Modeling Barriers to International Capital Flows: A Multicountry Framework

The AHP can be modeled to select an optimal investment portfolio OIP, herein a multinational portfolio composed of national markets where barriers to capital flows are least likely to ad

Modeling Barriers to International Capital Flows: A Multicountry Framework

A Seddik Meziani Montclair State University, USA

Abstract

To explain the bias in favor of domestic securities known as the “international diversification puzzle,” the literature has considered many possible irritants of capital movements across national boundaries but the results remain inconclusive This paper demonstrates that this complex multivariate problem can be addressed within an analytic hierarchy process (AHP)-driven expert system The AHP can be modeled to select an optimal investment portfolio (OIP), herein a multinational portfolio composed of national markets where barriers to capital flows are least likely to adversely affect its return Experts examined these barriers

in relation to six national markets and the euro zone The U.K turns out to be their market of choice closely followed by Canada, and the Euro Zone There is gain to be made from using the opinion of those with first-hand understanding of foreign markets and knowledge-based expert systems such as the AHP are best suited

to capture that expertise

Introduction

The underlying theoretical basis of diversification formalized in Markowitz Portfolio Theory and the Capital Asset Pricing Model has been well documented in the finance literature International diversification enables investors to reduce the unsystematic risk of investing in one economy Business cycles do not happen uniformly across countries; when one country is experiencing rapid growth, another may be in a recession By investing across countries, investors should logically eliminate from their portfolios part of the cyclical fluctuations that would arise from the domestic business cycle Such investors will only be exposed to systematic risk related to the global economy

Since Markowitz’s seminal work (1952), many of the studies that have explored the merit of holding international assets as a part of a strategically balanced portfolio confirm diversification as the most important motivating factor in international investment For example, in Worzala’s survey (1994) diversification is ranked as very important by a substantial majority of respondents In a survey of British investors, Baum (1995) also finds diversification as the main motivator of international investment

But in spite of the theoretical and matter -of-fact groundings of international diversification, many studies have demonstrated that investors nevertheless hold portfolios that consist nearly exclusively of domestic assets This violation of standard theories of portfolio choice is known as the “international diversification puzzle.” For example,

in 1991 French and Porteba report that U.S investors hold about 94 percent of their financial assets in the form of U.S securities For Japan, U.K., and Germany, the share of domestic assets in each case exceeds 85 percent They find an explanation to the apparent tendency of U.S pension funds to overweight their own equity market in explicit limits on cross-border investment known as the ‘prudent man’ rule In Japan where insurance companies cannot hold more than 30 percent of their assets in foreign securities this rule is also interpreted as limiting their degree of international exposure In France a foreign investor may not hold more than 20 percent of any firm without prior

approval from the Ministère de l’Economie et des Finances

In 1995, Tesar and Werner showed that domestic assets continue to overwhelmingly dominate portfolios despite the rapidly growing volume of international financial trade They examined the foreign investment positions

of major industrial countries and found that international investment as a fraction of the total domestic market of stocks and bonds equaled about 3 percent for the U.S., 4 percent for Canada, 10 percent for Germany, 11 percent for

Japan, and 32 percent for the United Kingdom Excluding the U.K., calculations of a diversified portfolio would have much higher fractions devoted to international assets

So why do investors seem to have this bias in favor of securities of their home country? Standard models of optimal portfolio choice cannot rationalize this pattern of asset holdings, even in the presence of unhedged foreign exchange risk Of the several possible reasons, Worzala (1994) finds that transaction costs in less liquid markets and particular taxation regimes such as a dividend withholding tax on payments to foreign shareholders could have significant repercussion for investment performance He considers them among the most significant irritants of capital movements across national boundaries

Barriers to capital movements can take many other forms such as foreign exchange and capital controls Exchange controls increase pure exchange rate risk while capital controls restricts capital flows across national boundaries Where formal capital controls on foreign investment exist, securities command abnormal risk premium Both effects are well documented in the literature (Errunza and Losq, 1985; Eun and Janakiramanan, 1986) Or perhaps, evidence given by Gatti and Tverski in 1990 that households behave as though unfamiliar gambles are riskier than familiar gambles even when they assign identical probability distributions to the two gambles should be given serious thought in future investment portfolio research

