Foreign portfolio investment involves transactions by residents of one country in equity and debt securities representing financial claims on and liabilities to residents of another country. The equity and debt securities include, among others, stocks, money market instruments, and private and public bonds and notes. In the case of equity securities, foreign portfolio investment is differentiated from foreign direct investment (FDI) on the basis of lasting interest and controlling position in the resident business entity by the nonresident investor.
While the dividing line between foreign portfolio investment and FDI is not always clear, in general foreign portfolio investment provides greater liquidity compared to FDI. As such, foreign portfolio investment increases the depth and liquidity of global capital markets. It enables investors to seek returns that might not be available in their home country. Furthermore, it allows entrepreneurs and businesses to tap into a greater pool of saving to finance their projects. However, foreign portfolio investment can be volatile, especially in the case where the recipient is a developing or emerging market country. Increasing amounts of foreign portfolio investment have been a defining feature of financial globalization.
Because there is a multiplicity of financial instruments bought and sold in international markets, foreign portfolio investment takes various forms. In the case of debt securities (financial instruments creating debt), foreign portfolio investment usually involves the trading of instruments such as sovereign bonds and bills, corporate bonds, commercial papers, and repos. In the case of equity securities (financial instruments representing ownership), the most common forms are stocks, shares, American depositary receipts (ADRs), and global depositary receipts (GDRs).
Foreign portfolio investment is conceptually different from foreign direct investment in the sense that the nonresident investor does not seek long-term relationship with and decision-making influence in the management of the resident business entity. In practice, foreign portfolio investment is distinguished from FDI by the 10 percent threshold rule. For example, if the nonresident investor obtains 10 percent ownership of a resident business entity, the transaction is considered to be direct rather than portfolio investment. This practice—with some variation in the threshold—is recommended by international financial institutions such as the International Monetary Fund (IMF) and Organisation for Economic Cooperation and Development (OECD) and followed by most countries in the world.
It should be noted that there are cases where the distinction between foreign portfolio investment and FDI is not clear. One example is the nonresident investor who holds more than 10 percent ownership in a resident business entity but who does not have an interest in its operations. Another example is the case where the nonresident investor acquires influence in the operation of a resident business by holding large amounts of debt securities issued by the business. The general consensus is that the cases where there is an overlap between foreign portfolio investment and FDI are of negligible magnitude.
Benefits And Risks
Foreign portfolio investment can provide significant benefits to investors and businesses across the world. For investors, the ability to invest in debt and equity securities in other countries can bring higher returns than investing in their home country. To give an example, the returns on financial instruments in developing and emerging market economies are significantly higher than what financial instruments in advanced industrialized economies yield. For businesses, foreign portfolio investment can reduce the cost of capital. The reduced cost of capital due to foreign portfolio investment is particularly important in countries where the domestic saving rate is low. Entrepreneurs and businesses in such countries can take advantage of borrowing from residents of other countries with high domestic saving rate.
Compared to other forms of cross-border investment, the advantage of foreign portfolio investment lies in reduced transaction costs. A comparison with FDI is illuminating. Acquiring a lasting and controlling interest in a business entity in another country is costly; it comprises transaction costs arising from legal procedures, bureaucratic details, and obtaining information. In contrast, debt and equity securities are traded in established markets with large numbers of buyers and sellers and with predetermined rules and procedures that incur smaller costs. As a result, foreign portfolio investment provides greater liquidity than FDI.
Reduced transaction costs and greater liquidity imply that foreign portfolio investor seeks maximum return across a spectrum of financial instruments in global markets. Because of this, foreign portfolio investment can be much more volatile than FDI, resulting in periods of systemic inflows and outflows of capital. If the size of foreign portfolio investment is large relative to gross domestic product, high volatility can have serious adverse effects. Large systemic inflows can lead to macroeconomic overheating, inflationary expansion, and exchange rate pressures; large systemic outflows of capital can cause liquidity crunch and financial depression. Foreign portfolio investment volatility increases with the frequency of various shocks to the economy, which might originate in domestic or global markets.
Foreign portfolio investment has been a central element of global financial integration. The growth of foreign portfolio investment started in the late 1970s and early 1980s, as advanced industrialized countries began deregulating their financial markets and liberalizing their capital accounts. The movement toward financial deregulation spread to developing and emerging market countries in the late 1980s and gained increasing momentum in the 1990s. As financial deregulation and capital account liberalization progressed, the opportunities for investment in international debt and equity securities expanded. The growth of foreign portfolio investment has accelerated in recent years with increasing global trade imbalances, which are reflected in current account surpluses in Asian economies and in the U.S. current account deficit. For example, the U.S. current account deficit is to a large extent financed by foreign portfolio investment (i.e., by foreign governments investing in U.S. fixed-income assets).
In general, foreign portfolio investment to developing and emerging market economies is more volatile than foreign portfolio investment to advanced industrialized economies. The volume of foreign portfolio investment to emerging market economies reached unprecedented levels in the 1990s; the combined volume of FDI and foreign portfolio investment flows has financed higher levels of domestic consumption and investment in these economies. However, high volatility of foreign portfolio investment has been a contributing factor in the financial meltdowns observed in developing and emerging market economies in the 1990s. Thus, despite its potential benefits, foreign portfolio investment induces a distinct set of risks for developing and emerging market economies.
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