A blog on financial markets and their regulation
Foreign Investment: Direct versus Portfolio
January 1, 2010Posted by on
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.