Attracting Portfolio Capital Inflows: National Political and Economic Attributes of Emerging Markets

Article excerpt

The general objective of this study is to discern and examine the role of macroeconomic government policies as well as the economic and financial attributes of host emerging market countries in shaping the destination of portfolio investments. The study identifies key "location advantages" that must exist in order to 'pull" portfolio investment. Further, it highlights public policy recommendations for attracting portfolio capital as a source of capital for developing countries.

This study finds a direct positive correlation between portfolio capital inflows and improvement in macroeconomic performance in the host economies. Countries in the emerging markets that were able to generate fast economic growth. engage in extensive privatization program, and adopted a public policy posture based on opening their economies to international trade and capital inflows were more likely to attract foreign portfolio equity investments than those developing countries that did not undertake significant market-friendly macroeconomic stabilization and fiscal consolidation programs.

Key Words: Financial Markets, Emerging Markets, International Stock

Markets, Political Economy, Economic Policies

Portfolio investments involve purchase of securities and fixed income investments by foreign individual and institutional investors in the domestic or local bond and equity markets of host countries. In contrast to foreign direct investment (FDI), where foreign companies obtain managerial control and operate productive facilities in the domestic economy, foreign portfolio equity investments (FPEI) normally transact through purchase of shares of companies quoted on stock markets. Portfolio capital flows can also be distinguished from 'sovereign borrowing' as well as private bank lending. 'Sovereign borrowing' involves banks lending capital to a government, and public enterprises enjoy an explicit government debt guarantee. Private bank loans entail lending by foreign banks to the domestic private sector, generally at short maturity.1

Foreign capital flows to the emerging markets of Asia and Latin America have revived considerably since the debt crisis of the 1980s. However, the magnitude and composition of these capital flows have shifted greatly. In the 1970s and 1980s, the bulk of capital flows to developing countries came through 'sovereign borrowing' by governments in the form of long-term syndicated credits arranged by groups of foreign banks.2 Since the mid-1980s, foreign direct investment flows to developing countries re-surged. In contrast, since the early 1990s foreign portfolio flows (hereinafter referred to as portfolio equity investments or FPEI) have been used significantly by foreign investors to purchase stocks and bonds in the securities market of foreign countries. FPEI has generally grown over this decade, with flows trebling in 1993 compared to a year earlier. The dramatic rise in the interest of global investors in the emerging economies of Asia and Latin American is evidenced by the spectacular rise in the value of the stock markets of the emerging economies. Between 1986 and 1995, stock market capitalization in emerging countries grew at a much faster rate than market growth in the developed countries. The emerging countries' stock market grew more than ten fold, from $171 billion to $1.9 trillion. During this time frame the market share held by emerging countries in the world stock market increased by 300 percent, accounting for 11 percent of the global stock market capitalization.

The Mexican financial crisis of December 1994 caused a short-term decline in FPEI flows, primarily in FPEI to Latin America.' Investment flows resumed a few months later, and by 1996 the volume of new equity raised on international capital markets by emerging market countries increased in one year by 34 percent, or $15 billion. This large increase illustrates the resilience of the emerging markets as an attractive destination for portfolio investments. …