Cautious hope for financial 2013

Both developed and developing economies should seize the current opportunity for rebalancing and restructuring

If the year 2012 was filled with financial scandals, ranging from Libor-rigging to money-laundering cases and huge trading losses, then the New Year seems to have brought hope to the global financial industry.

The past year's sense of panic has gone and a new wave of optimism has returned. Global stock markets have had a good start in January. The S&P 500 hit a five-year high and the FTSE All-world index was at its highest level for 18 months. The stock markets of many developing countries have clocked double-digit rises since last June.

Even within the eurozone, there has been a significant reversal of capital flight. According to ING, the Dutch bank, almost 100 billion euros ($133.25 billion) of private funds flowed back into Spain, Italy, Portugal, Ireland and Greece, equivalent to about 9 percent of the economic output of the five countries. In contrast, the first eight months of 2012 saw outflows of 406 billion euros from the five countries, following a 300 billion euro outflow in 2011.

There are good reasons to explain this optimism. Although experts are painting a mixed picture of the US economy, it is growing at more than 2 percent a year, and its unemployment rate is falling. The home price index has been rising since November at the fastest year-on-year pace since August 2006.

In addition, politicians in the United States avoided falling off the "fiscal cliff", and the Republicans in the House of Representatives have offered to extend the debt ceiling for three months.

Financial conditions in the eurozone have significantly eased, and the risk of a Greek exit in 2013 has been postponed. The European Central Bank said 278 banks would repay 137 billion euros, the cheap funds they took from ECB at the height of the debt crisis.

US-based investors are snapping up the new debt issues of eurozone banks in the rush for high returns, making overall sales of European bank's debt much healthier than in previous years.

Unquestionably, a return of market sentiment comes from central banks' ultra-loose monetary policies. The US Federal Reserve has been aggressive, launching four rounds of quantitative easing since the beginning of the financial crisis. If the Fed keeps buying assets at the current pace of $85 billion a month, the Fed's balance sheet will exceed $4 trillion by the end of 2013.

The European Central Bank has promised the unlimited buying of government bonds to save the euro. More recently, bowing to political pressure, the Bank of Japan increased its inflation target from 1 to 2 percent, and will buy 13 trillion yuan ($140 billion) of mostly short-term government debt each month in a fight to combat deflation.

The global financial regulators softened their tough stances and helped lift the mood of financial markets. The Basel Committee on Banking Supervision announced changes on liquidity requirements and delayed full implementation until 2019, causing European bank shares, in particular those of French and German banks, to immediately jump between 2 and 5 percent.

Another important reason for cheer is the economic performance of Asia. After a tough 2012, when economic growth plunged during the first half of the year to its lowest rate since 2008, the combined Asian economy will be anticipating a better year in 2013, and will remain the global growth leader in expanding faster than the world average.

Nonetheless, it is worth noting that the gloomy clouds have not entirely drifted away because many old, fundamental problems still remain unresolved.

Looking ahead, the global economic recovery could be fragile and uncertain. The US now faces significant fiscal drag on an already sluggish recovery. In the eurozone, there are still many obstacles to the formation of banking, fiscal, economic and political union. The recession in the eurozone periphery is spreading even to Germany and France. Periphery banks still lack capital and have liquidity concerns, and consumer and business confidence is depressed because of falling output. Poor growth in the periphery has the potential to complicate political measures aimed at tackling the ongoing financial and economic difficulties.

Another fear could be that the world is at risk of a currency war. The beggar-my-neighbor policies launched by the US, the eurozone and Japan may lead to other countries retaliating and depreciating their currencies, further stirring international trade tensions.

While inflation may serve as an option for debt elimination in some developed countries, it becomes a big challenge for many emerging economies. Policymakers are encountering the old dilemma in which they fear raising interest rates will attract more capital and fear keeping rates low to feed domestic credit growth and future inflation.

If 2012 was a year of booming bonds, 2013 already has some people theorizing a "great rotation" scenario in which funds flow out of bonds and into equities markets. The asset reallocation from sovereign bond markets to equities may pose significant risks to both stock and bond prices and bond yields.

On the whole, the rising optimism in the global financial markets reflects a good start, however tentative. The financial industry should not be complacent. Instead, it must seize the opportunity to continue its reforms and restructuring.

In order to adapt to the changing environment, banks should reposition their business strategies and reshape their operating models. Simply growing big is no longer suitable. It is important for banks to differentiate priorities and scope as competition intensifies across markets.

The fundamentals of China's banking industry remain quite healthy, despite the country's cyclical economic growth. However, given that leverage in the real economy has risen substantially in recent years, the level of risk has by definition also increased. The biggest threat to financial stability could be the huge amount of shadow banking and loans to local government financing vehicles. Against a backdrop of global easing, capital inflows could increase further to spur inflation and asset bubbles.

Therefore, it is time to hold the bottom line, preventing systemic risks building.