Let me tell you something pretty crazy…. I have one bank account in Estonia with a British bank and another South Africa. I’ve also invested in some stocks in the Netherlands and some bonds in the United States.

But, it is 2021, and I’m guessing that, actually, this is not very shocking to you.

These days it is quite normal that you can invest in financial products from all over the world. And even if you don’t do it, your bank or pension fund most certainly does. But, this wasn’t always the case. Financial globalization only started to take off in the late seventies / early eighties of the last century and, since then, it continuously became easier to invest across borders.

And you know what… that is great … for investors.

But… international investors have a reputation of being quite fickle. Meaning that, financially speaking, they are really likely to invest in a country that is currently booming. Only, to flee back to their home country at the first sign of trouble.

This will then cause huge boom-bust cycles in the countries on the receiving end of these capital flows.
So, have countries been right to open the door to international investors? or was it a mistake? And, if it was a mistake, what can they do to limit harmful effects of financial globalisation?

These are the questions I will answer for you in this blog post.

If you prefer to consume this story in video format, check it out here:

Okay, this story does not start Globally. Instead, it starts with local asset markets like houses, stocks, and bonds. As I discussed in my last post on the domestic financial cycle, these markets do not work like normal economic markets in the sense that they are characterized by positive feedback loops. This means that if the price of an asset goes up… more people will want to buy it, so that they can profit from it. The presence of a positive feedback loop in asset markets means that, for example, housing and cryptocurrencies markets are prone to boom-bust cycles.

Now, to make this even worse, there is also a positive feedback loop between finance and asset markets. If more loans are channelled into an asset market, the price of that asset will go up. And, if the price of an asset goes up it will ‘feel’ safer for banks to provide debt to investors in these markets, where the underlying assets often serves as collateral.

It was important to tell this story first because, just as local finance amplifies asset market bubbles, international finance amplifies both local finance and local asset market bubbles.

How international finance amplifies the financial cycle

To understand how this works, let’s start simple.

International finance can amplify local asset bubbles simply by increasing the pool of available investors. For example, think about truly global cities like New York, San Francisco, Hong Kong, and London. Property prices are astronomical in these cities. Far higher than in any other major cities in their respective countries. How is this possible? Well, a part of it can be explained by how easy it is for (wealthy) investors from all over the world to invest in property in these cities. If only local investors could invest there, housing bubbles would of course still be possible. However, with international investors entering the mix, the bubble can both grow larger and also much more quickly. From here, it’s easy to imagine a second channel. Not only can international capital amplify the investment potential in a nation, it can also amplify the debt potential. If local banks can amplify an asset bubble, imagine what global banks can do. For example, think about the famous 2006 U.S. housing bubble. This bubble was massive and there were plenty of Americans investing in it. However, strangely enough, it was largely financed by European banks such as the Royal Bank of Scotland, ABN Amro, and Deutsche Bank. That’s why the European banking sector was particularly hard hit when the bubble popped.

Okay, so these first two channels are pretty obvious right?

The domestic financial cycle is powered by both positive feedback loops in asset markets and banking and international capital can amplify both. But.. that is not all. So far, I’ve only talked capital flows in the same currency…

How do exchange rates come into the mix?

Exchange rates

In international economics the consensus is that exchange rates act as a sort of buffer. For example, if there is a big imbalance in trade, the exchange rate will often adjust to offset that imbalance. If a country exports a lot, demand for its currency will increase, and so it will become worth more. And, as its currency appreciates … its export industry will becomes less competitive … at least theoretically.

However, with finance this mechanism is flipped. Here again, and I think you can see that this is become a bit of a theme, we run into a positive feedback problem. Say that you want to invest in the Johannesburg stock exchange while living in Europe… You will have to buy the South African Rand with your Euro’s and use those South African Rands to buy local stocks. As a consequence, both the South African Rand appreciates and South African stocks prices will go up.

This is great for you as an investor because you just saw your stocks increase in Rand value and that got worth even more in terms of the Euro, the currency that you pay your bills with. In other words, the exchange rate appreciation amplifies the profits of investing in foreign asset bubbles, making it even more attractive.

Let’s now move on to the fourth and final channel about how international finance amplifies local financial cycles.

This channel is exactly about the institutions that have been tasked with preventing asset bubbles: central banks.

Globalization gave central banks the wrong incentives

The logic underlying this channel is that central banks can keep asset bubbles under wraps by keeping interest rates high in bubbly times and lowering them when the bubble has bursts. Central banks rarely do this in practice and his can partly be explained by the fact that financial globalization has given central banks strong incentives not to raise interest rates to counter asset bubbles.

The first incentive is that, for many export driven economies, central bankers are under pressure to try to keep the exchange rate relatively low to keep that export machine going. To keep their currency low, they keep their interest rates low. However, by keeping interest rates low, central banks make borrowing in their own country less risky. After all, lower interest rates means that borrowing is cheaper. This makes a domestic fuelled financial cycles more likely.

The next incentives stem from that fact that citizens of many countries are dependent on a currency and / or financial system of a neighbouring country. Most often this is the U.S. dollar and U.S. financial system. If this is the case, there are two more problems for local central bankers.

First, if U.S. interest rates are low, … this means that the U.S. banking system is likely to create more credit that can fuel an asset bubble in your country. This basically means that your citizens can borrow in the U.S. to fund a domestic asset bubble. In that case, it doesn’t matter what your central bank does with its interest rate since your citizens are using a different currency and financial system for a large part anyway.

Second, large international capital flows tend to chase interest rate differentials. So, if, for example, the European Central bank sets its interest rate at 0.0% and the Swedish central bank wants to raise interest rates to tame a local housing bubble, then a lot of European money will start flowing to Swedish banks which will also have higher interest rates. What should Swedish banks do with all of this European money? It’s all too easy to let it flow into mortgages.

Both of this means that central banks of small nations have strong incentives to follow interest rate movements of larger central banks. In practice, this is exactly what happens.

The four dangers of financial globalization

So, financial globalization can amplify domestic asset bubbles by:

  1. increasing available investment,
  2. increasing available debt,
  3. by introducing a new amplifying effect via the exchange rate,
  4. and, finally, by diminishing the power of central banks to use the interest rate to tame domestic financial cycles.

But, let’s not forget that, for investors it is great that they can invest all over the world. And also, for those companies needing funds to develop, there could be a lot of benefits thanks to this bigger pool of available finance.

So, that made me wonder: is it possible for countries to have it both ways?

Policy solutions

Well, in short the answer is … yes … in theory.

A first option is to encourage certain types of capital flows, such as investments in new factories, while making others more difficult. For example, by limiting foreign property ownership.

Second, if a country manages to keep its own house in order, so to say. If they prevent asset bubbles from developing in the first place, it is pretty hard for international investors to amplify them.

Finally, to get around the central bank incentive problems, they could coordinate their policies. For example, the U.S. Federal Reserve could take into account that while there is a need for low rates at home, this means lots of that money will flow to other countries … which might be in a massive asset boom. But, as you can imagine, in practice, this is pretty difficult since while central bankers are often under great pressure to do what is right for the nation, not the globe.