This essay focuses on the impact of portfolio investment (PI)flows in developing countries (DC). 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.
To address the problem of poverty in developing countries (DCs) economic governance and capital flows play a key role. The policy advice of the IMF for DCs was to liberalise the capital account, especially in the 1990s. 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 PI since they are much more stable. 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.
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.
Table of Contents
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
Research Objectives and Topics
This paper examines the impact of portfolio investment (PI) flows on developing countries, specifically evaluating whether these flows have a net positive or negative effect on economic growth. The study aims to address the volatility associated with PI and determine if capital controls are a necessary regulatory tool for policymakers in developing economies.
- Analysis of volatility trends in portfolio investment across different developing regions.
- Application of third-generation crisis models to explain financial instability.
- Evaluation of the relationship between capital market liberalisation, investment, and economic growth.
- Assessment of the long-term economic impacts of crisis-induced portfolio capital outflows.
- Policy recommendations regarding capital account liberalisation and the regulation of debt flows.
Excerpt from the Book
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.
Summary of Chapters
1. Introduction: This chapter outlines the global challenge of poverty, the role of capital flows, and the thesis that portfolio investments have overall positive effects on developing economies.
2. Overview of Portfolio Investment Flows in Developing countries: This section provides a data-driven analysis of the historical volatility and regional distribution of portfolio investment inflows between 1995 and 2008.
3. Third-Generation Crisis Models: This chapter introduces theoretical frameworks, specifically the Chan-Lau and Chen model, to explain the mechanics of banking and capital market crises.
4. Analysis of the Consequences of Portfolio Investment Flows in Developing Countries: This section reviews existing empirical studies to assess how portfolio investments impact economic growth and cost of capital in various income groups.
5. Evaluation of the Consequences of Portfolio Investment Flows in Developing Countries: This chapter reconciles empirical findings with theoretical crisis models, concluding that the negative impacts of capital reversals are typically short-lived.
6. Policy Advice: This chapter recommends against the enforcement of strict capital controls on portfolio equity, while suggesting that free debt flows may require targeted regulation.
7. Conclusion: This chapter summarizes the main arguments, reaffirming that the benefits of portfolio investment outweigh the risks, while identifying areas for future research.
Keywords
Portfolio Investment, Developing Countries, Economic Growth, Capital Account Liberalisation, Financial Crisis, Volatility, Third-Generation Crisis Models, Capital Controls, Banking Crisis, Emerging Markets, Financial Intermediation, Investment Flows, Economic Development, Debt Flows, Policy Advice.
Frequently Asked Questions
What is the core focus of this research?
The work investigates the impact of portfolio investment (PI) flows on the economies of developing countries, questioning whether such flows provide growth benefits or cause dangerous instability.
Which central topics are discussed in the paper?
The paper covers capital account liberalisation, the volatility of portfolio flows, the dynamics of banking crises, and the role of financial institutional development in economic performance.
What is the primary research goal?
The primary goal is to determine whether portfolio investments have a positive or negative impact on a developing country's economy and to provide evidence-based policy advice regarding the use of capital controls.
Which scientific methods are employed?
The author utilizes a critical analysis and literature review of empirical studies and theoretical frameworks, such as third-generation crisis models, to evaluate the consequences of international capital flows.
What topics are covered in the main body?
The main body covers a historical overview of PI trends, an explanation of modern crisis theories, an analysis of empirical growth impacts, and an evaluation of the long-term effects of financial crises.
Which keywords characterize this paper?
The paper is characterized by terms such as Portfolio Investment, Developing Countries, Capital Account Liberalisation, Financial Volatility, and Economic Growth.
How does the Chan-Lau and Chen model explain the Asian financial crisis?
The model suggests that crises are triggered by 'capital inflow inertia' followed by unmonitored bank intermediation, which leaves the economy vulnerable to an abrupt shock and a subsequent credit crunch.
Are there negative consequences to portfolio investments?
While the author acknowledges risks like currency depreciation and stock market collapses during crises, he concludes that these effects are typically transitory and do not negate long-term growth benefits.
What is the author's final advice for policymakers?
The author advises against imposing capital controls on portfolio equity because they may hinder growth, but suggests that policymakers should look into regulating free debt flows.
- Quote paper
- David Höhl (Author), 2018, The Impact of Portfolio Investment Flows in Developing Countries, Munich, GRIN Verlag, https://www.grin.com/document/465438
