EU Economy
Global cross-border capital flows down 60% from peak; FDI/ central banks now dominate in Europe
By Finfacts Team
Mar 4, 2013 - 7:26 AM

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Global cross-border capital flows have fallen more than 60% from their pre-crisis peak, with the UK seeing the biggest fall, highlighting the challenges created by a plunge in cross-border lending and the availability of funds for investment. Foreign direct investment (FDI) and central banks now dominate flows in Europe.

The McKinsey Global Institute (MGI) estimates that in the past three years to Q2 2012, private investors have withdrawn some $900bn from Greece, Ireland, Italy, Portugal and Spain.

MGI says that in 2006 and 2007, the amount of capital flowing into Ireland was more than twice as large as the country’s GDP (gross domestic product) - -  some of this data reflects flows to Dublin's International Financial Services Centre.

International loans and bond issuances have particularly dipped in Western Europe, where the debt crisis led many to withdraw funds and caused banks to concentrate on local markets. During four years in the middle of the last decade, more than $1tn in Western European bonds were purchased by foreigners each year. In each of the last two years, more bonds were sold back to the issuing country than were newly sold internationally.

Loans and investment flows between countries were worth $4.6tn last year - - down from $11.8tn in 2007, calculations by McKinsey, show . Much of the decline was the result of Europe’s debt crisis. Capital flows were steadier in the world’s developing economies.

MGI said that for three decades, the globalization of finance appeared to be an unstoppable trend: as the world economy became more tightly integrated, new technology and access to new markets propelled cross-border capital flows to unprecedented heights. But the financial crisis brought that era of rapid growth to a halt.

"Drawing on our proprietary database of financial assets in 183 countries, Financial globalization: Retreat or reset? continues the McKinsey Global Institute’s ongoing series of reports on global capital markets. More than four and a half years after the financial crisis began, we find that recovery has barely started, despite a rebound in some major equity indexes. Growth in financial assets has stalled, while cross-border capital flows remain more than 60% below their 2007 peak. Some of the shifts under way represent a healthy correction of the excesses of the bubble years—but continued retrenchment could damage long-term economic growth."

Download full report [pdf]

Among the report's findings:

  • Global financial assets -- or the value of equity-market capitalization, corporate and government bonds, and loans - - have grown by just 1.9% annually since the crisis, down from average annual growth of 7.9% from 1990 to 2007 . This slowdown is not confined to deleveraging advanced economies; surprisingly, it also extends to emerging markets. 
  • Several unsustainable trends - - most notably the growing size and leverage of the financial sector itself - - propelled much of the financial deepening that occurred before the crisis. Financing for households and corporations accounted for just over one-fourth of the rise in global financial depth from 1995 to 2007 - - an astonishingly small share, since providing credit to these sectors is the fundamental purpose of finance.
  • Cross-border capital flows have collapsed, falling from $11.8tn in 2007 to an estimated $4.6tn in 2012 (Exhibit 2). Western Europe accounts for some 70% of this drop, as the continent’s financial integration has gone into reverse. Eurozone banks have reduced cross-border lending and other claims by $3.7tn since 2007, and central banks now account for more than 50% of capital flows within the region.
  • Even beyond Europe, global banking is in flux. Cross-border lending has fallen from $5.6tn in 2007 to an estimated $1.7tn in 2012. In light of new capital and regulatory requirements, many banks are winnowing down the geographies in which they operate. Commercial banks have sold more than $722 billion in assets and operations since the start of 2007; foreign operations make up almost half of this total. Expanding the debt and equity capital markets will take on greater urgency as banks scale back their activities.
  • Emerging markets weathered the financial crisis well, but their financial-market development has stalled since 2008. As of 2012, their financial depth is on average less than half that of advanced economies (157% of GDP, compared with 408% of GDP), and this gap is no longer closing. Capital flows involving emerging markets, however, have largely rebounded. We estimate that in 2012, some $1.5tn in foreign capital flowed into emerging markets - - 32% of global capital flows that year, up from just 5% in 2000—surpassing the precrisis peak in many regions. Capital flows out of developing countries rose to $1.8tn in 2012. Although most outflows are destined for advanced economies, $1.9tn in “South–South” investment assets are located in other developing countries.
  • With the pullback in cross-border lending, foreign direct investment from the world’s multinational companies and sovereign investors has increased to roughly 40% of global capital flows. This may bring greater stability, since foreign direct investment has proved to be the least volatile type of capital flow, despite a drop in 2012.

With global financial markets at an inflection point, the report outlines two starkly different future scenarios. One path leads to a balkanized structure that relies more heavily on domestic capital formation. While this outcome may reduce the risk of another financial crisis, it may provide too little financing for long-term investment. A second scenario, envisioning a more sustainable approach to financial-market development and global integration, avoids the excesses of the past but supports robust economic growth.


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