All change – why institutional investors need to change tack

By | 2018-10-01T11:23:06+00:00 October 1st, 2018|
DFIs like Swedfund and Norfund can be important partners for forming bridges between Western institutional investors and promising emerging markets.

In a report commissioned by Norfund, Sony Kapoor, Managing Director of the Brussels-based think tank Re-Define, paints a grim picture of future prospects for institutional investors operating in Western countries.

Entitled “The winter is coming: The perfect storm that now confronts institutional investors and what they should do about it,” the report states that institutional investors are locked in markets with low or negative interest rates and hardly any upside left in the stock market. Their trillions of dollars in Western assets are producing little or even negative returns.

Kapoor’s solution is to match capital from institutional investors in the rich part of the world with promising investment opportunities in developing economies. “It is a marriage made in heaven,” he writes.

Bleak return landscape

Western pension funds, insurance firms and sovereign wealth funds, which together hold more than USD 80 trillion in assets, face fragility and a bleak return landscape that is unprecedented in recent history. The negative interest rate policy in Western countries could have “fatal consequences” for banks and sovereign wealth funds and the collapse in returns on pension funds would be nothing short of “catastrophic,” the report states.

Kapoor says that not even a Donald Trump presidency can change the underlying dynamics in the global economy which is turning emerging economies into the markets of the future.

Kapoor’s answer to this challenge is for Western investors to invest more in emerging economies with significantly higher growth and return prospects. Such investments will also help Western investors diversify their portfolios, which now lean heavily on listed stocks and the bond market.

But, according to Kapoor, institutional investors will have to make radical changes to be able to operate in these new markets. First of all, they will need to improve their governance and strengthen their boards and staff capacity. Investing in infrastructure and unlisted companies is a different ball game. “Unlike listed assets, which are easy to invest in, exploiting the unlisted opportunities requires specific domain knowledge, local expertise and direct investing capacity,” Kapoor writes.

The way Western investors reward their staff must also change from short to more long-term benchmarks. Kapoor criticises institutional investors for having too short-term a focus on stock market indexes when providing bonuses for staff. Performance benchmarking and compensation practices have to be changed, he says.

According to Kapoor, investors operating in these markets should enter into partnerships to leverage their expertise and tap into local knowledge. This is where the aid-financed risk capital funds come in. He proposes collaboration not only with host governments and like-minded investors, but also with development finance institutions (DFIs) to leverage expertise and human capacity and to tap into local knowledge.

Kapoor mentions several examples of such partnerships and highlights the World Bank’s private sector arm IFC’s Asset Management Company as one which allows co-investment with institutional investors. In a Nordic context, Swedfund, Finnfund, IFU (Denmark) and Norfund are such alternatives.

Managing Director at Norfund Kjell Roland agrees that DFIs can be an important facilitator to bridge the gap between capital in Western countries and markets in developing countries. He says managing risks in these markets is a key challenge:

“Five years ago we believed the market would do the job. Now, I think institutions like us [DFIs] will [for the long term] have an important role in building such a bridge,” he says to Development Today.

Roland says DFIs need to find new cooperation partners and develop flexible  new instruments. Blending small amounts of aid to trigger big private money is part of the discussion. “We must be much more innovative. Western project financing is useful, but it is only part of the answer,” Roland says.

Developing intelligent guarantee instruments is one way to go. As an example, Roland points to a new scheme where IFC in the World Bank has joined forces with the German insurance giant Allianz and the Swedish aid agency Sida.

Extraordinary measures

Roland says DFIs have had to take extraordinary measures to tempt investors to join in. For example, the Norwegian pension fund KLP has been allowed to sit on Norfund’s investment committee when all renewable energy projects are discussed and then they can pick and choose projects to invest in.

“Under normal commercial circumstances this would be completely wrong, and if other investors were lining up behind KLP we would have to do it differently. But first we need to show that such investments are profitable. Maybe with KLP success stories others will follow suit,” he says.

Kapoor believes the promising outlook in emerging economies is based on fundamental changes in the economy.

With the exception of China most developing countries will have favourable demographics. The population in Africais likely to rise from one billion to 1.6 billion in 2030, while the birth rate in Europe is only 1.58. Emerging economies are expected to benefit from this “demographic dividend” for years to come. Building new infrastructure, clean energy and job creation will be keys for growth.

In his analysis, Kapoor notes moreover that the debt level has fallen in many developing countries. Large economies like India, Indonesia and Mexico have undertaken serious structural reforms. “These emerging and developing economies have a big need for capital to invest in infrastructure, clean energy and expanding productivity,” he writes.

As for the Eurozone and the United States, total debt has risen to about 250 per cent of GDP and many countries still face big fiscal deficits. Despite “the largest fiscal and monetary policy stimulus in the history of the world”, in the wake of the global financial crisis of 2008, GDP in many developed economies has not reached pre-crisis levels.

Political risk in OECD area

The combination of low growth and investment, demographic decline and debt overhang mean that the days of “rising profits are gone” in the OECD economies. “If anything, capital losses on stocks are far more likely,” Kapoor warns.

For decades, political risk has been associated with developing countries. Now it has arrived in the OECD area. “This combination of rising political risk and shrinking political, fiscal and monetary policy space is very dangerous,” he writes.

Kapoor notes that the in-coming Trump administration has campaigned for a new economic policy. Commenting to DT, he says infrastructure spending and fiscal loosening could help the US economy in the short-term. But Trump’s protectionist policies will almost certainly have a negative impact on other OECD economies and on the United States in the longer term.

“In that sense, the anti-immigration, anti-globalisation sentiment Trump represents will only accelerate the OECD’s decline by making population and productivity dynamics even worse while increasing political risk,” he says.

Kapoor says that in the short term the new US administration could also have a negative effect on emerging economies through increased protectionism.

“But it will not change the fundamental drivers of growth which remain robust for the emerging and developing world, particularly for countries such as India where drivers of growth are primarily domestic,” he says.

The article first appeared on Development Today and can be accessed here.
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