Monday, 3 November 2008
Financial capitals unlikely to lose their clout
As New York and London continue to reel from the global financial crisis, pundits everywhere are confidently predicting a sharp decline in the relative financial importance of these two cities. Newer financial centres in the emerging world, they claim, especially newer Asian financial centres, will rise to wrest away their financial dominance. But history suggests that in fact the contrary will happen.
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Financial capitals unlikely to lose their clout
Michael Pettis
3 November 2008
As New York and London continue to reel from the global financial crisis, pundits everywhere are confidently predicting a sharp decline in the relative financial importance of these two cities. Newer financial centres in the emerging world, they claim, especially newer Asian financial centres, will rise to wrest away their financial dominance. But history suggests that in fact the contrary will happen.
In most ways there is nothing especially unique about the current financial crisis. It is just another in the sequence of crises that have ended each of the approximately six globalisation cycles of the past 200 years (save one, which ended in 1914 with the first world war).
Of course, we should expect the current crisis significantly to change the worlds of commerce, finance and politics in important ways, but many of these changes will simply return us to older times - times in which, for example, not every graduate of every elite university dreamed of becoming an investment banker (a career choice which for me and many of my early-1980s classmates was as unfamiliar as pearl-diving).
During the late stages of the liquidity cycles that underlie globalisation the world economy has always experienced massive growth in financial transactions and the power of financial institutions.
Banks get larger, often through acquisitions and growth abroad, and financial activity expands dramatically until finance seems to become the hub of all industrial, commercial and political activity.
But these periods are the anomaly, not the norm. Globalisation cycles have always come to an end, and they almost always end in financial crisis. The crisis itself inevitably leads to sharp deleveraging, a decline in international trade and investment, and a subsequent sharp reduction in speculative financial activity. As a consequence banks and financial markets suddenly become less central to economic activity.
A result of these crises has always been to increase the relative position of the dominant world financial centres at the expense of the smaller financial centres. Previous global financial crises, such as the global crises beginning in 1837, 1873, 1929, and 1972, were at least as brutal as the current crisis is likely to be, and yet during the subsequent years the leading financial centres actually saw their share of financial activity increase, while smaller centres often collapsed or shrank in relative terms.
Why this happened is not hard to understand. The great advantage the leading financial centres have over their smaller rivals is their greater liquidity. Large investors flock to these markets for their higher transaction volume and lower trading costs, and issuers follow to take advantage of more stable investor bases and higher prices.
But this advantage is eroded during the great liquidity boom that underpins globalisation cycles. As smaller financial centres benefit from massive increases in trading volume and financial activity in nearly every market in the world, and as pools of capital grow in smaller economies, their relative disadvantage declines.
They retain, however, their natural advantages - specialisation, access to information, and favourable time zones. It is always during the long boom periods that secondary financial centres grow in importance, as their advantages begin to outweigh their disadvantages.
When the liquidity boom ends, however, the sudden reduction in liquidity usually forces an adverse rebalancing of the advantages and disadvantages of the secondary financial centres. As the disadvantage of operating in less liquid markets increases, trading and new issuance migrate to the deeper markets of the primary financial centres - as traders put it, “liquidity draws liquidity”.
As global trading volume dries up, the value for investors and borrowers of accessing New York or London will be greater, not smaller.
It may very well happen that an Asian financial centre rises in relative importance as Asian growth exceeds that of the rest of the world, but this will have little to do with the current crisis. An Asian financial centre will or will not rise depending on several factors, the most important of which is how badly regulatory changes in New York and London are managed.
Other factors include the value of its currency for international transaction, the impartiality of its legal framework, political and regulatory independence, a governance framework that ensures that managers are minimally constrained by policy needs, and the size of the home market. The financial centre also needs to be perceived as politically safe and stable, and especially to be a safe haven in times of financial and political tension.
Hong Kong may, if it can isolate itself from the obvious limitations of the Chinese regulatory framework while taking advantage of Chinese economic growth, find itself benefiting from both trends. As the most liquid market in Asia, it may find that over the next several years activity in the smaller Asian centres migrate inexorably to Hong Kong, while access to China’s growing markets gives it a major home base. But don’t count out New York and London.
Michael Pettis is professor of finance at Peking University
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