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.

Posted at 1:37 pm IST on Fri, 1 Jan 2010         permanent link

Categories: international finance

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