Andrew G Haldane: The big fish small pond problem
Speech by Mr Andrew G Haldane, Executive Director, Financial Stability, of the Bank of
England, at the Institute for New Economic Thinking Annual Conference, Bretton Woods,
New Hampshire, 9 April 2011.
* * *
The views are not necessarily those of the Bank of England or the interim Financial Policy Committee. I am
grateful to Shekhar Aiyar, Shaheen Bhikhu, Martin Brooke, Damien Charles, Spencer Dale, Andrew Hauser,
Robert Hills, Glenn Hoggarth, John Hooley, Marius Jurgilas, Priya Kothari, Salina Ladha, Lara Lambert, Chris
Peacock, Jonathan Rand, Maureen Snow, William Speller, Jo Spencer, Iain de Weymarn and Peter Zimmerman
for comments and contributions.
1. Introduction
Global capital markets are engaged in a footrace. On the one foot, capital markets in
emerging market countries are widening and deepening in order to improve domestic capital
intermediation. On the other, international investors in developed countries are diversifying
their portfolios in order to boost returns and spread risk. Both are typically seen as essential
ingredients of global financial liberalisation and integration. Yet their implications for global
financial stability are potentially quite different. The first determines the absorptive capacity of
high-return, capital-recipient countries. The second defines the distributive capacity of
lowreturn, capital-providing countries. Any imbalance between the rate at which international
capital is distributed and absorbed may spillover to global capital markets. Reducing these
spillovers may require a rethink of the rules of the international financial system.
Experience during 2010 provides a good illustration. Gross portfolio equity inflows to
emerging markets surged as investors substituted out of low growth developed markets
(Chart 1). Gross equity inflows to certain emerging markets were large relative to domestic
market capitalisation (Chart 2). The resulting indigestion problem caused bubbly behaviour in
emerging asset markets. In response, a number of countries have thrown grit in the wheels
of finance through macro-prudential measures or capital flow restrictions.
These surges in foreign capital flows, and associated asset market spillovers, are far from
new. Through this century, a new wave of inflows to emerging markets has been building.
Although halted temporarily by the financial crisis, its effect has been to buoy emerging asset
prices (Chart 3). Earlier centuries have seen many similar episodes of capital flow surges
into emerging markets, from the South Sea bubble in 1720 to the East Asian crisis of the
1990s (Reinhart and Rogoff (2008)).
Historically, as these waves have broken they have often caused quite a splash, with sharp
capital and asset price reversals (IMF (2011)). Some commentators have called those capital
reversals "sudden stops" (Dornbusch, Goldfajn and Valdés (1995)). But the underlying
problem may be as much the start as the stop. The seeds of emerging market crises are
sown in the build-up phase, as inflows dwarf the absorptive capacity of recipient countries'
capital markets.
Capturing that dynamic requires a different metaphor - the "Big Fish Small Pond" (BFSP)
problem. The Big Fish here are the large capital-exporting, advanced countries. The Small
Ponds are the relatively modest financial markets of capital-importing emerging countries.
Past experience suggests that as big fish enter the small pond, this can cause ripples right
across the international monetary system, never more so than in today's financially
interconnected world.
This paper considers the BFSP problem. It plots the evolution of the international financial
network over the past quarter-century. And, within that, it assesses recent shifts in portfolio
choice by international investors which may have accentuated today's BFSP problem
(Section 2). More speculatively, it then considers potential future trends in portfolio choice
tomorrow's
and assesses their implications for BFSP problem (Section 3).
If recent trends are continued, the BFSP problem may become more acute over time. In the
race between capital market deepening in emerging markets and capital diversification in
advanced economies, the latter may gain the upper hand (or foot). The BFSP problem during
2010 may have been the thin end of a sizable wedge. That, in turn, may intensify the debate
on appropriate policy responses, such as the pace of capital liberalisation and the case for
capital restrictions (Section 4).
2. Today's BFSP problem
A useful panorama on financial globalisation is provided by mapping the evolution of the
global financial network over time. The topology of this network provides a simple, graphical
visualisation of liberalisation patterns. In particular, network graphics can be used to visualise
