Peter Praet: The future of global financial integration
Remarks by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
the Global Research Forum on International Macroeconomics and Finance, Federal Reserve
Bank of New York, New York City, 17 November 2016.
* * *
I would like to thank Arnaud Mehl for his contributions to this speech.
I. Backlash against financial globalization since the global economic and financial crisis
Financial globalization was a salient phenomenon of the past three decades, but since the
financial crisis of 2007-2009 there are increasing signs of a backlash against globalization.
The evidence for such a trend reversal is mixed.
Quantity-based measures of global financial integration, such as gross external assets relative to
world output, have flattened out, and would merely point to a pause.
Flow measures provide a gloomier picture: international capital flows are now down to half their
pre-crisis levels relative to world output, and are especially weak among mature
1
economies. Internationally active banks have increased domestic lending faster than foreign
2
lending. Several emerging markets have erected barriers to global finance and introduced
controls against capital inflows and, more recently, outflows.
Price-based measures of global financial integration, meanwhile, present a different picture:
international equity market co-movements, for example, remain strong. By some estimates, they
remain as high as ever in more than a century.
It is not just the extent of financial globalization, which might have changed since the financial
crisis, though. Its perceived benefits and costs in academic and policy debates have changed,
too. Before the crisis several studies already called for a "reappraisal" of the net benefits of
3
financial globalization. This has taken place along two main dimensions: (i) re-assessing the
stability of capital flows, and (ii) re-examining whether financial integration leads to a productive
allocation of savings and to agglomeration effects in certain geographic areas.
As regards the first dimension, the notion that financial integration which is based on long-term
instead of short-term capital flows is more resilient has become increasingly persuasive. For the
second, it has been recognised that financial integration typically only delivers lasting positive
4
effects on growth if countries meet certain thresholds of institutional development. In the
absence of sufficient institutional development, capital flows would most likely be used
unproductively, feeding unsustainable lending booms and encouraging excessive short-term
5
capital inflows. This can in turn leave countries vulnerable to sudden stops once optimism fades
due to local or global shocks.
Indeed financial cycles tend to have a global component, and hence the discussion about
financial globalisation has evolved into one about the "global financial cycle", which is driven by
US monetary policy. The assumption is that non-US central banks have lost their ability to
influence domestic long-term interest rates, even in the presence of flexible exchange rates, due
6 7
to the existence of "US-driven" global financial cycles. As a result, the classic trilemma may
have morphed into a dilemma between financial openness and monetary policy autonomy. In
addition to risks related to unsustainable lending booms, which can be fueled by capital flows,
policy makers and academics recently also stressed risks stemming from disruptive capital
outflows, which can endanger financial stability, for example if large amounts of bank deposits
are pulled out of a country.
In the context of this debate on financial integration, academic papers on the welfare optimality of
8
taxation of international capital flows have also thrived since the crisis. Moreover, the standard
international policy consensus on financial globalization has been shattered by the crisis. For
example, the IMF adopted in 2012 an institutional view that said temporary and targeted capital
flow management measures can be useful in certain circumstances, i.e. when the room for
9
manoeuvre for macroeconomic adjustment is limited. The Fund is now reviewing this
institutional view. It is expected that the effectiveness of capital flow management measures,
which have been recently used in emerging and some advanced economies, will be assessed in
a balanced way, taking into account all intended and unintended effects, which such measures
may generate.
In parallel, the OECD is reviewing its code of liberalization of capital movements. With the
review, the OECD aims to facilitate collective action by boosting transparency and shared
understandings on good practices related to managing and liberalising capital flows. A particular
area of interest is the treatment of capital flow measures that are used as macro-prudential
measures. For policy makers, this is important since at times there may be tradeoffs between
financial integration and financial stability.
II. Effective financial risk sharing rests on the soundness of institutions and policy rules
As part of this policy discussion, I would like to underline that openness to international capital
flows should continue to help diversify country-specific shocks. This would help to smooth
crossborder consumption between good and bad states of the world through international borrowing
and lending. Admittedly, the economic magnitude of gains from financial risk sharing remains
10
debatable. In monetary unions, financial risk sharing remains an essential channel for leveling
11
out the effect of asymmetric shocks across regions. Risk-sharing traditionally works through
two main channels: cross-border lending to households and companies; and cross-border
holdings of productive and financial assets.
