The past two decades represent an interesting phenomenon in the global financial world. Each decade has a story to tell that in almost all ways contrasts the story of the other. The earlier decade – from the late 1990s to late 2000s – is viewed as the golden era of modern financial world and was marked by increasing global trade, rapid growth of equity and debt markets (probably except for the dotcom bubble) in most stable economies and greater movement of labor and capital across borders. It was the triumph of globalization and few had predicted that there will be challenges or hurdles on this path.
However, a turning point occurred in this narrative in 2008 that left the financial world reeling in shock and probably even turned back the hands of the clock. Post the crisis, global trade has declined and not recovered to its pre-crisis peak, investor confidence has failed to pick up and countries across the world are struggling to push the growth gears of their economies.
In the light of the recent political and financial events, we view the 2008 global financial crisis as the pivot and analyze how the structure of global finance, economy and markets has transformed in the past two decades.
THE DECADE BEFORE
Emergence of the ‘Emerging Economies’
Post World War II, the major economies of the world had been weakened. The United States was the sole capitalist state that drove economic growth and it continued to lead the world until 1970s, when some of the Western European countries started to recover. This was followed by the rise of the Asian economies in the 1980s and the 1990s, primarily lead by Japan and later by China, after its leader Deng Xiaoping in 1978 liberalized the Chinese accompany. In 1991, after years of following socialist policies and acting as a welfare state with strict regulations in the private sectors, the then Indian Finance Minister Manmohan Singh (later Prime Minister), implemented a wave reforms that opened the doors of Indian economy to the private sector and foreign investments.
As a result of these events, during the decade before the 2008 crisis China and India, grew at over 8% annually. A similar wave of growth was being observed in Brazil and Russia. In 2001, the then Chairman of Goldman Sachs Asset Management coined the term BRIC – postulating that these four economies will be the driver of world economic growth. In 1998, the BRIC nations had a combined GDP of 8.31% of the world GDP in current US dollar value (World Bank Data). By 2008, this had increased to 14.47% and it now stands at 21.94%.
Innovation and globalization in financial markets
The era before the crisis transformed the financial world in two crucial ways – one, there was innovation in the financial instruments being offered which witnessed exponential growth and two, banks across the world diversified their businesses leveraging globalization.
In the two decades preceding the crisis, there was a growth in new financial instruments being traded such as derivatives and ETFs. Though some of these instruments had existed for decades, some even decades, it was only in the decade before the financial crisis that there was a spurt in the volume of these instruments being traded.
In the decade prior to the crisis, the
global daily average turnover in the listed futures and options exchange market increased by almost 8 times from $1.3bn to $9.5bn (based on notional amount, source: BIS). Similarly, the global daily average turnover for OTC foreign exchange derivatives on a ‘net-net’ basis in 2007 was $3.3bn, a three-fold increase from a decade earlier (source: BIS). However, the biggest spike was observed in the daily average turnover of OTC interest rate derivatives, which stood at $1.6bn in 2007, up 8 times from a meager $0.2bn in 1998. These numbers are representative of the growth that the derivatives market witnessed in the decade before the financial crisis.
Similarly, the growing financial markets provided banks an opportunity to expand their businesses, both geographically and in terms of the services provided. The fifteen-year period saw a steady increase in the number of foreign banks, from 784 in 1995 to 1,301 in 2007. For the period between 1998 and 2008, the cross-border claims and liabilities tripled from $9.1bn and $8.2bn to $34.4bn and $30.1bn, respectively (source BIS).
Banks also diversified their service lines and grew rapidly in this decade. The strong capital markets allowed banks to earn more income through services such as investment banking and wealth management. The intriguing aspect, however, is the growth of the shadow finance sector during the same period. The graph on next page reveals that the financial assets held by the shadow banking sector had surpassed that held by traditional banking sector.
The Consumption Era
In the decade before the crisis, the economies of most of the developed economies were being driven by increased consumer spending. The household savings rate, as a percentage of personal disposable income, was declining in most of the growing economies. The United States has historically had one of the lowest savings rate and lead this decline even in the decade before the crisis. The gross savings as a percentage of GDP in the United States had come down from 21.33% in 1998 to 15.49% in 2008. Since the 1970s, this was the second period with one of the lowest savings rate. However, this trend has seen a reversal since the economic crisis, changing the nature of how consumers allocate their income. Since 2008, the gross savings in the US has increased every year and now stands at 19.91%, fast approaching the late 1990s number.
Similarly, the household savings as percentage of the personal disposable income in United States, China, Australia and Switzerland reveals a similar trend. This phenomenon in four different regions of the world clearly indicates that the problem is not limited to the US economy.
While it is true that after every economic crisis, the savings rate tends to increase due to low consumer confidence in the future of the economy, what is surprising in this case is the time period for which this trend has continued. Even 8 years after the crisis, most global economies continue to be plagued by low spending by the larger population despite several efforts by the central banks to ease the availability of credit and to discourage savings through lower interest rates.
THE DECADE AFTER
Central Banks: The lone wolves
Until the 2008 financial crisis, the Central Banks played a supporting role to the government policies. However, post the crisis, the role of central bank has shifted from a side-actor to the key player.