"node size" - as a measure of the capital-absorptive capacity of emerging markets - the
Small Pond; and "link scale" - as a measure of the capital distribution of advanced
economies - the Big Fish.
As a first cut, we use a dataset developed at the Bank of England on stocks of cross-border
capital, spanning 18 advanced and emerging economies (Kubelec and Sa (2010)).1 This
enables us to track the growth in, and financial linkages between, countries over time.
Chart 4 plots this international network map at five-year intervals from 1980 to 2005. The
node size for each country is measured as the absolute sum of its external assets and
liabilities, while the width of the links between nodes measures bilateral gross external
assets. Both are in (log) dollar terms.
Taken over the past quarter-century as a whole, there is significant evidence of both capital
market deepening (increased node size) and integration (increased link size). On average,
total stocks of external assets have increased seventeen-fold over this period, rising from
around $1.5 trillion in 1980 to $26 trillion by 2005. Relative to these countries' GDP, they
have risen from 18% in 1980 to over 70% by 2005. This is consistent with a period of intense
financial globalisation.
Yet, despite this, the balance of global financial power has not altered markedly. The
financial core countries at the beginning of the period (such as the US and UK) remain core
at the end; the offshore financial centres (Hong Kong and Singapore) remain significant
throughout; while emerging markets remain, in the main, on the financial periphery.
To illustrate that, the share of intra-advanced country external asset stocks in the global total
was 77% in 1980. By 2005, that fraction had actually risen slightly to around 80%. Over the
same period, the contribution of advanced to emerging market external asset stocks in the
total fell from 13% to 5%, at the same time as the GDP share of emerging markets rose from
13% to 16%. So despite rising significantly in absolute terms, financial globalisation has not
obviously closed the gap between core and periphery. These aggregate patterns mask two
important, more recent trends. The first is the well-documented accumulation of official
foreign exchange reserves by emerging market countries, in particular since 2005. The stock
of global official reserves stood at $10 trillion by end-2010, having more than doubled since
2005. These flows are in some respects an oddity of international finance, with capital
flowing "uphill" from emerging to advanced economies and with emerging market investors
exhibiting a "foreign bias" for debt securities (Prasad, Rajan and Subramanian (2007)).
At the same time, a less well-documented trend in private-sector portfolio allocation has been
acting in the exact opposite direction. This has involved capital flowing "downhill" and is
associated with investors seeking instead to reduce "home bias" in their investment portfolio.
To see it, Chart 5 plots the global network map focussing on a subset of external asset
stocks, namely portfolio equity flows. The same pattern of intensifying global integration is
evident. Indeed, the intensification is altogether more dramatic: total holdings of external
equity have risen more than 200-fold over the past quarter-century, an increase of
$4.6 trillion.
But unlike for total external assets, the gap between core and periphery has been closing.
The relative contribution of intra-advanced country external portfolio asset stocks fell from
around 99% to 84% between 1980 and 2005. Over the same period, the relative contribution
of advanced to emerging market external portfolio asset stocks rose from virtually nothing to
over 8%. That is a fairly dramatic shift in international investors' portfolio choice.
What explains it? One plausible candidate is increased portfolio diversification by institutional
investors in advanced countries. It is well-known that international investment portfolios
exhibit an acute home bias, with portfolio shares much more heavily skewed towards the
home market than would be implied by conventional asset pricing models (French and
Poterba (1991), Forbes (2010)). There is a home-bias puzzle.
To illustrate, Table 1 constructs some equity home bias estimates for the G20 countries
between 1995 and 2007. Home bias is measured here as an index lying between zero and
one.2 So a value of unity indicates complete home bias - that is, a country holds no foreign
equity in its investment portfolio. A value of zero, meanwhile, suggests home bias has been
completely eliminated, with a country investing in proportion to the world market portfolio.
Intermediate values tell us the proportion a country is underweight foreign assets relative to a
world portfolio benchmark.
The following points are noteworthy:

