MANAGERIAL AND DECISION ECONOMICS, VOL. 8, 75-80 (1987)

Restrictions on Outward Portfolio Investment and Domestic Equity Markets

IAN HIRST Department of Business Studies, University of Edinburgh, UK

Governments sometimes impose restrictions on local investors which effectively prevent them from purchasing overseas equities. Reasons for doing this, from the government’s point of view, would include increasing the availability of risk capital to local companies and lowering its costs The paper analyses this argument in terms of modern portfolio theory. It is shown that, under certain circumstances, domestic equities and overseas equities may be complements rather than substitutes. In this case the effect of the restrictions would be to lower prices on the domestic stock exchange and to raise the cost of risk capita1 to local companies. Indications are given of the circumstances in which this effect is likely to occur. Policy makers who are not aware of the risk-spreading motives which underly much international portfolio investment in equities are likely to overestimate the benefits to local industry from forcing local equity investors to keep their funds at home.

INTRODUCTION

This paper considers the effects of restrictions on outward equity investment. Such restrictions are often imposed by governments concerned to protect their currency and their balance of payments, support local capital markets and encourage domestic industry. By forcing local equity investors to confine themselves to the domestic market i t is argued that risk capital will be more readily available to local firms and their cost of capital will fall. The paper that follow reviews this argument critically in the light of modern portfolio theory. Domestic equity investment and foreign equity investment should not necessarily be regarded as substitutes. Because portfolio risk can be reduced by investing in a spread of different national stock mar- kets, investments in different national markets can take on the characteristics of complementary economic goods. In an extreme case, raising the cost of overseas investment could reduce investor’s willingness to invest in the local equity market just as raising the price of petrol will reduce the demand for cars.

The result of this would be to raise the cost of equity capital for local companies and discourage investment in the local economy. The paper discusses the circum- stances in which these perverse consequences are likely to raise. It starts with a review of recent events in the international equity markets.

INTERNATIONAL EQUITY INVESTMENT EXPERIENCE

The performance of national equity markets is measu- red with some approximation by widely used stock

market indexes. The statistical analysis that follows is based on the performance of six indexes from five national markets.

Index Country

S & P Composite USA Tokyo New Japan W.G. Faz West Germany FT All-share USA SA Industrials South Africa SA Gold South Africa

The calculations are based on the value of these indexes recorded each month from April 1981 to April 1986. Over this period the mean monthly return and the standard deviation of the monthly returns were as shown in Table 1.

The indexes ignore dividends and therefore under- state the pre-tax returns that an investor would have received. Most risk in equity investment comes from capital gains and losses, so the omission of the dividend component of returns will not produce much bias in the measurement of risk.

The figures in Table 1 make it appear that the West German market offered the highest returns over the

Table 1. Risk and Return of National Markets Measu- red in Local Currency

Mean Standard deviation

USA Japan West Germany UK SA (Industrials) SA (Gold)

0.01 0 0.035 0.01 4 0.030 0.020 0.044 0.01 6 0.032 0.01 2 0.048 0.01 6 0.105

01 43-6570/87/0f0075-06$05.00 0 1987 by John Wiley & Sons, Ltd.

76 1. HIRST

period, with the South African gold market in second place alongside the UK and ahead of Japan. This is not a proper conclusion to draw. The indexes measure performance in local currency terms and need to be converted to a common currency base to reflect the experience of international equity investors. In Table 2 the monthly returns to a US dollar-based investor are listed. The choice of another currency as the base would have altered the mean returns but would not have altered the relative returns received in different markets. The effect on the risk measurement (standard deviation) is more complex. The unadjusted figures show that the South African gold index stands out as having a far higher level of risk than any other in the table, and this remains true when all the numbers are dollar-based. For all markets except the USA the risk levels shown in Table 2 include two components. These are the local market risk and the currency risk experienced by a dollar-based investor. It is not necessarily true that the currency factor will increase the risk of overseas investment. If the stock market of a foreign country tended to weaken at the same time that its currency strengthened, and vice versa, the two components of risk would tend to offset each other. This did not happen in the period to which our data relate. All the markets covered are riskier when measu- red in dollar terms than in local currency with the exception, of course, of the USA. The currency factor added considerably to the risk of international invest-

