A speech delivered by Olivier Klein, Chief Executive Officer of the BRED Group and Professor of Economics at HEC, with Laurence Scialom, Professor of Economics at the University of Paris Nanterre, Head of the economic think tank Terra Nova, Member of the Scientific Board of the ACPR, during the third conference of the Nocturnes de l’économie, organised at the University of Paris X Nanterre by the Association Les Journées de l’Économie, on 30 March 2017.
Jean-Marc VITTORI, lead writer for the daily newspaper Les Échos
This is the third time that this exchange of views on globalisation or rather on financial deglobalisation has taken place. The world experienced a financial crisis with increases in financial trading which were extremely buoyant before 2008, and since then curves which have changed direction. What does it mean? Is it going to continue? Is it desirable? I am going to start with Olivier Klein. Olivier is a statistician and economist by training. He graduated from HEC where he teaches economics and finance. He has also been a banker for some time, and for five years, Chief Executive Officer of BRED which is the major commercial bank of the BPCE Group. BRED may well have the image of a local and regional bank, but it also has branches of the bank in South-East Asia, in the Pacific, in East Africa, and even in Switzerland, as well as a trading floor. It is thus not only a French bank. Olivier, financial globalisation, what’s the state of play?
Olivier KLEIN, Chief Executive Officer of BRED, Professor of Economics and Finance at HEC
Financial globalisation, which started around the end of the 70s, the beginning of the 80s, led to a very significant increase in international capital flows. Consequently, outstanding gross foreign assets and foreign liabilities have, for example in the United States, risen from 25% of GDP, at the beginning of the 80s – in terms of foreign assets as well as foreign liabilities, hence for assets as well as liabilities, of the United States vis-à-vis the outside world – to 150% of GDP for assets and 175% for liabilities.
With regard to France, due to the effect of the eurozone which has naturally exacerbated these phenomena, liabilities and assets vis-à-vis the rest of the world have risen from 20% at the beginning of the 80s to 300% of GDP today. The phenomenon of financial globalisation is thus very clear. From the 80s to date, the international capital market has grown beyond recognition. From 2008 until recently, a slump in GDP growth and a very strong downturn in international trade growth have been observed. It is interesting to note that this downturn did not affect international capital flows, apart from interbank liquidity flows. Interbank liquidity flows by no means reverted to the level that they had attained before the crisis.
However, with regard to the money markets, apart from the interbank markets, these flows continued to grow, even after 2008 and financial interdependence continued to increase. I will just give you an example of this, which is due, particularly after 2008, to the fact that rates in European countries and in the United State tumbled to levels that were close to zero, and occasionally even below zero, due to the financial crisis.
A carry trade phenomenon, which is well known in finance, was subsequently witnessed. As investment yields were deemed to be too low in the United States, for example, capital was borrowed in the United States and short-term investments made in emerging markets, in dollars – as the emerging markets include countries that accept the American dollar alongside their own currency – or were changed into the local currency, and in both cases were invested at higher rates than the rates that were being offered in the advanced countries of origin, the United States in this case. In so doing, they naturally encouraged growth in the emerging markets and quite rightly.
However, they also obviously created potential instability because as soon as capital leaves in search of higher short-term yields, it is also likely to flee at the slightest threat by withdrawing very quickly. This creates potential instability in emerging markets, which could be serious. This is also why in 2013, when there was a move towards limiting quantitative easing in the United States – which had facilitated the investment of enormous amounts of capital in emerging markets – the tapering announcement alone, namely the limitation of quantitative easing, sufficed to cause a sudden withdrawal of part of the capital from the emerging markets to the United States. It suddenly dried up for some emerging markets which were relying on this capital for development purposes.
This is why the Fed, the central bank of the United States, now manages its ability to raise rates or to limit quantitative easing by including this phenomenon in its calculations as it is jointly responsible for what happens in the emerging markets. However, the United States also needs the emerging markets. The Fed thus manages this in a very cautious manner, with good reason. In conclusion, the correlation between the stock markets in the United States and the stock markets in the emerging economies has risen from around 58% before 2008 to around 75% at the present time. This correlation is a consequence of this very strong financial integration. But it also displays mimicry since at some point, everything may fall or everything may rise together, which could obviously be potentially destabilising. Hence, financial globalisation has very positive effects (ability to move capital between countries with the ability to finance and countries that need finance, for example), but at the same time to potentially increase financial instability. The degree of financial instability of the system depends on the methods of regulation in place.
