THE GREAT MISMATCH PART II: The Barriers to Efficient Capital Flows
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Efficient cross-border capital flows—allowing investors to search for reliable returns, and in the process, meet legitimate capital needs wherever they are—would be a more effective way to finance the global economy than today’s system. In theory, few dispute this. In practice, many barriers have been erected that hamper efficient flows. The deliberate or inadvertent barriers to efficient global capital flows have been erected by a unique combination of regulators, governments, historical conventions and path-dependencies, investor mindsets and capital-seekers themselves (see below exhibit).
CHAPTER 1: THE ROLE OF GOVERNMENT
In the first glow of the 1990s economic boom, as capital flows to many emerging markets increased substantially, any restrictions on the cross-border flow of capital were widely considered a mistake. However, the crises of the 1990s and the 2008 meltdown have left many today with sympathy for some forms of capital controls. Today, most asset managers and other market participants are not purists. They are likely to recognize the need for sensible regulation, but in looking at the state of capital flows around the world, they may conclude the regulatory regime is often far from sensible. It creates barriers to capital flows that serve neither investors nor those who seek investment.
BUREAUCRATIC BARRIERS AND RED TAPE
For Foreign Direct Investment (FDI), the hurdles are often posed by cumbersome red tape and sluggish bureaucracies. Investment in India, for example, has long been complicated by a myriad of regulatory hurdles that delay projects and divert capital to unproductive limbo. In June 2013, then-Prime Minister Manmohan Singh had to create the Project Monitoring Group, a separate body whose mission was to clear 463 stalled direct- investment projects, with a total worth of 22 trillion rupees ($362 billion). One year later in June 2014, the group’s project count had increased to 543. While still in its early days, progress toward the removal of red tape may have accelerated with the arrival of India’s prime minister, Narendra Modi, in 2014. Shortly after his election, Modi announced the abolition of the central government’s Planning Commission, a group devoted to five-year plans and a managed economy.
To cite another emerging-market example, investors in Vietnam also face complex regulatory systems that block or delay projects. Land cannot be privately held; legally, the government holds all land in trust for its people. Any development requires that the individual or entity responsible for the project be given land-use rights from the government, which involves both national and local authorities whose interests don’t always align. As one researcher found, for real estate development, “the ability of investors to get access to land and protection from corruption is largely determined by the attitudes of local authorities” and therefore varies significantly from location to location. This lack of uniformity in what is supposedly a national system adds considerable delay and uncertainty to projects. For example, while the national law on land-use rights specifies that it should take 23 days to obtain a decision, the median time for actually getting such rights was found to be 60 days.
Regulatory barriers are not unique to emerging markets: From 2008-2012, Australia had the most cross-border mergers and acquisitions withdrawn for regulatory reasons. Indeed, in some ways the greater technical capacity of regulators in developed markets gives them greater power to influence capital flows than their emerging-market counterparts.
Regulators, reflecting the politics of their governments, are usually worried about repeating some mistake that occurred in the recent past. “The regulatory framework and the regulators are often looking only backwards in time,” says Arvind Rajan, managing director and international chief investment officer at Prudential Fixed Income. Rules built on past experience are seldom tuned correctly for current conditions, Rajan says, “so the regulatory frameworks are also an effective impediment to a lot of capital flows.”
ONEROUS CAPITAL CONTROLS
There is no question, however, that a balance must be struck; completely uncontrolled capital flows pose serious risk for recipient nations. A tidal wave of capital can overwhelm the capacity of an economy to absorb new investment, making it vulnerable to shocks, inflation and both credit and asset bubbles. An analysis by the Organization for Economic Co-operation and Development of emerging and developed economies found that “the probability of a banking crisis or sudden stop increases by a factor of four after large capital inflows.”
Many countries have enacted regulatory regimes to mitigate such risks, but in the minds of many investors, they have not struck the right balance. The regulations often take the form of onerous capital controls. Even more worrisome than rules that bottle up capital are those that would seek to capture it after it has crossed a border. In considering any investment in emerging markets, Rajan looks not just for signs that he can get in, but also that he can get out. Some risky emerging markets, he says, have proved to be one-way streets for investors who can take a stake in a direct investment, debt or in equities but then get stuck. “You might not get your money out again—even if you avoid default and devaluation, there’s restructuring, redenomination and repatriation risk.”
