Risk and the Capital “Paradox” of Emerging Markets

20-01-15 11:10 | Markets and investments | Fredrik Wilander

Why doesn’t capital flow from low to high marginal product of capital countries and in the process equalize capital returns? 

In a seminal research paper from 1990, Nobel Prize winning economist Robert Lucas found that the returns to real capital, contrary to what neoclassical economic models predict, differ a lot between countries. The failure of capital returns to converge, especially between poor and rich countries, has since then been named the “Lucas Paradox”. Why doesn’t capital flow from low to high marginal product of capital countries and in the process equalize capital returns? Lucas himself proposed, but also dismissed, potential explanations such as capital-market frictions and human capital.

Enter risk

A new research paper by Norwegian economist Espen Henriksen at UC Davis and two co-authors, points out that  equalized capital returns only should exist in a deterministic setting. If we put risk into the picture, we would expect capital returns to differ if the riskiness in poor and rich country investments differ. At a first thought, this makes very much sense. We can only look at financial instruments to note that pricing of equities and corporate debt differ between Emerging Markets (EM) and for example the U.S. (for the case of EM Corporate Debt, I wrote about this here), with expected cash flows being discounted more heavily in EM. The riskiness of EM also became very apparent to investors in 2014, when many Emerging Economies hit a wall.

The natural starting point to investigate the role of risk is the consumption-based capital asset pricing model (CCAPM). While predicted returns on poorer-country portfolios should be higher, the quantitative differences in returns across portfolios of rich and poor countries can only be accounted for if investors’ risk aversions are exorbitantly high. This finding suggests that the “Lucas Paradox” resembles the

equity-premium and other related asset-pricing puzzles.

The authors draw upon two very important previous research papers; Bansal and Yaron’s 2004 paper in The Journal of Finance called “Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles” (which arguably is the most important research paper in asset pricing over the past 10-15 years) and a paper by Aguiar and Gopinath from 2007 in Journal of Political Economy called “Emerging Market Business Cycles: The Cycle is the Trend“.

1. The main contribution of the first paper is to show that a very important risk for investors is an asset’s exposure to long-run permanent shocks to future consumption. If the future (expected) dividend stream of an asset contains the same persistent “shock component” as do expected consumption growth, then this asset will be very risky since it will give negative returns at the same time as the investor gets bad news about his or her future consumption. Such assets should then command significant risk premium to compensate for this “long-run risk”.

2. For the purpose of Henriksen’s study, the second paper showed that in EM (relative to DM), permanent/random walk type shocks to productivity tend to be more important than transitory/mean reverting shocks in driving business cycles. The link between risk and required returns is, however, not a direct one: for an investor to demand risk premia, shocks to foreign growth rates must be related to shocks to her or his future income, in this sense, must be global. Country-specific shocks in emerging markets, even those that are long-run and persistent in nature, do not lead to higher required returns.

“Long Run Risk” as the driver of the “Lucas Paradox”

With the insights from 1) and 2) above, and taking the perspective of a U.S. investor who should invest in real capital either at home or in an EM economy (this is motivated by the fact that poor countries actually import a large part of their real capital) the authors develop a model of an international endowment economy with Bansal & Yaron style long-run risks. They document that investments in EM economies are more sensitive to common and persistent shocks to economic growth rates and that this risk is priced since differences in this exposure can explain between 60-70% of the spread in capital returns between poor and rich countries.

I think the key finding can be summarized like this: investments in emerging/poor economies are sensitive to shocks to long-run economic growth in these countries. While some of these shocks are idiosyncratic or country specific (so can diversified away and wouldn’t matter for pricing or required returns) some carry a common global component so should matter for a developed market investor. He or she will require compensation in form of higher returns in order to accept this risk.

Implications for financial investors

While the study looks at physical capital returns, I think it has implications also for financial investors. It could provide a theoretical motivation for the lower pricing of risky cash-flows in EM (probably there are other reasons as well, for example corporate governance and political risks). It also has implications for the diversification benefits of investing in Emerging Markets. While some risk is country specific, and investment returns between EM and DM assets in any case are far from perfectly correlated, there are also common shocks. Higher potential returns in EM economies thus do not represent a free lunch, neither a “foregone investment opportunity” waiting to be discovered and arbitraged away. If Henriksen and co-authors are right, expected returns need to be higher – and also won’t be arbitraged away. That is the essence of a (long-run) risk premium.

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