We live in a financial world without barriers. Investors can put their money in foreign stocks and in foreign countries. Companies on different continents can buy one another. Stock exchanges list companies of many different nationalities. All of the above may lead you to believe that investment practices are becoming global. I think that, on the contrary, we are now seeing a process of de-globalisation both at the investor and the corporate level. Why? Because by globalising financial markets, the benefits of globalisation have inadvertently disappeared.
As markets have integrated, the diversification benefits of investing abroad have decreased and the level of local activity among investors and institutions has increased accordingly. As companies have seen compliance costs rise under new financial regulation designed to protect investors, so they have refrained from seeking financing in better markets overseas. And as the elimination of barriers has induced more cross-border mergers, it has also induced nationalistic governments to become increasingly protective of so-called “national champions”.
Where should the process end? Certainly, regulators must continue to simplify international financial transactions, which are still subject to several legal regimes, depending on the nationality of the company, the nationality of the investor, the place where the transaction takes place and the location of the assets involved. In this area, we are witnessing convergence towards a single legal financial system, or at least to several systems, with very similar standards.
Similarly, there is no need for hundreds of stock exchanges. So, it is no surprise to see that some have merged while others have declared their intention to do so. Electronic trading, easier access to information, and the reduction in transaction costs are factors that explain this trend towards a single, global financial market.
What globalisation means for investors
As far as investors are concerned, globalisation is a positive force if it makes foreign investment easier and, thus, increases the potential for diversification. For many, this has turned out to be the case. For example, from March 2005 to March 2006, the return on the Colombian Stock Exchange was 138 per cent, while the return on the Athens Stock Exchange was 44 per cent. Over the same period, the New York Stock Exchange (NYSE) yielded a modest 15 per cent.
International investors are piling into such exchanges: the International Federation of Stock Exchanges reports that, in Colombia, the total value of shares traded has increased 386 per cent in the first quarter of 2006 relative to the same period in 2005. In Athens, trading has increased 80 per cent. On April 25, the Financial Times reported that US investors now allocate more than twice as much to international mutual funds as they do to domestic funds.
Yet the benefits of diversification are becoming less and less clear. Economists William Goetzmann, Lingfeng Li and Geert Rouwenhorst from the Yale School of Management have shown that the correlations between national stock indices have been the largest – and, hence, in terms of international diversification, the lowest – in periods of free capital flows. They also argue that the potential for further international diversification is very low. The only reason why diversification has brought benefits in the last few years is that the absolute number of investment opportunities worldwide has expanded dramatically with the emergence of new and significant capital markets.
The problem is that, as a result of globalisation, the opportunity set is now shrinking. In January 2005, there were 150 domestic companies listed on the Bolsa Mexicana de Valores, the Mexican stock exchange. As of the end of April 2006, only 130 remained. Some of those that left the market said they did so because they had been acquired by foreigners.
For example, G Accion, one of the largest real estate companies in Mexico, was bought by a US real estate investment trust (REIT) called AMB Property Corp. Others simply delisted because of dismal results resulting from foreign competition. Unefon, a Mexican mobile operator, blamed competition from companies such as Spain’s Movistar, as well as its stock’s poor liquidity.
Moreover, investors tend to favour domestic stocks, and those of companies physically close to them. Ning Zhu from the University of California, Davis has recently shown that the portfolios of individual investors consist of too many companies situated nearby, relative to what, in terms of the risk-return trade-off, should be optimal. Significantly, individuals also tend to invest more in remote stocks that spend heavily on advertising.
Another example of the individual investor’s aversion to foreign stock is the problem of “flow-back”. When a foreign acquirer buys a US company, US investors who receive foreign stock in exchange for domestic stock tend to sell it immediately after the acquisition. The foreign stock used as acquisition currency then flows back to the originating country. There is no reliable estimate of the extent of this problem because depository banks in the US do not release information on the flow-back of American depository receipts, arguing that it is proprietary information.
Mostly, it is institutional factors that drive individuals to invest in foreign markets. In a recent study, John Ammer from the Federal Reserve Board, Sara Holland from the University of California at Berkeley, and David Smith and Francis E Warnock of the University of Virginia, found that US investors increase their holdings in foreign stocks that initiate a listing in the US. This happens especially when companies have had a history of weak accounting practices because US regulations force them to be more transparent. Professor Ammer et al. conclude that improvements in information availability make foreign stocks more valuable for domestic investors.
As mentioned earlier, money is flowing into Colombian stocks. A big reason is transparency. Of the 20 Latin American countries it studied, the World Bank ranked Colombia the second best (after Peru) in terms of investor protection. If companies want to attract investors they will try to comply with the highest accounting standards. They will do so by either moving to financial markets with a reputation of transparency or by demanding the appropriate corporate governance reforms from their regulators.
