Changes in the International Investor Base and Implications for Financial Stability

Cross-border financial asset accumulation has tripled over the past decade. While some of this increase represents a continuation or resumption of trends that have been evident for some time, recent years have witnessed several new developments, notably the broadening of the investor base eager to hold international assets. Certain classes of investors, such as private institutional investors from mature market (MM) economies and official institutions from emerging market (EM) economies, have gained in importance in global financial markets. Analyzing changes in the international investor base and investment allocation behavior is fundamental to understanding the buildup of strengths and weaknesses in international financial markets. Decisions that key investors make about where to allocate their assets not only affect the prices of financial assets, but also have wide-ranging implications for economic performance and welfare in various countries. The size of these cross-border flows and the rapid pace of financial innovation have given rise to concerns about financial stability, because in the past, booms in cross-border financial investment were followed by crises. Even if greater stability can be expected in the longer term, the process of transformation and the specific conditions under which it occurs may temporarily generate additional vulnerabilities. The objective of this chapter is to enhance understanding of the globalization and diversification of the investor base as well as the implications of these trends. In particular, the following issues are addressed: What have been the key changes in the investor base for cross-border flows and investor behavior over the last decade? How do these changes in the investor base and investor behavior affect the composition and volatility of capital flows and the pricing of financial assets? What are the key risks associated with these changes in the investor base and what are the factors that exacerbate or mitigate those risks? The chapter reviews evidence on the accumulation of international financial assets and on the asset allocation behavior of institutional investors, and on this basis assesses implications for cross-border capital flows and global financial stability. The most comprehensive information available, especially for fast-growing portfolio investments, is used to analyze the key changes in investor behavior over the past decade. However, the complexities of links and networks of investors, which have intensified with the globalization of capital flows, along with the lack of information and data, make a comprehensive analysis a daunting task. This chapter concentrates on those forms of international capital flows that have achieved prominence over the past decade; it is expected that future Global Financial Stability Reports will examine specific issues in more depth. The chapter identifies three key factors affecting the level and nature of cross-border financial flows: (1) the growth in assets under management of institutional investors; (2) changes in the asset allocation behavior of such investors, including a decline in home bias and increased investment in internationally oriented hedge funds; and (3) the rise of EM official sector and sovereign wealth funds as key players. In addition, traditional forms of cross-border asset accumulation such as bank lending and direct investment have regained momentum following the lull in the post-1990s crises period. Note: This chapter was written by a team led by Ceyla Pazarbasioglu and Daniel Hardy.