Banks and Cross-Border Capital Flows - Assignment Example

Lecturer: Introduction Financial globalization comprises the cross-border capital flows and total investments ofeconomies globally. In this view, it plays a significant role in spreading the risk and taking advantage of growth rate and interest rate differentials. Financial offshoring describes financial globalization in the context of a country utilizing its influence overseas to conduct business. Economies engage in financial globalization to enhance growth of their home capital markets and strengthen their liquidity. Nevertheless, small local financial markets may be negatively affected by increased capital inflows. Financial crises may spread through financial globalization such as the recent global recession caused by the 2007 subprime crisis in the US and 2008 banking crisis in Europe. This paper evaluates whether the process financial globalization has been significantly weakened by the recent global financial crisis that led to the collapse of world trade in a pace that has not been witnessed since the Great Depression in the 1930s. It also investigates if this constitutes a problem for the international financial system and the countries within it. The paper presents some practical suggestions for national and international financial regulators in the light of what has happened to financial globalization over the last five years (Ceballos, Didier and Schmukler, 2012). Impact of recent Global Financial Crisis on Financial Globalization The process of financial globalization in terms of Foreign Direct Investment, foreign bonds and overseas lending maintained a steady growth since early 1980s from a low of 0.5 trillion USD to a high of 1.8 trillion USD by 2007. However, this trend changed with the occurrence of the recent financial meltdown. With the high global financial linkage, the financial crisis was felt in many economies globally. The foreign capitals flows declined by 60% (Lund & Dobbs, 2013). Economies became more wary of their global financial assets after the global recession. The annual growth in equity market capitalization and purchase of foreign business and government bonds declined by 6% to 1.9% and has been the case in both developed and developing economies globally. Cross-border lending began to decline from a high of 5.6 trillion USD in 2007 to a low of 1.7 trillion USD in 2012. This decline is associated with the selectiveness of banks and narrowing the scope of global operations by banks as a result of fresh investment and regulatory requirements to caution domestic markets against financial risks. Most of the international commercial banks have disposed assets and suspended operations of over 700 billion USD since the financial crisis began in 2007 (Lund et al., 2013). International trade declined by 32% by the end of 2008 after the recent financial crisis. According to the World Trade Organization, the volume of exports dropped by 8% in 2009 and continued to decline in subsequent years, with exports from the developed economies reducing by 14% while those of the emerging economies reduced by 7%. The decline is associated with the drying up of financial credit as a result of the freezing of inter-bank credit market, collapse of asset-based and mortgage supported securities. Borrowers opted to use formerly approved loan commitments due to the high cost of lending. New loan applications significantly dropped as potential borrowers made efforts to regulate cash holdings. Generally, credit availability declined as banks made efforts to increase liquidity thereby negatively affecting international trade (Ceballos, Didier and Schmukler, 2012). The global financial crisis also led to the emergence of protectionism as a response to the ripple effect of the crisis, such as increased tariffs for used cars in Russia and China’s restrictive food standards that placed embargos on pork from Ireland among other trade barriers that have slowed international trade. People who felt economically insecure globally called upon their leaders to enhance protection against trade that they considered unfavourable. Foreign Direct Investment flows decreased from early 2009 to a low of 44%. A reduction in the access to capital and high cost of finance led to a decline in the investment capacity of firms. The financial crisis negatively affected the inclination to invest, particularly in the developed economies where the crisis began as multinational companies focused on limiting the cost of local and cross-border business (Brunnermeier et al., 2014). Developing economies were able to cope with the financial crisis although the development of financial markets slowed down after the crisis. The financial depth gap between the developed and emerging economies has remained high at 157% of GDP in emerging markets and 408% of GDP in the developed economies by 2012. According to (Lund et al. 2013) this gap is not expected to change soon. Nevertheless, capital flows in developing economies have recovered, with about 1.5 trillion USD being considered to have flowed in to them in 2012. These flows accounted for 32% of the international capital flows in 2012 compared to 5% in 2000. A short-lived slump in the flows was experienced in 2008, after which growth was restored in 2009 (Laura, 2013). Emerging economies have also increased investment asset outflows to a high of 1.8 trillion USD in 2012, many of which are established in other emerging economies. Problem for the International Financial System and Countries The impact of the recent global financial crisis on financial globalization affected the international financial system and the countries within it. It was varied across different economic consortiums globally. The UN categorised these groupings as; the developed countries that were largely the originators of the financial crisis especially the US through the 2007 subprime mortgages and UK in the banking crisis of 2008, the newly industrialized countries including China and India among others, developing countries. FDI in the developed economies declined significantly in 2008 while there was a notable increase in the FDI inflows to the developing economies. Cross border mergers and acquisitions declined after the financial crisis to a low of 39% leading to the changes in the FDI inflows to the developed economies (Lane and Shambaugh, 2010). According to UNCTAD (2009), the financial systems of developing economies had insignificant links to those of developed economies that were severely affected by the financial crisis and hence FDI inflows were maintained. Commodity prices rose and this could have positively influenced the financial systems of developing countries. Nevertheless, the growth