Determinants of Foreign Portfolio Investment

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Countries with low levels of saving can turn to foreign capital in order to afford the capital expenditure necessary for investments. In a small open economy, building a large infrastructure project or constructing a modern factory will have a greater chance of completion if enough funding is available, and usually this can be obtained from foreign sources. This is called foreign direct investment—foreign capital that is invested in local projects, in which foreign residents own and control the activity. But foreign funds are invested not only in infrastructure projects or factory construction; most of the time, foreign capital is placed in short-term instruments like bonds, stocks and mutual funds. This is called foreign portfolio investment—foreign capital that is placed in money-market instruments and in stocks where the total shareholdings amount to less than 10 percent (BSP, 2007). The difference between foreign portfolio investment (in the Philippines, for example) and Filipino portfolio investment abroad is called the net portfolio investment.

Sources of foreign capital are varied, but they generally fall into the categories set below (Bates, 1999):

Capital Flows from the Major Industrialized Countries
(Billions of U.S. Dollars)
Portfolio Investment (Capital Markets)12.4330.0
Direct Investment (Multinational Companies)34.7215.0
Bank Loans (Commercial Banks)46.255.0
Foreign Aid* (Governments/Multinational Institutions)13.358.9 Source: Global Public Policy, Wolfgang H Reinicke
* OECD Data. Only includes flows from OECD countries to developing countries.

From the table above, we can observe that private portfolio investment has increased in importance over the two decades between 1975 and 1995. From about 10% of all flows from developed countries, private foreign investment in capital markets now accounts for over half of all international capital flows. The less volatile, longer-term and permanent foreign direct investment is still very important, but bank loans and foreign aid to poor countries has declined dramatically over the years. This is an indication of the importance of private participation—as opposed to government intervention—in international capital markets, and of the role that private capital plays in the growth and development of emerging markets.

This is because, first and foremost, foreign portfolio investment brings obvious benefits. Bates (op. cit.) says in particular that raising capital for expansion would be easier with foreign participation, bringing higher liquidity, lower cost of credit, and increased output levels. Foreign participation in local markets also brings in foreign skills, technology, and market tools to allow risk hedging for local players.

However, international capital flows bring in potential costs. Where institutions are weak, particularly in poor countries, foreign capital will simply allow corrupt government officials to exploit the market or degrade the environment further. Most memorably, emerging markets are exposed to “contagion”—when a collapse of investor confidence in one country results in capital flight in another. For example, in 1998, a debt default by Russia dried up international credit to Brazil.

It is important, therefore, to examine the determinants of foreign portfolio flows in order to take advantage of them. The reason is that portfolio flows are good, or exhibit their benefits, when they flow into the country; they become bad, or actualize their potential costs, when they flow out. There can be no doubt that an increase in net portfolio investment is something that every country desires. It is thus very important to encourage it.

The paper proceeds as follows. The rest of this section presents the data on trends in net port-folio investment and related macroeconomic indicators, as well as a review of related literature on the subject of international capital flows. Section II...
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