Obviously many factors can constraint the flow of capital movements across national boundaries Various methodologies have been used to explain investors’ bias in favor of domestic securities but the results remain clearly inconclusive This study advocates a different approach to this multivariate problem It suggests that this problem

can also be addressed within an analytic hierarchy process-knowledge-based expert system

First, the finance literature is used to identify the most significant barriers to international capital flows These barriers are then submitted to the review of a sample of international investment experts operating in the New York metropolitan area Using their market experience, they identify the most formidable of these barriers by comparing them to each other They also compare them in relation to a sample of countries they were provided with This identification and selection process ultimately generates the optimal investment portfolio (OIP) This diversified portfolio best represents a frictionless multinational portfolio It is composed of national markets where barriers to international capital flows are least likely to adversely affect its return This process takes full advantage

of practitioner s’ knowledge of these markets by providing them with a comprehensive model that integrates the effect of all the interactive parameters

The Analytic Hierarchy Process (AHP): A Knowledge-Based System Model

This research illustrates how the OIP can be formed based on the analytic hierarchy process (AHP), first developed

by Saaty (1980) The AHP is a simple decision analysis model appropriate when the decision maker wants to deal with complex, unstructured, and multi-attribute problems in arriving at the overall best decision Applications of the AHP have been reported in numerous fields such as conflict resolution, project selection, budget allocation, transportation, health care, and manufacturing, but it has yet to be applied to portfolio selection The strength of the AHP lies in its ability to mimic practitioners’ judgment about the importance that would be attached to different influential factors and to structure a complex and multi-attribute system matrix The AHP assumes the three basic principles o f logical analysis: constructing hierarchies, establishing priorities, and maintaining logical consistency

Structuring The Hierarchy

The AHP initially breaks down a complex multi-criteria decision-making problem into a hierarchical structure The hierarchy pyramid is structured by enumerating the relevant elements that should enter into the decision outcome The elements are then grouped in levels

The top level of the hierarchy, referred to as focus, consists of a single element or goal, which is the overall objective The elements that affect the decision are called attributes or criteria They are included in the subsequent levels, each of which may have several elements Attributes are mutually exclusive and their priorities are

independent of the elements positioned below them in the hierarchy The lowest level of the hierarchy is referred to

as alternatives, which are decision options (see Fig 1) (Saaty, 1980)

Setting Priorities

Once the problem has been decomposed and the hierarchy constructed, the prioritisation procedure starts in order to determine the relative importance of the elements on the next higher level The pair-wise judgment starts from the second level (first level of attributes) and finishes in the lowest level alternatives The AHP uses pairwise comparisons to establish priority weights for all elements in the hierarchy Pairwise comparisons are repeated until all combinations of elements have been exhausted The level comparisons result in a “priority vector,” which indicates the relative importance of the elements with respect to each criterion

The decision maker must express preference between each pair of elements Each pairwise comparison is scored as: equally important (1), moderately more important (3), strongly more important (5), very strongly more important (7), and extremely more important (9) (Saaty, 1980; 1982) An even preferential number scoring system can also be used to represent comparisons among a pair of attributes This method of ranking enables the decision maker to incorporate his/her experience and knowledge in an intuitive and natural manner

Maintaining Logical Consistency

After forming the preference matrices, the mathematical process commences in order to normalize and find the priority weights for each matrix The AHP process then determines the consistent nature of the pairwise comparisons (i.e consistency ratio (CR)) for all matrices If the CR value is larger than 0.10 (which is the acceptable upper limit for CR (Saaty, 1982)), it implies that there is a 10 per cent chance that the elements are not compared well In this case the decision maker must review the comparisons again

The mathematical process then starts to integrate the assigned weights in order to develop an overall evaluation process (i.e the mathematical process to determine the CR values and the corresponding weights for each alternative) Although the mathematical process of the AHP is tedious, the use of expert system makes it simple and accurate to apply (Turban, 1993)

Level I: Overall Focus

Objective

Sub-attribute Sub-attribute Sub-attribute Sub-attribute Sub-attribute Sub-attribute

Fig 1: A GRAPHICAL REPRESENTATION OF THE MECHANICS OF THE AHP

Level III:

