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 percent 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.
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 percent annually since the crisis, down from average annual growth of 7.9 percent from 1990 to 2007 (Exhibit 1). 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 $11.8 trillion in 2007 to an estimated $4.6 trillion in 2012 (Exhibit 2). Western Europe accounts for some 70 percent of this drop, as the continent’s financial integration has gone into reverse. Eurozone banks have reduced cross-border lending and other claims by $3.7 trillion since 2007, and central banks now account for more than 50 percent of capital flows within the region.
- Even beyond Europe, global banking is in flux. Cross-border lending has fallen from $5.6 trillion in 2007 to an estimated $1.7 trillion 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 percent of GDP, compared with 408 percent of GDP), and this gap is no longer closing. Capital flows involving emerging markets, however, have largely rebounded. We estimate that in 2012, some $1.5 trillion in foreign capital flowed into emerging markets—32 percent of global capital flows that year, up from just 5 percent in 2000—surpassing the precrisis peak in many regions. Capital flows out of developing countries rose to $1.8 trillion in 2012. Although most outflows are destined for advanced economies, $1.9 trillion 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 percent 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.
MGI principal Susan Lund discusses the world’s progress in recovering from the 2008 financial crisis and scenarios for the future of global capital markets.
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.
The steps that policy makers take next will help determine whether nations turn inward or a new and more sustainable phase in the history of financial globalization begins. Completing the global regulatory-reform initiatives currently under way will be crucial, along with building more robust capital markets, creating new financing mechanisms for borrowers that lack access to the market, and removing restrictions that limit the most stable forms of cross-border investment.
Whatever the policy outcome, banks and investors will have to make fundamental shifts in strategy, organization, and geographic footprints. Nonfinancial corporations, too, may find it difficult to access capital in some parts of the world if the global financial system remains stalled. Corporations themselves, however, may play a larger role as providers of capital, particularly to their own supply chains. If this development leads to an increase in foreign direct investment, it may have a stabilizing influence on cross-border capital flows.