Equity home bias remains very significant across every country in the world. The
unweighted average home bias across the G20 in 2007 was around 0.78. Weighted by
market capitalisation, average home bias was 0.66. So, in weighted terms, G20
countries' holdings of foreign equity are around a third of the value they would be in
the theoretically optimum market portfolio.

This home bias is lower among advanced than emerging market economies. The
un-weighted home bias index in 2007 was 0.63 for advanced countries, while for
emerging market G20 economies it was 0.90. For those emerging economies which
maintain capital restrictions, such as India and China, home bias remains almost
complete.

On average, there has been a decline in equity home bias across G20 countries
over time. Among advanced G20 economies, the un-weighted home bias index has
fallen from 0.75 in 1995 to 0.63 in 2007. Weighted by market capitalisation, it has
fallen from 0.79 to 0.61 over the same period. Foreign equity holdings have gone
from a fifth to a third of their theoretical benchmark.

While seemingly modest in index terms, the implied portfolio reallocations amount to
very sizable portfolio equity flows. That is because stocks of outstanding equity
assets are enormous. For example, a fall of 0.1 in the weighted home bias index for
advanced countries in 2007 relative to 2006 would have equated to a portfolio
reallocation to foreign markets of around $4.5 trillion. That is a big fish. To give
some context, the market capitalisation of all G20 emerging market countries in
2007 was $6.8 trillion. That is a smallish pond.
 For individual countries, some of the falls in home bias have been fairly dramatic -
for example, in Germany, France and Italy. Changes in US patterns of home bias
are also very significant in financial terms. The fall of 0.17 in measured US home
bias between 1995 and 2007 corresponds to an annual average portfolio
reallocation to the rest of the world of around $370 billion (or 1.4% of non-US global
GDP).

The pace at which home bias has been reduced is all the more striking because,
over the same period, emerging markets have become a larger slice of the global
portfolio pie. Between 1995 and 2010, the emerging G20 countries more than
quadrupled their share of the world equity market portfolio, from 4% to 21%
(Chart 6). Had advanced country portfolio allocations remained constant over this
period, measured home bias would have risen rather than fallen.
These trends in international portfolio allocation have been a key driver behind the emerging
BFSP problem during the course of this century. Portfolio reallocation by the big fish has
outpaced growth in the small pond of emerging capital markets. The upshot has been large
and mounting financial ripples. These strengthening waves of capital inflows have, in turn,
prompted some emerging countries to construct protective policy seawalls, such as capital
flow restrictions and macro-prudential policies. Recently, these measures have included:

In Hong Kong, the authorities imposed a cap on loan-to-value (LTV) ratios and a
maximum loan amount on certain properties, alongside an increase in stamp duty
on sales in October 2009.

The Chinese authorities in 2010 increased taxes on properties resold within five
years and offered greater administrative guidance on financing, including lower LTV
ratios for second and third homes and a mandated increase in mortgage rates for
second homes.

In Brazil, the authorities reintroduced in October 2009 a tax on non-resident portfolio
equity and debt inflows, with a broader coverage and a higher rate. They also
increased the tax on the margin payments required on foreign exchange futures and
other derivatives. In early 2011, reserve requirements on short foreign exchange
positions were introduced.

In South Korea, four sets of measures have been introduced: stronger foreign
currency liquidity standards for banks (November 2009); reduced short-term
external bank debt and limiting foreign currency bank loans (June 2010); a
macroprudential stability levy, planned to be introduced in 2011, on banks' non-deposit
foreign currency liabilities (late 2010); and the reintroduction of a withholding tax on
foreign purchases of treasury bonds (January 2011).

In Turkey, the central bank raised reserve requirements, and reduced policy rates,
to address accelerating credit growth and financial stability.

In Thailand, a withholding tax was imposed in October 2010 on non-resident interest
earnings and capital gains on state bonds.

In Indonesia, the central bank introduced in June 2010 a package of measures,
including a one-month holding period requirement for central bank securities.
3. Tomorrow's BFSP problem
From a public policy perspective, one key question is whether the frequency and amplitude
of these global financial ripples will rise or fall in the period ahead. In other words, will
tomorrow's BFSP problem be greater or lesser than today's? To answer that, we need to
return to the global financial footrace. Judging that race involves balancing two powerful
forces of financial liberalisation:

