The Limits of Financial Globalization
April 02, 2007
Barriers to international investment have fallen sharply over the last 60 years. In the last 30 years alone, the dollar amount of cross-border stock and bond transactions by U.S. investors has jumped from about 6% of U.S. GDP to over 350% of GDP. These massive cross-border capital flows, together with steady increases in global trade and production, have led some economists to predict that investors everywhere will eventually end up holding the same “world market portfolio,” with proportional representation by all economies with traded assets. And corporate finance specialists have theorized that comparably profitable companies operating in the same industry but based in different countries will have similar capital and ownership structures, and roughly the same costs of capital and market values.
But the reality is that the positive impact of financial globalization has been limited. Significant cross-country differences in investment, financing, and corporate ownership persist and investors everywhere continue to hold disproportionate amounts of domestic securities in their portfolios. One of the most prominent economists to predict convergence was René Stulz, editor for many years of the Journal of Finance and a recent President of the American Finance Association. When stepping down from that role in January 2005, Stulz used his President’s address, which he called "The Limits of Financial Globalization," as an occasion to explore why these predictions had failed to materialize.
In the edited version of his talk that appears in the Winter 2007 issue of the Journal of Applied Corporate Finance, Stulz focuses on two kinds of governance problems, or what he refers to as the “twin agency problems.” One is the tendency of controlling shareholders (said to be found in most listed companies outside the U.S. and U.K.) to transfer value from the other (“minority”) shareholders to themselves through self-dealing of various kinds. The other problem, which complicates and compounds the first, is the tendency of governments to expropriate wealth from all shareholders, controlling and minority.
To manage these problems, especially in countries with less investor-friendly legal and regulatory regimes, the controlling shareholders typically “co-invest” with outside minority investors by retaining large equity stakes. As Stulz argues, such co-investment is needed to reassure outsider investors that the interests of the controlling shareholders are largely consistent with their own, and that the insiders will attempt to shield outsiders from the depredations of the state. And when such companies need additional outside funding, instead of raising new equity, they show an unusually strong preference for debt—which preserves their concentration of ownership.
But if such co-investment improves the terms on which outsiders provide capital, it also has a big downside: The concentrated ownership and higher leverage means that such companies are sacrificing the much larger risk-bearing capacity, and much lower cost of equity, that comes with having a large diversified shareholder base; and given the limits of their insiders’ wealth, the companies are far more likely to pass up promising growth opportunities for lack of funding.
The twin problems can also have more subtle side effects. For example, a company operating under a confiscatory regime may find that, by increasing “transparency” for minority holders, it exposes the firm to further state expropriation and so reduces value. And in a similarly pessimistic note, Stulz mentions his own research that shows the difficulty for even well-governed companies to achieve high governance ratings from third-party agencies when the firms are based in countries with weak governance systems.
But for all his skepticism about the accomplishments of globalization, Stulz ends by repeating the predictions he and other economists made years ago. Both governments and the private enterprises within their jurisdictions have strong motives for finding more effective ways to manage the twin agency problems; and, “when they do,” as Stulz says in closing, “the citizens of developing and developed nations alike will benefit from increasingly global financial markets.”
To read additional summaries of articles contained in the current issue of the Journal of Applied Corporate Finance, click here.