FINANCIAL GLOBALISATION AND GLOBAL CRISIS
Before discussing financial globalisation and the global financial crisis, we first look at the dynamics of financial globalisation and the general benefits and risks with respect to financial globalisation.
The dynamics of financial globalisation
Financial globalisation (FG), viewed as the totality of all global linkages through cross-border capital flows, has become an increasingly important aspect for emerging economies as they integrate with more-developed economies. FG is seen as the net financial flows measured as the aggregate of foreign assets and foreign liabilities to GDP ratio (Lane & Milesi-Ferretti, 2007). FG is relevant to an emerging economy for a number of reasons:
• The changing composition of the national balance sheets, whereby the
foreign financial assets either exceed or fall below the foreign financial
- • The role of FG in the transmission of shocks caused by global financial crises.
- • The contribution of FG to the economic development of a nation.
- • International risk management (through sharing) and smoothing business cycles.
- • The overall implication of FG effects on the macroeconomic and prudential policies at national, regional, and global levels.
Yeyati and Williams (2014) argue that despite the common notion that financial globalisation (also referred to as the IFI ratio) has been increasing in emerging economies since the mid 1980s with an acceleration in the 2000s, there has only been a marginal growth, and international portfolio diversification has been limited and on the decline over time. Using an FG proxy controlled for financial market deepening and relative price effects, Yeyati and Williams revealed a more stable FG pattern during the 2000s. Lund et al. (2017) find that developing countries are becoming more and more financially globalised and that the share of foreign assets of developing countries rose from 8% to 14% in the last decade.
Cross-border capital flows have dropped by 65% since the global financial crisis (GFC). This is potentially because global banks took strict measures such as retrenchment. The decline could also be due to the stability of the FG, which seems to be emerging over time (Lund et al., 2017). An interesting observation is that despite the retrenchment by global banks and a cut in diaspora remittances, FG still continues.
During the period 2006-2007, FG seemed to be strong and was creating more robust financial linkages across the globe. Advanced economies benefited more from this, while emerging economies adopted a more cautious approach. This disparity in the experiences of FG by both advanced and emerging economies would later be tested by the GFC, which was sparked in 2008 and which highlighted the properties of FG in a real setting.
In 2007, the global inventory of foreign investments stood at USD103 trillion, which had increased to USD132 trillion by 2016. There is also evidence of vibrancy in the financial and capital markets globally, with 31% of the bonds owned by foreign investors, up from 18% in 2000. There is a notable increase in China's total stock of foreign bank lending, FDI, and portfolio equity and bond investments.
Although FG is expected to affect asset prices, the economic performance of any nation depends on the actual intensity and sensitivity of cross-border capital flows despite existing controls and restrictions. Many closely regulated economies act as important recipients and sources of foreign capital flows. They are therefore more financially globalised and are even more exposed to any global financial crisis that may hit them. However, liberal economies are regarded as risky by international investors, who tend to avoid them. These economies become locked out of the global market swings and trends. This explains the mixed effect of the 2008 GFC on various economies: some are most affected (e.g. the US, Venezuela, Iceland) and others are least affected (e.g. the United Arab Emirates, Armenia, Morocco).
The benefits and risks of financial globalisation
The new dispensation of FG presents interesting challenges and opportunities. FG is beneficial for an emerging economy. Flowever, it can also be costly for emerging economies. First, FG is responsible for the financial deepening of local markets by way of availing credit to the private sector and equity. FG can also help in risk sharing by countries in the long term. FG can serve as a useful tool in international risk sharing as a way of hedging consumption against local income shocks emanating from a specific nation.
Some of the positives of the new era of FG include the following:
- • There is a remarkable increase in FDI and equity flows, which command a higher share of gross annual financial flows than they did during the precrisis period.
- • Global current, financial, and capital account imbalances have reduced significantly from 2.5% of world GDP in 2007 to 1.7% in 2016. This means the global financial system is less vulnerable to shocks, which led to the GFC of 2008. This, coupled with the dramatic reduction in the huge US deficit and Chinese surplus, has contributed to a reduction of the potential impact that a small spark can have in the global financial space.
- • Financial institutions across the world have improved cushions to offset future losses. Most banks now have stronger risk management systems.
Despite the benefits that FG presents in the postcrisis period, there are risks that come with it. Some of the risks presented by the new dispensation of FG: 
FIGURE 7.2 Benefits and risks of financial globalisation
Source: Authors' construction strategies adopted by the banks that should foster long-term sustainability. Regulators are also expected to build systemic risk-monitoring capabilities with real-time react capabilities to any economic shocks originating from inside or outside the nation's borders. Innovative tools for managing capital market volatility and reducing the imbalance between capital and financial accounts need to be devised.