Table 2. Risk and Return of National Markets Measu- red in US Dollars

Mean Standard deviation (US dollars) (US dollars)

USA 0.01 0 0.035 Japan 0.01 9 0.052 West Germany 0.021 0.056 UK 0.01 2 0.049 SA (Industrials) - 0.002 0.096 SA (Gold) 0.002 0.1 34

ment during the period covered by our data. The risk involved in a dollar-based investment in South African Industrial shares was twice as great as the risk for a local investor. It is interesting to compare these general Findings with those of Solnick (1974). Studying an earlier time-period, he found currency risk to be less important. The increased volatility of currencies in recent years has clear significance for international portfolio investment.

International investors are ultimately concerned not with the risk and return of single national markets but with the performance of their own portfolios which are spread across a range of national markets. The perfor- mance of these portfolios will depend not only on the risk of individual national markets but also on the co- movements between them. The lower the covariances between the pair of national markets, the more effective international diversification will be. Table 3 shows the correlation matrix between the unadjusted returns in the different national markets, and Table 4 the matrix calculated on the basis of returns measured in US dollars.

THE THEORY OF INTERNATIONAL EQUITY INVESTMENT

A hundred years ago there was active international portfolio investment. Equity markets were much less developed, and most international investment was on a fixed-interest basis and was denominated in currencies which were tied to gold. There were a number of issues, including some large ones, which went into default, but when the bonds and debentures were originally issued they were regarded by both borrower and lender as being low-risk.

The economic logic of international investment at that time was to move capital from countries with low domestic interest rates to those with high domestic

Table 3. Correlation Matrix of Local Currency Returns USA Japan UK

USA 1.000 0.252 0.427 Japan 0.252 1.000 0.461 UK 0.427 0.461 1.000 West Germany 0.1 76 0.1 07 0.271 SA (Industrials) 0.257 0.1 67 0.1 08 SA (Gold) 0.1 51 0.01 4 0.1 33

Wen Germany South Africa (Ind.)

0.1 76 0.257 0.1 07 0.1 67 0.271 0.1 08 1.000 - 0.052

- 0.052 1 .ooo 0.036 0.582

South Africa (Gold)

0.1 51 0.01 4 0.1 33 0.036 0.582 1 .ooo

~~ -~

Table 4. Correlation Matrix of US Dollar Returns USA Japan UK

USA 1.000 0.335 0.370 Japan 0.335 1.000 0.555 UK 0.370 0.555 1.000 West Germany 0.1 55 0.435 0.425 SA (Industrials) 0.290 0.243 0.240 SA (Gold) 0.234 0.201 0.269

West Germany

0.1 55 0.435 0.425 1 .ooo 0.1 98 0.251

South Africa South Africa (Ind.) (Gold)

0.290 0.234 0.243 0.201 0.240 0.269 0.1 98 0.251 1 .ooo 0.777 0.777 1.000

OUTWARD PORTFOLIO INVESTMENT 77

ones. In practical terms, this meant that capital was leaving countries like the UK, with large domestic savings in relation to its domestic investment oppor- tunities, to the USA, Asia, Africa and Australia, where there was opportunity for productive investment in lands with untapped natural wealth.

The simple logic of international investment at that time was that money was moving in search of the highest possible return. In accordance with this logic, the flow of capital was a one-way street. If it made sense for UK capital to go to Australia it did not make sense for Australian capital to go to the UK.

The logic of private international investment in the late twentieth century is often different. Much portfolio investment is on an equity basis, and investors must weigh up both risk and return in their decisions. Multinational companies invest internationally to exploit their technological and marketing strengths. These motives lead to a much more complicated pattern of international capital flows in the 1980s than in the 1880s.

International investors are interested in risk and return, but in constructing their portfolios they will be guided by their expectation of what these variables will be in the future rather than what they have been in the past. The kind of information provided in Tables 1-4 is therefore only of value in so far that it can be used to predict the future. Most analysts would agree that five years is far too short a period, and evidence over a much longer timespan is preferred.

