The yawning gap at the heart of the financial system
Note: This piece first appeared in a Special issue of the Swiss newspaper NZZ alongside other invited interventions by Axel Weber, Phlipp Hildebrand, Urs Rohner, Marcel Walker and Parag Khanna.
Two particularly pernicious and inter-related challenges confront the global financial system. On the one hand, pools of trillions of dollars of savings, particularly in OECD economies, are trapped in sub-optimal investments earning poor returns. On the other, many developing countries face a serious shortage of capital, even for investments that can generate high financial and economic return. The world’s financial system fails to intermediate between the two at any scale. This leads to several perverse consequences.
Long-term investors from rich countries, such as pension funds and insurance firms, have crowded mostly into developed country bonds and stocks. Even truly unconstrained investors such as the giant Norwegian sovereign wealth fund have ninety percent or more of their portfolio invested in such assets. Total allocation to developing countries remains far below the more than 40% (and growing) share of global GDP that they now command. Allocation to unlisted assets in developing countries, which often lack the deep liquid markets that characterize OECD economies, is negligible. Perversely, large pools of savings in developing economies, particularly sovereign wealth funds and foreign exchange reserves, are also after the same listed securities in developed economies.
This global bias towards listed liquid securities in OECD economies has multiple drivers and creates outcomes that are globally suboptimal.
What drives this bias?
Of the more than $100 trillion globally held by insurers, pension funds, mutual funds, sovereign wealth funds and reserve funds, nearly 70% originates in developed economies. Such funds almost always have a ‘home bias’ and a broader ‘familiarity bias’ that means the majority of investments are also concentrated in the developed world. Perceptions of higher political and credit risk as well as a lack of expertise on developing countries amplifies this bias.
As the risks of pensions and insurance payouts are increasingly being borne by savers, recent regulatory moves have sought to “de-risk” the investments pension funds and insurers can make. Requirements to mark portfolios to market, for example has driven investment away from equities and other assets perceived to be risky towards bonds. This regulation, combined with a more stringent supervisory approach against illiquid and unrated assets has sharply reduced the scope for developing economy investments.
Principal agent problems mean that trustees and pension fund owners have a preference for measuring relative performance on a regular and verifiable basis. Asset managers want annual bonuses and face asymmetric payoffs. Because the principals are risk averse, underperformance is more risky than outperformance may be rewarding. Both mean that more ‘exotic’ asset classes such as infrastructure in emerging economies, where near-term performance is harder to measure and verify, suffer. Because indices such as the S&P 500 and the Barclays Capital Aggregate Bond Index are often used as benchmarks, many asset managers tend to hug them closely.
Not all the funds considered here are genuine long-term investors. Insurers and pension funds need to make regular payouts to policyholders and mutual funds can be redeemed at will. Central bank reserve assets need to be liquid so they can be sold off in the event of market stress to generate cash. These liability requirements seriously limit how much money is actually available for investing in less liquid assets in developing economies.
Only a small proportion of this hundred trillion is genuinely unconstrained with the flexibility of being invested in any asset class in any part of the world.
Why might this be a problem?
Because large pools of capital chase listed liquid equity and debt securities in OECD economies it naturally depresses the returns available. Under the prevailing low rate environment for example, the Norwegian oil fund, earned a negative 0.1% return on its $350 billon fixed income portfolio in 2013. Given the demographic decline in developed economies, low returns on investment are an especially acute problem. Higher returns in emerging economies are consciously foregone.
Constrained investors often claim to be ‘well-diversified’ but this is within a small universe representing less than 40% of productive capacity in the global economy. Developed economies have high levels of financial and economic inter-linkages with each other and are facing similar risks from poor demographics and record levels of public and private debt. In actual fact, the funds are not well diversified and also face large systemic risks. The pro-cyclical behavior engendered by regulation and managerial incentives further amplifies their risk. Correlations between supposedly uncorrelated assets tend to shoot up during a crisis now that most large funds use similar models and information and make similar investments in large indices. Given this, larger investments in developing economies would actually reduce risk through true structural diversification.
The micro-level problems discussed so far have macro consequences for the global economy. Capital flows uphill from less-developed capital-poor economies with better investment opportunities towards rich economies that are already saturated with capital and face lower growth prospects.
It was such perverse flows that contributed to inflating asset price bubbles in the United States and the European Union by helping drive interest rates lower and facilitating the excessive growth of credit to unproductive investments.
The index driven pro-cyclicality of behavior by the large asset managers also imposes large costs on developing countries that alternate facing capital gluts and sudden stops depending on risk appetite and monetary conditions in the developed world, especially the United States. Too many of the flows into developing countries take the form of flighty portfolio capital that buys up liquid securities. This was most recently underscored by the emerging market volatility following the announcement of tapering by the US Fed.
Facing the threat of ‘sudden stop’ developing countries continue to build up large reserves of foreign exchange that flow back into the developed world driving down the cost of credit further and the vicious cycle gets perpetuated.
While volatile flows of portfolio capital and bank loans do channel money into emerging economies, this is not necessarily the kind of money they most need. The absence of suitable capital inflows deprives poorer economies of opportunities to develop through building infrastructure and productive capacity in their economies that can not only increase their growth rates but also deliver hundred of millions from poverty.
How can this problem be addressed?
In trying to make pensions and insurance safer for the ordinary savers whose hard-earned savings such funds channel, financial regulators may collectively have increased their riskiness and reduced their potential return. Allowing such funds to put a proportion of their savings into unlisted assets such as growth equity and infrastructure in developing economies would simultaneously increase their effective diversification reducing risk and increase the returns on offer.
Steps towards mitigating requirements to mark whole portfolios to market would help drive at least some investments into higher-yield illiquid assets. Allowing funds to invest in unrated securities would also help. Introducing fiduciary requirements to stress test portfolios against an excessive exposure to common risk factors would also help drive true structural portfolio diversification into developing economies. Changing norms towards absolute rather than relative performance as well as towards longer-term compensation structures would also help.
Expanding global safety nets, such as central bank swap lines and the size of the IMF, as suggested by Raghuram Rajan would also help reduce the incentive for developing country central banks to accumulate precautionary reserves.
Another very important measure would be for the international financial institutions such as the World Bank and the Regional Development Banks to build up ambitious co-investment vehicles to attract long-term investments into developing economies. The Asset Management Company, for example, has already managed to attract more than $6 billion from almost 30 investors to invest alongside the International Finance Corporation, the private sector arm of the World Bank. The EBRD is contemplating setting up a co-investment vehicle too. These initiatives, which draw on the long developing country presence and good investment track record of the International Financial Institutions, need to be scaled up ambitiously.
A more efficient and ambitious use of guarantees through vehicles such as MIGA, the multilateral investment guarantee agency would also help, particularly to reassure risk-averse investors to plough money into developing economies.
Given a choice many of these long-term investors expressed an enthusiasm for buying small chunks of a well-diversified portfolio of developing country infrastructure projects. Problem is, no such portfolio exists. Using the momentum provided by the OECD’s project on long-term finance, the Australian G-20’s focus on infrastructure investment and the European Union’s initiative on long-term finance, there is a need for governments to take the lead to launch the development of a infrastructure project facilitation and securitization facility perhaps under the umbrella of development finance institutions acting jointly.
Taken together these measures have the potential to simultaneously increase returns for long-term investors, increase growth rates in developing economies and enhance global financial stability. Time to get moving then.
Sony Kapoor is Managing Director of Re-Define, an international Think Tank and a World Economic Forum Young Global Leader