Investing in Domestic vs Foreign Markets in a Volatile Economy

Pros and cons on foreign capital inflows

Weak economies do experience cash shortages. The reasons are either they generate low revenues so that they could hardly keep up with their government expenditures or that most of them are saddled up with addressing the prevalence of graft and corruption sometimes perpetrated by top government officials themselves whose motives are for personal aggrandizement while in power, rather than help stabilize the economy through the proper and effective implementation of tax regulations.

This is not to mention the existence of red tape and the over-complicated procedures of transacting business, strict capital controls and putting of limits on foreign portfolio investments in the domestic markets in these host countries. As a consequence, economic developments are stunted and foreign investors are discouraged from further parking their huge investments in these weak markets. Instead, they seek stable markets where their investments are protected.

However, there are instances when they loosen up their cumbersome financial regulations to attract foreign investments in order to buoy up their capital base. But this can only happen if the host governments have put in place the proper economic fundamentals that would attract foreign investors to come in. Among the significant factors that are utmost in foreign investors’ preferences are the peace and order situation and the implementation of proper safety nets that would safeguard foreign investments. One of the foremost foreign investments is the portfolio investment.

In a working paper entitled Foreign Portfolio Investors and Financial Sector Stability: Lessons from the Asian Crisis written by Jeong Yeon Lee of Standford University, it pointed out that the Asian financial crisis was demonstrated by major weaknesses in the domestic financial system.

The paper identified the problems as “inconsistent and shaky macroeconomic management; severe asymmetric information problems (e.g. inadequate accounting, auditing, and disclosure practices) in the financial and corporate sectors; and inadequate prudential supervision and regulation of domestic financial institutions and markets.”

The Asian experience also suggests that short-term foreign debt poses special problems for the maintenance of financial sector stability, the paper added.

Foreign portfolio investments largely contribute to the process of financial innovation in the domestic market. “If foreign investors provide financial services as well as capital flows, the import of financial services results in additional efficiency gains through increased competition and the spread of good practices,” the paper stated.

It continued: “…the availability of foreign investors willing to lend can dampen business cycles by reducing the need for households and firms to contract consumption and investment spending when hit by negative shocks to domestic production and income.”

At the global level, capital flows created by foreign investors permit a more efficient allocation of world savings and direct resources to their most productive uses. Global capital flows produce opportunities for intertemporal trade, portfolio diversification, and risk sharing, the paper said.

But the paper also identified potential risks that are associated with these potential benefits from foreign portfolio investment flows into the host countries. It further stated that foreign investors have the tendency to make host economies more susceptible to volatility.

Consequently, weak economies are susceptible to financial shocks owing to their weak fiscal policies, unsound banking systems, and highly distorted domestic markets. Likewise, the paper found out that the presence of foreign investors can intensify herding behavior and play a key role in crisis contagion. “The actions of foreign investors can amplify the effects of policy distortions”, it said.

Independent economists have found that economic crises are borne out of the portfolio investors’ penchant for moving huge sums of money in and out of the host countries’ capital markets thereby disrupting their financial sector stability. A good example, the paper said, was the Asian financial debacle wherein hedge funds were identified as the major culprit in destabilizing some of the Asian economies.

Despite these sad lessons, weak economies cannot simply walk away from global capital markets by imposing strict capital control regulations on incoming capital flows from abroad. “The best way to maximize net benefits is to keep the door open to global capital flows while minimizing the risks they pose to financial sector stability by attacking unwanted distortions at their sources.”

To give the host economies a better understanding on the possible intricacies of foreign portfolio investments is to have a much clear grasp of the tradeoff between the benefits and risks associated with foreign portfolio investors, the paper said.