Over the last sixty years the UK stock market has given an average annual return that has been 9% above the Treasury Bill rate (Dimson and Brealey, 1978). In the USA since 1926 the premium has averaged 8.8% (Ibbotson and Sinquefield, 1976). These numbers are often taken as a guide to the future. They should be used very cautiously. It is true that we need to measure over a long time period. Stock markets are volatile; if we measure over the decade of a bull market (such as has been experienced over the last 10 years) the average return will seem extremely high. Over the decade of a bear market, returns will appear poor. Fifty years is long enough to cover several ups and downs in the markets. Unfortunately, it is also long enough to cover major changes in the role of the stock market and the individuals and institutions who invest on it and in the economy generally. Things have changed a lot since the 1930s and it is a pity that our best methods of measuring stock market returns does not recognize this. There is other bias, too. You will notice that the only cited returns are from countries that were victori- ous in World War 11. The experience of German investors who put their money into the market in 1936 was presumably less satisfactory.

One controversial issue is whether the levels of risk and return offered by different national markets are independently determined or whether there is some rational relationship between them. In technical terms, is the international equity market segmented or integrated?

It is agreed that risk has a price, and that companies

with riskier shares must offer a higher expected return on their equity capital. It is also agreed that not all risk is priced, because much of it can be diversified away within portfolios. What is controversial is whether risk is priced in the same way in all the world’s equity markets (an integrated market) or whether individual national markets are separate, each pricing risk in its own way. Markets may be segmented as a result of prejudice and chauvinism, causing investors to keep their fundsin their own domestic markets, or there may be specific investment barriers (tax regulations, etc.) which treat domestic investors differently from foreign ones.

An Integrated World Market

The extent to which national markets are segmented affects the behaviour of equity investors whose funds are internationally mobile. An integrated world mar- ket would be dominated by the US market which accounts for about two-thirds of the world market measured by market capitalization. Investors would be well advised to spread their funds broadly across the full range of available equity markets. Those who confine themselves to their home market would be at a disadvantage, and those who had a small home market would be at a particularly severe disadvantage.

South Africa is a case in point. The matrix shows that correlation is low between returns on the South African market and those on other major markets. The implication of this is that US and European investors will be attracted to the South African market, for a small part of their funds, because of the diversification benefits it gives. The other side of the coin is that South African investors will be keen to balance their domestic risk by putting a substantial part of their funds overseas.

Segmented Markets

Markets may be segmented either for reasons of prejudice and ignorance (irrational segmentation) or because economic barriers have been erected between them. In an irrationally segmented market there is potentially a double benefit from international diversi- fication. As well as spreading risk, it will be possible to pick up extra return justified by the national risk of foreign markets which is diversified away in the investors own broadly spread portfolio. International diversification needs to be selective in this case. There may be some national markets with low expected returns which should be avoided.

If there are discriminatory barriers to international equity investment the picture is more complicated. Most national regulation favour the investor who keeps his money at home. We need to consider whether the international equity market is segmented, and, if so, what factors cause the segmentation.

Because we cannot measure expected returns accu- rately we cannot observe segmentation directly. There is reason to think, though, that there has been signifi-

78 1. HIRST

cant segmentation within the last decade or two. Lessard (1976) has found that company share prices are much more strongly linked to the movement of their home market than to the movement of shares in the same industry worldwide. This is true even for indus- tries like oil, which are highly international in their operations. There have been other studies that have looked at multinational companies to see whether their share prices respond proportionately to the different national markets where they do business. The conclu- sion of these studies have been that the share prices of multinationals react disproportionately strongly to movements in their home market index and surpris- ingly weakly to movements in the indices of other countries where they do business (Jacquillat and Solnick, 1978; Senchack and Beedles, 1980).

The next question is why this segmentation occurs. Those who work in financial markets talk about ‘market confidence’ and ‘market sentiment’, and are inclined to analyse stock markets in terms of crowd psychology. Different national markets often speak different languages, read different newspapers, watch different television and read reports by different teams of research analysts. Perhaps it should not be surpris- ing if different national markets value the same com- paring differently.

Yet we should never forget arbitrage, one of the most powerful economic forces. If there is a valuable new perspective to be gained, surely US investors will get hold of UK stockbrokers’ work on, for example, North Sea oil, and British investors can subscribe to Barron’s and the Wall Street Journal. Language barriers might seem more serious, but they do not seem serious enough to stop the development of genuinely intern- ational bond markets.

