Equity flows, banks, and Asia.

• Author: Stulz, Rene M.
• Position: Evaluation of the worldwide capital market

After World War II, capital markets in different countries were almost completely segmented from each other. Individual investors generally could not buy securities in other countries because they could not acquire the correct currency. Since then, dramatic changes have occurred. Currencies typically are convertible and most major obstacles to capital flows among developed countries have been removed. This evolution has allowed equity investors to invest in most countries in the world.

Unfortunately, throughout history, periods with limited barriers to international investment were followed by periods with stronger restrictions. Since the devaluation of the Thai baht last year, many countries have faced economic difficulties; many economists and policymakers have argued that the so-called "Asian flu" has spread too far and too decisively. Led by fears of contagion and encouraged by some prominent economists, some countries, for example Malaysia, have taken measures recently to restrict capital flows. Though fixed exchange rates can breed speculative attacks and contagion, we should not forget that countries benefit from open equity markets. There is little evidence that the presence of foreign equity investors will lead to irrational movements in equity markets.

In a recent paper,(1) I discuss the costs and benefits of opening equity markets to foreign investors. With closed equity markets, investors within a country. have to bear all the risks of that country. Therefore, they charge a higher risk premium to bear risk, which translates into a higher cost of capital. The cost of capital determines which investments are worthwhile. An increase in the risk premium means that riskier investments with a greater expected return are replaced by safer investments with a lower expected return. Consequently, a country whose investors cannot diversify' risks internationally has an economy that invests in safer projects with lower risk. This practice hampers economic growth. When the investors in a country become able to share risks with foreign investors, the cost of capital falls, and the economy invests in riskier projects that contribute more to growth because the cost of bearing risk is lower.

As countries have progressively liberalized, we have seen the emergence of a world capital market, which for a number of years included most developed countries. Eventually, it was joined by emerging markets. The theory predicts that, as the world capital market grows with the addition of new countries, the risk premium for bearing risk falls. As a country joins this world capital market, its cost of capital also falls. However, the evidence shows that the decrease in a country's cost of capital when it opens its capital market has been smaller than predicted. Recent papers by Geert Bekaert and Campbell R. Harvey(2) and P. B. Henry(3) indicate that the fall in the cost of capital when an emerging market opens its capital market might be on the order of two hundred basis points when theory predicts a much larger drop.

The Home Bias and Portfolios of Foreign Investors

Part of the reason that the cost of capital does not fall as much as predicted is that when markets open up, foreign investors do not acquire as much equity as expected, In general, investors have a strong preference for their own country's equity. This phenomenon is called the home bias in equity' holdings. Though the home bias has been studied for more than 20 years, it has recently become more of a puzzle, because some of the reasons for its existence seem to have disappeared. For instance, earlier research emphasized differences in transaction costs and taxes as an explanation for the home bias,(4) but these differences have diminished over time. As Linda L. Tesar and Ingrid M. Werner point out,(5) in some cases foreign investors trade more than domestic...