A major question facing financial policymakers – and a key topic of debate at the recent World Economic Forum – is whether capital markets can cope with the huge demand expected for credit worldwide in the coming years. The answer will be critical in determining the outlook for both developed and rising economies during the rest of the decade and beyond.
Much depends on global authorities’ success in establishing a consistent and predictable framework of supervision for international markets, in adopting a more coordinated approach to regulation, and in developing deeper and more liquid credit markets in fast growing economies.
The numbers involved underline the importance of the issue. According to World Economic Forum research, credit supply must rise by more than $100 trillion in the next 10 years – double its current levels – to meet demand for new funding worldwide. Standard & Poor's (S&P) estimates that public and private sector borrowers worldwide will need to raise or refinance around $70 trillion of bonds between now and the end of 2015.
In the developed world, much of this total will be accounted for by sovereign issuers, but a large slice will be required by firms looking to finance growth and replace loans, bonds and structured securities issued at low cost before the crisis that are now maturing.
Greater credit demand in emerging markets
The real rate of investment growth in China, India, Brazil and other fast growing markets is expected to continue in the high single digits over the next few years, and developing economies as a group are investing more than twice as much in infrastructure (including residential real estate) as the mature economies. The result is exploding demand for finance, especially debt capital. According to the World Economic Forum, Asia will face the challenge of meeting high credit demand growth of $40 trillion.
Against this backdrop, there is a risk that demand for credit worldwide will outstrip supply. Banks, especially in Europe and the US, face new constraints on lending, as they seek to rebuild balance sheets, de-leverage, and meet new regulatory capital requirements. This leaves a large gap in the provision of credit that will need to be filled by the capital markets.
In the past couple of years, that is precisely what has happened. Corporate bond issuance – which remains far larger than equity issuance -- has greatly outpaced bank lending in recent years and maintained a high tempo so far in 2011. High-yield debt issues worldwide rose 70% in 2010 to a record high. Paradoxically, despite the return of financial conservatism, yield-hungry investors still show a healthy appetite for risk.
But while capital market supply has risen to meet demand recently, there may be a limit to its capacity. The call for capital over the next few years will be greatest in those countries where financial markets are in an early stage of development and there is greatest reliance on traditional or informal banking systems.
Stronger market infrastructure ensures efficient capital allocation
The big surplus economies have plentiful savings for investment, but they need stronger market mechanisms to allocate capital efficiently and productively. This is already creating credit blockages, for instance, for small and medium-sized enterprises (SMEs) in the emerging world.
At the same time, there is a danger that ongoing global imbalances may prompt financial protectionism – or encourage further uncoordinated financial regulation – and that in turn may disrupt or slow global capital flows.
Recent reform efforts, in areas ranging from proprietary trading to credit derivatives and credit ratings, have been piecemeal and parochial. That risks creating more uncertainty for investors, disrupting capital flows and locking up much needed liquidity.
How should policymakers respond? Nurturing efficient, deep and internationally integrated capital markets will be crucial to both the west’s ongoing economic recovery and the rising economies’ drive for growth. Well-calibrated and coordinated regulation and supervision, high levels of transparency and careful monitoring and management of systemic risk can all contribute to a sound and sustainable system.
Capital markets thrive on confidence that comes from certainty and consistency, and their component parts – from consumer finance through to sovereign balance sheets -- are deeply interconnected. That calls for policy measures that are comprehensive and coordinated, both across markets and across the capital formation and investment process – including, for instance, the fast growing and largely unregulated shadow banking sector.
Innovation is another ingredient. New initiatives will be required to facilitate funding for segments of the economy held back by capital shortages, such as the SME and environmental finance sectors. That includes reviving securitisation as a simple and transparent funding channel for banks lending to both businesses and consumers.
Finally, further progress is needed to develop deeper, more efficient and more globally integrated capital markets in high-growth regions like Asia, where markets are fragmented and have varying standards and rules. That would help diversify sources of funding beyond the banking sector and provide a mechanism for productively recycling excess savings from surplus economies, at home and abroad.
Nurturing the credit markets is critical to global economic growth
This requires a clear commitment to improving market infrastructure in the developing world, strengthening transparency and pricing of credit risk, and broadening participation by international firms and investors in local markets. Investors must be confident their debts will be serviced. And controls that disrupt the integration of markets and limit the free flow of capital should be avoided.
Nobody wants a re-run of the excesses we saw in credit markets in the past decade. In fact, the mismatch in supply and demand for capital in the coming years may contribute to higher long-term interest rates, which – in contrast to the pre-crisis period – should drive more rational allocation and pricing of credit.
But policymakers should recognise that the sustainable supply of credit is critical to all our economic futures. While equity capital will continue to play its part, we depend today more than ever on the debt markets to bring savers and borrowers together, allocate capital to risk opportunities, and enable risk diversification.
In the next few years, these markets will need to make an even bigger contribution to supporting growth, building infrastructure, and creating jobs worldwide. Nurturing their development as transparent, well-governed and liquid sources of funding must be a policy priority.
The author of this article, Deven Sharma, is president at Standard & Poor's.