The bond market parallel is a relevant one because bonds are denominated in many different currencies. It is sometimes argued that investors think in terms of their own currencies when measuring risk. Looked at in this way, all foreign investments have a currency risk that is missing in domestic investments. Because there is a whole extra category of risk involved in foreign investment it is argued that investors will tend to keep their money at home.

There are some reasons to doubt this argument. First, it is not always necessary to accept currency risk in foreign portfolio investment. Major currencies can be hedged. A second factor is that investors today surely do not think of their own currencies as risk-free. With the exception of insurance companies with liabilities fixed in local currency terms looking for assets to match, most investors are more interested in purchasing power than currency units. The inflation of the 1970s has surely made investors aware that there are risks in all currencies, including their own.

To paraphrase Dr Johnson, a man is seldom so free of nationalist bias as when he is investing his own money. The behaviour of individual investors would surely support the development of a single, integrated world equity market. To the extent that markets are segmented, governments are responsible.

Government Policies that Produce Segmentation

There are a variety of ways in which a government may, intentionally or otherwise, segment the market. Most such policies have the effect of keeping local money at home. There may be direct prohibition of citizens owning overseas equity. There may be a particularly unfavourable exchange rate at which such equities have to be purchased. There may be tax benefits associated with equity investment which are only available when the investment is made on the local market.

There are other cases where the ostensible objective of government policy is to keep foreign investors out. In Sweden and Switzerland, for example, some shares are reserved for nationals and only a limited number can be sold at outsiders.

From the point of view of economic analysis all these different policies have one feature in common. They force the returns available to investors in the local market out of line with those available in the wider world. In the model which follows we shall only consider the simplest form of restriction whereby local investors are simply forbidden to purchase equity other than in their home market.

It is worth noting that governments are often more effective in segmenting the market for equity invest- ment than for fixed-interest investment. A government whose currency is used in international trade will find it very difficult to maintain a domestic interest rate which is out of line with the rates in other currencies. According to the Interest Parity Theorem, high domes- tic rates must prevail if the currency is expected to depreciate and low rates if it is expected to appreciate. Attempts to maintain domestic rates out of parity will require a much broader range of restrictions than those needed to segment the equity market. In any case, governments are often more enthusiastic about helping the industrial sector by fostering the availability of risk capital than they are about stimulating the commercial and consumer sector through low domestic interest rates.

THE MODEL

The model is based on the following assumptions. The local stock market offers an expected return of R, and a standard deviation of return of cp The stock markets of the rest of the world offer an expected return of Rw and a standard deviation of return ow. These measures of return and risk are measured on an inflation adjusted, purchasing power basis in each case. Inves- tors are assumed to be interested in returns measured in purchasing power rather than currencies. The risk- free rate of interest is measured on the same basis and is same in all countries. The local stock market offers a high risk, and high return compared to the rest of the world:

&>RW UL ’ c w

OUTWARD PORTFOLIO INVESTMENT 79

L 0 Risk

Figure 1. Portfolio choice for a domestic investor before and after prohibition of overseas equity investment.

The correlation coefficient between local and foreign stock market returns is pLw. Local investors have identical utility functions which are locally quadratic, and have identical initial wealth endowments:

U ( W ) = A + bW - c W 2

The equilibrium for each local investor is shown in Fig. 1 . The line joining L and W traces the combin- ations of risk and return available from portfolios invested in both the local and world markets. The line from F which is tangent to the curve at B is the efficient frontier, given that a risk-free investment is possible.

For a quadratic utility function the indifference curves in risk/return space are concentriccircles centred on K . K is the rate of return that would give maximum utility. If W , is the initial wealth of each investor,

K=-- b 1 2c w,

The point A, where an indifference curve is target to the efficient frontier, identifies the investment choice of each ofouridentica1investors.Thereturnandriskat this point are R, and oA.

The values of R , and o, can be defined mathemati- cally as follows. Consider first the line LW. Suppose that the portfolio has proportion a in W and (1 - tl) in L. For this portfolio, p ,

R p = aR, + ( 1 - a)RL, of = a 2 & + (1 - a).: - 2a(1- a)pLwowa,

( 1 ) (2 )

The point B on this line is defined by the tangency condition

dRp - RP - R f do, OP -~ -

Writing out the expression for dR, this becomes

The simultaneous solutions of Eqns (1)-(3) gives values for a, op and R,. These values identify the point B on the diagram, with return and risk RB and uB, respectively. The efficient frontier, the line FB, has therefore been identified.