Financial globalisation and the global financial crisis
The question whether financial globalisation materially contributed to the GFC remains debatable. Did the rise in cross-border capital flows exacerbate the GFC? What role did FG play in the aftermath of the crisis? When the global financial crisis happened, it was a litmus test for the financial globalisation model. Since financial globalisation operates through a determination of asset prices and responsiveness of funds flows to shocks, any foreign capital flows may be affected by any shocks in the market.
Arguably, the participation of foreign investors, mainly foreign banks, fuelled the crisis. This was more so with the growth of asset-backed securities markets in the US, which were pivotal to the precrisis experiences in 2007-2008. Bernanke, Bertaut, DeMarco, and Kamin (2011) note that the financial institutions, especially banks in Europe, were the major purchasers of asset-backed securities. They would obtain large dollar funding from the US money market. The immanent risk in these transactions was the exposure of European parent banks to any volatility in case a small spark arose in the global financial services.
FG led to the speedy growth of the balance sheets of many banks. Globally active banks grew rapidly in size and complexity. This made it even more difficult for national regulators and central banks to sufficiently monitor their risk profiles. Credit growth plummeted in most countries due to the ability of local banks to lend owing to an upsurge in the cross-border capital flows. Emerging markets growth may have fuelled the buildup of weaknesses in global credit markets. This may have led to a securitisation boom. Given all these factors, credit markets became vulnerable that occasioned the GFC. In a way, FG magnified the impact of the possible causes of the crisis, such as weaknesses in credit market regulation and the upsurge of financing activities, which were largely unregulated. In the aftermath of the crisis, global productivity slowed down.
Several proposals have been made to reform the global financial architecture, focusing more on the two Bretton Woods institutions - the IMF and the World Bank. The next section discusses these proposed reforms in the global financial architecture.
REFORMING THE GLOBAL FINANCIAL ARCHITECTURE
The global financial architecture in the 1980s and 1990s operated largely in an unorganised manner, one in which institutions, especially the Bretton Woods institutions, came under serious criticisms from both the left and the right of the political spectrum. The conditional, policy-based lending at the time was central to these criticisms from the left. Spratt (2009) identified the major criticisms of these institutions:
- • The Bretton Woods institutions, particularly the first two (i.e. the IMF and the World Bank), were dominated by developed countries, which tended to influence the policies with respect to lending programmes of these institutions.
- • The so-called Washington Consensus of economic policy prescriptions (mostly seen as neoliberal policies) were regarded as serving the interests of Western countries. Box 7.4 explains the Washington Consensus.
- • The two Bretton Woods institutions seem to have a one-size fits-all method for addressing issues in developing countries. They were accused of using the same template for all countries, irrespective of the economic conditions.
- • The influence that the IMF and the World Bank wielded gave them much power to compel countries to implement these reforms, since they were conditional to qualify for financial support. The Bretton Woods institutions seemed to have no consideration for the concerns of citizens of these countries and the social implications of their reforms.
- • The Bretton Woods institutions' lending programmes led to developing countries' carrying high levels of debt.
These left-wing critics contend that policies of the IMF and the World Bank have contributed to the high poverty levels in developing countries, especially in regions like Latin America and sub-Saharan Africa that implemented these reforms. Asia seemed to have been least affected by the conditionality associated with SAP, and therefore, the poverty reduction that the region experienced could not be attributed to the reform policies the IMF and the World Bank prescribed.
BOX 7.4 The Washington Consensus
The Washington Consensus consists of ten economic policy prescriptions, which are considered to constitute the 'standard' reform package to address financial crises and determine policy to ensure economic development in Latin America, Southeast Asia, and other developing countries. The term was originally used by John Williamson, the English economist, at a conference at the Institute of Development Studies in 1989. Williamson's use of the term 'Washington Consensus' was meant to capture the common understanding among policy advice by Washington-based institutions, particularly the IMF, the World Bank, and the US Treasury Department. The Washington Consensus was meant to promote free trade, floating exchange rates, free markets, and macroeconomic stability and became the basis of the SAPs and for that matter the lending conditions by the IMF and the World Bank.
The general principles originally stated by Williamson (1990) in 1989, included ten specific policy areas:
- 1 Fiscal discipline (with avoidance of large fiscal deficits relative to GDP).
- 2 The redirection of public expenditure priorities ('especially indiscriminate subsidies') toward broad-based provision of key pro-growth, pro-poor services like primary education, primary healthcare and infrastructure investment.