In a monetary union like the euro area, which has no central fiscal authority, both channels
should have contributed to containing the fallouts from economic shocks in member states.
What we have experienced is the opposite: financial flows amplified the crisis when some euro
area countries faced a sudden stop. This followed years of increasing cross-border lending and
borrowing and excessive risk-taking, mainly through bank-based financial intermediation. When
panic led to an abrupt reversal of financial flows and fragmentation of the euro area banking
system, the central bank had to take over the role of the interbank market in providing liquidity to
banks in stressed countries.
The Great Moderation masked the fault lines in the Economic and Monetary Union's financial
architecture. The Great Recession revealed all the cracks, including the pernicious link between
euro area banks and sovereigns. The sovereign debt crisis resulted in capital controls in two
euro area countries, leading to a temporary reversal of financial integration in Europe.
This proves that expected benefits of risk sharing can turn sour ex post, for example if the
composition of flows is too risky and too vulnerable to abrupt changes in international investor
sentiment. The key policy-relevant question is, which institutions and rules are necessary for
financial risk sharing to achieve all the benefits it has in theory?
Financial risk-sharing benefits and, more broadly, financial integration are deeply rooted in the
soundness of institutions and policy rules. This is in line with the already mentioned empirical
findings on the lasting growth effects of capital flows, which depend on institutional thresholds.
Sound institutions and policy rules are necessary to guarantee clear definitions of property rights
and procedures in case of financial stress, to ensure the stability of the domestic financial
system through regulation, supervision and resolution frameworks, to mitigate the cost of
crossborder and cross-currency transactions, and to create a level playing field for financial tax
regimes. In addition, the benefits from financial integration will only materialise if underlying
economic stability prevails.
The institutions and policy rules in question vary in their extent and reach, depending on whether
one considers the national level, the euro area level or the global level. At the national level, for
instance, the existence of a national currency guarantees that there is no exchange rate risk
hampering capital flowing from one region to another; tax rules are usually applied uniformly
across a nation, which prevents arbitrage; and the regimes for regulation, supervision and
resolution are identical, at least for specific parts of the financial sector, such as banks, which
strengthens depositors' confidence.
At the global level, financial stability arrangements naturally differ across countries. There has
been significant progress in aligning global frameworks for regulation, supervision and resolution,
but more still needs to be achieved. There is no global jurisdiction for cross-border and
crosscurrency transactions across countries and tax regimes differ widely from one country to
another, offshore financial centers and non-cooperative jurisdictions being extreme cases. Last
but not least, underlying economic conditions and policies widely differ across countries, which
affect incentives for cross-border capital flows and for financial integration to deepen or weaken.
And at the euro area level, financial stability arrangements before the crisis were not in line with
the requirements of monetary union. While Member States shared a single currency, there was
no single framework for supervision and resolution. There was also a general lack of awareness
of the risks that such a fragmented institutional framework could pose for area-wide financial
stability. This led to a general misperception of financial risk, and short-term, uni-directional
financial flows.
III. Strengthening the necessary institutions and policy rules is essential for the euro
area to reap the full benefits of financial integration
The financial crisis of 2007-2009 and the sovereign debt crisis of 2011 were wake-up calls for
our continent. They exposed the incompleteness of our monetary union, the fragility of our
financial integration, and the limited scope for action of institutions other than the ECB.
In short, they strongly underscored the need to move to a genuine Economic and Monetary
Union. Euro area leaders have since launched the Banking Union, to be complemented over time
with the Capital Markets Union, to deepen financial integration within the euro area. The Banking
Union will help strengthen cross-border lending to households and companies within the euro
area. The Capital Markets Union aims to strengthen integration of capital markets within the area.
This, in turn, will help strengthen cross-border holdings of productive and financial assets. The
Banking Union and the Capital Markets Union involve the creation of new institutions and policy
rules, which will help the euro area to reap the full benefits from financial risk-sharing.
Some of the key ingredients of the Banking Union are already in place: the Single Supervisory
Mechanism was created in 2014, the same year as the Directive on Deposit Guarantee
schemes was adopted, which harmonises the level of deposit protection and payout periods in
the European Union. A Single Resolution Mechanism has been operational since 1 January 2016.
