Monday, March 16, 2009

Crisis Reduces Financial Globalization

For a long time, cross-border financial integration kept increasing along with trade integration. In most countries, there were significant net sales of domestic equities and bonds to foreigners, while domestic investors were net buyers of foreign equities and bonds. This was in many cases motivated by a wish for diversification based on the theory that if your investments in your domestic stock market went sour, that could be compensated by gains in your foreign holdings.

That theory has seemingly been refuted in the current crisis. Whenever for example the U.S. stock markets have a sell-off, so will the Asian and European markets the next day. That correlation have held almost always except for when news published after the U.S. close support a different movement, but that usually means that the U.S. stock market will also move in that direction.

In a longer-term perspective, there will be significant decoupling between different markets, and diversification can thus reduce risk for long-term investors. But in the short- to medium term perspective, global equity markets will usually move in the same direction. And as many or even most investors have a short to medium term perspective, this means that they now likely find diversification less worthwhile.

Meanwhile, bond investors have discovered that because of the dramatic exchange rate fluctuations, investments in foreign bonds are something which will increase risk in your portfolio. Domestic bonds (particularly government bonds) will not fluctuate very much in value, but foreign bonds could fluctuate quite dramatically in value in terms of your own currency, meaning that this diversification will actually increase risk in your portfolio, something which the increased exchange rate volatility has illustrated.

And while that increased risk in the past was compensated for with higher interest rates, the big drop in interest rate differentials has reduced that advantage with cross-border bond investments.

Likely as a result of all of this, we can now see that financial integration is being partially reversed. Evidence for this was provided in the latest Treasury International Capital Data. In the year to January 2008, foreigners (as in non-Americans) made net purchases of $191 billion of American equities and $764 billion of American equities. But in the October 2008 to January 2009 period, they net bought just $3.5 billion of American equities while they net sold $93 billion of American bonds.

Similarly, in the year to January 2008, Americans net bought $85 billion of foreign equities and $153 billion of foreign bonds. But in the October 2008 to January 2009 period, they net sold $47 billion of foreign equities and $12 billion of foreign bonds.


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