TWN Info Service on Finance and Development (Jun17/02)
28 June 2017
Third World Network

Globalisation risks need careful management, not backlash, says BIS
Published in SUNS #8485 dated 20 June 2017

Geneva, 19 Jun (Chakravarthi Raghavan*) -- Increased economic globalisation has contributed to a remarkable increase in living standards across the world and while its adjustment costs and financial risks need careful management they do not justify a backlash against globalisation, according to the Basel-based Bank for International Settlements (BIS).

In Chapter VI of its annual report for 2017, released for publication at 1800 hrs CEST on 18 June, the BIS, commonly known as the central bank for the world's central banks, adds: "Tighter global economic integration has been hugely beneficial. Globalisation has been instrumental in raising living standards and has helped lift large parts of the world population out of poverty. Trade openness has greatly enhanced productive efficiency and vastly improved consumption opportunities. Financial openness, in addition to supporting international trade, allows greater scope for diversifying risks and earning higher returns. It also makes funding more readily available and facilitates the transfer of knowledge and know-how across countries."

In a foreword, released along with Chapter VI, Jaime Caruana, General Manager of the BIS, says: "Arguments that question the benefits of globalisation have been receiving greater attention in the public debate. This shows that we risk forgetting the lessons of the past and taking for granted the gains in living standards, productivity and prosperity achieved over the last half-century.

"In this year's Annual Report, we recommend taking advantage of the current tailwinds to growth to build economic resilience as a basis for sustained growth. Preserving the benefits of globalisation is a key element of this strategy. ... The focus we are putting on this issue reflects the importance of maintaining and developing these links and the changing nature of the debate about the global economy.

"Critics often blame globalisation for the rising inequality in some industrialised countries. Empirical studies show that other factors, mainly technology, have played a bigger role. It is true that the burden of adjustment often weighs heavily on specific sectors or regions. But sound domestic policies can help those who are negatively affected overcome these obstacles.

"Another criticism is that financial openness makes economies more vulnerable to ebbs and flows in global finance, and allows spillovers from one country to another. We should recognise that the global financial system is subject to procyclicality and excesses, just as domestic financial systems are. But the right answer is not to roll back financial openness. Rather, it is to put in place the necessary safeguards, just as the policy community has done in response to domestic financial liberalisation.

"This will allow us to reap the benefits while addressing the challenges involved. The role of global currencies such as the US dollar, and of globally active banks, calls for close international cooperation in this regard. Indeed, as we show in the chapter, real globalisation entails financial globalisation - the two are inseparable, in that it is not possible to reap the benefits of trade and investment without international finance. One can think of globalisation as consisting of three layers.

"That real and financial globalisation go hand in hand is obvious in the first layer, where cross-border payments and credit are needed to facilitate trade of commodities and finished goods. But it is also true for the second, which involves more complex international trade. Financial openness allows the financing of cross-border investments and whole global value chains that distribute production across countries. It also allows hedging of the corresponding financial risks. It is only in the third layer that financial links are established solely for financial purposes.

"The analysis in the special chapter we release today should serve as a reminder of how globalisation has boosted economic welfare. Instead of retreating from the ties of global trade and finance, we should reinforce them. Instead of loosening them, we should make them more resilient. We must work together to create well designed policies, both domestically and internationally. Only then can we make sure that globalisation will continue to lift economic growth and living standards around the world for generations to come."

The BIS is to hold its annual meeting on Sunday (25 June) at Basel. It normally releases its entire annual report on that day, but this year has released Chapter VI of its report, a week in advance of the meeting. The remaining chapters and data are due to be released on 25 June.

Only when all the remaining chapters are made public, and the report as well as the arguments in it with supporting data can be read together would it be possible to make an overall assessment.

However, the unusual release of only Chapter VI, titled "Understanding globalisation", and its message reinforced by the BIS General Manager's foreword, suggests that the BIS and its constituent central banks are worried that in the current state of politics and public debates in the advanced economies, there will be concerted efforts by some governments to rein in and discipline financial institutions, and put the brakes on financial globalisation.

Restraining these efforts may in fact though result in increasing public mistrust in governments, and in particular central banks, several of whom appear to have conflated their duty to safeguard public interest with their actions, since the 2008 Great Financial Crisis (GFC), to shore up the positions of banks and finance capital (at the expense of the tax-payer), rather than as regulators act to punish those in charge of banking and financial institutions who have misbehaved and indulged in financial shenanigans, bringing the system to near collapse.