- 3 Tax reform (broaden the tax base and adopt moderate marginal tax rates).
- 4 Interest rate liberalisation (interest rates that are market determined and positive but moderate) in real terms.
- 5 Competitive exchange rates.
- 6 Trade liberalisation (liberalisation of imports - emphasising the elimination of quantitative restrictions, such as licensing - and any trade protection to be provided by low and relatively uniform tariffs).
- 7 The liberalisation of foreign direct investment inflows.
- 8 The privatisation of state-owned enterprises.
- 9 Deregulation (i.e. abolition of regulations that impede market entry or restrict competition, except for those justified on safety, environmental, and consumer protection grounds, and prudential oversight of financial institutions).
- 10 Legal security for property rights.
After publishing the list of policy prescriptions, advocates of neoliberalism deployed the term 'Washington Consensus' for their own purposes. Williamson (1999) recognised that the term was being used according to a different interpretation from the original prescription he provided. He opposed the alternative use of the term that became commonly known as 'neoliberalisation' in Latin America or 'market fundamentalism'.
Williamson (2000) realised that his 1989 policy design was flawed in the sense that it ignored financial supervision, without which financial liberalisation could result in poor lending and ultimately crisis, requiring the taxpayers to bear the costs. He argued that looking beyond the policy prescriptions based on the Washington Consensus was necessary, by focusing on the important role of institutions in addition to policies that promote equity in income distribution as well as rapid growth in income.
There have also been strong arguments made by the right that criticise the Bretton Woods institutions. These institutions arguably tend to represent some form of pseudo-world government in the making and have no legitimacy. The IMF in particular prescribes policies that seem to be counterproductive. Again, according to right-wing critics, the presence of the IMF encourages moral hazard among borrowing countries and the lending institutions. Both borrowing countries and lending institutions may engage in irresponsible and careless behaviour, knowing that in the event of a crisis, the IMF will be present to provide a bailout plan (Spratt, 2009).
These were some of the issues that invited a number of proposals and recommendations for reforming the global financial architecture, after the Asian crisis. In spite of the recommendations for reform, the global financial crisis that was set off in 2008 brought to the force major weaknesses in the precrisis global financial architecture that was meant to prevent, manage, and resolve crises in the international financial system. We discuss some of these proposals for reform made before and after the global financial crisis.
Earlier proposals on reform
First, the Bretton Woods Committee Report (1997) suggested that the Bretton Woods institutions, particularly the IMF and the World Bank, need to be more transparent regarding information about their operations and also pay particular attention to addressing legitimate public concerns. Second, the UN Report (1999) made a number of recommendations for reforming the global financial architecture:
- • The need for improved consistency (and complementarity) of macro- economic policies at the international level, including public scrutiny of the policies and operations of the central banks and the IMF.
- • Reforming the IMF to be able to provide for adequate international liquidity in times of crisis.
- • The adoption of improved codes of conduct and financial supervision at both the national level and the international level, in the interests of borrowers and creditors.
- • The preservation of relative autonomy of capital account issues in developing countries for the appropriate regulation of short-term capital flows or avoidance of sudden capital reversals.
• Providing time-bound and time-focused debt rescheduling, where and when necessary, rather than protracted and chaotic debt renegotiations that aggravate the costs of a debt crisis to borrower countries.
The International Financial Institution Advisory ('Meltzer') Commission, appointed by the US Congress in 1998, which submitted its report in 1999, also made certain recommendations. The Meltzer Commission Report (1999) noted that the operations of the World Bank were associated with high cost and low effectiveness. The IMF also paid little attention to the financial structure of developing countries, as its short-term crisis management was considered costly. Its responses were considered too slow, its advice inappropriate, and its efforts at influencing policy and practice intrusive (Rao, 2003). The Meltzer Report focused on eliminating moral hazard associated with the IMF, which was considered as the main cause of reckless borrowing. The commission proposed several reforms, specifically to the functioning of the IMF, to address these problems, though the report also considered the role of the World Bank, the RDBs, the WTO, and the BIS. The role of the IMF in particular was seen as relevant to avoiding financial crises and resolving crises that may occur.
Other reports included the Geneva Report (1999) and the Overseas Development Council Report (2000). Williamson (2000) reviewed the findings of these various reports and made the following recommendations:
- • The IMF should narrow its activities and focus more on its core competencies in the areas of surveillance and ensuring macroeconomic stability among member countries.
- • The IMF's surveillance should take the form of surveilling the world economy its member countries.
- • The IMF should focus on the role of being a lender of last resort to member countries affected by crisis, and countries should have to 'prequalify' for assistance, instead of the conditionality, which is linked to IMF lending.
