The McKinsey Global Institute's recent 3rd Annual Report found that the world's financial assets expanded to $140 trillion by the end of 2005, an increase of $7 trillion from a year earlier. And $140 trillion is a big number -- about 10 times the size of the entire U.S. economy.

Global financial assets include everything you can think of -- equities, government and corporate debt securities, and bank deposits. And growth in global financial assets has significantly outpaced growth in the global GDP. Harvard professor Ken Rogoff estimates that trade in financial assets is growing about 50% faster than the growth in trade in goods and services. If current trends persist, global assets will exceed $228 trillion by 2010.

Growth in Global Financial Assets: What Does it All Mean?

Growth in global financial assets is important because it improves financial depth. Deeper financial markets are beneficial because they are more liquid, they improve access to capital for borrowers, and they share and price risk more efficiently. In mature financial markets with ample liquid assets, financial assets can be larger than underlying GDP because they reflect future expected returns and growth. In 1980, the world's financial stock was roughly equal to world GDP. By 1993, it was double the size, and by the end of 2005, it had risen to 316% -- more than three times world GDP.

But increase in financial depth can be a mixed blessing. Increases due to asset-price bubbles and rising government debt are bad. Increases due to growth of equity markets, supported by earnings, are good. While the 1980s was the decade of government debt, the 1990s were fueled by growth in private debt. In the late 1990s, global financial depth exploded due to very high equity-market valuations, then fell in tandem with the collapse of global stock markets.

In 2005, financial depth increased by 16%, exceeding its previous high in 1999. The good news is that nearly 70% of the deepening came from growth in the stock of equities -- the third straight year that equities were the largest contributor to growth of global financial assets. In the U.S. and the eurozone, earnings accounted for all of the growth. Earnings growth also drove most of the rise in the Japanese market.

This expansion in global financial assets is clearly taking the world economy into uncharted territory. Cassandras await a financial Armageddon and point out that an increase in global debt over the past 25 years has been largely responsible for the increase in global financial assets. The Don Quixotes argue that economic historians will look back in the late 20th and early 21st centuries as the era when financial markets became efficient enough to match borrowers and lenders on a global playing field. How you feel about the global economy's prospects depends largely on which of these views you adopt.

Global Assets: U.S. Still Top Financial Dog

The United States remains the Gulliver of the global financial markets with $50 trillion of assets. The eurozone is second, with nearly $30 trillion. Japan ranks third with $19 trillion and the U.K. market has less than $8 trillion of financial assets. Asian financial markets remain fragmented and have very different characteristics. Japan has a huge government-debt market, whereas China holds 75% of its more than $5 trillion in financial assets as bank deposits. India's financial system is a financial Tom Thumb, with only $1.4 trillion in assets -- possibly ranking as the global dark horse in the decade to come.

The growth trends for 2005 paint a different picture. Surprisingly, the eurozone contributed most to the growth of financial assets, with 22% of the total. The U.S. contributed 20%. Emerging markets basically matched both Europe and the U.S. by accounting for 21% of growth. Impressively, emerging markets achieved this growth with just $15 trillion in assets. Emerging markets now account for 14% of global financial assets, up from just 7% a decade ago.

The Global Game: Here to Stay

As important as the growth in global assets is the level of global capital flows. These global capital flows topped $6 trillion in 2005 and now are above the levels reached at the height of the 1990s stock-market bubble and more than double their level in 2002. Roughly 80% of global capital flows are between three regions: the United States, the United Kingdom, and the eurozone. But smaller regions are playing an important role. Capital inflows to emerging markets have grown twice as fast as inflows to developed countries over the past 15 years. Latin America and Eastern Europe, both in the thralls of fascist or Communist dictatorships of one ilk or another only 20 years ago, have developed significant capital-flow links with the United States and Europe. Surprisingly, Asian countries have the largest links not with Japan or Hong Kong, but with the U.S., the U.K., and the eurozone

In the 1990s, many investors dismissed global investing as a fad. That has changed. The deregulation of financial markets, the emergence of technology and the addition of three billion capitalists to the global markets has ushered in a new era for global investors. Consider that the NYSE is not only merging with Euronext, Europe's largest stock exchange, but the NYSE also has just taken a stake in India's leading stock exchange. Also consider that the best-performing U.S. equity fund in 2006 was one managed by a Polish bank in Warsaw. Twenty years ago, Poland was behind the Iron Curtain. This time around, global investing is here to stay.

Sincerely,

Nicholas A. Vardy
Editor, The Global Guru

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