Level IV:

Application Of The AHP Model

The hierarchy in this application contains four levels (see Fig 2) The first level of the hierarchy identifies the objective: selection of the OIP The second and third levels are the intermediate levels, which include the criteria and subcriteria used to achieve the overall objective These are the macro (criteria) and micro (subcriteria) barriers that determine the choice of the OIP The fourth and final level of the hierarchy lists the particular national markets from which this portfolio will be constructed The macro and micro barriers to international capital flows are defined

in Table 1

Pairwise comparisons are used to establish priority weights for all the elements of the hierarchy First, the decision maker provi des judgments about the relative importance of each macro and micro barriers of levels two and three in terms of its effect on the overall objective Next, a preference is specified for each national market (level four) relative to each barrier Given the information on the relative importance of the barriers and national market preferences with regard to each barrier, a mathematical process is used to synthesize the information and provide priority measures indicating the ranking of all the national markets

Table 1: DEFINITION OF MACRO AND MICRO BARRIERS TO INTERNATIONAL INVESTMENT

? Discriminatory Taxation: In some overseas markets, U.S investors are more heavily taxed than domestic

investors

? Exchange Risk: U.S investors in overseas markets are subject to the risk of dollar appreciation, which

diminishes their total return when profits are repatriated

? Legal Restrictions: U.S investors face a complex web of regulations and rulings overseas, including:

o Foreign Ownership: Limitation of the percentage of foreign ownership of financial assets or restriction of ownership to specific areas

o Market Regulations : Foreign ownership flowing into or out of overseas markets might be restricted through the imposition of capital controls

? Liquidity Risk: In a shallow overseas market with insufficient demand, attempts to liquidate assets on a

large scale reduce the market value of the assets

? Political Risks : Funds invested internationally fall under the jurisdiction of the host country, subjecting

international investments to rules established by local governments no matter how arbitrary or unfair such regulations may appear The most common types of political risks are:

o Expropriation of Assets: The government of the country where funds are invested confiscates the capital investment

o Repatriation of profits: U.S investors are unable to convert earnings into dollars for the

repatriation of profit because of the host government’s rigid currency rules

? Psychological Barriers: Distance from overseas markets and perceived differences in work habits and

standards may cause investors to hesitate in investing in foreign markets This reluctance can be triggered

by the following:

o Language Barriers: U.S investors can find it particularly difficult to conduct business in a national market that uses a language with which they are unfamiliar

o Source of information: Availability and dependability of information on individual companies and industries may vary greatly from one national market to another This set of data, if available, may be hard to translate into familiar standards for comparison purposes For example, differences

in accounting measurement and auditing practices between the United States and other countries may make the financial statements from a firm located in a foreign market harder to interpret

? Transaction costs: These are the costs incurred in placing the order and securing the certificates Because

of the international dimension of the investment, these costs can be higher than domestic costs Major transaction costs are:

o Custodial fees : These fees cover international custodial services such as automated trade

notification, cash management services involving different currencies, and a network of sub custodians in different countries

o Management Fees: These are fees charged by international money managers They might be higher than those charged by domestic management because they reflect higher costs in terms of international database subscription, research, communication costs, and so on

Bold nodes represent macro barriers to international investment whereas clear nodes represent micro barriers

The basis of this procedure is the completion of an “n x n” matrix where the entries (aij) set forth the answers to the series of questions included in the survey For example, “Which national market (ai or aj) is more advantageous for the U.S global investor with respect to foreign exchange risk?” Using the comparison scale, the answer to this pairwise comparison is entered into the “n x n matrix.” If the entry “9” is shown at the a12 position (e.g., Euro Zone vs Australia), this means that national market a1 (Euro Zone) is “extremely favored” over national market a2 (Australia) with respect to “foreign exchange risk.”