Portfolio diversification among advanced economies;
 Financial deepening among emerging markets.
Plotting the future path of these factors is far from straightforward. But some quantitative
thought-experiments can help clarify the balance of these forces. To keep these experiments
as transparent as possible, consider the simplest possible one-factor model of financial
liberalisation. The one factor is the level of economic development of the G20 economies, as
proxied by GDP per capita.
Theoretically, we would expect financial liberalisation to be shaped by economic
development. This is consistent with the economic growth literature emphasising the positive,
two-way relationship between financial deepening and economic growth (Levine (2005)). The
cross-section and time-series evidence presented here supports that hypothesis.
To generate projections for the single factor - GDP per capita - we use a calibrated
crosscountry convergence model, in the spirit of Barro and Sala-i-Martin (1992) and Mankiw,
Romer and Weil (1992). These GDP per capita projections are then adjusted for expected
future changes in population growth to give a set of cross-country projections for GDP from
2010 to 2050. Chart 7 shows the global distribution of G20 GDP at decadal intervals over this
period. These projections are necessarily tentative, but are broadly in line with external
estimates.3
Nominal GDP in the emerging G20 exceeds that in the advanced G20 by 2030. The
advanced economies' share of G20 GDP halves between 2010 and 2050, from 70% to 36%,
while the emerging G20 economies' share rises from 30% to 64%. Over the next 40 years,
advanced and emerging countries will most likely swap GDP shares. By 2050, China's share
of G20 GDP is 22% and India's 18%, with the US falling to 20%. In the thought-experiment,
this shift in the balance of global activity has important implications for the balance of global
capital flows.
(a) The evolution of home bias
With mixed success, theoretical studies have sought to explain cross-country patterns of
home bias (Lewis (1999) and Karolyi and Stulz (2003)). Perhaps the most cogent
explanations are grounded either in legal restrictions (including capital controls and lack of
property rights) and information asymmetries between home and host countries (Gehrig
(1993)). Globalisation is likely to have eroded both of these market frictions somewhat over
the past decade, in particular among emerging markets. That is consistent with the evidence
in Table 1.
Predicting the future course of these (legal and information) factors is far from easy. But one
plausible instrument for financial diversification is economic development. Cross-country
evidence suggests so. Chart 8 plots a cross-section of measured equity home bias in
58 countries against levels of GDP per capita in those countries in 2005. The correlation is
strong and significant: GDP per capita accounts for almost 60% of the cross-sectional
variation in home bias. As a ready-reckoner, every $10,000 per capita rise in GDP is
associated with a fall in home bias of around 0.1.4
Using economic development as an instrument for portfolio diversification, GDP per capita
projections can be used to simulate the possible future course of home bias. Futurology of
this kind of course comes with large caveats and confidence intervals. Given the simplicity of
the model, it is a thought-experiment rather than a forecast. And underlying that experiment
is an assumption that advanced countries continue to grow and diversify their equity
portfolios, but at a slower rate than catch-up emerging market economies.
Table 2 shows the evolution of equity home bias at decadal intervals out to 2050 for the G20
in this thought-experiment. Some clear points emerge:

All G20 countries see a reduction in home bias. The un-weighted G20 average
home bias index falls by 0.33 between 2010 and 2050. That is roughly the same
rate of descent as over the past 10 years or so.

Among a number of advanced countries, home bias has been significantly eroded
by 2050, in some cases perhaps implausibly so. For example, in the US home bias
falls from 0.51 to 0.09.

