The Impact of Portfolio Investment Flows in Developing Countries

Table of Contents

Table of Figures

Table of Abbreviations

1. Introduction

2. Overview of Portfolio Investment Flows in Developing countries

3. Third-Generation Crisis Models

4. Analysis of the Consequences of Portfolio Investment Flows in Developing Countries .

5. Evaluation of the Consequences of Portfolio Investment Flows in Developing Countries

6. Policy Advice

7. Conclusion

Bibliography

Table of Figures

Figure 1: Portfolio Inflows by Region (US$ billions)

Figure 2: Change in PI by Region

Figure 3: Change in PI by Development Status

Figure 4: GDP per Capita Growth in Asian Countries

Table of Abbreviations

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1. Introduction

“Poverty continues to be the greatest global challenge of our time” said the Social Development Commission Chair of the United Nations, Ion Jinga, in 2016 (United Nations 2016). To address the problem of poverty in developing countries (DCs) economic governance and capital flows play a key role (The International Bank for Reconstruction and Development / The World Bank 2001, 8).

The policy advice of the IMF for DCs was to liberalise the capital account, especially in the 1990s (Lubin 2018, 78). Economists like John Williamson criticised the capital account liberalisation clearly and held it accountable for the Asian crisis that overtook the so-called “tiger economies” in 1997. He favoured foreign direct investments (FDI) compared to portfolio investments (PI) since they are much more stable (Williamson 2004, 9). But how volatile are PI and what are their effects on the economies of DCs? Which legal framework should politicians in DCs set to manage the effects of PI? This essay will face these questions.

My thesis statement is that PI have positive rather than negative effects on a DC’s economy since they seem to reduce the cost of capital, increase investment, and accelerate growth. Thus, capital controls should not be enforced on PI.

First of all, I will give an overview of portfolio investment flows in DCs. Afterwards, I will introduce the third-generation crisis models. Then, I will analyse the consequences of PI in DCs. Next, the consequences of PI will be evaluated, also with regard to third-generation crisis models. Given this evaluation, I will state my advice for policy makers.

2. Overview of Portfolio Investment Flows in Developing Countries

In all developing regions except the Arab States, total portfolio inflows declined heavily between 1995 and 2008. Portfolio inflows rose during this period from $0.01 billion in 1995 to $1.4 billion in 2008 in Arab States (UNDP 2001, 102).

Figure 1: Portfolio Inflows by Region (US$ billions)

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Source: Ibid.

As demonstrated in figure 1, the Asia and Pacific region (A&P) gets the majority of portfolio inflows. Their inflows declined between 1995 and 2008 by 535 percent. The portfolio inflows in Africa deteriorated by 441 percent. Portfolio inflows declined by 116 percent for the Latin America and the Caribbean region (LAC). Europe and the Commonwealth of Independent States (ECIS, Europe and Central Asia) suffered the most through a decline of 1,505 percent. Portfolio inflows fell by 667 percent in high-income DCs and by 224 percent in low-income DCs between 1995 and 2008. Portfolio inflows rose after the end of the Asian crisis in 1998. They collapsed in 2002 after the crisis of 2001. Portfolio inflows had a boom period between 2002 and 2007 and a crash afterwards during the financial crisis. This demonstrates that portfolio flows are highly prone to volatility (UNDP 2001, 102).

This volatility is even more evident, when considering the following graphs.

Figure 2: Change in PI by Region

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Source: Own diagram. Data: Ibid., 104.

Figure 2 illustrates that the regional averages in the LAC region exhibit the highest volatility of portfolio inflows. The least volatile region is A&P.

Figure 3: Change in PI by Development Status

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Source: Own diagram. Data: Ibid.

Figure 3 indicates that portfolio inflows in middle-income DCs are more volatile than in other development groups. The volatility of low-income DCs is the lowest.

3. Third-Generation Crisis Models

The first- and second-generation crisis models failed to predict or explain the Asian financial crisis. They focus on currency crises but the Asian crisis was more than that. It also was a banking and capital market crisis (Krugman 1999, 316-317).

To find more suitable theoretical frameworks for explaining these kind of crises, third-generation crisis models were created. One approach was delivered by Chan-Lau and Chen. Their model suggests that, in the beginning, capital inflows and credit lending were not keeping pace with the rapid economic growth for a long period of time. This is called “capital inflow inertia”. That is the case because even when foreign credit supply increases, banks will not intermediate all the credit due to the costly nature of monitoring it. Afterwards the foreign credit supply and the capital inflow increase because the banks switch to unmonitored intermediation. In the third phase of the model, an adverse shock leads to a sudden fall of credit supply. As a consequence, a financial crisis occurs in form of a large outflow of external capital. This leads to a domestic credit crunch. Between their approach and the actual Asian crisis are links: There was a period of low capital inflows despite high rates of economic growth during the take-off stage of Asian tiger economies. In the 1990s capital flows abruptly increased. This was followed by drastically reduced bank lending in Asia (Chan-Lau and Chen 1998, 3, 5, 21).

At the core of Chan-Lau and Chen’s model is an inefficient financial system. Such systems have costly and inefficient monitoring technologies. They are prone to capital inflow inertia and an abrupt large capital outflow. A crucial implication of the model is that a DC’s economic crisis is usually preceded by a period of large capital inflows, as long as they are not countered by policy interventions. Furthermore, they stress that the reversal of capital inflow may have very negative effects on the social welfare. Productive activities are reduced, while unemployment is increasing. Therefore, they stated that policy instruments can be a tool to reduce and smooth the volatility of capital flows. This could include instruments regarding interest rates, financial sector reform,prudential regulation, capital controls and measures that could affect economic fundamentals (Ibid., 8, 22).

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