One result of a pairwise comparison of elements within the matrix structure is that a diagonal that runs from the upper left corner of the “n x n” matrix to its lower right corner is composed entirely of cells with the value

“1.” This depicts the comparison between a national market and itself Once the upper triangular portion values above the “1 diagonal” are known, the lower triangular portion values can be determined because the transpose values are reciprocals (Saaty, 1982) Subsequently, in our example above, 1/9 is entered at the symmetric position

a21 Once all the entries of the matrix are available, one can easily solve for the priority weights for all elements in the hierarchy

Sample Design

The size of the sample is limited to seven markets to minimize inconsistencies in respondent judgments A larger sample would generate an excessive number of pairwise judgments, which would heavily tax the capacity of the respondents to be consistent throughout the survey (Miller, 1956) Also, as the collaboration of U.S global investment experts is critical to the completion of this study, a larger sample would mean a longer survey, which could limit the number of responses, thereby weakening the results of the analysis Choice of the countries used in this analysis assumes that a low correlation coefficient between the U.S market and other national markets is a key capital flow driver It is generally accepted that if markets tend to experience somewhat identical cycles, diversification across national markets will be less effective

Note that, in the sample, the Euro Zone is the area in which the euro is the single currency for its twelve members.1 Due to a lack of common statistics, the inclusion of the Euro Zone in the sample is justified by showing the correlations of Germany and France with the U.S in Table 2 This choice should be self-explanatory In addition

to being considered the two “economic engines” of Europe, their macroeconomic aggregates are widely viewed as having initially set the benchmarks for inclusion in the Euro Zone

Table 2 reports the correlations coefficients among the monthly returns of nine major stock markets in 1987-2000 Of the eight correlations reported between the United States and the eight other markets (bottom row), the highest is the coefficient between Canada and the United States (0.77) This comes as no surprise since Canada, being a neighboring country and the largest U.S trading partner, has strong business linkages with the United States The next highest correlation is found between the U.S and the U.K markets (0.67) Given the strong linguistic and economic ties between the two countries, the high correlation is also not surprising On the other hand, the lowest correlation is found between the U.S and the Japanese markets (0.26) This is to be expected considering that the 1990s saw the United States in a long and strong business cycle expansion But the decade brought only severe recession in Japan

The correlation coefficient matrix as a whole conveys that capital markets are becoming increasingly integrated However, although their convergence has gradually decreased some of the benefits of international portfolio diversification, the correlation coefficient between markets are still far from 1.0, indicating that there are still factors acting against their total integration

Data Collection

The AHP does not need a formal data set It requires that experts use experience gained in the field to state judgments on criteria and alternatives In this case, qualitative judgments on the barriers to international capital flows as defined in Table 1 are obtained from a 25-page questionnaire mailed during the fourth quarter of 1999 and first quarter of 2000 to 40 randomly selected firms operating international investment divisions in the New York metropolitan area Bearing in mind that this study is based on the interview survey method conducted in an international context, the response rate could be considered fairly high with 15 respondents completing the survey.2

The respondents are high enough in their institutions’ management hierarchy to have decision responsibility Their experience making international investment decisions ranges from 3 to 10 years with an average of 4 years and 9 months The names of the institutions that responded and accepted to be subsequently interviewed are listed in Table 3 Note that this list excludes five participants who did not answer all the questions in the survey because of their stated lack of expertise in some of the specific national markets included in the sample All of the respondents insisted on having their names and remarks kept confidential Two respondents also insisted

on having the names of their employers undisclosed In effect, the survey’s findings reflect the answers of 15 representatives although Table 3 lists only 13

TABLE 2: CORRELATION COEFFICIENTS AMONG MONTHLY RETURNS OF MAJOR STOCK MARKETS, 1987-1998

(All returns are converted to U.S dollars)

Correlation Coefficients

Australia (AU)

Source: Morgan Stanley's Capital International Perspectives (1999).

The survey outlines a scenario in which a U.S investor is considering adding foreign securities or other types of foreign investment products to a portfolio of U.S assets.3 It asks respondents to evaluate the specific barriers to international capital flows as defined in Table 1 Other factors, such as inflation or interest rate differentials, were to be considered equal for the purpose of this study The AHP model and the logic of its procedures were explained to the respondents and illustrated with simple examples by a group of graduate students who met with them The same group of students met with them subsequently to go over the answers and collect some of their thoughts

The first part of the questionnaire asks the respondents to use their perspectives as expert global investors (without regard for a particular national market) to evaluate the relative importance of each barrier to international investment They did this through a series of pairwise comparisons of each barrier to every other barrier The AHP matrices of levels two and three of the hierarchy in Figure 2 are calculated from these pairwise judgments

