The Metamorphosis of Finance and Capital Flows to Emerging Market Economies
Policy Center for the New South PP-24-21
The decade after the Great Financial Crisis of 2007–09 brought significant changes in the volume and composition of capital flows in the global economy. Portfolio investments and other non-bank financial intermediaries are responsible for an increasing share of foreign capital flows, while banking flows have shrunk in relative terms. This paper considers the implications of such a metamorphosis of finance for capital flows to emerging market economies (EMEs). After examining capital flows from the global financial crisis to the 2020-21 pandemic crisis, we analyze the extent to which a normalization of monetary policies in advanced economies may lead to shocks in those flows, as well as why exchange rate fluctuations between the U.S. dollar and other major currencies can affect capital flows to EMEs. Finally, we assess the range of policy instruments that EME policymakers tend to resort to manage risks derived from capital-flow volatility.
The decade after the Great Financial Crisis (GFC) of 2007–09 saw significant changes in the volume and composition of capital flows in the global economy. Portfolio investments and other non-bank financial intermediaries (NBFIs) are behind an increasing share of foreign capital flows, while banking flows have shrunk in relative terms. This policy paper studies the implications of such a metamorphosis of finance for capital flows to emerging market economies (EMEs).
Changes in capital flows accompanied structural shifts in financial intermediation in capital-source countries, with NBFIs increasingly shaping the demand for and supply of liquidity in financial markets. The channels of systemic risk propagation have changed with the higher profile acquired by NBFIs, with leverage fluctuations through changes in margins rising in weight.
Risks associated with capital flows to EMEs have changed accordingly. Foreign capital potentially brings benefits to emerging market economies (EMEs). However, wide swings in capital flows carry high risks to macroeconomic and financial stability, including the adverse effects of sudden stops to capital inflows and challenges faced by economies with weaker institutions and less-developed financial markets.
Capital inflows in emerging market economies are driven by both global and country-specific drivers. The abundance of global liquidity since the GFC has pushed investors to search for yield, with shifts in risk appetite becoming a source of fluctuations. On the other hand, changes in the macroeconomic fundamentals and institutional frameworks of EMEs have made investors more selective.
The weight of global factors came to the fore in the first half of 2020, when the financial shock in advanced economies caused by coronavirus outbreaks led to a substantive wave of capital outflows from emerging markets, with unprecedented speed and magnitude. The shock was mitigated subsequently by central banks’ counter-shock policy moves in source countries, as well as by EME policy tools in managing the risks associated with extreme shifts in capital flows.
This policy paper first examines the metamorphosis of finance and of capital flows after the GFC, up to the shock to capital flows to EMEs during the 2020-21 coronavirus crisis. Then we analyze the extent to which a normalization of monetary policies in advanced economies may lead to shocks in those flows, as well as why exchange rate fluctuations between the U.S. dollar and other major currencies can affect capital flows to EMEs. Finally, we assess the range of policy instruments that EME policymakers tend to resort to when managing risks derived from capital-flow volatility.
1. The Metamorphosis of Finance
1.1 Global Capital Flows After the GFC
After a strong rising tide starting in the 1990s, gross capital flows reached a peak with the GFC. Figure 1 (left panel) shows how inflows rose rapidly between 2002 and 2007, reaching US$12 trillion (close to 22% of global GDP). After falling steeply during the GFC, flows have trended sideways, never recovering their pre-GFC upward momentum.
Figure 1: Capital Flows by Type and Region (as % of world GDP)
Source: BIS (2021).
As detailed in Canuto (2017) and BIS (2021), the decade after the GFC (2007–09) brought substantial changes both in the volume and composition of global capital flows. When one excludes the significant flows to China, the volume declined globally.
The overall stabilization at lower flow levels has taken place alongside a deep reshaping of cross-border financial flows, featuring de-banking and an increasing weight of non-banking cross-border financial transactions. Sources of potential instability and long-term funding challenges have morphed accordingly.
The post-GFC descent in flows was pronounced for bank loans, which are classified among ‘other’ investment flows in Figure 1 (left panel). Portfolio debt and equity flows were also lower in the post-GFC period, while foreign direct investment (FDI) maintained its strength. Market-based sources of funding replaced banks, while foreign participation in the local markets of EMEs grew. On the borrowers’ side, banks were also substituted by corporates and public-sector entities.
The U.S. dollar has remained the dominant currency for cross-border operations and investments, but the currency composition of flows has become more diversified. As we will discuss later, that has consequences for EMEs.
Another change in composition accompanied the decline in global flows after the GFC, namely, a substantial decline in flows between advanced economies, while EMEs became more prominent as destinations. Financial globalization had mainly happened among advanced economies (AEs). Rising cross-border movements of financial assets from the mid-1990s was remarkable among AEs. Levels of financial openness (the sum of foreign assets and liabilities as a proportion of GDP) relative to trade openness (the sum of exports and imports as a proportion of GDP) were similar for both AEs and EMEs until the mid-1980s, when they shifted upward in the case of AEs, rising rapidly particularly after the mid-1990s (Canuto, 2017). Cross-border financial assets and liabilities went from 135% to above 570% of GDP after mid-1990s for AEs, whereas they moved from approximately 100% to 180% of GDP for EMEs.
