Concern over cross-border capital flows
Since the global financial crisis, cross-border capital flows have steadily increased.
When globalization was at its zenith, huge rewards flowed to those who eliminated layoffs in global supply chains. It wasn’t until the pandemic hit – when lockdowns in Asia threatened the world’s supply of goods – that it became clear just how fragile the system could be. Global financial supply chains are equally crucial, but even less well understood. A similar shock may be in store.
Since the Global Financial Crisis (GFC), cross-border capital flows have steadily increased. In 2020, the stock of cross-border financial assets reached $130 trillion, an increase of almost 60% since 2007. Measured against global GDP, at 153%, they now exceed the peak just before the bankruptcy of Lehman Brothers.
As the scale of investment has exploded, its character has changed. The share of many European countries in the total has declined, while Asia’s share has rapidly increased. Emerging markets are also slightly larger. The biggest banks in the world are smaller, better capitalized and less international than they used to be. Cross-border bank lending stood at $34.6 trillion at the end of June, a fraction above its 2008 peak. In contrast, market finance rose significantly.
Insurers, pension funds and a host of unsavory financial intermediaries have become big international investors in their own right. An example is an alliance formed in 2020 between Algemene Pensioen Groep and National Pension Service, the largest pension funds in the Netherlands and South Korea respectively, which invested in a Portuguese toll road provider and in housing Australian students.
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Just as supply chains are a source of efficiency, cross-border investments combine investors in one part of the world who have capital to spare with investors in another who are eager to put it to use. The benefits trickle down to jobs and development. Everybody wins.
But there are dangers. Foreign investors, especially established institutions, may not understand how much risk they take. High-yield bonds today offer lower yields than ten-year Treasury bills before the financial crisis. This has pushed companies seeking higher returns towards riskier, illiquid and opaque assets. In economies with more savings than local investment opportunities, this often means heading overseas where investments are less secure and less well understood. Before the financial crisis, several German banks lost money when structured credit in America deteriorated in 2007.
Outside observers are no clearer about the risk than investors. Information on cross-border banking activities is extensive, in part because the Bank for International Settlements (BIS), which supports central banks, has collected data on the international claims and liabilities of traditional lenders since 1963. However, disclosure for other financial institutions is limited. By definition, cross-border investments involve issuers covered by regulators in one country and buyers covered by regulators in another. Often no one understands the risks. You can tell that the value of global portfolio investments has skyrocketed, but not specifically where they are invested or by whom.
Some investors will not correctly assess the risk of default. Others will overestimate the liquidity of their investment or its exposure to currency fluctuations. A potential example is the Formosa bond market, where international companies sell debt securities denominated in various currencies to Taiwanese life insurers. About $200 billion in bonds are outstanding, a total that has more than doubled in the past five years. Because there has been a lot of financial engineering, the debt is difficult to assess.
In March 2020, investors caught a glimpse of the dangers awaiting them. During the turmoil in dollar funding markets, major Asian institutions ratcheted up the pressure by rushing to hedge their exposures. Regulators are aware of the threat. In December, the bis warned against the opaque activities of non-banking financial institutions in the foreign exchange markets. The Financial Stability Board, a group of regulators, has also recently called for a better understanding of systemic risks. Whether investors are cautious enough is more doubtful.
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