Emerging market home bias remains in many cases significant even by the end of
the period, reflecting their higher starting point. Average emerging market home bias
in 2050 is not dissimilar to advanced country home bias in 2010.
 The implied reductions in home bias would have a potentially significant impact on
the pattern of global capital flows. For example, if home bias in the G20 was to fall
as projected, then the sum of gross inflows to individual emerging markets
- including flows from both advanced and other emerging markets - is on average
$6.3 trillion per year over the period.
It would be easy to quibble with the detail of these projections. For example, cross-country
information frictions, and hence home bias, may never be fully eliminated. East or West,
home may remain best. Nonetheless, the slow, secular fall in this bias does not appear
implausible if recent portfolio patterns are a reliable guide to the future.
(b) The evolution of financial depth
Theory would predict a positive, two-way relationship between financial depth and economic
development. Not only does greater development spur the deepening of capital markets to
finance investment projects, but deeper capital markets themselves may act as a spur for
growth as they improve the efficiency of the financial intermediation process (Levine (2005)).
Cross-country evidence again supports that hypothesis. Chart 9 plots the cross-sectional
relationship between the log of GDP per capita and financial depth (measured as the ratio of
equity market capitalisation to GDP). The correlation is positive and reasonably strong: GDP
per capita accounts for almost half of the cross-sectional variation in the market
capitalisation-to-GDP ratio. On average, a 10% rise in GDP per capita is associated with an
increase in financial depth of around 1.5 percentage points.
In principle, the relationship in Chart 9 could be used to simulate forward financial depth in
the G20 economies. But, unconstrained, such a simulation would imply a potentially
unbounded relationship between market capitalisation and a country's GDP. Because market
capitalisation is the discounted value of future profit streams from companies, that seems
implausible.
Charts 10 plots equity financial depth for the US and UK since 1929 and 1965 respectively.
Between 1929 and 1990, the financial depth ratio in the US was roughly flat, at around 50%.
As the US liberalised this ratio shifted upwards, averaging around 100%; it has remained
roughly at these levels since. The UK has followed a similar pattern. To reflect these findings,
in the simulations an (arbitrary) cap of 100% is placed on countries' market capitalisation to
GDP ratio, once they have reached current levels of US GDP per capita.
Using the relationship in Chart 9 and the GDP projections, equity financial depth in the G20
countries can be projected forward. Many of the advanced countries have only a short
distance to travel to reach 100%, given their starting point. Among the emerging G20, the
average financial depth ratio rises from around 50% in 2010 to around 100% by 2050
(Chart 11). In other words, the pace of financial deepening in the emerging G20 countries is
rather gradual. If anything, this may understate the likely pace of change.
Nonetheless, these trends imply a rather striking shift in the composition of the global market
portfolio. Chart 12 shows how this evolves, measured at 10-year intervals.5 Some notable
points are:

The share of G20 emerging markets in global equity market capitalisation rises from
21% in 2010 to 56% by 2050. Over the same period, the contribution of advanced
G20 economies falls from 66% to 31%.

Within this, China's share of the market portfolio almost triples to around 20% in
2050. India's share rises five-fold to 15%. Together, these two countries' market
capitalisation is larger in 2050 than in all G20 advanced economies combined.
 In money terms, the stock market capitalisation of the G20 emerging markets rises
to around $300 trillion in 2050, while the G20 advanced economies amount to
$170 trillion. The global market portfolio pie increases fourteen-fold between 2010
and 2050.
4. The BFSP problem and public policy
Having projected paths for home bias and market capitalisation among the G20 countries,
the two can now be combined to give an illustrative general equilibrium projection of global
flows of funds. This general equilibrium is a relatively complex one, for it involves the
intersection of three forces in global finance:

First, the tendency towards increased diversification among advanced country
investors. This causes more water to flow downhill - a capital flow substitution
effect;

Second, the same trend among emerging economies but from a higher base. This
would tend to push water uphill - a countervailing capital flow substitution effect; and

Third, a change in the composition of the global market portfolio as emerging
economies account for a larger slice of the pie - a capital flow income effect.
By combining these three factors, we can form a proximate picture of the emerging pattern of
global capital flows. These projections are based on the same restrictive set of modelling
assumptions. Nonetheless, they provide a transparent window on possible emerging
patterns. Are the forces of financial deepening in emerging capital markets sufficient to
outpace the reduction in advanced country portfolio home bias, lessening the BFSP
problem? Or does portfolio reallocation by advanced economies risk swamping embryonic
emerging capital markets exacerbating this problem?
Chart 13 looks at the ratio of annual average capital flows to G20 emerging markets relative
to their market capitalisation over the period 2010 to 2050. It is the analogue of Chart 2,
using projections of both numerator and denominator. The highest and lowest annual inflows
over the projection period are also shown to capture potential annual variation in capital
flows. Chart 14 plots annual gross capital inflows to emerging markets over the same period.
Some notable points include:

Over the period 2010 to 2050, the average scale of capital inflows, relative to market
capitalisation, for the G20 emerging markets is around 8% per year. That is greater
than the peak inflow experienced in the recent past, including in 2010, during which
time asset prices rose significantly and protective policy measures were put in place.

