The Great Mismatch: Addressing Barriers to Global Capital Flows
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Cross-border capital flows are at an inflection point. While in aggregate they have not returned to pre-crisis high watermarks—primarily driven by a significant decline in bank lending—they are increasingly varied in their scope and direction. More countries around the world are seeking and providing capital across borders than ever before. And asset managers and asset owners—not just governments, corporations and banks—are becoming increasingly influential in determining the scale and stability of global capital flows.
Yet capital around the world is being deployed inefficiently—large pools are not getting the returns they should, even as many needs for investment, both public and private, go unmet. This “great mismatch” is driven by a confluence of governments focused on near-term electoral cycles and rent-seeking, emerging-market financial institutions lacking investment management expertise and depth, and investors prioritizing short-term gains over sustainable long-term investment priorities.
Correcting this mismatch represents one of the most significant opportunities for global growth over the next decade. Success will require both long-term institutional investors and policymakers re-thinking long-standing assumptions and re-shaping their role in global markets. This report provides the backdrop and lays the case for six key recommendations over both the nearer and longer term:
Nearer Term – A New Strategic Mindset
- Re-thinking standard indexing and asset allocation approaches, especially the use of benchmarks
- Updating investment frameworks to better capture true opportunities and risks, including the use of more differentiated metrics beyond the nation state
- Continuing to reduce home country bias where appropriate
Longer Term – Transforming Global Frameworks
- Developing new valuation tools that better capture the investment opportunity set in economies with sparser and less lengthy historical data
- Establishing consistent standards for governance, transparency and professional investment practices across countries
- Evolving the global governance framework to better represent emerging market economies in multilateral financial institutions such as the World Bank and IMF
PART I: Where Are We Post-Crisis?
For a century and a half, the flow of capital around the world has experienced periods of steady expansion and optimism, only to see sharp declines during periods of financial instability and crisis. Three decades of steady growth in capital flows ended with the start of World War I. A post-war recovery in flows (much of it driven by lending to cover government deficits) collapsed at the start of the Great Depression. Bank lending saw a heyday in the 1970s until the Latin American debt crisis of 1982. The 1990s boom in foreign direct investment (FDI) and portfolio flows also came to an abrupt end.
And, of course, the global economy of the 2000s saw rising flows until the global crisis of 2008 set them back once again.
Since the 2008 global financial crisis, aggregate cross-border capital flows into G20 nations, including inflows from both other G20 countries and non-G20 countries, have steadied, but they have only partly returned to pre-crisis high watermarks. They remain below the average level, on a percentage of GDP basis, for the G20 over the past decade. (See Exhibit 1 below.)
The G20 is used in the following figures as a proxy for the global economy, both because it provides the most robust capital account data and because it represents more than 80% of global GDP. The G20 includes the following developed-market countries: Australia, Canada, France, Germany, Italy, Japan, the U.S. and the UK.
The G20 also includes the following emerging-market countries: Argentina, Brazil, China, India, Indonesia, Republic of Korea, Mexico, Russia, Saudi Arabia, South Africa and Turkey. The EU is also a G20 member and is classified as a developed market in this report.
However, the underlying sources of cross-border flows followed different patterns. Bank lending remains severely depressed and has proven volatile since 2009, with a high likelihood of continued uncertainty given the evolving regulatory environment around bank capital standards. On the other hand, FDI and portfolio investment have largely recovered and sometimes even exceed their highest levels of the past decade. (See Exhibit 2 below.)
Despite a post-crisis slowdown, aggregate cross-border capital flows have become more multi- directional in nature, incorporating more of the emerging world into the exchange of capital. Indeed, key emerging-market countries are now attracting closer to their “fair share” of capital, in proportion to their share of global GDP—a significant change from a decade ago. (See Exhibit 3 below.)
Accordingly, flows into G20 emerging markets have grown almost five times between 2005 and 2013 while developed G20 economies have witnessed more than a one-third decline in the same time frame. (See Exhibit 4 below.)
Several indicators point to continued growth in multi-directional capital flows in the years to come.