Jean-Marc VITTORI
This is precisely the question that I wanted to put to Laurence Scialom, Professor of Economics at the University of Paris Nanterre, a financial economics expert, a qualified member of the NGO Finance Watch, inter alia. Olivier has described this tremendous acceleration of financial globalisation in figures. He explains to us that, with the exception of one segment, namely interbank loans, this globalisation is continuing. Does it have positive effects which have often been presented as a result of these increased capital flows?
Laurence SCIALOM, Professor of Economics at the University of Paris Nanterre, Head of the economic think tank Terra Nova, Member of the Scientific Board of the ACPR
Financial globalisation was being sold to us before the crisis as providing a huge amount of benefits. It was supposed to enable better allocation of capital, better risk spreading, finance and hyper financialisation which, closely linked to financial globalisation, was meant to sustain growth. However, these promises have not been kept on the whole.
In very broad terms, the allocation of resources, international capital movements, particularly very short term ones, finance existing assets rather than real activities. They namely finance housing bubbles and stock market bubbles. This was very evident during the Asian crisis, for example. These capital inflows – notably in the emerging markets, but also in Europe before the creation of the euro – frequently had the effect of increasing the nominal exchange rate and decreasing the competitiveness of these countries. Just when it appeared to be unsustainable, there was an exchange rate crisis and capital outflows.
There are evidently problems with regard to the allocation of resources. Furthermore, the derivative markets and the risk transfer markets were sold to us as enabling better risk spreading. In fact, risk has never disappeared. Quite simply, what has in fact happened is that risk has been concentrated in relatively opaque areas. As we have seen, the crisis of 2007-2008 was the first financial engineering crisis. There had never been a crisis on this scale – the fact that a crisis created in a small segment of American finance spread throughout the world – if these products had not been packaged in securitised products which everyone had purchased as the better tranches had good ratings and did not require a capital advance, this particular crisis would not have happened.
This was a real crisis, namely a financial engineering crisis and was closely related to financial globalisation. Lastly, very recent analyses show that hyper financialisation is detrimental to growth rather than sustaining it. In fact, financial development goes hand in hand with growth up to a certain level of financial development, but all the developed countries are considerably above this level.
Conversely, financial development is detrimental to growth in all these countries. It tends to be predatory. Links have also been shown to exist between hyper financialisation and increased inequalities, namely in the analyses of Reshef, Philippon and others. None of this produced the expected results. However, paradoxically today, with the decline in interbank loans – as deglobalisation is first and foremost taking place in the banking sector and in Europe – deglobalisation is a tragedy. In fact, the resulting fragmentation of the European financial area contains the seeds of a deeper crisis, which could even lead to a euro crisis. This is actually a paradox. I believe that it is not so much a question of borders as a question of financial regulation which should be posed.
Jean-Marc VITTORI
What you are proposing to us is rather depressing because you are saying that globalisation has been disastrous and that deglobalisation is tragic… I’d like to come back to Europe because it is natural to come back there as what has happened in terms of the decline in interbank flows is largely the result of what has happened in Europe. But before coming back there, Olivier, as far as the rather critical judgement pronounced by Laurence on the effects of financial globalisation are concerned, do you share this opinion or do you think that it has nevertheless not been completely devoid of benefits?
Olivier KLEIN
I teach more or less the same thing, namely that there is quite a strong correlation between periods of financial globalisation historically and financial instability. I consequently believe that there is indeed a causal link between globalisation, when it is unregulated or poorly regulated, and the recurrence of financial crises, which have occurred time and time again since the end of the 80s, although they had ceased to exist in the developed countries during the period in which the markets were less globalised.
However, financial globalisation has also enabled, one way or another, the development of China for example. China has in fact been able to export more, by financing all or part of the current account deficit of the United States which imported its goods. It was accordingly able to base its development on exporting the goods it was producing for the developed countries. In a way and in a number of cases, with effect from the 2000s, it was because capital was circulating on the international market which countries could have used for development, not by obtaining finance from developed countries, contrary to popular belief, but by financing imports from developed countries which were coming from emerging markets. In other more classic cases, there were emerging markets that were able to accelerate their growth due to the capital that was obtained from advanced countries.