The end-result may be to unleash forces that may result in the second wave of globalisation to come to an end just as the first did in the last century.

Globalisation, the BIS report says, has had a profoundly positive impact on people's lives over the past half- century.

Nevertheless, despite its substantial benefits, it has been blamed for many shortcomings in the modern economy and society. Indeed, globalisation has faced more severe criticism than technological innovation and other secular trends that have potentially had even more profound consequences.

This chapter outlines how increased economic globalisation - tighter trade and financial integration - has contributed to a remarkable increase in living standards.

"Adjustment costs and financial risks need to be carefully managed, but they do not justify a backlash against globalisation."

Trade and financial openness are deeply symbiotic. Trade integration not only relies on, but generates, financial linkages. Banks with international operations underpin trade financing and follow their customers into foreign markets.

Trade denominated in a foreign currency can require hedging, with counterparties accumulating international positions. Firms may build capacity in a foreign country with an attractive skill or resource base in order to export from there. Managing the financial asset and liability positions built up through trade induces still deeper financial linkages, including international trade in financial services.

Tighter global economic integration has been hugely beneficial. Globalisation has been instrumental in raising living standards and has helped lift large parts of the world population out of poverty. Trade openness has greatly enhanced productive efficiency and vastly improved consumption opportunities.

Financial openness, in addition to supporting international trade, allows greater scope for diversifying risks and earning higher returns. It also makes funding more readily available and facilitates the transfer of knowledge and know-how across countries.

Globalisation has also posed well-known challenges. Gains from trade have not been evenly distributed at the national level. Domestic policies have not always succeeded in addressing the concerns of those left behind. The requisite structural adjustment has taken longer, and been less complete, than expected.

Furthermore, unless properly managed, financial globalisation can contribute to the risk of financial instability, much like domestic financial liberalisation has. And, not least through financial instability, it can increase inequality.

But globalisation has also often been made a scapegoat. For instance, there is ample evidence that globalisation has not been responsible for the majority of the concurrent increase in within-country income inequality.

Attempts to roll back globalisation, BIS says, would be the wrong response to these challenges. Globalisation, like technological innovation, has been an integral part of economic development. As such, it should be properly governed and managed.

Countries can implement domestic policies that boost resilience. These include flexible labour and product markets (the boiler-plate standard advice since the 1980s by tenured academics and economists at international institutions, none of whom advocate application of such policies to their own employment) and policies that enhance adaptability, such as retraining programmes.

Close cross-country linkages imply that policies and actions of individual countries inevitably affect others. Hence, international cooperation must supplement domestic policies. In particular, a global regulatory framework should be the basis for a sound and resilient international financial system.

In outlining the deep interconnectedness of trade and financial openness, the BIS report maps out the historical path of globalisation - from the "first wave" leading up to World War I, through the "great reversal" of the interwar years, to the revival and surge in globalisation post-World War II in the "second wave."

Recent suggestions of "peak globalisation", BIS says, are misleading, and it goes on to review how the structure of trade and financial integration has evolved in the second wave: the impact of globalisation on welfare, its contribution to the substantial growth in incomes and the dramatic decline in poverty as well as the risks to financial stability linked with financial openness.

In some concluding observations, BIS discusses policy measures that can further enhance the benefits of globalisation and minimise the adjustment costs.

In advancing this line of argument, the BIS report appears to be crossing swords with (or ignoring views of) economists like Prof. Dani Rodrik, with his characterisation of developments as "hyper-globalisation" and mooting policy changes running contrary to the BIS advocacy of trade and financial integration of the global economy.

And in a post on 14 June at the New York Times blog under the title "A Finger Exercise On Hyper-globalization," Nobel Laureate in economics Paul Krugman, discussing the surge in trade from around 1990 to the eve of the Great Recession, has argued that this has been the result of an even seemingly small decline in transport costs having a large effect on the location of production, since it drastically reduces the production cost advantage emerging markets need to have.

And in turn this leads to an even more disproportionate effect on the volume of trade, leading to a sharp increase in shipments of intermediate goods as well as final goods, a lot of "value chain" trade.

In Krugman's view, this is what happened after 1990, partly because of containerization, and partly because of trade liberalization in developing countries. "But it's also looking more and more like a one-time thing," he says.

International trade and financial openness, BIS says, go hand-in-hand. Trade is facilitated by financial links, such as international payments and credit, and in turn results in financial links, such as the accumulation of international assets and liabilities.

As a result, it is not surprising that countries that are more open to trade also tend to have higher financial openness.