The post-GFC global trend mainly reflects changes in flows to AEs, which corresponded to 18% of world GDP in 2007, and then moved down to below 7% after the GFC (Figure 1, right panel). Flows to financial centers comprised part of the trend increase before 2007 but became more volatile between 2009 and 2019. Although the share of world GDP of assets located in financial centers declined, they have remained ascendant over the past decade.
Such flows to financial centers have reflected the financial and tax strategies of multinational enterprises, aimed at minimizing costs and the tax burden. BIS (2021) called it the “financialization of foreign direct investment (FDI).”
Also worthy of mention is the deeper regional integration among EMEs. That is the case particularly of EMEs as FDI and portfolio investors in other EMEs, even though AEs remain the most important funding sources in EMEs across all types of investment.
Some features of “the new dynamics of financial globalization” may bring greater stability (McKinsey, 2017). Higher capital buffers and minimum amounts of liquid assets have reduced the weight of bank lending and the intrinsic features of mismatch and volatility of banks’ balance sheets. The larger share of equity and FDI, in turn, may carry longer-term return horizons and closer alignment of risks between asset purchasers and originators. The unwinding of huge debt-financed current-account imbalances characteristic of the global economy in the run-up to the GFC has also contributed to such a view of global finance entering a more stable phase (Canuto, 2021b, ch.7).
On the other hand, as previously noted, flows of FDI partially correspond to disguised debt flows and/or transfers motivated by tax arbitrage or regulatory evasion. Cross-border debt flows—including securities—in turn, are also sensitive to global factors, besides being highly sensitive and procyclical with respect to monetary-financial conditions in either source and/or destination countries.
There are also ‘blind spots’ left by de-banking, hitherto not preempted by non-banking financial transactions. For instance, cross-border de-risking by global banks has entailed closure of correspondent banking relations in many countries, in which the paucity of alternatives has led to negative consequences for local financial dynamics (Canuto and Ramcharan, 2015). Furthermore, the arms-length distance between asset holders and liability issuers intrinsic to debt securities and portfolio equity, in the absence of the project-finance role played in the past by international investment banks, often constrains the cross-border financing of greenfield investment projects.
Additionally, as we will see below, the rise of NBFIs and market-based intermediation has brought a greater likelihood of, at times of stress, liquidity/maturity transformation and leverage procyclicality, leading NBFIs to a heightened ‘dash for cash’ and sudden increases in demand for liquidity.
1.2. European Banks at the Core of Both Surge and Pause of the Wave of Financial Globalization Since the 1990s
European banks have been at the core of both surge and pause of the wave of financial globalization since the 1990s. The substantial piling up of European banks’ foreign claims in the run up to the GFC was followed by an equally substantial retrenchment (McKinsey, 2017).
Figure 2 (left panel) shows this. From 2007 to 2016, Eurozone banks reduced their foreign claims by US$7.3 trillion, and other Western European banks reduced their foreign claims by US$2.1 trillion.
Figure 2: Eurozone Banks’ Foreign Claims (2000-2016)
Source: McKinsey (2017).
Lending by European banks was behind two of the major contributing factors to the rising wave of financial globalization. First, the inauguration of the euro, which was followed by markets initially converging their assessments of risk premiums across the zone downward toward German levels, boosted cross-border transactions. According to BIS (2017):
“Between 2001 and 2007, 23 percentage points of the increase of the ratio of advanced economies’ external liabilities to GDP was due to intra-euro area financial transactions and another 14 percentage points to non-euro area countries’ financial claims on the area (p.102).”
European banks also played an active role in the asset bubble-blowing process in the U.S. financial system that preceded the GFC. European banks used U.S. wholesale funding markets to sustain exposures to U.S. borrowers through the shadow banking system. Despite their small presence in the domestic U.S. commercial banking sector, their weight in overall credit conditions was magnified through the shadow banking system in the United States that relies on capital market-based financial intermediaries, which intermediate funds through securitization of claims (Shin, 2012).
From the standpoint of the balance-of-payments between the U.S. and Europe, those transactions netted out. Nonetheless, in an accounting sense they represented short-term borrowing combined with long-term lending by European banks, with a corresponding double counting as cross-border financial transactions.
The retrenchment of European banks’ foreign claims followed both the U.S. asset-bubble burst starting in 2007 and the Eurozone crisis from 2009 onward. Alongside business-driven reasons—losses, decisions to deleverage balance sheets—tighter banking regulation and the orientation toward domestic assets assumed by post-crisis unconventional monetary policies also weighed. These factors have also led to deleveraging, balance-sheet shrinking, and domestic reorientation by banks in the other crisis-affected AEs. Although some banks from outside the latter have expanded their foreign lending, levels of global financial openness have been maintained, thanks to growing flows of non-lending instruments (debt securities, portfolio equity, and FDI).