I believe that the issue is not about deciding whether globalisation is good or bad per se. That is how it should be understood, at any rate. The real issue, it seems to me, is to ask what can be done to try and limit financial instability in a financially globalised world. In that respect there are evidently a lot of questions to be asked.
When the theory is examined, it is obvious that there were some serious misconceptions inherent in the promises of financial globalisation. All things considered, it is evident that the most serious financial crises have returned. In my humble opinion, it stems from the fact that finance is inherently unstable because it is very difficult to assess a property asset by giving it a fundamental value. What is the equilibrium price of a property asset, namely an equity asset or a real estate asset? Financial markets are anticipatory.
Whenever an asset is bought or sold it is because there is an anticipation of the future trend in the price of this asset in one direction or another. These markets are sensitive to shifts in sentiment, hence to mimicry, to conventions, because the future is de facto difficult to predict as the asymmetry of information on financial assets is significant and because, as a result, the cognitive biases of the players are decisive.
However, this does not mean that financial markets are not needed as well as banks. Not only are banks necessary, financial markets are as well. Banks cannot do everything, firstly, because they have amounts of capital assets that are necessarily limited for the purpose of making loans, while observing their own solvency ratios and secondly, because financing requirements are far greater than the financing capabilities of banks.
Banks are indispensable and are the economic factors that most frequently provide stabilising effects because they are regulated and manage long-term relationships with their customers, with the aim of ensuring that they repay the loans granted and do not play on the variation in the instantaneous valuation of their commitments based on very short-term market developments. They are accordingly much less sensitive to sudden shifts in sentiment that are inherent in financial markets, which do not set a benchmark for the fundamental value shown.
However, financial markets concomitantly provide additional support to the action taken by banks in terms of financing the economy, as I have just said, as well as their ability to spread exchange rate, interest rate, credit risks, etc., as a result of the derivative markets. It should be emphasised that the division of the share of funding borne by the financial markets and the share borne by the banks is also a structural issue which partially determines the overall level of financial stability.
Lastly, it is all very well to regulate the banks themselves, but it is by no means sufficient. Moreover, at this moment we are seeing that investment funds, investment trusts, insurers, all of shadow banking generally, are starting to take risks for which they are not regulated and for which they do not always have proven expertise. In my opinion, that could present a problem in the coming years, particularly during the next real economic crisis or even during a sharp downturn. Regulation must apply to all players, otherwise it is inadequate by definition and encourages circumvention of the regulations.
Yes, of course, there is inherent financial instability. And yes, there is a need for finance. This means finding the theoretical and practical means that would enable it to be regulated as well as possible to prevent systemic crises.
Jean-Marc VITTORI
So finance is necessary. This finance is inherently unstable so it must be regulated, all the more as globalisation is continuing. What are the main sectors which require action?
Laurence SCIALOM
I think that we are now at a crossroads. We have made progress in certain areas. Banks are undeniably better capitalised but, at the same time, they had previously been so badly capitalised that even if they had tripled their capital, it would not have sufficed. I also think that there is a false sense of security, in other words to prevent the banks from capitalising further, they are compelled to issue types of debt that enable a bail-in. In other words, to avoid asking the taxpayer, a decision was made to ask those individuals and entities that have claims against the banks. These are the famous bail-in instruments.
The problem is that I am firmly convinced that this is not feasible in the event of a systemic crisis because it is likely to create mass contagion, as we have seen. In Italy, which was nevertheless a rather specific case as savers were holding securities, but the taxpayer was obviously on the front line there. But in the event of a systemic crisis, I think that it would be a vehicle for propagation purposes. Because who holds them? They are different financial players…
Enormous progress has been made in enacting bank liquidity regulations. However imperfect they are, they recognise that liquidity risk is the Achilles’ heel of banks, and particularly of European banks due to their funding structure, which is very dependent on obtaining liquidity on wholesale funding markets.
In my opinion, insufficient progress has been made in regulating shadow banking. This time, the action that has been taken falls far short of the action that should have been taken. A particularly serious issue is the excessively close ties between systemic banks and shadow banking. Interbank loans have declined, but not loans by banks to shadow banking. This is patently obvious in the latest empirical analyses of these issues.