experienced during and after the recession was lower than before, and in two years it began to decline. The general ranking of the leading host economies for FDI have changed as a consequence of the recent financial crisis. The US has remained the principal host and source of FDI globally, and hence the far reaching ripple effect of the 2007 financial crisis. The UK was unable to maintain its second position after the US in terms of FDI inflows and outflows. The international financial systems suffered as a result of decreased per-capita income as a result of as a result of closure of subsidiaries of multinational companies that contribute 30% of the global exports (Forbes and Warnock, 2011). The companies play a significant role in the global financial system having employed over 75 million workers by 2008. They were adversely affected by the recent financial crisis and lost their capacity to participate in FDI. The value of their overall production, turnover and human resource capacity in the various subsidiaries globally were negatively affected leading to massive job losses. Property prices in major host economies declined as many subsidiaries closed down while potential investors in FDI shunned making long term commitments fearing a recurrence of the financial crisis (Yeyati and Williams, 2011). Financial institutions of developing countries were affected differently on the basis of the extent to which they are associated with assets of businesses that were hard-hit by the sub-prime mortgages (Lane and Shambaugh, 2010). For example, the government controlled Chinese financial system continued to thrive because there exists a weak link to international financial institutions. However, the system has experienced secondary threat resulting from the downturn in the stock market as well as property prices. These in turn have caused a reduction in in the capital of banks and big companies that require significant amounts of capital in form of cash. Banks lowered lending in a bid to increase their capital which in turn lessened investments, lowered economic growth and intensified unemployment. As the world trade declined, the financial systems of developing countries were negatively affected since most of their economic growth is attached to export earnings that reduced by 7.3% in 2009. This was associated with low demand for export products from developing countries to developed economies and a significant decline in tourism (UNCTAD, 2009). Suggestions for National and International Financial Regulators It is important to enhance the regulation of the international financial system including the international banks that form the foundation of the global financial system. This requires effective data collection regarding the global activities of the banks. It is also important to develop strong analytical models of global financial system’s risk that are necessary in the interpretation of the data acquired for purposes of establishing protective policy responses (Lane and Shambaugh, 2010). Monitoring market discipline is a significant action that can be boosted through incentives to banks that will motivate them to avoid unwarranted risk taking and hence increased bank safety. It is also imperative to establish global resolution systems with the capacity to deal with catastrophes among the international banks. Development of sturdier safety nets is also a significant component of global policy reform. Even though the IMF has expanded in terms of resources, its lending capability has not been able to match the pace of cross-border commercial growth positions (UNCTAD, 2009). With the certainty of the problems associated with preventable defaults to the debtor economy as well as the contagion repercussions to the international financial system, it is important to maintain global liquidity establishment as a basic element in the global financial structure. On the other hand, the increasing magnitude of global balance sheets and the financial cost of shielding global liquidity facilities strengthen the significance of developing bailout structures that restrict ethical risk issues. It is necessary for the global financial system to be adequately equipped to handle insolvency cases of economies as well as banking systems. Along with international level institutional restructuring, establishment of regional institutions is necessary to deal with the increased financial integration in certain regions such as the euro region in Europe. These institutions can be useful in the enhancement of macro-economic and fiscal stability (Forbes and Warnock, 2011). National governments need to adapt policy structures that enhance handling of financial globalization since an occurrence of a widespread financial meltdown significantly affects the local financial system. Generally, national policy reforms need to be in line with the international financial reforms. Domestic bank policy structures that restrict systemic and financial budgets of failing banking institutions are necessary in the enactment of financial regulation in the local context (Forbes and Warnock, 2011). Nevertheless, effective establishment of macro-prudential frameworks that can control systemic risks remains a significant challenge to national governments. They must be prepared to dynamically implement a challenging macro-prudential structure. It is necessary to implement tax and governing policies that are not favourable to debt financing rather than equity financing to curtail unwarranted leveraging in the non-financial sector (Yeyati and Williams, 2011). Conclusion Foreign capital flows declined by 60% while international trade reduced by 32% by the end of 2008. Protectionism tendencies emerged as a response to the recession. Developed economies were hard-hit by the financial crisis compared to the developing economies. Financial institutions of developing countries were affected differently by the financial crisis depending on their global linkage with affected businesses. It is necessary to enhance the regulation of international financial system. Strong analytical models are also necessary to help avoid risks. Global resolution systems with capacity to deal with financial catastrophes are necessary. Stronger safety nets are also necessary through the global policy reform. National governments need to adapt policy frameworks that facilitate handling of financial globalization. References Brunnermeier, M., Gregorioa, J., Lane, P., Rey, H., and Shin, S., 2012. Banks and Cross-Border Capital Flows: Policy Challenges and Regulatory Responses, VoxEU, [online] Available at: [accessed 13 March 2014]. Ceballos, F., Didier, T., & and Schmukler, S., 2012. 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