Three interrelated developments in global capital markets are:
- The sustained rise in gross capital flows relative to net flows;
- The increasing importance of securitized forms of capital flows; and
- The growing concentration of financial institutions and financial markets.
Taken together these trends may signal what some others have referred to as a ‘quiet opening’ of the capital account of the balance of payments, which is resulting in the development, strengthening and growing integration of domestic financial systems within the international financial system. Finance is being rationalized across national borders, resulting in a breakdown in many countries in the distinction between onshore and offshore finance. It is particularly evident and most advanced in the wholesale side of the financial industry, and is becoming increasingly apparent in the retail side as well.
Taken together these three effects have contributed to a sharp rise in volatility – in both capital flows and asset prices – which may be characterized as periods of turbulence interspersed with periods of relative tranquility. Investor behavior (the supply of international capital) is a critical reason behind the rise in volatility. These broad trends have some important implications for the ongoing development of capital markets and institutions, including those in developing countries.
1. The Sharp Rise in Gross Capital Flows
The evidence points to an acceleration of capital account opening in most regions of the world since the late 1980s. The effects of opening in the formal sense of liberalizing transaction taxes and regulatory and legal restrictions on capital movements have been augmented by the liberalization of domestic financial sectors and by technologically induced reductions in transaction costs. This opening has resulted in a sharp rise in gross capital movements relative to net capital movements.
2. The Rise in Securitized Forms of Capital
International capital flows have increasingly been in a securitized form. At a global level, direct intermediation through bonds and equities has begun to dominate more traditional forms of capital, such as syndicated bank lending and foreign direct investment.
The current trend to securitization of capital flows to emerging markets possibly had its origins in the global debt crisis of the 1980s. At that time private capital movements primarily involved syndicated bank credit. Following the extensive losses that many of the large international banks sustained during this period, there was a marked reluctance on their part to extend sovereign credit in the form of syndicated loans. Their espoused strategy has been to focus on so-called bankable business, in the form of trade credit or loans for specific commercial purposes with clearly identifiable cash flows and/or suitable collateral. The debt and debt-service reduction agreements at the end of the decade that resulted in the issuance of tradable, collateral-backed Brady bonds in exchange for outstanding loans provided the basis on which emerging market bonds have been erected. Impetus also came from the accelerating trend in mature markets toward nonbank forms of financial intermediation.
In the United States and Europe, the larger internationally active banks have sought to diversify into higher margin, fee-generating activities in an attempt to raise their return on equity. It is worth noting that this trend has been further stimulated recently by the rapid expansion of Euro-area securities markets, which has accelerated the shift by European banks into wholesale finance. As noted below, the expansion of Euro-securities markets has provided new opportunities for emerging market finance. While bank lending is still the dominant form of corporate finance in Europe, the direction of the trend seems clear enough. Similarly, in Japan, it is a reasonable conjecture that restructuring of the banking system will lead in time to a marked increase in directly intermediated finance.
3. The Consolidation of Financial Institutions
The past few years have witnessed an acceleration of consolidation among financial institutions in mature markets and a similar trend is now gathering momentum in emerging market countries. The main forces driving consolidation include: attempts to reap economies of scale and scope (a search for cost reductions driven by competitive pressures on margins and shareholder pressure for performance); improvements in information technology, as well as the onset of e-commerce and the spread of e-banking; and deregulation, particularly that which is encouraging the spread of universal banking. Most merger and acquisition activity during the past decade has involved the banking sector, and has resulted in the creation of large and complex financial institutions (LCFIs).
Consolidation is also affecting securities exchanges. In addition to the effect of technology on trading, the main causal factors are the liberalization of commissions, reduction in barriers to foreign entry, removal of antiquated trading rules and changes to governance structures. In many countries, the rapid growth and consolidation of private pension funds has been a major factor driving financial sector consolidation.
Credit: International Finance-CU