I also think that the issue of banks that were “too big to fail” has not been properly addressed. Following on from what I have said about the bail-in, I am convinced that the implicit Government guarantees will continue to have enormous consequences for all banks. This is why I personally was in favour – and am still in favour – of a separation… but not along the lines of the Glass-Steagall Act, but rather a separation along the lines of Vickers and Liikanen, in other words subsidiary creation, with different capital ratios, different boards of directors, etc.
Jean-Marc VITTORI
Before giving the floor to the students for their questions, I would nevertheless like to talk about the specific situation in Europe. Something has clearly happened in Europe with regard to financial globalisation which has undergone a major departure from financial globalisation. Olivier, how do you explain this? How is it going to develop?
Olivier KLEIN
Europe is in fact the one place in the world which is witnessing financial deglobalisation, and this is not good news at all. My interpretation is simple. The eurozone is unfinished. I myself was in favour of the eurozone, I simply said that in order for it function efficiently and sustainably it required elements which are more than the sum total of convergence criteria. As in the US dollar zone in the United States, there no coordination of economic policies and possibilities of making either fiscal transfers or partial debt mutualisation, which ultimately also involves fiscal transfers. This has not been done.
And the markets did not notice. From the creation of the euro until 2010, they have failed to pose the right questions. Then they suddenly realised that contrary to what they had imagined – they had believed that they could look at the current account balances across the eurozone, and not for each country, that there were countries with large current account deficits which could have found it difficult to obtain funding without the solidarity mechanism within the eurozone. The markets took fright and suddenly, quite naturally, triggered a brutal, contagious and dangerous cycle of national public debt and interest rates, embroiling these countries in a vicious circle which could have triggered the collapse of the eurozone. No one was willing any more to provide funding to those countries in the eurozone with a large current account deficit. Fortunately, Mario Draghi intervened and explained that the CEB was going to protect the eurozone by purchasing public debt, then by implementing quantitative easing and last but not least by stating the famous “whatever it takes” in 2012.
Without that, the eurozone would have collapsed. Today, the fact is that the eurozone still does not have a private equity market which finances, through the surpluses of countries with a surplus, countries with a current account deficit. It goes through the euro system, through the European Central Bank. This becomes evident, by taking a closer look at the situation, in the Target 2 balances. Countries with a current account surplus are lending more and more to the central bank and countries with a deficit are borrowing more and more from the same central bank. This represents the cumulated current account positions and financial positions of these countries.
This is the way countries with a current account deficit are obtaining funding for the time being, de facto without the assistance of the markets. This is naturally not sustainable as there may be countries – and Germany is one – that sooner or later are likely to refuse to structurally fund countries with continually growing deficits via the euro system, while they themselves have growing surpluses. Even if these surpluses and these deficits are also the result of the structural setup of the eurozone as it exists today, they are nevertheless unsustainable.
We now have a situation in the eurozone where the private equity market no longer functions. Everything relies on the central banking system, namely the euro system. To enable the system to work well and for the markets to accordingly resume their role, we lack the degree of trust that is required between the countries in the eurozone and the cultural bond that could result in solidarity, even partial, between them. This would manifest in several aspects of federalism and would lead to full monetary union and hence a more stable monetary zone.
In this regard, the fact that France is implementing its essential structural reforms is the condition that is essential to enable Germany to envisage the implementation of elements of solidarity in the system.
Jean-Marc VITTORI
Laurence, I think that you have outlined the main points.
Laurence SCIALOM
Financial fragmentation in Europe today is a result of the fact that the euro is an incomplete currency. The aims of the central currency have been federalised but the fact that over 80 % of the currency that is created is banking currency has been forgotten. Moreover, Europe has banking systems that are excessively concentrated with very large banks. Of course, when the situation started becoming rather critical, the banking union was created.
What is the banking union? It means that the largest systemic banks are going to be supervised at federal level and that the problems are also going to be resolved at federal level. However, there is a third pillar which remains unresolved, namely federal deposit insurance. As long as this third pillar has not been constructed, as long as we are not out of the woods, one euro in a Greek bank will not be worth one in a German bank, for the simple reason that the Greek depositor is less well protected than the German depositor. This was very evident when the situation with regard to Italian banks became strained. You have a great deal of Italian bank assets that had been invested with banks in countries that appeared to be more robust.
As long as there is no back-stop, namely a dose of federalism, as has just been mentioned, and as long as Member States are called upon to bail in their own banks, we are not out of the woods.