Given the likely variation in these inflows year by year, the picture is even more
striking. Potential "peak" inflows are into double digits for the majority of G20
emerging markets. As context, peak portfolio equity inflows to East Asian countries
in the three years preceding their 1990s crisis averaged 4% of market capitalisation.
 For some individual emerging market countries, these capital inflow patterns are
dramatic. For example, over the period 2010-2050, average inflows to India and
Indonesia exceed 10% of their equity market capitalisation.
Taken together, these projections do not suggest a dissipation of the BFSP problem. More
likely, they suggest it could intensify, perhaps significantly, in the period ahead. If capital
markets operated efficiently, these portfolio flows need not cause waves in emerging credit
and asset markets. In practice, frictions in the functioning of these markets mean that asset
market spillovers seem very likely to persist. In other words, the splashes from the big fish
risk causing waves every bit as great, and potentially greater, than those seen recently.
On this run of history, the global flow of funds could become an increasingly powerful
generator of global financial instabilities. In that event, pressures could mount on
policymakers to protect against the rising tide of capital flow-induced instability, including
through capital restrictions and macro-prudential measures. Some of these measures, if not
unthinkable, would have been frowned on as recently as a decade ago. When Malaysia
imposed restrictions on capital movements in 1998, it was castigated by the international
community. And when the Hong Kong authorities intervened in their stock market in the
same year, many international policymakers blew a raspberry.
What a difference a decade makes. What a difference a crisis in advanced economies
makes. Ideological aversion to throwing grit in the wheels of international finance appears, if
not to have disappeared, then to have moderated. Where once it was raspberries, today's
policymakers are blowing kisses. Capital restrictions and macro-prudential policies have
entered the policy bloodstream, if not yet the mainstream. The debate today is how best to
integrate such tools into established macroeconomic policy frameworks.
The issues here are thorny ones. They include:

Should capital restrictions be used by emerging markets as a last resort once
conventional macroeconomic policies have been exhausted? Or should they instead
play a supporting role in all seasons, to avert excessive capital surges and
accompanying fluctuations in financial activity? And what guidelines, if any, should
apply to the policies of advanced countries as the source of such capital surges?

Are capital flow restrictions better conceived as a temporary or permanent
measure? On the one hand, temporary measures might better reflect the need to
respond with exceptional measures only in exceptional circumstances. On the other,
nesting capital restrictions within a pre-agreed framework could improve the
credibility and predictability of these measures among international investors.

Should differing rules of the game apply to different sources of capital inflow (foreign
direct investment versus portfolio flows versus banking flows)? And should different
rules apply to flows of different maturity (short versus long-term)? Different sources
and types of capital are believed to behave very differently during capital upswings
and downturns (IMF (2011)). It would be odd for public policy to ignore those
behavioural differences.

What are the respective roles of capital restrictions and macro-prudential policy? At
present, the two are viewed rather differently, with views on capital restrictions
mixed, while macro-prudential policies are increasingly the consensus. Yet these
two sets of tool may differ more in detail than in principle. Macro-prudential policies
may also have a role to play in moderating credit growth in the source of capital
surges - the advanced economies.

What are the respective roles of capital restrictions and financial market deepening
as responses to the BFSP problem? One policy option for emerging economies is to
strengthen and deepen their domestic capital market infrastructure, so that it is
better able to absorb and intermediate incoming foreign capital. A reduction in those
capital market frictions would tend to lower the asset market spillover costs of the
BFSP problem.
 Finally, what guideposts should be provided by the international community in
tackling the BFSP problem? The IMF recently began to explore such a framework
(IMF (2011)). This raises a set of key questions about global financial governance.
Are global financial network externalities sufficiently large to justify the international
community imposing rules of the financial road? And how much driver discretion
should instead be left to nation states which ultimately may bear the costs of the
BFSP problem?
These are big public policy questions. They are by no means new ones. If the quantitative
experiments presented here are even roughly right, these questions may assume a new
urgency in the period ahead. The BFSP problem is real. It may be rising. The result would be
growing waves of global financial exuberance, punctuated by crashing capital busts. This
roller-coaster has the potential to leave some nation states feeling queasy. They may even
wish to get off. What is at stake may be more than just the future stability of the international
financial system.
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