1.3. Morphing Financial Intermediation in Advanced Economies Behind the Metamorphosis of Capital Flows
The metamorphosis of global capital flows accompanied the evolution of market-based intermediation in advanced economies, after the Great Financial Crisis of 2008, when the weight of NBFIs in the financial system has risen. Banks—and their affiliated broker-dealers—remain an important component of the mosaic, but they are now part of a broader set of institutions that route the flow of funds and facilitate trading. NBFIs have become more important in debt intermediation, with implications for risk sharing in the financial system.
According to the Financial Stability Board, NBFIs accounted in 2020 for about 50% of global financing activities (FSB, 2020). Figure 3 displays the rise of NBFIs in financing U.S. corporate debt. While, in the 1980s, banks funded about 30% of non-mortgage debt through loans, their share has fallen to 10%; market-based finance (bonds and commercial paper) now comprises 65% of corporate debt. Mutual funds, insurance companies, and pension funds held almost 80% of corporate and foreign bonds as of 2020, with a substantial increase for mutual funds (Figure 3).
Figure 3: Holders of Corporate and Foreign Bonds Among U.S. Financial Institutions
Source: Aramonte et al (2021).
Similar trends have also appeared internationally. Figure 4 shows the rising role played by NBFIs in Europe, particularly by asset managers.
Figure 4: Growth in Bank vs Non-Bank Assets in the Eurozone
Source: Aramonte et al (2021).
The bond holdings of broker-dealers—which are often part of banking groups—diminished after the GFC, even as the overall market expanded (Figure 3). This is quite different from the dynamics pre-GFC, when broker-dealers played a major role in driving the shift from a bank-centric financial system towards a market-based one, and their balance sheets saw a ten-fold expansion between 1990 and 2008, with a corresponding increase in leverage. The role played by European banks that we previously highlighted illustrates that. Since the GFC, regulatory tightening over the activities of banks and their affiliated broker-dealers, demographic changes, and a greater weight of capital markets in providing for retirement, as well as technological change and the pursuit of operational efficiencies, have led to a rising role of market intermediation and NBFIs (Aramonte et al, 2021).
How do stability properties tend to change with such a metamorphosis? NBFIs bring a range of attributes to the financial system and the economy, such as greater diversity in the ecosystem, and the advantage of less-correlated trading motives among intermediaries. NBFIs may fill the gap when banks retreat from certain intermediation activities.
On the other hand, like banks, NBFIs can also feed systemic risk, i.e. disruptions to the activity of a financial intermediary generating substantial costs—particularly as externalities—for other financial institutions or non-financial firms. At times of stress, liquidity/maturity transformation and leverage procyclicality may lead NBFIs to a heightened ‘dash for cash’, suddenly increasing demand for liquidity.
The roles of market prices and of balance sheet management by NBFIs raise new issues. The debt capacity of an investor is increasingly dependent on the debt capacity of other investors in the system, so that leverage enables greater leverage, and spikes in margins can lead to system-wide deleveraging. Deleveraging and ‘dash for cash’ scenarios become two sides of the same coin, rather than being two distinct channels of stress propagation (Aramonte et al, 2021).
The greater weight of NBFIs means that risk exposures are increasingly intermediated and held outside the banking system. Instead of banks warehousing liquidity and credit risks on their balance sheets, such risks are increasingly outsourced to NBFIs. Such structural changes have mitigated counterparty credit risk but have led to a financial system more sensitive to large swings in liquidity imbalances. After all, the business models of NBFIs are typically built around exploiting liquidity mismatches, and tend to, on net terms, provide liquidity in good times. During periods of financial turmoil, however, NBFIs often retrench, and their liquidity supply can suddenly turn into substantial liquidity demand.
We saw such an intense ‘dash for cash’ turmoil in March 2020, at the apex of the pandemic financial shock, when investors shifted away abruptly and massively from risky assets to cash-like assets, thereby making explicit such structural NBFI vulnerabilities with spillovers that impacted other participants in the financial system. Ultimately, it was the central banks’ flexible use of their balance sheets, including the crossing into areas previously considered outside their territory, that stopped the adverse feedback loops and helped to restore market functioning.
Such features of NBFI-based, market-based financial intermediation have been carried over to global capital flows, as the latter have accompanied the former.
2. Capital Flows to EMEs
2.1 Capital Flows to EMEs From the GFC to the Pandemic Shock
Capital inflows to EMEs held up well after the GFC, even if occasionally passing through high turbulence (Figure 5). They slowed sharply in some years (Canuto, 2013a; 2016; 2018; 2021a):
Figure 5: Capital Inflows to EME regions
Source: BIS (2021).