Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI) | UGC NET Commerce Preparation Course PDF Download

Portfolio Investor

A portfolio investor is an individual or institution that diversifies their investments across various financial assets, typically creating a portfolio that includes securities like stocks, bonds, mutual funds, exchange-traded funds (ETFs), and other investment instruments. The primary objective of a portfolio investor is to mitigate risk by spreading investments across different assets and asset classes, aiming to achieve a balanced and potentially more stable return on investment.

Introduction to Foreign Portfolio Investment

Foreign portfolio investment refers to the practice of foreign investors purchasing stocks, bonds, and other financial assets issued by companies in another country. Unlike foreign direct investment (FDI), foreign portfolio investors do not gain control or management rights over the companies in which they invest. Instead, they invest in financial securities, not in the actual assets or operations of those firms. Their involvement is limited to financial returns, which are influenced by dividends, interest income, and capital gains. Portfolio investors do not have any influence over the companies they invest in and are considered passive owners of financial assets.

Foreign portfolio investments are typically liquid and short-term, as investors can buy and sell financial assets quickly. The returns from these investments depend on the performance of the underlying financial assets. Portfolio trends are often influenced by market conditions and may involve an element of chance rather than strategic planning and analysis.

While foreign portfolio investments can provide capital and stimulate the growth of financial markets, they can also introduce risks, such as increased market volatility. As a result, governments manage these investments through measures like capital controls and taxes to balance the benefits of stable portfolio inflows with the potential risks. When effectively managed, foreign portfolio investment can contribute to the growth of financial and economic markets.

Types of Foreign Portfolio Investment (FPI)

Foreign portfolio investments can take several forms:

• Equity Investment: Involves purchasing shares of foreign companies listed on a stock exchange. Equity investments provide investors with a share in the profits and growth potential of the companies.

• Bond Investment: Involves buying bonds issued by foreign governments or companies. Bondholders receive periodic interest payments and the principal amount upon maturity.

• Money Market Investment: Refers to investments in highly liquid, safe, and short-term securities like Treasury bills, bank certificates of deposit (CDs), and commercial paper.

Factors Affecting Foreign Portfolio Investment

Several factors influence foreign portfolio investments:

• Economic Growth Prospects: Higher growth opportunities in a country attract more investors.

• Interest Rates: Higher and more stable returns make a country more attractive to investors.

• Risk-Return Tradeoff: Investors evaluate potential returns relative to the risks involved when deciding on foreign portfolio investments.

• Currency Movements: Depreciation of the local currency can make investments cheaper for foreign investors and improve future repatriation of returns, boosting inflows.

• Political Stability: Countries with stable political environments are more attractive for investments, while political instability can deter inflows.

• Regulatory Environment: Strict regulations can act as barriers to foreign investment, while more relaxed regulations encourage investment.

• Macroeconomic Stability: A stable macroeconomic environment, including low inflation and sustainable fiscal policies, is attractive to investors.

• Financial Market Development: Well-developed financial markets are more likely to attract foreign investments.

• Size of Local Capital Markets: Larger and more liquid domestic capital markets offer greater opportunities for foreign investors.

• Volatility of Returns: High volatility in returns can make foreign investors cautious, affecting the inflow of portfolio capital.

• Corruption Levels: High levels of corruption can deter foreign portfolio investors due to the risks of delays and lack of transparency.

• Capital Controls: Restrictions on capital transactions, such as bans, quotas, and taxes, can limit the inflow of foreign portfolio investments.

Benefits of Foreign Portfolio Investment

Foreign portfolio investment offers several benefits:

• Provides Capital for Economic Growth: It channels foreign savings into the domestic economy, financing corporate growth and government debt, thus supporting economic growth.

• Develops Capital Markets: Increased foreign participation in local stock and bond markets leads to higher trading volumes, liquidity, and sophistication in these markets.

• Increases Competition: The entry of foreign investors increases competition in domestic financial markets, driving local players to improve efficiency and services.

• Transfers Skills and Technology: Foreign portfolio investors bring global experience, technical know-how, and market insights, which can benefit local capital market participants.

• Risk Diversification: Portfolio investors can diversify risks by investing in a wider range of assets across multiple markets, reducing the volatility of their returns.

• Higher Returns for Locals: Foreign interest in local assets tends to drive up their prices in the short term, providing gains to existing local investors.

• Improves Corporate Governance: The scrutiny of foreign investors can encourage companies to adopt better governance practices and transparency to attract more portfolio inflows.

• Offers Exit Options for Locals: Foreign portfolio investment provides local investors with an avenue to exit their investments by selling to foreign investors, enhancing liquidity.

• Macroeconomic Benefits: Stable foreign portfolio inflows can help manage current account deficits, stabilize currency values, and build foreign reserves.

Limitations of Foreign Portfolio Investment

Foreign portfolio investment also has several limitations, including:

• Foreign Ownership Limits
• Sectoral Restrictions
• Regulatory Approval Requirements
• Currency Controls
• Taxation Policies
• Trading Restrictions
• Disclosure Requirements
• Anti-Money Laundering (AML) and Know Your Customer (KYC) Regulations
• Political and Economic Stability
• Repatriation Restrictions

Examples of Foreign Portfolio Investment

Here are some examples of foreign portfolio investments:

• Equity Investments: Foreign investors purchase stocks listed on domestic stock exchanges, such as the NSE or BSE in India. For instance, foreign institutional investors in India hold over 20% of the total market capitalization of listed companies.

• Bond Investments: Foreign mutual funds and pension funds invest in bonds issued by governments and companies in the local market. For example, about 35% of outstanding government bonds in Japan are held by foreign investors.

• Money Market Investments: Foreign hedge funds and wealth funds allocate a portion of their portfolios to money market instruments in the domestic market, such as Treasury bills.

Factors Affecting International Portfolio Investment

Several factors influence international portfolio investments:

• Expected Returns: Investors allocate capital to countries where they anticipate the highest returns for the level of risk involved. Higher expected returns attract more portfolio flows.

• Risk Level: Factors like political instability, currency risks, and default risks affect portfolio investments. Lower risk levels and more stable environments attract more funds.

• Interest Rates: Higher domestic interest rates relative to global rates make an economy more attractive to fixed-income portfolio investors.

• Macroeconomic Stability: Economies with low and stable inflation, sustainable fiscal deficits, and prudent monetary policies are preferred by portfolio investors seeking stability.

• Regulatory Environment: Strict investment rules, restrictions, and taxes reduce portfolio inflows, while less stringent regulations encourage more foreign participation.

• Financial Market Development: More developed and sophisticated banking and capital markets are better equipped to attract and manage global portfolio flows.

• Currency Stability: Stable currencies are more attractive to portfolio investors, while volatile and depreciating currencies can deter capital inflows.

• Political Stability: Political unrest and risks deter portfolio investments, while stable environments with inclusive institutions are preferred.

• Market Liquidity: More liquid and less volatile financial markets are better able to absorb portfolio flows without major disruptions.

• Global Liquidity: Abundant global liquidity and the search for higher yields benefit economies that can tap into such funds through portfolio investments.

Conclusion

International portfolio investments are influenced by a combination of economic, financial, institutional, and political factors that shape the risk-return dynamics for investors in different economies. No single factor is decisive on its own. Foreign portfolio investment involves acquiring financial instruments issued by domestic firms by foreign investors. The examples provided illustrate common ways in which such portfolio flows occur globally.