What’s it: Foreign portfolio investment refers to short-term investment in financial instruments (such as stocks and bonds) in another country. For example, US investors buy Indonesian government bonds or shares on the Indonesia Stock Exchange. For purchases on the stock market, this investment does not give the investor direct control and ownership of the company’s assets.
Together with foreign direct investment, portfolio investment is one of the common ways to invest abroad. For destination countries, both are sources of loanable funds, which are important for increasing their productive capacity.
In national accounting, foreign portfolio investment is a component of capital transactions in the balance of payments. The balance of payments shows the amount of money flowing in and out of a country during a specific period, usually quarterly or one year. It consists of two current accounts and capital accounts.
Example of foreign portfolio investment
Portfolio investment involves buying securities in the capital market. Suppose a US investor buys shares of a company on the Indonesia Stock Exchange. In that case, that is an example of foreign portfolio investment. Such investments are to get returns immediately, either from capital gains, dividends, or coupons.
Securities can vary between countries and depend on how developed the capital market is in each country. In Indonesia, for example, the capital market is relatively underdeveloped, so there are relatively few types of instruments.
In Indonesia, the favorites of foreign investors are government debt securities and stocks because they are liquid. Their ownership in both instruments is more than 20%. Meanwhile, foreign investment in alternative instruments such as mutual funds, ETFs, and corporate bonds is relatively small.
When foreign investors buy Indonesian government debt securities, they expect to get returns in capital gains and coupons. Meanwhile, when they buy stocks, they expect to get capital gains and dividends.
Because it involves two different currencies, foreign investment also involves exchange rate risk, which affects the realized returns.
Foreign portfolio investment characteristics and its difference to foreign direct investment
Foreign portfolio investment can come from individuals, companies, or even governments of other countries. Apart from gaining returns, investing is also a way for foreign investors to diversify their portfolios in international financial markets.
Foreign portfolio investment is different from foreign direct investment, both in terms of investment horizon, liquidity, control, risk, and required capital.
Not actively exercising control over investment
For example, when buying company stock, foreign investors do not have direct control over the business. They are not involved in company management. It differs from direct investment, which allows them to control the company’s operations by being the controlling shareholder.
The market involves many investors who make trades. Thus, the activity of buying and selling securities is also high. When it comes to selling securities, investors can easily find buyers. Likewise, when looking for a seller, they can quickly find it.
But remember, liquidity varies between instruments and between countries.
Short term oriented
Foreign investors can exit the market at any time. When they have achieved the target return, they divert investment to other countries. They also come out when foreign markets offer more attractive returns than markets in the first country.
Likewise, when a country’s economic fundamentals deteriorate, they can quickly leave. Therefore, portfolio investment is considered hot money because it is susceptible to sudden outflow in response to domestic and global sentiment.
On the other hand, foreign investment is long-term oriented. That may involve setting up new businesses, building production facilities, and offices.
That is why destination countries usually prefer foreign direct investment to portfolio investment. Apart from being less prone to sudden reversals, direct investment contributes to the destination country’s welfare by creating more jobs and income.
Losses on portfolio investment come primarily from movements in prices and exchange rates. This differs from direct investment, where investors also bear the risks inherent in business operations and performance.
Portfolio investing requires less investment capital and research. For example, in investing in stocks, they buy a fraction of the outstanding shares (less than 10%).
On the other hand, under direct investment, they have to buy a large portion of the company’s stock to gain control. Therefore, direct investment involves significant money. For this reason, investments usually come from multinational companies or venture capital firms.
Factors affecting foreign portfolio investment
Main considered factors when buying securities in other countries are:
- Economic growth prospects. Foreign investors seek to take benefit from economic prosperity in the destination country. And, they tend to withdraw their investment during periods of the weak economy, such as recessions.
- Sovereign risk. The high risk reflects the high chance of default by the government to pay back its debts. To measure it, foreign investors usually use sovereign ratings to decide the weight and allocation of investment in several countries, especially in the bond market.
- Interest rate. Foreign lenders prefer countries with high-interest rates because they offer high returns.
- Tax rates. High tax rates reduce returns realized from capital gains, dividends, or interest. Therefore, foreign investors usually choose to invest in countries where taxes are low.
- Exchange rate. Exchange rate movements expose translation risk because foreign investment involves two different currencies, the destination country’s currency and the currency of operation. Exchange rates sometimes generate translation gains and, at other times, generate losses. Also, an excessively volatile exchange rate increases uncertainty, reducing investors’ interest in investing.
Advantages of foreign portfolio investment
Portfolio investment offers some benefits, including a source of loanable funds in destination countries and portfolio diversification by foreign investors.
Source of supply of loanable funds
For example, when a foreign investor buys corporate bonds, the company can use them to fund business expansion. Likewise, with government bonds, the government can use them to finance infrastructure.
Foreign investment is increasingly important when saving rates, financial literacy, and access to capital markets in the destination countries are low. It is a catalyst for economic growth and an increase in the productive capacity of the economy.
The capital market provides foreign investors with a reasonably simple way to diversify their portfolios in international markets. They can optimize between risk and return on investment.
Exchange rate translation gains
Potential investors to benefit from exchange rate movements. It becomes a source of returns other than capital gains, coupons, or dividends. When the destination country’s currency appreciates against foreign investors’ functional currency, they profit when realizing capital gains or dividends.
Say, the rupiah exchange rate against the U.S. dollar strengthens. When US investors realize and translate rupiah capital gains into US dollars, they get more US dollars.
However, the opposite effect also applies. When the rupiah exchange rate against the U.S. dollar depreciates, US investors earn less when translating capital gains.
Disadvantages of foreign portfolio investment
Foreign portfolio investment also carries some risks for both foreign investors and destination countries. For destination countries, this type of investment is more prone to reversals because it is short-term oriented. They quickly exit the market when the economy shows signs of weakness. They are also likely to exit when they find a country that offers higher returns.
Foreign capital outflow causes exchange rate depreciation. It can destabilize an economy when it occurs on a sudden and massive scale. For this reason, some countries still adopt restrictions on capital outflows.
Other disadvantages of foreign portfolio investment are:
- Vulnerable to short-term movements of exchange rates. It dramatically affects the income from investment and the total value of the foreign portfolio.
- Political risk exposure. Changes in the political environment affect investment norms, economic policies, and investment in the destination country.
- Low liquidity. Although offering high potential returns, capital market liquidity in developing countries tends to be low, resulting in high price volatility.