It goes without saying that the 2008 financial crisis altered the way capital flows between countries. Cross-border capital flows fell by 60% between 2007 and 2012. We now have enough perspective to evaluate how this might affect future flows to emerging economies.
Risk perceptions altered dramatically in 2008. It no longer seemed a good idea to buy Greek bonds at more-or-less the same yield as German bonds. Lending to Irish or Spanish home-builders or American NINJAs (no income, no job or asset) was no longer a viable business plan. Within the financial sector, counterparty risk (the financial institution you were dealing with might go broke) was belatedly recognised. Over-leverage (having almost no capital to absorb shocks to asset values) ceased to be a smart way to make big profits. In short, sanity returned to financial markets and the fall in capital flows reflects this.
The private capital flows which had funded the excessive external deficits of the European peripheral countries dried up, although the impact was softened a little by official flows from the various rescue operations. European banks rapidly retreated from international markets as they deleveraged, abandoning the large funding role they had played in emerging countries.
Traumatic though this was for the players in global finance, the impact on emerging countries has turned out to be modest. The best evidence for this is the continuing rapid growth in most emerging economies, sustained by domestic saving, with minimal reliance on external capital. The earlier inflows had often been in excess of overall funding requirements, with the surplus going to build up foreign exchange reserves.
Foreign direct investment (FDI) is the component that matters for economic growth: this continued to flow, largely unabated, through the 2008 drama. Banks in countries not much affected by the crisis (eg. Japan) stepped in to partially replace the retreating European banks. More remarkably still, the crisis prompted more domestic companies to issue bonds rather than rely on banks. Korea, for example, was able to replace bank inflows with bond raisings. [fold]
As foreign fund managers started taking a harder look at Indonesian government debt or Korean bonds, they saw that these were safer than the debt of some advanced countries which, in the mindless optimism of the pre-2008 era, had been given high rankings by the credit rating agencies. Fund managers were also attracted by the 'search for yield'; easy monetary policy in advanced countries took interest rates close to zero, making emerging-economy yields look attractive.
There has been a perceptible shift in mind-set. Until 2008, advice on financial development followed the broad prescription of the Washington Consensus. Countries should rely on market outcomes, reducing restrictions and regulations. New entrants (especially foreigners) should be warmly welcomed as they enhance competition. The longer-term objective was to develop a full-service financial sector offering a wide range of financial products such as derivatives and forward markets. Capital market development would foster securitisation and financial engineering, effectively tapping into the flows of global capital.
In practice, the market-sensitive, short-term, volatile component of the inflow was of little use to emerging countries. They could not fund longer-term projects with this flighty money.
With the experience of the 1997-8 Asian crisis reinforced by the 'sudden-stop' capital reversals in 2008, the shrinking role of the banking flows should be seen as a plus rather than a minus. Countries will do better to create an attractive environment for FDI (emerging countries account for 38% of global GDP yet host only 7% of the global stock of FDI) and foster a deep government bond market with a stable yield curve which nurtures the corporate bond market. The over-arching aim is to link up the sources of longer-term overseas funding (for example, pension funds or sovereign wealth funds) with priority projects such as infrastructure. The objective is to attract 'patient' capital: investors who will stay put.
Private-public partnerships, which have been the centre of attention in multilateral development banks, will still find a place in this new environment, but they have often turned out to be overly complex in their legal requirements and disappointing in their ability to allocate risk sensibly. Old-fashioned instruments such as bonds (perhaps directed specifically at infrastructure funding) could be the new vogue.
Despite falling flows since 2007 and ongoing deleveraging, it seems unlikely that globalisation of capital is under threat in the way discussed in this McKinsey report. The big financial contraction reflected the excesses of the previous period. The need for longer-term funding is too pressing and the differential profit opportunities (dynamic emerging countries versus stagnating advanced countries) are too great. Of course the flows will not all be 'downhill' to the emerging economies. China's capital outflows are now substantial and 'south-south' flows are becoming more important. Closer integration of global financial markets seems irreversible.
Core elements of the Washington Consensus are still relevant: financial sectors in most emerging countries are still shallow and over-regulation stifles financial deepening. But more policy effort should go into fostering a simple but robust institutional structure, with legal certainty and high transparency. The G20, G30 and McKinsey reports reflect this shift in mood but there is a still a long way to go before this stronger institutional environment is in place.
Photo by FLickr user CaptSpaulding.