That balance between efficiency and protection from volatility is needed, Rajan says. “I’m not arguing for a completely unfettered capitalist system,” he says. “If a country wants to develop its resources, it should do the things that it needs to do. But the trick there is to do it in a way that interferes as little as possible with the workings of the free market. And many times rules actively discourage investors, and when they do, then it’s a destruction of capital flow as opposed to being an encouragement of the right ones.”
GOVERNMENT CAPITAL EQUALS POLITICAL CAPITAL
The political uses of capital allocation by government or quasi-governmental entities are many. In some parts of the world, “the investments by government entities like state-owned enterprises—or other kinds of very complicated arrangements like the ones that China is implementing in Africa—play a very big role,” says Mauro Guillén, a Wharton professor and director of the school’s Joseph H. Lauder Institute of Management and International Studies. “So for some countries, especially in Africa and perhaps also some Latin American countries, that kind of investing activity represents a very large percentage of the total.”
Potential investors and host governments have some common goals, especially the ultimate reputational and commercial success of a project, but they also have a number of divergent objectives. Rajan says, “For example, while investors are risk averse and sensitive to changes in political support for their projects, governments often cannot commit beyond their electoral cycles and have objectives such as job creation, social responsibility and socioeconomic development that may be at odds with nearer-term commercial imperatives.”
It might be, for instance, that a project for which there are specific social and political incentives— hypothetically, for example, a copper mine in Zambia—never would make economic sense without a tax-friendly environment because the whole enterprise could otherwise be done for a better return in say, Chile, Rajan says. “Thus, in order to attract private capital, the government of Zambia may have had to change the rules of the capitalist game by providing special tax incentives for some time in support of their long-term development agenda. Of course, it helps if such rules are not reversed during the next political cycle.”
Ultimately, infrastructure capitalism is a multi- period, multi-player game where the economics of investments have to be reconciled with political and social goals, and investors must engage with players whose objectives and time horizons are quite different. Unfortunately, in this context, there is also the potential for graft, corruption and short-termism and a possibility for sub-optimization and bad design. “There are many ‘bridges to nowhere’ out there but every one of them came from somewhere,” Rajan says.
This is why investors cannot and should not expect completely unfettered market-based policies in many emerging markets. After all, even today’s developed-market powerhouses, like the U.S. and Western Europe, went through long periods in the 19th and 20th centuries of extreme protectionism during which they walled themselves off from global market forces.
THE DIFFICULTY IN CHANGING DIRECTION
Emerging markets that are wary of opening themselves to capital flows often have understandable reasons, Rajan notes. These are rooted in their history, when exploitation of their labor or resources left them with few rewards compared to those reaped by foreign investors. But some developing nations try to learn from that history and work to create government interventions that foster, rather than hinder, capital flows. What they often learn from that effort, though, is how difficult it can be, and how long it can take, to get traction in a new direction.
One such intervention is the free trade zone of the sort implemented in many emerging markets from South America to Africa to Asia. “What needs to happen,” says Rajan, “is a political acceptance of the value of free-market phased-capital investment in a context where it’s not obvious to the builders of these countries. They can be forgiven a certain amount of skepticism.” A phased-in free trade zone provides incremental proof of concept by demonstrating the benefits of less restrictive cross-border capital flows.
“Some portion of the $50 trillion to $70 trillion that presumably needs to go into emerging-market infrastructure projects over the next quarter century or so will find a way to do that more efficiently if it has examples to follow,” Rajan says. “And frankly, you won’t get that money to budge unless you create those clean examples.”
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.
 Strike, Stephanie L. “Breaking Down Barriers to US Investment in Vietnam’s Real Estate Market.” Pac. Rim L. & Pol’y J. 15 (2006):857.
 Lind, Michael. “Free Trade Fallacy.” Prospect, January (2003)