Indian Express, 28 April 2005
Portfolio flows reflect sound companies and a well-designed equity market
India attracts about one-fourth of the world’s portfolio flows and barely 3 per cent of the world’s FDI. Is this something to worry about?
FII inflows to India in the last six months have exceeded US $8 billion. FDI flows have been less than one third of this amount. Very often arguments are made that this is not good. Instead of having so much portfolio investment, India should have been attracting more FDI. However, contrary to this common belief, research suggests that attracting FII may be a sign of good health and attracting FDI, a sign of bad health of the economy. In contrast to the commonly held unfavorable view of FII flows, evidence suggests that countries with good institutions and markets attract more FII, while countries with poor laws and institutions attract more FDI.
FDI is problematic for foreign investors because it means bringing into a country managerial capacity and organisation. In contrast, FII is easy. Only money needs to be invested for earning returns. No effort is required to build organisational capacity for operating in that market. But if a country does not have a well-developed stock market, foreign investment has limited choices. In the well-developed markets of Europe, for instance, the share of FII in total capital flows is high. In contrast, in the countries of Africa, FDI is the dominant form of foreign investment flows. However, too many investors do not want to venture into poor countries so the total foreign private inflows are small.
In the poor countries of Africa, often the share that goes into the primary and extraction sector — such as mining and oil — is high. In rich OECD countries the share of FDI in total capital flows is low at barely 12 per cent. As countries develop, the total capital flowing to them goes up with the increase in per capita income. However, the share of FDI in it goes down. Foreigners learn to trust their markets and institutions and do not feel the need to go there physically to earn returns. That is why economists in Latin America have been getting concerned about the rise in the share of FDI in total flows. The share of portfolio investment has collapsed and this is seen to be a loss of confidence in their markets and institutions.
In the light of the above evidence, it is not surprising that the share of FII in total capital flows to China are very low. It is an indication of the bad accounting, bad corporate governance, market design problems, and the fundamental inconsistency between communism and the stock market. India should not be embarrassed about attracting portfolio flows. This in fact reflects its success in building sound companies and a well-designed equity market. It is a sign of good health.
But what about the impact upon the economy, of FDI versus FII? In the conventional argument, there are two reasons why FDI is preferred to portfolio investment. First, it is believed that FDI will stay in India in the event of a currency crisis and, second, it is believed that FDI has a greater impact on growth. The dominant view is that FDI is “bolted down” as it involves investment in physical plants and equipment and these are very hard to get rid of.
Studies of currency crisis usually compare the stability of FDI with that of debt, particularly short-term debt, and in comparison with short term debt, FDI has indeed been found to be more stable. But that does not mean that FDI cannot move. Latin American economist, Ricardo Hausmann, has argued that there are important mistakes that flow from problems of measurement. In a country’s balance of payments, FDI flows are defined as the increase in the equity position of a non-resident owner who holds more than 10 per cent of the shares of a firm. It also includes the loans received by a local company from the parent owner. About 20 per cent of FDI takes the form of loans from the parent company.
Moreover, since the firm is merely a set of assets that are “owned” — in other words, financed — by creditors and shareholders, we must not think of FDI as the firm and its assets. Instead, it is just one of the sources of financing for the firm. FDI is not bolted down, machines are. At the time of a crisis, the foreign company can either sell its equity or take a loan against physical assets and take money out of the country. Indeed, economists Graham Bird and Ramkishen Rajen have found that despite the bulk of capital inflows into Malaysia being FDI, there was a currency crisis.
The argument that FDI raises the growth rate of a country also finds only mixed support. FDI is not found to raise growth when it goes into the primary sector. The impact is ambiguous in the case of services. When it comes to manufacturing, cross-country evidence does suggest that FDI raises growth. But, here again, growth can remain limited to the specific industry in which the FDI went. Worse, it may even remain limited to the firms with FDI. The spillover effects of technology, management and corporate governance that is often expected to accompany FDI is not automatic. The growth impact of FDI is thus not automatic. It is only countries that have good institutions, skilled labour, openness to trade and well-developed financial markets that gain from FDI. In the absence of these, even if a country attracts FDI, its usefulness is limited.
The message for India is clear: instead of trying to increase FDI flows artificially, and restrict FII flows artificially, India must focus on improving markets, institutions and the regulatory framework to encourage investment — whether domestic or foreign. Domestic investment is largely responsible for growth in any economy. Whether foreign investment comes or not should be a side show. Policies should focus on creating a healthy well-functioning market and world-class infrastructure.