Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Foreign Investment: Direct versus Portfolio

Ever since the Asian crisis, there has been a sort of consensus
that foreign direct investment (FDI) is the best and most stable form
of capital inflows while foreign portfolio flows (FII in Indian
parlance) are more volatile and therefore less desirable.

Ever since the global crisis began, I have been reading a lot of
financial history (starting with the last 500 years and slowly going
further back). It now appears to me that the aversion to the
volatility induced by portfolio flows is extremely short sighted.

In the long run, the volatility gets washed out and what counts is
the average growth rate of the economy. The short term (high
frequency) is all noise (volatility) while the signal (mean) is
apparent only in long time series (low frequency). Lessons drawn from
short time series of data are probably wrong.

Looking back at some of the major emerging markets of the
nineteenth century (US, Canada, Australia and Argentina) puts things
in a totally different perspective. I particularly enjoyed the
discussion about nineteenth century US in Chapters 7 and 8 of Atack
and Neal, (The Origin and Development of Financial Markets and
Institutions; From the Seventeenth Century to the Present
Cambridge University Press, 2009).

Of all the big emerging markets of the nineteenth century, the US
relied most on portfolio flows and Argentina relied the most on
foreign direct investment. By 1890, the results of the different
trajectories were quite apparent.

In the long run, the volatility of the growth rate is largely
irrelevant; it is the average that counts. Despite frequent financial
crises and corporate bankruptcies, the US grew faster. More
importantly, it was also able (despite the damage inflicted by
populist politicians like Andrew Jackson) to build a domestic
financial system that ultimately made it less dependent on foreign
markets and institutions.

Applying that historical lesson would suggest that India should
remain friendly to foreign portfolio flows while developing domestic
financial markets. We must simply learn to live with the volatility
and occasional crises that come in their wake.


3 responses to “Foreign Investment: Direct versus Portfolio

  1. Mav January 2, 2010 at 10:40 pm

    Sir, Isn’t just one comparison case of US and Argentina good enough to draw conclusion on FDI v/s FPI? Also, the long term horizon is so long that the saying “in the long run we are all dead” really applies in this case. I don’t see why fin mkts can’t be made better/mature with FDI being preferred more over FPI. US for did not do better than Argentina because of better fin mkts – there we much more important factors which contributed to that.

    • Jayanth Varma January 3, 2010 at 11:08 am

      1. Yes, there is a problem of inadequate data when it comes to these things, but 19C US is not the only example. The UK in the 18C (Dutch portfolio capital) would be another example.

      2. There were other factors at work, but these are intertwined with the financial markets with causation running in both directions. Even the political system evolves differently if you rely on FDI versus domestic financial markets and FPI.

      3. Transformation into a developed country necessarily spans more than one generation. Policy makers must accept that they would be dead before the fruits of their labours are seen – it is always the next generation that reaps the benefits. That is true even if you go to the other extreme and rely on a state led industrialization like in China. Deng is dead and it is his successor’s successor who is enjoying the fruits of what Deng did 30 years ago.

      • Mav January 4, 2010 at 4:25 pm

        Thanks for your reply sir. Really appreciate it. It would be great to hear your thoughts in detail on why FPI is a better proposition than FDI in Indian context.

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