- • The World Bank and the RDBs need to concentrate on providing technical assistance and public goods and facilitating private sector flows to middle-income countries. They should replace loans going to developing countries with grants, with the condition that the recipient countries have a good record of delivery.
Proposals on reform after the global financial crisis
The global financial and economic crisis of 2007-2010 exposed the flaws in the precrisis global financial architecture in terms of its implementation and structure. Looking back, the warning signs were quite clear, given the policy lapses and wrong judgements. Schinasi and Truman (2010) argue that the global financial architecture, in terms of structure and implementation, was not effective in advancing corrective measures at the national, regional, continental, or global level until the global financial system was affected by a full-scale global crisis. Elson (2017) suggests that the global financial crisis has raised questions regarding the effectiveness of the global financial architecture's crisis-prevention capabilities, and clear defects can be identified in its international guidelines for financial regulation, international policy coordination, the oversight of global financial stability, and the global financial safety net. Even though some improvements have been made in reforming the global financial architecture as well as the Financial Stability Board (FSB), a significant number of reforms are still needed to enhance the ability to safeguard global financial stability and address global crises. The FSB, as an international body, exists to promote global financial stability by ensuring that the development of regulation and the formulation financial sector policies are well coordinated. Box 7.5 provides a profile of the FSB.
BOX 7.5 Financial Stability Board
The Financial Stability Board (FSB) was founded in April 2009 and is responsible for monitoring and providing advice concerning the global financial system. It was created to succeed the Financial Stability Forum (FSF), which was established in 1999 by the G7 ministers of finance and governors of central banks in line with the recommendations that Dr Hans Tietmeyer, president of the Deutsche Bundesbank, gave. Dr Tietmeyer was commissioned by the G7 to propose new structures to enhance cooperation among the various international and national supervisory bodies and IFIs in order to ensure the promotion of global financial system stability.
He recommended the setting up of a FSF that was endorsed in February 1999 at a meeting by G7 ministers and governors in Bonn. The first FSF was convened in Washington, DC, in April 1999. In November 2008, the G20 countries' leaders asked for an expansion of the FSF to enhance its effectiveness. The membership of the FSF was expanded and re-established as the FSB. This was announced at the G20 Leaders' Summit in April 2009.
The FSB was established to specifically carry out the following functions:
- • Assessing vulnerabilities affecting the global financial system and identifying and reviewing, on a timely and ongoing basis in a macro prudential perspective, the regulatory, supervisory, and related actions needed to address these vulnerabilities and their outcomes, promoting coordination and information exchange among authorities responsible for financial stability.
- • Monitoring and providing advice on market developments and their implications for regulatory policy
- • Monitoring and providing advice with regard to best practice in meeting regulatory standards
- • Undertaking joint strategic reviews of the international standard setting bodies and coordinating their respective policy development work to ensure this work is timely, coordinated, focused on priorities and addresses gaps.
- • Setting guidelines for establishing and supporting supervisory colleges.
- • Supporting contingency planning for cross-border crisis management, particularly with regard to systemically important firms.
- • Collaborating with the IMF to conduct early warning exercises.
- • Promoting member jurisdictions' implementation of agreed commitments, standards, and policy recommendations, by monitoring the implementation and through peer review and disclosure.
It is composed of a Steering Committee and three Standing Committees, (i.e. Standing Committee on Supervisory and Regulatory Cooperation [SRC)], Standing Committee on Assessment of Vulnerabilities [SCAV], and Standing Committee on Standards Implementation [SCSI]).
The FSB certainly has a significant role to play to promote stability in the global financial system. Strict adherence to and implementation of the international standards by members of the FSB is critical to achieving the overarching objective of international financial stability.
-  The volatility of gross foreign capital flows increased. According toLund et al. (2017), over 60% of the countries experience a huge decline,surge, recovery, or reversal of lending yearly. This has led to volatilityin exchange rates and has led to difficulties in managing macroeconomic fundamentals. • A potential bubble in equity market valuations may emerge. This isdue to the increased valuations on equity markets in some markets. • Financial contagion risk is now becoming immanent because moreand more countries are participating in the global financial architecture. The risk may be more prevalent in developing and emergingeconomies, which are characterised by insufficient transparency andliquidity in their financial markets. The response to the new dynamics in FG can be met by embracing technologies in banking to increase efficiency, improve customer experience, andinnovate. The use of big data analytics and machine learning algorithmsmay help in understanding the risks much better in an international marketcontext. Domestic banks must also remain alert to being de-risked in thewake of closer scrutiny and transparency requirements in the global financialservices space. This also translates into looking again into the international