Global Financial Integration

By: Dr. Robert Clark - Dean, Schroeder Family School of Business Administration, University of Evansville

Categories: Economy, Financial, Globalization

No matter who you are these days – whether you’re a homebuyer seeking a mortgage, a homeowner seeking to refinance, or a business looking for a loan – the recent market turbulence has created tremendous uncertainty. That’s why the Federal government recently took unprecedented steps to stabilize and reassure markets. When credit markets dry up, even individuals and companies with strong credit are shut off from capital.

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After their recent gyrations, it is difficult to anticipate the future state of global financial markets. However, one thing is certain: the global financial market environment has shifted dramatically over the past few days and weeks. Yet the fundamental issues of risk and return haven’t changed; with high risk comes high return, and with low risk comes low return.

The evidence clearly demonstrates that the depth of financial market woes can impact our region’s economic development. As American General Finance’s parent American International Group illustrated even at $1 trillion, AIG’s size did not protect it from market forces, leading to its eventual governmental takeover. This leaves the corporate headquarters scrambling to find buyers for business lines to repay the governmental bailout, and creates significant uncertainty for local operations.

Current markets clearly reflect an environment where risks were underestimated (and, consequently not compensated for correctly). Greed drove some business executives to excesses; privatizing gains, while socializing the losses, was a prescription for financial ruin.

The costs of this current debacle could reach $2 trillion, according to a BusinessWeek estimate. With $500 billion already committed, the press reports of a market environment that is the worst since the 1930s don’t seem too exaggerated. However, today’s financial market complexities are even greater due to their interconnections. A meltdown on Wall Street impacts markets around the world almost instantaneously. It is estimated that it takes U.S. financial markets less than 5 seconds to reflect new information. This makes markets especially susceptible to fears and rumors.

Despite recent turmoil, the U.S. markets are still the world’s leading financial centers. In 2007, McKinsey & Co. consultants estimated that global financial assets were $140 trillion, versus $12 trillion in 1980. Of that total, U.S. markets were estimated to represent $50 trillion in financial assets. This included bank deposits, government and corporate debt securities, and equity securities. Thus, U.S. market integrity and security are essential to orderly global financial markets.

Although the U.S. is the world’s leading economy, other markets have been impacted by our ongoing market crisis, as well. Emerging markets are particularly at risk to the recent financial gyrations. Often, these securities markets do not have the multiple hedging strategies available in more developed financial markets.

Russian markets have been hit particularly hard by current events. Falling oil and commodity prices make it difficult to forecast future market valuations. Pressures caused regulators to close stock markets during the worst of the crisis. Other markets reached their highest and lowest trading limits, and were forced to close. The Russian government provided a $120 billion rescue package to stabilize the markets. The package included massive infusions of liquidity to banks, and a promise to spend up to $20 billion to buy blue-chip stocks, tax breaks for oil companies, and restrictions on short selling and margin trading of shares. The Chinese markets in Shanghai were down significantly in 2008, yet with the government announcing plans to purchase listed companies shares and cancel the tax on securities purchases, markets moved up their daily limit.

The fundamentals of valuation are earnings and growth. The premium for risk recognizes that investors require increased compensation for risk taking. The inability of analysts to forecast earnings created a significant panic in financial markets. Market stability will allow investors to return to traditional, growth-based valuation models and restore confidence in the market.

Governmental intervention was needed to break the downward spiral and wild fire atmosphere in the securities markets. Market uncertainty makes it impossible for analysts to value securities and forecast their future.

The financial markets have initially responded positively to the U.S. government plans to intervene in markets in this unprecedented manner. The plan to inject liquidity into the banking system is aimed at providing funds for home loans, business loans, and consumer loans. The Treasury action reflects fears of decades of market stagnation, like those seen in Japan. The inability of Japanese banks to purge their books of bad loans prevented them from providing the financial liquidity necessary for businesses to grow, keeping the Japanese economy in a state of stagflation that belied the world’s second largest economy.

Market recovery is essential for economic growth and development. Markets will eventually return to an appropriate risk and return relationship. In the meantime, individuals should remain alert and weigh their opportunities carefully.

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