Emerging markets across the world are opening their markets to investors in ways that would have been unimaginable a few years ago—China’s Shanghai Free Trade Zone, India’s relaxation of regulations to attract overseas capital and Saudi Arabia’s opening of its stock market to foreign investors in 2015 are just a few examples. This upsurge in capital flows into emerging markets is reflected in day-to-day investment management. “There was a time when it would have been pretty exotic to invest in Korea or Taiwan,” says Edward F. Keon Jr., managing director and portfolio manager at QMA, a business of Prudential Investment Management. “Now, it’s not much different than buying shares of IBM.” (See Exhibit 5 below.)
Despite these promising signs, significantly more still needs to be done to improve the allocation of capital around the world. With what may be a long-term and permanent retreat of bank lending, other forms of capital flow—namely FDI and portfolio investment— must fill the gap in order to sustain growth, especially in emerging markets.
In some regions, largely in developed markets, capital remains under-invested or provides lackluster returns. In other areas, largely in emerging markets, private and public needs for investment go unmet.
As Joseph Stiglitz, winner of the 2001 Nobel Prize in economics, recently wrote, “The problem is a financial system that [...] has failed at its core task: intermediating savings and investment on a global scale.”
In part, the barriers to global capital flows reflect a perception of risk in emerging-market investments that has a paradoxical consequence: Many capital-hungry emerging nations are actually net exporters of capital. “You have a number of [emerging-market] countries that are exporting capital because they feel more comfortable with returns elsewhere,” says Jürgen Odenius, managing director at Prudential Fixed Income, and chief economist and head of Global Macroeconomic Research. This perception, he adds, tends to divert capital away from some emerging markets although returns there in principle should be higher than elsewhere.
Similarly, a lag between perception and reality can also be seen in developed markets where, many believe, the investor’s toolkit has not kept pace with changes in the world economy, making it difficult to accurately evaluate risk-return trade-offs. To put it simply, investment language has not evolved at a pace necessary to support today’s complex and sophisticated markets.
An examination of the current account of G20 countries demonstrates this perception-reality mismatch. A number of developed-market G20 nations run current account deficits and import capital to cover their spending, while a number of emerging-market countries run current account surpluses, meaning they have capital savings that they export (in theory, the current and capital accounts of a nation should offset). While this is due in part to the U.S. and other developed markets being seen as a safe haven for assets, it may also be because of a lack of understanding about opportunities available in emerging markets or insufficient ability to deploy capital there in an efficient manner. (See Exhibit 6 below.)
Why is so much capital sitting idle or sub-optimally utilized? Why, at the same time, are so many capital-hungry companies and projects failing to find investors? And why do so many nations view capital flows with suspicion, as fundamentally unreliable?
In this report, we explain what barriers prevent the sustainable and efficient allocation of capital, explore potential changes in the near future and discuss how investors and other stakeholders might respond.
Part II, to be published on October 22, begins to untangle the current barriers to the efficient allocation of capital around the world—regulations, conventions, cultural hurdles and other reasons why substantial amounts of capital are underinvested in a world where many potentially attractive enterprises and projects are eagerly seeking funding.
This report was jointly produced by Prudential Investment Management (PIM) and Knowledge@Wharton, the online research journal of the Wharton School of the University of Pennsylvania.
The paper was researched and written with the close cooperation of investment professionals within the investment businesses of PIM, and scholars and practitioners affiliated with Wharton. The primary interviewees include:
- Franklin Allen, professor of finance and economics, The Wharton School (currently on leave at Imperial College London)
- Mauro Guillén, professor of international management and director of the Joseph H. Lauder Institute of Management and International Studies, The Wharton School
- Edward F. Keon Jr., managing director and portfolio manager, QMA, a business of Prudential Investment Management
- Joshua Livnat, managing director and senior researcher, QMA, a business of Prudential Investment Management
- Vinay Nair, visiting professor, The Wharton School, and founding principal, Ada Investments
- Jürgen Odenius, managing director, chief economist and head of Global Macroeconomic Research, Prudential Fixed Income
- Arvind Rajan, managing director and international chief investment officer, Prudential Fixed Income
- Michael Schlachter, managing director and head of Multi-Asset Class Solutions, Prudential Investment Management
The full report is available for download here.