Dual listings in decline
Unfortunately, companies tend to see global expansion only as a means to sell products or services in new markets, not as a means to take advantage of new sources of financing. ABN-Amro delisted its stock from the London Stock Exchange in March 2006. Nestlé is now listed only in Zurich, after being delisted in London and Paris. And since the passage of the Sarbanes-Oxley Act in the US, virtually no European company has sought a dual listing on the NYSE.
In 2006, only one of the 11 foreign companies to have initiated a cross-listing on the NYSE has been European; four are Canadian, and the rest are from Latin America. BMW generated 23 per cent of its 2005 revenues in North America, yet its stock does not trade in any US market. And the trend is increasing: 27 non-US companies left the NYSE in 2004 (six per cent of the foreign companies listed there), versus 22 in 2003. In a recent survey among 217 public companies by Financial Executives International, an international association for CFOs and other senior finance executives, 93 per cent responded that the costs of complying with Sarbanes-Oxley exceed its benefits. In the case of foreign companies, for which compliance is more burdensome, the situation is even worse.
In the process of convergence towards a unified system of financial regulation, investor protection is paramount. But since Sarbanes-Oxley was enacted to protect investors, the unwillingness of companies to comply with it suggests that investors do not want to be protected. Or at least they do not want to pay the cost for protection. All in all, what this suggests that we are moving to a situation where companies operate globally, but investors access them locally, both because investors prefer to do so and because companies are reluctant to make their stock available overseas.
The problem with “national champions”
Put governments on top and the process of de-globalisation is complete. Some governments will impose barriers to the free flow of financial resources by blocking acquisitions by foreign companies in their own country. Politicians have personal and party objectives that often clash with the interests of company owners and managers. In recent months, for example, we have witnessed the battle between European governments and potential foreign acquirers trying to gain control of so-called “national champions.”
In April 2005, the French government rallied in defence of Danone following rumours that PepsiCo was preparing a takeover bid in that strategically vital sector – the yoghurt business. Danone was deemed by the government “a French icon and off-limits to foreign ownership”. In a similar reaction, the French government recently favoured the acquisition of Suez by Gaz de France, to prevent Suez being bought by Italy’s Enel.
The Spanish government has been proactive to the point of enacting ad hoc legal rules to block the acquisition of Endesa by German power group Eon. The Polish government also interfered in the merger of banks Unicredit and HVB.
Governments that protect national industries from “foreign predators” are not new. The defence industry was deemed a national champion in the US for decades, while at the same time its interests were strongly promoted abroad. Similarly, the governments of France and Spain have favoured the creation of strong domestic energy companies, but at the same time, Spanish and French companies are among the largest foreign investors in Latin America. In February, the Economist reported that only 43 per cent of the employment generated by companies on the French CAC 40 is actually in France.
The defining feature of economic patriotism is that it must be unidirectional. And this is appealing for the electorate: let our companies be as international as possible, but let them be ours. However, economic patriotism does not make any sense when governments that oppose foreign mergers use the interests of consumers as an argument. Basic economics dictate that horizontal mergers that reduce the number of participants in an industry result in reduced output and higher prices. In contrast, a cross-border merger that substitutes one competitor for another does not affect competition. Moreover, my own work with Christos Cabolis, from the Athens Laboratory of Business Administration, shows that when a cross-border merger brings about improvements in investor protection, the whole financial system in the receiving country benefits. Still, President Jacques Chirac summarised his opposition to the bid for Suez by declaring: “France doesn’t want to surrender to a purely financial operation.”
What’s more, the concept of corporate nationality has itself blurred as a result of the liberalisation of financial markets. The nationality of a company is legally defined by the country where it has its headquarters. But the country of incorporation can be easily changed, without affecting the company’s operations.
Endesa is a Spanish company with a 100 per cent Spanish board of directors, but which generates only 42 per cent of its profits in Spain and Portugal. Even worse for the arguments of the Spanish government, only 29 per cent of the company’s shareholders are Spanish. In other words, the majority of Endesa’s consumers are not Spanish, and the vast majority of its shareholders are also foreigners.
Some may even argue that the nationality of the company is a stereotype. Do drivers of Volvo cars really drive a Swedish product? Volvo is a wholly owned subsidiary of Ford, and it manufactures 53 per cent of its vehicles in Belgium. In some countries, such as Switzerland and the US, tax inspectors now deem the nationality of a company to be that of its controlling shareholder.
Conclusion
What should national financial authorities do to attract companies and investors in the era of de-globalisation of investments? Improving the transparency of a market results in benefits for the incumbent companies, but it does not attract other businesses when there is a cost of compliance. It seems that companies want rules that are simpler, not necessarily better. And they need passive governments that do not interfere in the functioning of markets with patriotic arguments.
Arturo Bris is professor of finance at IMD, and the Robert B & Candice J Haas Associate Professor of Corporate Finance at the Yale School of Management. He has worked extensively on issues of corporate governance, financial regulation and international valuation.
