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Cross-Border Lending and Investing Slows, But May be More Sustainable

By Bill Camarda

There has been a substantial retrenchment in cross-border lending and investing over the past decade, particularly in Europe, according to a new report by the McKinsey Global Institute. But McKinsey also suggests that the world may be returning to a "potentially more stable and risk-sensitive era of financial globalization," which may offer a firmer foundation for sustainable long-term growth.1

Moreover, as researchers from the International Monetary Fund (IMF) recently noted, even as cross-border lending and investing have declined, certain international trade connections have actually deepened due to the growth of regional cross-border finance by in-region institutions, i.e., not based in the U.S., U.K., or Europe. The IMF notes these regional linkages could improve resiliency by reducing dependence on core global lenders.2

 

Cross-Border Lending and Investing Down by Nearly Two-Thirds

 

McKinsey's report begins with a striking statistic: gross cross-border lending and investing (i.e., capital flows) plummeted by 65 percent between 2007-2016, as measured against global GDP.3 Together, Foreign Direct Investment (FDI), purchases of bonds and equities, lending, and other cross-border investments currently represent just 4.3 percent of global GDP. That's down from 12.4 percent in 2007, and it's roughly the same level as in 2004, just after foreign capital flows began to soar.4

 

Since 2007, there has been an especially sharp contraction in cross-border lending, especially from banks within the Eurozone. These banks' foreign loans and claims are down by roughly $7.3 trillion, with the decline roughly split between lending inside and outside the Eurozone.5

 

Recent research published by the Bank for International Settlements also notes the disproportionate impact of Eurozone bank retrenchment on total global cross-border lending . A June 2017 BIS working paper shows that "the shrinkage of cross-border claims around the world originates in Europe… European banks uniquely restored their capital ratios through asset shrinkage, and foreign claims bore the brunt of it."6

 

BIS researchers point to several reasons why banks retreat to their home markets, including lower expected returns abroad, higher risk aversion, policy choices shaped in the context of support they may be receiving from home governments, and unconventional monetary policies intended to promote domestic lending.7

 

McKinsey also calls specific attention to Basel III rules now coming into effect. Though Basel III doesn't explicitly penalize cross-border lending, "the extra capital buffer that must be held by the largest systemically important financial institutions… is an additional incentive for scaling back and reducing the complexity that global operations create."8 The Institute of International Finance notes that tightening Basel III capital requirements "could accentuate de-risking trends by global banks… with [especially] adverse impacts on cross-border capital flows into emerging markets."9

 

Reductions in cross-border lending, while widespread, haven't been universal. Banks from China, Canada, Japan, and certain other developing and advanced economies have actually expanded foreign lending over the past decade, though McKinsey is uncertain whether this expansion will be profitable and sustainable.10 Moreover, as IMF's research has discovered, countries located at the periphery of global finance are becoming more connected on a regional basis, as new "non-core" cross-border lenders gain prominence through targeted regional expansion.11 Using a variety of technical measures, IMF has identified deepening regional roles for financial institutions in China, Australia, Brazil, Hong Kong, Singapore, Canada, and India.12

 

Less Volatile Cross-Border Capital Flows Increase in Prominence

 

With cross-border lending down overall, "less volatile FDI and equity flows now command a much higher share of gross capital flows" than before the 2007-2008 financial crisis, McKinsey notes.13

 

In fact, the overall proportion of global foreign investments to GDP hasn't changed much since 2007, and it's far higher than in 2000.14 Since the turn of the century, the proportion of bonds and equities owned by foreign investors has risen from 17 and 18 percent to 27 and 31 percent, respectively.15 The McKinsey report considers this to be additional evidence that some form of financial globalization is here to stay.

 

McKinsey attempts to quantify national economies' integration into the global financial system through its new Financial Connectedness Ranking. Unsurprisingly, it finds that advanced economies and international financial centers are the most highly integrated; the list is topped by the U.S., Luxembourg, the U.K., Netherlands, and Germany. But it also finds that China has risen from 16th to 8th, and other developing countries are also becoming increasingly embedded in the global economy.16

 

As the global economy has regained strength, imbalances of current, financial, and capital accounts have fallen from 2.5 to 1.7 percent of global GDP, and developing countries have once more become net recipients of cross-border lending and investing.17

 

Taken together, McKinsey believes, these trends could augur well for a new era of financial globalization that is more stable, risk-aware, and inclusive, noting: "We are beginning to see global finance broaden to a larger number of countries and players, many of them developing economies that are becoming more financially connected."18

 

Significant Cross-Border Finance Risks Still Remain

 

