Where will shocks to the global financial system come from in the next decade? How much should we worry about the US–China trade war? Massimo Massa, Rothschild Chaired Professor of Banking and Professor of Finance at INSEAD, gives his take on the biggest issues facing financial markets and why the sector must address swelling government debts.
From trade war and Brexit to mounting national debts, manifold issues confront the global financial industry as we approach the next decade. But what’s the most critical challenge the sector needs to deal with, and what should organisations be doing now to prepare?
For Massa, the most urgent issue is the need to deleverage, particularly among highly indebted governments such as those in France, Italy and the US.
As he puts it, “Government debt is the biggest elephant in the room. Financial systems will become more resilient when central governments stop running deficits and start deleveraging.”
However, as interest rates rise after years of rock-bottom rates and governments try to reduce their debt, imbalances and political fallout from new or higher taxes seem inevitable. “The question is, how will governments deleverage without imposing constraints on capital flows and taxes that can curtail growth?”
Rise of FinTech, and changing corporate governance
Massa cites the growth of financial technology, or FinTech, as a second vital issue that the sector must confront. A convergence of technology and big data is enabling smaller, nimbler companies to deliver financial services to customers in innovative ways, threatening the predominance of established financial players, particularly banks.
“In response, the banking industry needs to restructure in order to gain competitive advantage, but it doesn’t know how to do that because its traditional business model – universal banking – is in shambles,” he says.
Also rising up organisations’ agendas is the issue of changing corporate governance as more companies go public by issuing only cash flow rights, as opposed to voting rights. This practice is raising questions about how corporate governance should evolve in an environment where voting rights have become rare, or where nobody wants to exercise them. As Massa points out, the practice of reducing shareholder rights can have negative consequences for firms. “It can lead to less transparency, for example, and also potentially intensify opportunities for shareholder conflict,” he says.
Debt, growth and China
Then there is the issue of systemic shocks – the kind that can threaten to derail major players. The global financial system may be more robust today, thanks to the tools central banks developed to manage their economies after the 2007–2008 crisis, but it is not yet foolproof.
Massa believes government debt is an issue that could negatively impact the financial system as heavily indebted countries face massive deleveraging. “There have been irresponsible demands for more government benefits in countries like France, Italy and now the US,” he says. “This creates huge amounts of debt, and some countries are even considering not paying back.”
Another shock may come from irrational growth expectations. As Massa points out, “The global industry has become used to high growth. What’s more, forecasts of asset returns – to take just one example – have become unreasonably high. How much should stock markets adjust, especially as we move toward situations of lower yield and stagnation, or even recession?”
Unsurprisingly, perhaps, Massa also views China as a potential source of shock, but not because of its slowing economy. In his view, the biggest risk will come from a revaluation of Chinese assets as the country becomes more integrated within global financial markets. For instance, should the Chinese bond market become part of a global index of bonds, China would probably represent about 50 per cent of the global market because of its sheer size.
“Such a development would require significant reshuffling in large asset managers’ portfolios and drastically impact the value of bonds issued by smaller countries,” he says.
US–China trade war – a political game
As for China’s trade war with the US, Massa takes a sanguine view about any potential capital dislocations. That’s because he believes the two countries are playing a game that’s more political than economic.
“The truth is that their financial markets are closely linked. So, to argue that China would pull its investments in US government bonds makes very little sense. China has so much to gain from accessing global financial markets.”
Massa adds that the US–China trade dispute is symptomatic of a broader shift in the global economy, rather than a root cause of global trade tensions in and of itself. “The real issue is that the three major global trade blocks – the US, Europe and China – have started diverging. So, we’re now dealing with a financial system that has three major ecosystems, not just one.”
What about Brexit, that other current source of ongoing geopolitical tension? Massa believes that the UK’s departure from the European Union (EU) could lead to the union becoming more tightly integrated.
“When the UK was part of the EU, it always pushed for a more open market. But once it has exited, we’ll see more pressure being exerted from those who favour a closer union – the French, Germans and Spanish,” he says.
Taxes and black swan events
As the day of fiscal reckoning nears for countries with ballooning national debts, Massa also has a piece of advice for financial institutions: know how to manage your taxes.
“At the end of the day, the only solution to government debt is a massive wealth tax or additional taxes. So, to be successful, institutions have to know their taxes.”
On a more practical note, Massa encourages financial institutions to prepare to operate in an environment where they not only have a good deal of financial instability and volatility to contend with, but also black swan events. These extreme events may take the form of shocks to financial markets and also political risks.
“Keeping abreast of trends is vital to anticipating and managing risks. Higher education can play an important role in ensuring financial institutions are well prepared,” says Massa, who is also the Programme Director at INSEAD’s Executive Master in Finance, a programme dedicated to financial executives who wish to prepare for a leadership position in Finance.