The point A is the position on the efficient frontier chosen by investors. Since their indifference curves are concentric circles centred on K , A is identified by the requirement that { FAK be a right-angle. R , and CT, can therefore be found from the solution to:

We have now determined the equilibrium portfolio if investors are permitted to invest in foreign securities as well as domestically. We now need to identify the equilibrium if investors are restricted to the domestic market. In this case the efficient frontier is FL, and C, the preferred portfolio along this frontier, is identified by the same requirement of tangency between the frontier and an indifference curve. We also define the point D on FL as the portfolio which contains the same amount of investment in the local market as A.

The effect ofexchange restrictions on the local market then depends on the relative positions of C and D. If C is below D on FL, then investors reduce their holdings in the local market because they have been prohibited from investing in foreign equities. If C is above D, they will invest more locally.

Exchange controls will reduce local equity holdings if the vertical distance between A and C exceeds that between A and D. In mathematical terms the conditions is that:

Our model is oversimplified in one major respect. Even if the above inequality holds, investors in the aggregate cannot withdraw their funds from the local market. Prices must be established at which ail the shares are held. If the inequality (6) holds, the effect of exchange restrictions will be to lower share prices in the local market and to raise the cost of equity capital to local companies. This is, of course, the reverse of what governments hope to achieve by prohibiting outward equity investment.

80 I. HIRST

CONCLUSIONS ~ ~~

The model had demonstrated the possibility that controls on outward equity investment may backfire on the country that imposes them. The consequence might be that domesticstock prices would fall and that thecost of risk capital to domestic companies would rise. This outcome is a possibility. The model offers no guidance on its likelihood. It should also be noted that the model takes R , and R , as independent exogenous variables, although in equilibrium in an integrated world capital market they would be simultaneously determined. There is no implicit assumption that the initial position has arisen as a consequence of global integration of the equity markets.

Restrictions on outward equity investment are likely to be least beneficial to the domestic equity market under the following circumstances:

When there is low correlation between returns in the local market and returns in the rest of the world. When local investors hold a high proportion of their funds in local equities before the restrictions are introduced. When overseas investors have tended to shun the local equity market despite the potentially attrac- tive combination of risk and return that it offers.

The second and third of these circumstances are obviously linked. Local investors must dominate the

local market if foreigners have been reluctant to invest there.

The present tendency in most industrialized coun- tries is towards a liberalization of international capital movements. There has been a tendency to remove restrictions rather than to impose new ones. The model presented in this paper can also be applied to this situation. If the economic environment is such that imposing restrictions would depress the local equity market, removing those restrictions would cause the local market to rise.

It would be a mistake to generalize too strongly from individual events, but two recent incidents may be of some interest. In October 1979 the UK government unexpectedly removed all restrictions on overseas portfolio investment. The immediate response of the local market was in the direction that convention would predict. The UK-All-Share Index fell by 23”A on the following trading day. A fall of this magnitude does not suggest that the scale of the support given to the local market by exchange restrictions was very large. A second relevant incident was the announcement by the French government in April 1986 of an intention to remove exchange restrictions on capital movements. In this case the immediate response of the Bourse was a slight rise. The benefits of exchange restrictions for local stock markets are by no means clearcut. Overseas equities are partly substitutes for local shares, but they are also partly complements. The balance between these two attributes will vary in different circumstances. Policy-makers must take both of them into account.

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R. G. lbbotson and R. A. Sinquefield (1 976). Stocks, bonds, bills and inflation: year by year historical returns (1 926-1 974). Journal of Business, 49, January.

B. Jacquillat and B. H. Solnick (1978). Multinationals are poor tools for diversification. Journal of Portfolio Management, Winter.

D. R. Lessard (1 976). World, country and industry relationships

in equity returns: implications for risk reduction through international diversification. Financial Analyst Journal. January/February.

A. J. Senchack and W. L. Beedles (1980). Is indirect inter- national diversification desirable? Journal of Portfolio Management, Winter.

6. H. Solnick (1 974). Why not diversify internationally: Financial Analysts Journal, JulylAugust.