McKinsey acknowledges that significant potential risks remain. While cross-border lending represents a smaller percentage of overall capital flows, it remains volatile: "Over 60 percent of countries experience a large decline, surge, or reversal in foreign lending each year."19 That, in turn, drives volatility in exchange rates and undercuts macroeconomic stability.20

 

McKinsey notes that "equity-market valuations have reached new heights," in some places exceeding economic growth rates.21 The continuing interconnectedness of worldwide markets means financial contagion is always possible. So, too, while new financial centers are emerging, not all of them offer sufficient transparency and oversight.22

 

While FDI may be less volatile than cross-border lending, it too can be volatile. The United Nations Conference on Trade and Development (UNCTAD) reports that global FDI flows fell 13 percent in 2016, dropping 29 percent in Europe while rising 38 percent in transition economies, notably Kazakhstan and the Russian Federation.23

 

Finally, even if markets stand on a more secure footing, change remains relentless. Like other observers, McKinsey believes new digital platforms, blockchain technologies, and the growth of machine learning may create new ways for capital to flow across borders, and to widen participation in capital markets.24 For example, McKinsey estimates that blockchain-based clearing and settlement could save $50-$60 billion in B2B cross-border payment costs, and blockchain might enable rapid growth in international small-scale peer-to-peer lending.25

 

In such a cross-border financial environment, banks will face new risk management and competitive challenges, McKinsey says. Regulators, too, will need to keep pace with technology, develop new tools for managing volatility, and build more resilient global architectures for managing large-scale financial risk.26

 

The

Takeaway:

Since 2007, global cross-border lending and investing have experienced sizable overall declines, especially those involving Europe. But, according to McKinsey, financial globalization "is still very much alive – and could prove to be more stable and inclusive" in the coming years.27

Bill Camarda - The Author

The Author

Bill Camarda

Bill Camarda is a professional writer with more than 30 years’ experience focusing on business and technology. He is author or co-author of 19 books on information technology and has written for clients including American Express Private Bank, Ernst & Young, Financial Times Knowledge and IBM.

Sources

1. The New Dynamics of Financial Globalization, McKinsey Global Institute; https://www.mckinsey.com/industries/financial-services/our-insights/the-new-dynamics-of-financial-globalization
2. “The Global Banking Network in the Aftermath of the Crisis: Is There Evidence of De-globalization?” Eugenio Cerutti and Haonan Zhou, International Monetary Fund; http://www.imf.org/en/News/Seminars/Conferences/2017/06/21/~/media/7F71063B46804E57A6BEA6752D8A452D.ashx
3. The New Dynamics of Financial Globalization, McKinsey Global Institute; https://www.mckinsey.com/industries/financial-services/our-insights/the-new-dynamics-of-financial-globalization
4. Ibid.
5. Ibid.
6. “BIS Working Paper No. 650: Financial deglobalisation in banking?” Bank for International Settlements; http://www.bis.org/publ/work650.pdf
7. Ibid.
8. The New Dynamics of Financial Globalization, McKinsey Global Institute, ii. https://www.mckinsey.com/industries/financial-services/our-insights/the-new-dynamics-of-financial-globalization
9. “Basel Capital Reforms: Impact on Emerging Markets,” Institute of International Finance; https://www.iif.com/system/files/cf_em_impact_study_vf_0.pdf
10. The New Dynamics of Financial Globalization, McKinsey Global Institute, ii. https://www.mckinsey.com/industries/financial-services/our-insights/the-new-dynamics-of-financial-globalization
11. “The Global Banking Network in the Aftermath of the Crisis: Is There Evidence of De-globalization?” Eugenio Cerutti and Haonan Zhou, International Monetary Fund; http://www.imf.org/en/News/Seminars/Conferences/2017/06/21/~/media/7F71063B46804E57A6BEA6752D8A452D.ashx
12. Ibid.
13. The New Dynamics of Financial Globalization, McKinsey Global Institute; https://www.mckinsey.com/industries/financial-services/our-insights/the-new-dynamics-of-financial-globalization
14. Ibid.
15. Ibid.
16. Ibid.
17. Ibid.
18. Ibid.
19. Ibid.
20. Ibid.
21. Ibid.
22. Ibid.
23. “Global FDI Flows Slip In 2016, Modest Recovery Expected in 2017,” United Nations Conference on Trade and Development; Global Investment Trends Monitor. http://unctad.org/en/PublicationsLibrary/webdiaeia2017d1_en.pdf
24. The New Dynamics of Financial Globalization, McKinsey Global Institute; https://www.mckinsey.com/industries/financial-services/our-insights/the-new-dynamics-of-financial-globalization
25. Ibid.
26. Ibid.
27. Ibid.

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