In addition to foreign direct investment, the most significant commponent of private capital flows has been in the area of portfolio Investment. With the increased liberalisation of domestic financial markets in most developing countries and the opening up of these markets to foreign investors, private portfolio investment now accounts for a significant and currently rising share of over – all net resource flows to developing countries. Basically, portfolio investment consists of foreign purchases of stocks (equity), bonds, certificates of deposit,
and commercial paper. As usual, the middle-income countries have been the
favoured destination of these flows, with sub-Saharan Africa all but neglected.
As in the case of the FDIs of multinational corporations, the benefits and costs of private portfolio investment flows to both the investor and the developing-country recipient have been subjects of vigorous debate.’* From the investor’s point of view, investing in the stock markets of middle-income countries with relatively more-developed financial markets permits them to increase their returns while diversifying their risks.
From the perspective of recipient developing countries, private portfolio flows in local stock and bond markets are a potentially welcome vehicle for raising capital for domestic firms. Well-functioning local stock and bond markets also help domestic investors diversify their assets (an option usually open only to the wealthy) and can act to improve the efficiency of the whole financial sector by serving as a screening and monitoring device for allocating funds-to. industries and firms with the highest potential returns.
But from the macro-policy perspective of developing country governments, a key issue is whether large and. volatile private portfolio flows into both local, stock and short-term bond markets can be a destabilising force for both. the financial market and the overall economy. Some economists argue that these flows are not inherently unstable.!> Developing countries that rely too heavily on private foreign portfolio investments to camouflage basic structural weakness in
the economy, as in Mexico, Thailand, Malaysia, and Indonesia in the 1990s, are more than likely to suffer serious long-term consequences. Like MNCs, portfolio investors are not in the development business. If developed-country interest rates rise or perceived profit rates in a developing country decline, foreign speculators will withdraw their “investments” as quickly as they brought them in. . What developing countries need most is true long-run economic investment (plants, equipment, physical and social infrastructure, etc.), not speculative capital. A number of developing countries now combine incentives for the former. and disincentives for the latter. Controls were strengthened in the years following the 2008 global financial crisis as potentially destabilising “hot money poured into several middle-income countries in response to low interest rates in developed countries. – ; In summary, private portfolio financial flows have risen and fallen dramatically in recent decades. Their volatility and the fact that they respond primarily to global interest-rate differentials, as well as to investor perceptions of political and economic stability, make them a very tenuous foundation on which to base medium or long-term development strategies.
Asia’s financial collapse in 1997, Russia’s in 1998, Brazil’s currency turmoil in 1999, Argentina’s crisis ‘ in 2001-2002, and the dramatic downturn in flows to developing countries in 2009 underlined the instability or fragility of global capital markets.!” Rather, developing countries need to focus first on putting fundamental conditions for
development into place, because evidence shows that both MNCs and portfolio investors follow growth rather than lead it.