It implements the EU-wide Bank Recovery and Resolution Directive in the euro area.
Banking Union, however, remains work in progress. Further steps are under discussion, such as
a fiscal backstop for the Single Resolution Fund and the creation of a European Deposit
Insurance Scheme. These aspects will no doubt remain high on the European policy agenda,
because our continent needs to strengthen the integration of its banking and capital markets
substantially in the absence of alternative risk-sharing mechanisms, at least for the time being.
To sum up, sound economic policies as well as policy rules and institutions that are necessary
to oversee their implementation at a European level, remain a prerequisite for financial integration
to support financial stability. They benefit not only to the euro area, but to the global economy at
large.
1
See Matthieu Bussière, Julia Schmidt and Natacha Valla (2016), "International Financial Flows in the New
Normal: Key Patterns (and Why We Should Care)," CEPII Policy Brief, 2016-10, CEPII research centre.
2
See Caroline Van Rijckeghem and Beatrice Weder di Mauro (2014), "Deglobalization of Banking: The World is
Getting Smaller," CEPR Discussion Papers, 10139.
3
For instance, it was argued that a critical reading of the empirical literature lent some "qualified support to the
view that developing countries can benefit from financial globalization, but with "many nuances"; see Ayhan
Kose, Eswar Prasad, Kenneth S. Rogoff and Shang-Jin Wei (2006), "Financial Globalization: A Reappraisal",
NBER Working Paper No. 12484.
4
See Kose et al. (2009), op. cit.
5
See Caballero, J. A. (2014), "Do surges in international capital inflows influence the likelihood of banking
crises?" Economic Journal.
6
See Hélène Rey (2013), "Dilemma not trilemma: The global financial cycle and monetary policy independence".
In: Jackson Hole Economic Symposium 2013.
7
According to the trilemma, in a financially integrated world, fixed exchange rates export the monetary policy of the
centre country to the periphery. The corollary is that if there are free capital flows, it is possible to have
independent monetary policies only by having the exchange rate float; and conversely, that floating exchange
rates enable monetary policy independence (see e.g. Obstfeld and Taylor (2004)).
8
See e.g. Olivier Jeanne and Anton Korinek (2010) "Excessive Volatility in Capital Flows: A Pigouvian Taxation
Approach", American Economic Review Papers & Proceedings 100(2), pp. 403-407 and Emmanuel Farhi and
Ivan Werning (2014), "Dilemma not Trilemma? Capital Controls and Exchange Rates with Volatile Capital
Flows," IMF Economic Review 62, pp. 569-605.
9
Under the IMF new institutional view, CFMs should not substitute for warranted macroeconomic adjustments.
Circumstances which allow for CFMs on capital inflows include for example a situation in which the economy is
overheating, the exchange rate is overvalued and reserves are at adequate levels. Similarly, CFMs could be
applied on capital outflows if the economy is stagnating, FX exposures are high, and reserve levels are
inadequate.
10
In many studies gains are of second order of magnitude as financial integration enables a reduction of
consumption volatility but does not affect output (see Nicolas Coeurdacier, Hélène Rey and Pablo Winant, 2015
"Financial Integration and Growth in a Risky World", NBER Working Paper, No. 21817).
11
One estimate suggests that the standard deviation of income growth uncertainty is reduced through financial
markets by as much as 35% across U.S. states (see Stefano G. Athanasoulis and Eric van Wincoop, (2001),
"Risk Sharing Within The United States: What Do Financial Markets And Fiscal Federalism Accomplish?," The
Review of Economics and Statistics, 83(4), pp. 688-698. According to a recent IMF paper, cross-country risk
sharing in the euro area is not only more limited (roughly half that seen in existing federations), but also falls
sharply in severe downturns. See "Fiscal Risk Sharing: New Evidence for the Euro Area", IMF Technical
Background Note, September 2013. This is largely in line with recent evidence contained in the ECB's annual
report on financial integration, which stresses that risk sharing in the euro area has increased with the
introduction of the euro, but remains at relatively low levels. It also suggests that risk sharing is particularly
fostered through various forms of equity holdings, underlining the importance of the capital markets union and
its emphasis on equity markets. See ECB (2016), "Financial Integration in Europe", April 2016.