In the second part of the questionnaire, the respondents are asked to make pairwise comparisons of the national markets with respect to each impediment in levels two and three of the hierarchy Responses to the second part of the survey are used to construct level four of the hierarchy

All responses were combined using the geometric mean for each pairwise judgment to estimate the relative priorities The resulting (geometric) mean judgments are evaluated using Saaty’s eigenvector method to estimate the priority of each barrier in terms of its contribution to constraining international capital flows and its subsequent weight in determining the OIP

Findings

Table 4 shows respondents evaluation of the seven macro barriers of level two of the hierarchy in relation to each other (pairwise) and with respect to the selection of the OIP The vector of priority weights in the bottom row can be interpreted to describe either the importance of one macro barrier over another or the relative attention that each should be paid in the selection of a national market for investment

AT&T Investment Management Corporation Mellon Financial Company

Hoffmann-La Roche, Inc Teachers Insurance Annuity Association

International Paper Company Name of institution withheld upon request

Lucent Technologies, Inc

* Five organizations responded partially to the survey and thereby were not included in the analysis

Source: Respondents were selected from "The Money Market Directory of Pension Funds and their

Investment Managers", Standard & Poor’s, 1999

TABLE 3: LIST OF RESPONDENTS*

The priority weights show that “foreign exchange risk” is the most important barrier, and “psychological barriers” the least important “Foreign exchange risk” is given almost 20 percent more weight than the next highest barrier, “political risks,” and approximately 46 percent more weight than “discriminatory taxation.” These results imply that a national market with a stable currency is the most important criterion to U.S global investors If the currency of the market in which the funds are invested weakens against the dollar, earnings will convert into fewer dollars

Although this result outlines the important role played by foreign exchange markets’ in the world economy,

it comes as a surprise especially in light of the many financial tools that could be used to neutralize “foreign exchange risk.” Experts, however, justified their answer emphasizing that these tools are not “exactly free” and are often “as good as the ability of analysts to forecast the path of a currency.” Some brought up past predictions of a strong euro that proved to be wrong.4 But, in reality most respondents acknowledged that they have become especially wary of “foreign exchange risk” after the severe currency crisis in Mexico in late 1994 followed by that of Asia in 1997 and then Russia, Brazil, and Turkey.5 As expected, these crises are hardly the ingredients for successful investing

In descending order of importance, the other highly ranked impediment is “political risk.” Defined as the inability to repatriate profits or/and likelihood of the capital investment being expropriated (micro impediments from level III of the hierarchy in Figure 2), the former seems to give more worry to the respondents than the latter This result does not come as a surprise given that most countries have hardly any recent history of expropriations As shown in Table 5 (Panel b), on the average, the respondents believe that the likelihood of a foreign government restricting repatriation of profits (0.106) is about twice as likely than a potential threat of expropriation of foreign assets (0.056) Seemingly, respondents have learned hard lessons from the rigid currency rules adopted by Asian countries in an effort to stop extreme short-term capital movements

Macro Discri- Exchange Legal Liquidity Political Psycho- Transaction

Impediments minatory Risk Restrictions Risk Risks logical Costs

Taxation

Risk

Restrictions

Risk

Risks

Barriers

Costs

Weights

TABLE 4: SECOND LEVEL OF THE HIERARCHY:

COMPARISON MATRIX OF THE MACRO BARRIERS TO CAPITAL FLOWS

Other macro impediments of importance to the respondents are “legal restrictions,” “liquidity risk,” and discriminatory taxation.” Components of “legal restrictions” are “foreign ownership” and “market regulations.” Their weights in Table 5 (Panel a) represent the priority of each one of these micro barriers in the selection of the OIP For example, the first weight represents the portion of “legal restrictions” attributed to “foreign ownership” (0.086) The two weights are not very different, although the respondents express a slightly higher concern for

“foreign ownership” problem in national markets where foreign capital can be limited by percentage than for

