in previous cycles, the miners are selling close to the bottom of the market. As one senior trader said: “In the medium term, they are so wrong.”