Promoting foreign portfolio equity investment

In recent years, foreign portfolio equity investment (FPEI) in developing countries has expanded rapidly. This increase has taken place against the background of structural changes in international capital markets, which shifted emphasis from banking intermediation to financial security and which were increasingly influenced by the important role played by institutional investors.

FPEI has also been encouraged by structural reforms in developing countries, which have increasingly moved towards more market-oriented economic systems. The surge in FPEI has also been underpinned by a steady recovery- and growth-record of recipient developing countries, which has allowed high returns on emerging markets (EMs). However, the number of beneficiary countries is still small, as only some 15 developing countries/economies are now able to attract such flows on a significant scale. These are typically middle-income countries with a meaningful domestic industrial base. The conditions for attracting an increasing volume of FPEI to a larger number of recipient countries are mainly linked to domestic efforts to implement policies conducive to growth and to strengthening the operational framework of local stock markets. In addition, developed countries can also help to increase such flows by relaxing their regulations on the investment policies of their institutional investors in EMs.

The main advantage of FPEI flows is that the service on capital imported is linked to returns of the investment made, thus helping to match service payments to ability to pay and serving as an effective instrument to share risks between investors and borrowers. As foreign investors are attracted above all by high returns, such flows are closely linked to the performance and competitiveness of private companies, which much depend on a stable and enabling business environment.

Beyond the benefits of FPEI as a mechanism to channel foreign savings to developing countries, the question arises as to the role of stock markets in their financial systems. A growing number of developing countries have recognized the useful role that stock markets can play in enhancing the efficiency of domestic financial systems, and have established and developed stock markets. Stock markets can usefully complement the banking sector by providing risk finance and ensuring a healthy corporate financial structure. On the other hand, stock markets can entail costs, as their price mechanism can at times be destabilizing for the economy, especially if markets are thin and highly concentrated and if the regulatory framework is weak. There is some evidence on the positive contribution of stock markets in the mobilization of resources in developing countries. Further research, however, is needed to analyse in greater depth the contribution of stock markets to an efficient allocation of resources.

Despite the striking progress made by major EMs whose performance is now comparable to that of developed markets (DMs), the state of many EMs is still characterized by high volatility, high market concentration, lack of liquidity, inadequate market regulation or weak capacity to enforce rules. These factors can to a large extent discourage foreign investors. Widespread reforms are needed to improve the functioning of EMs. This will necessitate an important involvement of governments to ensure an adequate institutional, legal, and regulatory framework for a proper functioning of local stock markets.

FPEI flows, however, can also have an adverse impact on the domestic economy, if they are based primarily on short-term speculative motives. Experience has shown, though, that fears in this respect have been largely unfounded: global investors have tended to "invest" in EMs, and foreign equity flows have not shown large fluctuations. Nevertheless, FPEI flows have generally increased the volatility of EMs, due perhaps to a faster transmission of information. This possible effect on markets which are known to be already volatile might justify a gradual opening of EMs to foreign investors.

On the investors' side, the enormous potential represented by the pool of savings held by institutional investors in OECD countries may increasingly seek investment outlets other than those offered by mature markets. As investment managers become more familiar with EMs, a relaxation of home country policies concerning investment portfolios of institutional investors could allow a multiple increase in FPEI.

Overall, prospects for increasing FPEI further in developing countries seem to be promising, given the large potential of institutional savings and progress made by EMs. Indeed, the continuing progress made in raising standards in many EMs and in enhancing the competitiveness of domestic companies through improvements in economic management are likely to make these markets even more attractive, as volatility may consequently be reduced and high growth prospects are expected to induce high returns.

Facilitated by:
Establishing equity markets
Type Classification:
G: Very Specific strategies