Question

Portfolio investment towards developing countries: instrument of growth or instability?

There is an enormous controversy on the role that FPI (Foreign Portfolio Investment) plays in developing countries. For some authors FPI is an instrument of capital investment and growth; for some others it is a tool of financial and macroeconomic instability. The scope of this research project is to shed light on this debate and provide recommendations on how FPI can promote growth and reduce instability.

Answer 1

The pattern of capital inflows in developed and developing economies are different because of dissimilar economic and political structures. From the point of view of the host country, especially the developing countries, portfolio flows are considered to play a pivotal role in bridging the saving-investment gap and providing foreign exchange to finance the current account deficit. While the investors of developed countries invest in portfolios of different countries to diversify the risk and earn more returns, foreign portfolio investors generally go for short-term investment to reap the benefits of good economic conditions and they tend to withdraw their investments during the period of recession. This article identifies the determinants of foreign portfolio investment (FPI) in developed and developing economies. Though the movement of capital among different countries is researched in depth by existing literature, the present study adds to the literature by identifying the institutional factor involving the freedom index. The institutional factors aid in identifying the determinants of FPI among select developed and developing countries. This study seeks to answer, where the funds of foreign portfolio investors are headed. And also the reasons of attractiveness for FPI among different sets of countries. The sample of the study is limited to a set of 19 developed and developing counties for a period of 10 years (2004–2013). We study the determinants of FPI for a group of developed and developing countries using fixed and random effects.The results of the model also incorporate the persistence effect considering the lagged value of a dependent variable. The study empirically tests the various factors that determine the inflows of FPI and analyses their performance during different stages of the economic cycle in the last 10 years. Implicitly, in the case of developed countries, it was observed that interest rate differential, trade openness, host country stock market performance, and US stock market returns are a significant trendsetter, while in developing countries, freedom index, interest rate differential, host country stock market performance, trade openness, US stock market returns and crisis period (2006–2008) significantly influence the inflow of FPIs. The dynamic model supports that as a group of 19 countries, portfolio investments are significantly influenced by interest rate differentials, freedom index, US stock market, and host country stock market returns.