Foreign Portfolio Equity Investments in Economic Development

During the last two decades, reform of local capital markets and relaxation of capital controls to attract foreign portfolio investments (FPIs) became an integral part of development strategy. The proximity of market openings and large, sudden shifts in international capital flows gave credence to the notion that the liberalization was the primary culprit in precipitating the Mexican and the East Asian crisis and that international capital movements need to be restricted. Hence, in this paper, we reassess the benefits and costs of FPIs from the perspective of the recipients by integrating the theoretical literature with available empirical evidence, by providing new evidence, and by putting forward new concepts. After a brief discussion of the role of capital markets in economic development, we present evidence on contribution of emerging markets towards resource allocation and mobilization and the relationship between market development and growth. Next, we provide an in-depth analysis of the developmental role of FPIs. Specifically, we discuss the various FPI contributions and present empirical evidence regarding the relationship between FPIs and market development, degree of capital market integration, cost of capital, cross-market correlation and market volatility. It is clear that the evidence on benefits of FPIs is strong, whereas the policy concerns regarding resource mobilization, market co-movements, contagion and volatility expressed by policy makers and some academics are largely unwarranted. Finally, we make some policy suggestions regarding preconditions for capital market openings, market regulation, and liberalization sequencing in the hope that they would help towards preventing future crisis