It is not clear from the released chapter whether the BIS economists think that financial openness involved openness to trade.

The report views Europe as the most integrated financially. However, while within Europe trade is open, vis-a-vis the rest of the world, claims of EU's "openness" to trade is questionable. Its agricultural markets and trade, for example, are highly protected.

The relationship between real and financial openness, BIS says, however, evolves with the degree of integration and development. Conceptually, it says, one can think of three globalisation layers.

The first, most basic layer is trade of commodities and finished goods and the corresponding simple international financial links, such as cross-border payments.

The second layer involves more complex trade and financial connections. It includes trade in intermediate goods and services associated with the efficiency-driven fragmentation of production across countries and the corresponding financing arrangements.

The third layer concerns the financial transactions increasingly used to actively manage balance sheet positions.

These positions include the stocks of assets and liabilities, and exposures more generally, created by the first two layers, as well as the allocation and diversification of savings, not necessarily related to trade. The third layer thus introduces some decoupling between real and financial openness.

The links between trade and financial openness are most immediate in the first globalisation layer. In the second globalisation layer, international financial linkages support a greater degree of specialisation in trade and production, notably in the trade of intermediate goods.

The third globalisation layer is characterised by intricate financial links established solely for financial purposes.

The three layers share some common elements. One is the use of global currencies. As the dominant global currency, the US dollar is used to denominate around half of trade, roughly half of global cross-border bank claims, more than 60% of central banks' foreign exchange assets, and features in 90% of foreign exchange transactions. Thus, the dollar plays a central role in determining global financial conditions.

Globally active financial institutions operate in many countries across multiple continents. Through their international presence and sophistication, they facilitate the global transfer of funding and financial risks. Balance sheets that are managed at a consolidated level create close international financial linkages.

The first globalisation wave, which died out with World War I and the Great Depression, saw a substantial increase in both real and financial cross-border linkages. Its collapse was as remarkable as its build-up: the "great reversal" in the interwar period witnessed an almost complete unwinding.

The second globalisation wave, starting after World War II, has far outstripped the first. Trade openness surged beyond its prewar peak as countries traded more, and more countries traded.

For the world as a whole, trade openness has doubled since 1960. Trade growth in the two decades up to the mid-2000s was particularly rapid: China and former communist countries re-entered global trade and the second globalisation layer expanded quickly.

The specialisation through the division of production stages across national borders resulted in the unprecedented expansion of GVCs (global value chains).

Financial openness increased with trade openness in both waves, but its rise has been much more marked in the second.

Available estimates, while highly imperfect, suggest that financial openness is more than triple its prewar peak.

The rapid expansion in financial openness from the mid-1990s has been concentrated in advanced economies.

Though the BIS has refrained from drawing any conclusions from this, it would suggest, that perhaps the rapid expansion in financial openness in advanced economies (compared to the modest ones in EMEs) accounts for the backlash against globalisation in the advanced economies.

GVCs have been a key driver of trade growth, especially in manufactured goods, facilitated by the improvements in market access, transport and technology: with high- and low-skill tasks increasingly located in different countries, trade in intermediate goods and services now accounts for almost two thirds of total global trade.

EME (emerging market economy) participation in GVCs has increased dramatically. In 2014, EMEs were involved in half of GVC trade. The share of GVC trade between EMEs has more than doubled. China alone is now responsible for 19% of GVC trade, up from 7%.

And in the process, intra-EME trade integration has increased at a faster rate than that of advanced economies, alongside EMEs' greater heft in the world economy.

Large TNCs dominate global trade. With operations in multiple countries, they often play a prominent role in GVCs.

For example, in the United States around 90% of trade involves TNCs, and half is between related entities within a TNC. Despite the expansion in EME trade, TNCs remain more prevalent in advanced economies.

Just as TNCs play a key role in trade, large internationally active financial institutions increasingly dominate global finance, particularly in advanced economies.

Standard BoP (balance of payment)-based measures of financial openness tend to underestimate the degree of global interconnectedness, just as they do for the non-financial sector, where TNCs' subsidiaries produce for their local market.

For EMEs, overall financial openness has grown only slightly faster than trade openness, but the composition of external liabilities has changed substantially to support greater risk-sharing.

The rise in globalisation has been in check since the Great Financial Crisis (GFC) of 2007-09.

International trade collapsed during the GFC and, despite a rapid rebound, has remained relatively weak. In real terms, global trade has barely grown in line with global GDP.

