The Great Mismatch: Addressing Barriers to Global Capital Flows (Part III)
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PART III: The Barriers to Efficient Capital Flows (continued)
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 2: FOUNDATIONS OF FINANCE
It is all too easy, and quite common, to blame government regulation for impeding the function of the free market. However, some of the barriers to efficient capital flows are caused by gaps within the investment industry itself. Investors who are willing or even eager to plunge into certain markets find that certain nations and regions lack the supporting infrastructure of developed-world finance: stock markets, bond markets and world-class analytic and risk measurement tools. Then, too, in some nations, the professions of investment management and investment advisor do not exist. As a consequence, there is not a culture to support and educate local investors, or help those from abroad.
LACK OF PROFESSIONAL INVESTMENT MANAGEMENT
For a variety of reasons rooted in history, culture, politics and economics, investment expertise, and more broadly, a professional money management sector, are lacking in many parts of the emerging world. In some nations (India, for example), investment managers and advisors are in place, but they lack access to the high-quality research and analytic tools available to leading firms, says Vinay Nair, a visiting professor at Wharton and founding principal of Ada Investments. In most frontier markets, professional money management for individuals and institutions is in its infancy. Without such expertise, it is difficult for local investors to make educated decisions concerning their finances and investments, and it is more difficult for foreign investors to identify and correctly assess opportunities to place capital.
Indeed, professional money management will be essential for new markets and institutions to play their anticipated role in improving the efficiency of capital allocation. Without the market discipline that professional management brings, a new stock or bond market or other financial infrastructure can easily fall prey to inefficiency, inaccurate pricing or over-regulation.
At the moment, an investor contemplating an emerging market has to price in the effects of a variety of risks, Prudential Fixed Income’s Rajan says. As noted earlier, there is repatriation risk. But there is also counterparty risk and “accounting and transparency risk with respect to what you can trust in terms of financial reporting and audit statements,” he adds. “And all the infrastructure of accounting, legal and credit ratings may be much less developed.” The costs of such risks decline with the presence of professional money managers with local knowledge.
For now, Rajan says, “in a lot of emerging countries, local investments are fraught. So you need boots on the ground. That could be taken as an exhortation to the local authorities to make that possible. But it’s also a statement to encourage international investors to take advantage of those cases where those opportunities are created to put some boots on the ground or establish local partnerships.”
MISSING THE BASICS: MARKETS AND FINANCIAL INFRASTRUCTURE
However, no amount of knowledge transfer or local expertise can make up for another fact of global economic life: Many capital-hungry nations lack deep markets—especially those that issue and trade debt— and other financial infrastructure necessary for the capital flows they seek.
For example, one stubborn fact about many emerging markets is that their needs are organized into buckets that are too small for the fire hose of developed-world investment practices. Hence, in a market whose overall needs are enormous, investors often find that any particular offering isn’t big enough, notes Wharton’s Nair.
A great deal of capital is sitting with large firms that aren’t interested in “bite size” deals, he says. Meetings with top private equity firms in India can reveal that “there are long periods where these private equity teams have done no deals—say five years,” he says, “because there are only 10 or 20 deals anywhere in the nation where you can put $300 million or $400 million to work on one project. If you look at small to mid-cap private equity funds, which are putting $5 million to $10 million to work, they’ve been active. But obviously the [opportunities] are not large enough to attract too many of my students to go start private equity funds in India.”
The problem is that “there’s an optimal marginal speed or rate at which capital can be deployed efficiently,” says Prudential Fixed Income’s Rajan. “And it’s a function, to a large extent, of what is already there.” In a place where much infrastructure remains to be built, “the rate at which you can add infrastructure may be a very high rate in percentage terms, but it’s a very small amount of capital in absolute terms.” In a very real sense, then, it takes infrastructure to make infrastructure—both in the financial sense of the term (markets, investment instruments and professional investors) and in the literal (roads, sewers, housing and the like).
“One way you can circumvent that,” Rajan says, is intervention by a government or government-owned entity for strategic reasons. “So in Angola in 2002, after the end of a multi-decade civil war, the new government struck an infrastructure-for-oil deal with China to build energy, transportation, telecommunication, agribusiness and other major projects for the next decade or more. And the Chinese suddenly appeared with their equipment and their engineers and their oil-backed loans, and all over Angola these enormous new works projects started. By 2014, bilateral trade between China and Angola totaled $36 billion. So that kind of scale can happen. But it can only happen in those special cases where both sides have something very specific to offer that the other needs.”
Even without such scale and without a single giant investor, it is important to note that emerging markets can be quite rewarding to investors before they have established the institutions and procedures that are common in the developed markets. As long as there is basic transparency and the rule of law in an emerging market, QMA’s Keon says, investors have the information they need to make sound choices and the assurance that their assets are accessible. “It is all about reliable data,” he says. “It doesn’t have to be perfect. If we can see price, company earnings, liquidity and capacity, we can assess.” In a nation without established, well-designed structures for investors to rely upon, trust—in the information available and in the rule of law—is something investors build up over time, Keon says.
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.