Globalization backlash and capital flow headwinds

The last twenty years has seen a significant ebb and flow in financial globalization. Global capital flows increased significantly up to the financial crisis only to decline with global recession. The deleveraging by banks and financial institutions has placed a damper on flows so that they have not returned to pre-crisis levels. There has been a backlash to financial globalization.

Chart 2 shows the drop-off in gross and net capital flows. These are much larger than 20 years ago but are flat for the post crisis period.

Gross flows to emerging markets are at similar levels to the mid-200 period. Advanced economies are  where the declines have been most dramatic.

However, declines in financial globalization also is connected with polices and the currency wars now occurring across countries. It in not just private capital flows responding to a crisis and now being more conservative. It is a changing market structure making it more difficult to invest abroad. We can describe at least five reasons for the deglobalization in financial markets. Some of the reasons are not going to change in the near-term because they are structural.

• Bank regulation to keep money at home 
• The push toward lower interest rates
• Lower global growth
• The difference in sovereign ratings
• The push toward capital controls 

The increase in capital requirements on banks means that there will be less money to invest around the world. Banks can be awash with excess reserves, but lending will be constrained given the new risk weighting from Basel III and the desire to stay liquid. The rules of the game are structured for banks to hold less risky and smaller loan portfolios.

The reduction in global lending is also an artifact of the low and equal rates around the world. If there is no rate differentials, there will be smaller flows of money in and out of countries. Money will flow in response to return differences.

The slower growth in emerging markets and around the world in general will mean less lending around the globe. The elasticity of lending  to growth can be flexible but the direction is clear. Slower growth will cause slowing in global lending.

Differences in sovereign ratings. There was a general increase in ratings around the world pre-financial crisis. That lifting in credit quality has reversed or at least stalled, so lending around the world has become a riskier affair.

The push to capital controls as a means of controlling credit and growth has become more acceptable relative to pre-crisis thinking. If interest rates are zero, there have to be other means of controlling credit employed by police-makers. Capital controls are becoming more acceptable as a means of reducing capital movement.

The world of finance is in for continued slow growth in capital flows. The backlash and headwinds are unlikely to change in 2015.