In nominal terms, trade appears even weaker, failing to keep up with GDP growth owing to the fall in the relative prices of traded goods and services, particularly commodities. The GFC also brought to a halt the rapid rise in standard BoP-based measures of financial openness.

The interaction of real and financial factors within the first two globalisation layers in part explains the easing in both trade and financial openness. More generally, the pullback in trade and financial openness reflects a desire to reduce risk, most obviously by financial institutions, but also by non-financial companies, as seen in the decline in disruption-sensitive GVCs.

However, at least on the financial side, the apparent pause in globalisation needs to be interpreted with caution.

First, conventional measures somewhat overstate the reduction in openness. Second, the pullback in finance has been limited to some types of flows. It has been concentrated in cross-border bank loans.

However, the contraction in bank lending is not as severe when measured using alternative metrics of financial openness, based on the location of headquarters of economic units, or on nationality basis that consolidates the corresponding balance sheet.

BIS international banking statistics (IBS) indicate that this transnational component has been much more stable post-crisis. Furthermore, there is some evidence that EME banks, many of which are not captured by the IBS, have substantially increased their international presence through foreign offices. This trend is especially pronounced at the regional level.

Globalisation, BIS says, has greatly contributed to higher living standards worldwide and boosted income growth.

Over the past three decades, it has been an important factor driving the large decline of the share of the world population living in significant poverty, and of income inequality across countries. For example, poverty has fallen markedly in China, where the development of export industries has been a key force behind the rapid growth of GDP and incomes.

Over the same period, the income gains have not been evenly spread. The biggest gains have accrued to the middle classes of fast-growing EMEs and the richest citizens of advanced economies. In contrast, the global upper middle class has experienced little income growth.

This has seen within-country income inequality increase in advanced economies and even many EMEs. The share of income accruing to the top 1% of income earners has increased substantially since the mid-1980s. High inequality appears to be harmful to growth and has undermined public support for globalisation.

There is strong empirical evidence that globalisation is not the main cause of increased within-country income inequality; technology is.

[In discussing the benefits of trade and financial openness, the BIS report uses differing language for trade and finance. This suggests that benefits of trade openness is rooted in empirical evidence, while there is lack of adequate empirical evidence for finance openness, with BIS using language like "should", "could", "can" and the like terms. SUNS]

Both trade and financial openness can be expected to increase the rate of economic growth. Overall, trade has been found to boost growth in many economies. Trade also directly benefits consumers, as they can choose from a greater variety of higher-quality products.

Financial openness SHOULD (emphasis added) also boost growth, by enabling a more efficient allocation of capital and facilitating the transfer of technology and know-how. Empirical work has not universally identified increases in income or growth from increased financial openness.

It has also been suggested that the benefits from capital account deregulation may be less direct and take time to detect. Last but not least, many of the existing empirical studies treat trade openness and financial openness as independent variables, thus implicitly assuming that trade integration could take place without financial integration.

Yet, argues BIS, trade and financial openness tend to go hand-in-hand.

While national income undoubtedly increases with trade, the gains are unevenly distributed - a general feature of economic dynamism. The winners and losers are unevenly distributed across skills, income levels and location. Trade between advanced economies and EMEs generally increases the return to advanced economy skilled labour, which is relatively scarce globally.

In contrast, the returns to unskilled labour in advanced economies may well diminish because of the greater competition from the large pool of unskilled EME labour. Conversely, unskilled labour in EMEs MAY (emphasis added) benefit.

At the same time, trade also leads to relative price falls for goods disproportionately consumed by lower-income households, boosting their relative purchasing power. Given these offsetting effects, the net effect on inequality from trade openness is uncertain in economic models.

There are also opposing channels through which financial openness could affect income inequality, enhancing opportunities for income generation of low-income individuals. Indeed, there is evidence that greater access to (domestic) finance can increase incomes of the poor.

Alternatively, if financial openness, and FDI (foreign direct investment) in particular, increases capital intensity and the returns to skill, the benefits could accrue to higher-income individuals or if domestic institutions are not strong enough to prevent special interest groups from capturing the associated gains.

Trade and financial openness can also increase inequality by favouring income from capital sources, reduce labour's "pricing" power, putting downward pressure on wages, and constrain the feasibility of taxing capital, contributing to higher taxes on labour income.

