There is no place like home

November 24, 2011

(Paul Donovan is a Managing Director and Global Economist at UBS. The views expressed in this column are the author’s own and do not represent those of Reuters)

Most economists believe that nearly everything in this life can be reduced to an economic explanation.

This even applies to popular culture. The Wizard of Oz has been explained as a parable of late 19th century economics, as a veiled commentary on the gold standard versus the use of silver that dominated the 1896 presidential election in America. The yellow brick road is gold, the cowardly lion was William Jennings Bryan (a pro-silver politician). The wicked witches represented Wall Street (east) and railroad interests (west). Dorothy had to put on silver shoes to make her way to the Wizard of Oz (the U.S. President). She then learned that she could escape the bizarre, fantasy world of Oz and get back to reality by clicking her heels and repeating “I want to go home”.

Confronted by the bizarre, fantastic world of the Euro today, investors could learn from the Wizard of Oz. Global investors may well want to click their heels and mutter “I want to go home”. After two decades of globalising capital flows, investors may once again feel the urge to have their money at home, or at least closer to home than has been the case hitherto.

Why should investors favour home or regional markets? In a rational world, investors should search for the best risk adjusted returns they can find, and put their money there. However, as the Euro only too clearly demonstrates, we do not live in a rational world.

There are two forces at work here. The first is the fact that political risk is playing a larger and larger role in the world’s financial markets. Governments have an increasing impact through regulation, government debt (and default fears), intervention in currency and bond markets and policy statements.

What this means is that the performance of markets can no longer be interpreted through economic activity alone. Increasingly, one must understand the political environment and the likely changes that that environment may bring to bear on investments. For many investors this is a development that they have not experienced before: political risk was a declining force in financial markets in the two decades that preceded the global financial crisis. The problem is that political risk is very often specific to a country or to a culture.

While economic risks can be thought of as a “pure” risk that can be evaluated according to a common global standard, political risk is necessarily peculiar to individual countries.

The challenge for investors is therefore how to understand political risks in countries that are thousands of miles away. It is sometimes difficult to get comprehensive information (politics, after all, can rarely be reduced to statistics in the way that economics can). Moreover, human nature means that investors will often see foreign political cultures through the distortion of their own political experiences. For example, an American’s view of European politics is likely to be affected by America’s political culture. That is almost certainly the wrong way to think about European politics.

The second force encouraging investing closer to home is not the voluntary pressure of interpreting political risk, but the compulsion of regulation itself. The recent crisis in Italy prompted a wide variety of doomsday prophesies about Italy being unable to finance its debt. However, these extreme scenarios ignored the fact that — if the alternative were sufficiently dire — the Italian authorities may simply seek to force domestic investors to buy domestic Italian assets. The idea that investors (particularly insurers and pension funds) can invest wherever they like is in fact a relatively recent innovation. Just twenty years ago, most investors were heavily regulated and set proportions of their portfolios had to be invested in specific assets (generally domestic government bonds).

In one sense, this can be considered relatively reassuring. If a country has a stock of domestic savings it can draw upon to finance its debt, then disaster scenarios about debt finance seem relatively unlikely. One of the problems for Greece was the lack of domestic savings that could be mobilised. If the savings are there (and they are in many countries), then either concerns about overseas investments or the compulsion of new regulation will likely lead to domestic resources being mobilised. This mobilisation may take place after much financial system stress, but home country bias can be created.

In an economic sense, this is not an efficient outcome. Distorting capital markets leads to a misallocation of resources. It may also challenge emerging markets, which are by definition capital poor. If governments or political risk forces investors to buy local government bonds, they will have to sell other assets.

Emerging markets, which have seen significant capital inflows in recent years, may find that those flows are less reliable in the future. The economic logic of investing in emerging markets may be as good as ever, but if politics and regulation are overruling economics then logic may not have much of a role to play.

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