# **5 Summary and conclusions**

“Why doesn’t capital flow from rich to poor countries?” asked Robert E. Lucas, Jr. One view is that, precisely because emerging markets lack capital, many highly profitable, investable, and commercially viable projects fail to receive financing owing to frictions that impede the flow of capital across international markets. Such frictions could include government regulations, limited banking sector development, or rich country investors’ misperceiving investment in poor countries to be riskier than it actually is. A counter view attributes lack of capital in poorer countries to poor (or extremely poor) risk-adjusted returns to investing. A major challenge to distinguishing between these hypotheses has been the lack of data that would enable a systematic evaluation of risk-adjusted returns to private equity markets over long periods of time and across many countries. In the presence of idiosyncratic country shocks, only with data for many years and many countries is it possible to test for persistent differences in returns between rich and poor countries.

Data from the IFC portfolio on the return to private equity across 58 years and 130 countries provide the best available evidence yet on these questions. In contrast to previous macroeconomic literature, notably Caselli and Feyrer (2007) and Chari and Rhee (2020), we find significant differences in returns across countries. Quantitatively, a less integrated market appears to be more important than economic growth for returns: a one standard deviation decrease in financial openness or banking system depth within a country is associated with a substantially greater increase in return than the corresponding association with a one percent increase in cumulative annualized real GDP growth over the life of an average investment. This finding suggests that the extent of capital market integration, rather than differences in underlying economic performance, is most useful in explaining differences in private investment returns across economies, consistent with the model elaborated in Section 2.

It is worth noting that the data do not allow us to measure the extent to which the IFC invests in businesses that otherwise would not receive funding, the degree to which IFC investments mobilize additional capital or the size of environmental or social externalities created by private investment. We see these as important topics for future research. The data do confirm that a source of the IFC’s return on equity (Figure 1, Panel A) has been private equity investments specifically in countries with less financial openness and development, and with socialist legal origins.

The analysis of the IFC portfolio does provide insights for international investors contemplating investments in emerging markets from which they hope to realize above market returns on equity. Imperfect integration of international capital markets– less developed banking systems and capital controls–may enable especially attractive opportunities for investors to earn returns. The combination of results on openness and macroeconomic variables suggests that the highest returns should be available in economies that are both growing rapidly and are opening and deepening their financial markets. These results also provide a potential explanation for the IFC’s declining performance over the past decade and the underperformance of emerging markets in other data sets. Economies that open up typically remain open, and as countries develop, private sector credit 24