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12/02/2015

The Great Mismatch: Addressing Barriers to Global Capital Flows (Part IV)


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PART IV: 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).

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CHAPTER 3: 
INVESTORS AND THEIR INCENTIVES

Systemic factors like government regulation and lack of supporting structures are relatively easy to identify in many markets. Harder to acknowledge are the preconceptions, mindsets and incentive structures of investment professionals and investors. These too are a source of barriers to efficient capital flows.

At first glance it seems indisputable that capital, when put to work, can foster economic growth and its attendant benefits. Roads in India, schools in South Africa, new businesses in China or Bulgaria
or Argentina—these cannot be built without capital, and in many cases that capital is missing. This is also true in many developed countries, which are rightly fretting about crumbling infrastructure without clear plans for a fix. (In fact, global demand for the funding of infrastructure investments could easily reach $57 trillion by 2030, according to global management consultancy McKinsey & Company.[1])

Yet the past two decades have supplied skeptics with plenty of ammunition. The economist Jagdish N. Bhagwati famously wrote in 1998, “When we penetrate the fog of implausible assertions that surrounds the case for free capital mobility, we realize that the idea and the ideology of free trade and its benefits [...] have, in effect, been hijacked by the proponents of capital mobility.” Bhagwati’s point is that the classic arguments for free trade apply when nations trade goods, but not when they exchange capital. There is a difference, as he puts it, between “trade in widgets” and “trade in dollars.”[2]

THE TROUBLE WITH “HOT MONEY”

The problem with capital exchanges is that capital mobility makes it all too easy for investors to 
chase high but short-term yields in nations where borrowing for the short term is commonplace. And this problem of inherently unreliable “hot money” is not confined to equity portfolios or bank loans. Even direct investment in bricks and mortar can be withdrawn, albeit more slowly, if investors are fearful of loss. Since the great upturn in private investment in emerging markets in the 1990s, nation after nation has coped with sudden floods and droughts of capital and their effects. In many cases, the influx (and exit) of foreign capital merely exacerbated problems that were inherent to the nations’ financial systems. “Most crises have resulted from the opening of unsound systems to capital flows,” Maurice Obstfeld of the University of California, Berkeley, has written.[3]

Thus, there is little doubt that international capital flows expose nations to risk in ways that domestic investment does not. The list of emerging-market crises that affected foreign investors over the
past 25 years is long: It includes Chile in the early 1980s, and, in the 1990s alone, Argentina, Mexico, Russia and Turkey. And, of course, that was also the decade when Thailand triggered a slew of currency and payment crises throughout Asia in 1997-1998 following heavy borrowing in foreign currencies and the subsequent deep devaluation of the baht. In addition to Thailand, Indonesia and South Korea were deeply affected, with others suffering significant economic setbacks. (See Exhibit below.)

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At the same time, emerging markets have found themselves whipsawed by the changing goals and assessments of developed-market investors, who can flood a nation with investment one year and pull out fast in the next. Many of the 1990s crises in emerging-market nations, for example, were triggered or exacerbated by foreign investors abruptly taking their money out.

On the other hand, cross-border capital flows can also trigger a virtuous cycle, spurring the creation of jobs, increasing income and thus increasing demand for goods and services, which in turn creates more jobs. Capital invested from other nations is a spur to economic growth in nations that lack indigenous sources of capital and is a boon to local investors.

In short, capital flows have obvious benefits, but these do not occur in all times and places. Nor
 do different modes of capital flow have the same effects—direct investment, for example, is less susceptible to sudden changes, while bank loans are more so. It is not sufficient then to promote any and all forms of cross-border capital flow at all times. It is vital for investors to identify which types of capital flow should be fostered in particular nations at specific times.

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.

[1] http://www.mckinsey.com/insights/financial_services/money_isnt_everything_but_we_need_$57_trillion_for_infrastructure

[2] Bhagwati, Jagdish. “The Capital Myth: The Difference Between Trade in Widgets and Dollars” Foreign Affairs. 77 (1998): 7. 


[3] Obstfeld, Maurice. “Reflections Upon Rereading The Capital Myth”, (2005): pdf downloaded from http:// www.columbia.edu/~ap2231/jbconference/Papers/Obstfeld_Bhagwati%20Conference.pdf. 


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