Across the world, the growing importance of the central banks has been attributed to several factors, including the increasing debt of US Government due to the bailout program, and the political and structural weakness of the EU Commission in case of the Eurozone. Similarly, Japan had changed 7 Prime Ministers between 2006 and 2012, as the economy had continued to struggle for over a decade since the Asian financial crisis in 1998. In the given circumstances, Central Banks across the world had to step in to save their economies from a catastrophic collapse. Most resorted to Quantitative Easing programs, purchasing huge amounts of securities and debts to pump in more money into the economy and reducing interest rates, in some countries lower than 0%.
However, unlike any of the previous financial crisis, these measures failed to lift the economies to the expected level and growth remained tepid years after Central Banks pursued these measures. The lack of fiscal support in many countries with these monetary policies have pushed the Central Banks to a corner, left fire-fighting alone. In the words of Mark Carney, Governor of the Bank of England, “Monetary policy has been keeping the patient alive, creating the possibility of a lasting cure through fiscal and structural operations. It has averted depression and helped advanced economies live to fight another day, so that measures to restore vitality can be taken.”
Bleeding banks – regulations and penalties
In the aftermath of the crisis, there was a demand to bring to book those responsible for it and to regulate the financial industry. The US Government responded with a number of regulations under the Dodd-Frank Act. The EU, on the other hand, decided to implement a single rulebook for all its member state banks and has enacted 30 rules since 2012 after it established three supervisory authorities. Compliance with these regulations has greatly impacted the profitability of these banks.
At the same time, inquiries were setup to investigate the role of these banks in the creation of the crisis. The US Justice Department has already settled $82 billion with 8 banks so far. Deutsche Bank has been the most recent victim, finally settling for an amount of $7.2bn, down from the initial amount of $14bn which was widely believed the bank would not be able to pay. Adding to the DoJ settlements, the various lawsuits against the banks takes up the total amount to over $150bn.
The increased regulations and continuous inquiries have hit the financial systems hard and banks have struggled to stay profitable in the past few years.
Rise of populism – end of globalization?
The greatest driver for economic growth in the past three decades was globalization – borders were opened for trades via free trade agreements, migration rate increased significantly and a number of activities were outsourced from the developed to the developing countries. Until a few years ago, the general perception was that globalization benefits all and just like each of the previous stages of globalization, the common consensus was that this phase, too, will last forever.
However, the prolonged recovery after 2008 crisis caused huge sustained levels of unemployment in the developed economies. There was growing discontentment against movement of jobs and labor from these economies to the emerging world. On the back of these conditions, two major unexpected events happened in 2016 which have probably set in motion the reversal of globalization.
Populism is now mainstream. And this sentiment is affecting the nature of politics in the West as ‘nationalism’ is gaining momentum. Whether this wave of populism will merely redistribute the jobs and wealth or stall global economic growth is to be seen over time.
Growth of alternate finance
While most of the commentary on the last decade has been bleak and pessimistic, there is a knight in the shining armour. The growth of alternate financial systems promises to revolutionize the industry. Finance and technology have blended together to disrupt the old model of banking. There are 4 main areas that have seen phenomenal growth and captured our attention – crowd-funding, peer-to-peer lending, microfinance and invoice trading.
In Europe, the total volume of transactions in this industry experienced a growth of 144% and 92% in 2014 and 2015 respectively. In the Americas, the industry grew to $36.49bn in 2015, a 212 per cent annual increase from the $11.68bn in 2014.
The leader in this category is peer-to-peer lending, where a number of unsecured personal loans are pooled to support a business venture. The success of Grameen Bank in Bangladesh has become a model for microfinance across the world. Microfinance involves creating small loans for the impoverished people without any collateral, and is considered vital to kick start economic growth in many economies.
While various industry reports claim that firms that have been funded using alternate finance have performed well, only time will tell whether there are flip sides to this growing industry. In that direction, it is imperative that the authorities frame appropriate regulations not only to support these new institutions but also regulate their activities. In the US, conflicts are already emerging between Federal regulators and State regulators on FinTech.
The global financial crisis has moved the world in a direction different from where it was headed to before the crisis. Almost a decade after the crisis first appeared, we are still seeing the effects on the global financial and political landscape.
In 2017, the outcome of elections in a number of European nations will demystify where we are headed to. On the other hand, the election of Trump has finally set the stage for monetary policy divergence, which will probably help central banks steer out of the spiral of quantitative easing and maintaining low interest rates. In this regard, one cannot discount the role of changing demographics in some of the advanced economies. A recent paper published by the Federal Reserve concluded that with aging demographics, low interest rates is the ‘new normal’.
The question we are left with is – will the coming years see us returning to the pre-crisis era or take us further away from where we were before the crisis?
1 Stijn Claessens and Neeltje van Horen: “The Impact of the Global Financial Crisis on Banking Globalization”.
2 Robert Wardrop, Bryan Zhang, Raghavendra Rau and Mia Gray: “Moving Mainstream – The European Alternative Finance Benchmarking Report “.
3 Robert Wardrop, Robert Rosenberg, Bryan Zhang, Tania Ziegler, Rob Squire, John Burton, Eduardo Arenas Hernadez & Kieran Garvey: “The Americas Alternative Finance Benchmarking Report”.
4 Gagnon, Etienne, Benjamin K. Johannsen, and David Lopez-Salido (2016). “Under- standing the New Normal: The Role of Demographics,” Finance and Economics Discus- sion Series 2016-080. Washington: Board of Governors of the Federal Reserve System, http://dx.doi.org/10.17016/FEDS.2016.080.