In practice, BIS says, trade and financial openness appear to have made only a fairly small contribution to the increase in income inequality. For financial globalisation, this effect is likely to have been somewhat larger in low-income countries. While declining labour shares have been linked to globalisation, the evidence indicates that it is not the only driver. Importantly, the impact of trade on inequality depends on obstacles to adjustment. These effects can be persistent if labour is immobile across regions and industries.

Globalisation, BIS concedes, can affect economic growth, poverty and inequality by its impact on financial stability. Financial crises can result in a permanent loss of income, have a devastating effect on poverty and increase inequality. Unfettered financial openness can contribute to financial instability unless sufficient safeguards are in place.

Highly mobile international capital can behave in a very procyclical manner, amplifying financial upswings and reversals. Foreign currency exposure, in particular in dollars, transmits tighter global financial conditions and exposes countries to foreign exchange losses. And, close financial linkages between globally active financial institutions can spread financial stress, although they may also act as a buffer when problems have a domestic origin.

This global currency channel is especially powerful in the case of the US dollar - the dominant international currency. The outstanding stock of US dollar-denominated credit to non-bank borrowers outside the United States, a key indicator of global liquidity conditions, stood at $10.5 trillion as of end-2016.

This outsize external role means that changes in the US monetary policy stance have a substantial influence on financial conditions elsewhere.

And since monetary policymakers, including those in control of major international currencies, are focussed on domestic conditions, they could unintentionally end up contributing to financial imbalances well beyond their national borders.

The globalisation surge over the past half-century has brought many benefits to the world economy. Openness to trade has enhanced competition and spread technology, driving efficiency gains and aggregate productivity. The resulting stronger income growth has supported a remarkable decline in global poverty and cross-country income inequality.

Financial openness, properly managed, CAN (emphasis added) also independently enhance living standards through a more efficient allocation of capital and know-how transfers. (The BIS chapter does not say whether in fact it does.)

While globalisation increases living standards, the gains are not equally distributed.

The distributional implications of trade and financial openness need to be addressed to ensure fair outcomes within societies and continued support for growth-enhancing policies and economic frameworks, including global commerce. Other factors - most notably technology - have played a dominant role in the increase in income inequality. Just as there is no suggestion to wind back technology, reversing globalisation would be greatly detrimental to living standards.

Financial openness exposes economies to potentially destabilising external forces, but this risk can be managed by designing appropriate safeguards. Since international trade and finance are inextricably intertwined, particularly in the first two globalisation layers, reaping the benefits of trade would be impossible without international finance.

That is why the policy solution is not to reduce financial openness, but rather to carefully address the associated risks, BIS argues.

The challenges of managing economic change are not unique to globalisation. As with other secular trends, well designed policies can offset the adjustment costs associated with globalisation and enhance the gains from it.

On the domestic front, countries can implement policies that boost resilience, including well-articulated macroprudential frameworks on a firm microprudential base, and the capacity to address directly any debt overhang and asset quality problems that might arise during financial busts, in order to repair balance sheets and improve overall creditworthiness.

Indeed, EMEs have been taking important steps in this direction since the mid-1990s. And this has gone hand-in-hand with a better external balance sheet structure, helping to reduce their vulnerability to external factors, including through considerably stronger net international investment positions, substantial increases in their foreign exchange reserves and a higher FDI share.

International cooperation that addresses global linkages must supplement domestic policies. The special roles of global financial institutions and global currencies transcend international trade and the financial interactions directly linked to it in the first two layers.

An internationally agreed joint regulatory approach is needed to ensure that policymakers properly manage global financial risks, not least those associated with the highly procyclical third layer. Because policies and actions of individual countries affect others, multilateralism is key for delivering the best outcomes for all.

The first priority for global financial institutions is to complete the international financial reforms already under way, which will go a long way to boosting the resilience of the global financial system.

An agreed global regulatory framework is the basis for effective supervision of internationally active banks, including mechanisms for cross-border information-sharing, and fostering a level playing field, a precondition for efficiency and soundness at the global level.

As regards global currencies, effective crisis management mechanisms remain important, and naturally require international cooperation. A greater emphasis on preventing the build-up of financial imbalances appears desirable. At a minimum, this would mean taking more systematic account of spillovers and spill-backs when setting policies.

International cooperation is also needed beyond finance to ensure a level playing field in trade and areas such as tax.

Multilateral trade agreements provide the largest common markets to maximise efficiency. Such well-designed domestic and international actions can ensure that globalisation continues to be a greatly beneficial force for the world economy and people's living standards, BIS concludes.

[* Chakravarthi Raghavan is the Editor Emeritus of the SUNS.] +