“market regulations” such as imposition of capital controls

Constraints on ownership of financial assets to specific industries are still common in many countries Although not included in the survey, some respondents gave the example of China still banning foreign investment

in the telecommunications and banking industries whereas its financial markets still remain off limits to foreign firms They also believe that the financial markets of most emerging economies lack both depth and liquidity for dollar-denominated debt, equity, interest-rate derivatives, and repurchase agreements

On the other hand, macro barriers such as “psychological barriers” and “transaction costs” (0.067 and 0.068, respectively) are judged by our sample of experts as insignificant impediments These results are quite puzzling at first because one would expect a U.S investor about to venture into unfamiliar markets to be affected by such factors “Psychological barriers” such as the numerous differences in work habits and work standards that may exist between foreign markets and U.S financial markets, and higher “transaction costs,” such as the extra costs involved in securing the ownership of a foreign certificate, would seem impossible to ignore when diversifying a portfolio across national boundaries

Table 5 (Panels c and d, respectively) breaks these two elements into the micro barriers of level III for the specific purpose of gathering more information from the respondents on their relative importance: “language barriers” and “sources of information” are micro aspects of “psychological barriers” while “custodial fees” and

Legal Foreign Market Political Expropriation Repatriation

Restrictions Ownership Regulations Risks of Assets of Profits

?max = 2.001; C.I = 0.001; C.R = 0.001 ?max = 2.000; C.I = 0.0003; C.R = 0.0003

Psychological Language Sources of Transaction Custodial Management

?max = 2.0002; C.I = 0.0002; C.R = 0.0002 ?max = 2.0006; C.I = 0.0006; C.R = 0.0006

Table 5: THIRD LEVEL OF THE HIERARCHY:

COMPARISON MATRIX OF THE MICRO BARRIERS TO CAPITAL FLOWS

The results show that survey participants believe these particular micro barriers should contribute only marginally to the selection of the OIP When further interviewed, respondents justified their answer by the assertion that most U.S investment firms trading internationally have established their own international links, thereby eliminating the need for costly intermediaries Local staffing has reduced “psychological barriers.” A number of respondents mentioned that “language” is not much of a hindrance as most of the foreign experts they deal with speak adequate English When asked about differences in accounting and reporting practices in the sampled national markets, participants responded that a knowledgeable local staff, versed in local accounting practices, provides them with an effective way to cope with this problem.6

The pairwise comparison procedure is also used to determine the priority ranking of the seven “national” markets in terms of the barriers to international investment (level four of the hierarchy) The question asked now is:

“Of the two national markets being compared in terms of a specific investment barrier, which one should be favored?” Tables 6 and 7 show the matrices and the national market priority weights for macro and micro impediments These results show reasonable consistency indices, which indicate that experts responded with largely consistent judgments

The priority weights summarized in Table 8 (excerpted from Table 6) show that four out of the seven macro barriers are judged less important in the case of Canada and the U.K than for the other national markets:

“transaction costs,” “psychological barriers,” “political risks,” and “legal restrictions.” These results indicate the respondents’ preference for these two markets The respondents’ evaluat ion of the micro impediments underlying

“legal restrictions” and “market regulations” also show that they are less of an impediment to the U.S investor in Canada and the U.K Japan shares respondent preference with the U.K with regard to “liquidity risk.” This is not a surprise, as Japan and the U.K have the two largest capital markets outside the U.S That U.K and Japanese markets are the most liquid after the U.S is of particular interest as an important market selection criterion

On the other hand, the results in Table 8 indicate that in Australia foreign investments are taxed the least, followed next by the U.K., Canada, and the Euro Zone “Discriminatory taxation” is judged the highest in Japan The Japanese market does not seem to be an obvious choice for an investor who is reluctant to pay higher taxes

With “foreign exchange risk” the most heavily weighted macro impediment (0.217), the national market that is most favored by the respondents with respect to this factor will be prominent in the selection of the OIP In this case it is the U.K.—not an unexpected result as the British Pound had tended to be more stable than the euro or the yen For investors especially wary of currency fluctuations, the British market should be the market of choice, followed by the Euro Zone, Canada, and Japan Although the Hong Kong dollar has been quite stable in the midst of Asia’s crisis, respondents remain quite skeptical With new problems in the financial system cropping up almost daily, they believe that it is a matter of time before China’s central bank will introduce radical changes, such as allowing the currency to float freely