After decades of rapid growth and surges in capital inflows, East Asia faced a sudden withdrawal of capital flows and a sharp crisis in 1997-98, which brought the growth in much of that region to a screeching halt.There is a similar debate on capital inflows now after the recent crisis.
A less emphasised feature in 1997-98 was the decline in portfolio flows following the initial bank panic as investors also tried to scale down their exposures in the region. In contrast, FDI flows remained remarkably stable throughout the period. In fact, FDI inflows experienced a jump up in 1998 and 1999, likely driven by a fire-sale of assets in the region as well as greater inflows to China. In the more recent global financial crisis, the bulk of the capital withdrawals from Asia were due to portfolio capital with short-term bank reversals playing a secondary role. Once again FDI figures appear quite stable.
It is not surprising, therefore, that bank flows plus portfolio flows have been termed ‘mobile capital’ with policy focus on either trying to limit these flows via capital account restrictions or through prudential measures, or ensuring that the central bank holds enough low-yielding liquid assets (foreign exchange reserves) to cover possible sudden withdrawals.
There are many currency crisis models that conveniently explain the volatility of short-term capital flows. The essence of these models is that a relatively small initial loss of confidence can quickly translate into panic and a mass exodus of funds. In contrast, FDI is determined by long-term fundamental economic characteristics, which are more stable. Indeed, FDI is often presented as being relatively irreversible in the short-run. Since it is supposed to enhance the productive capacity of the host country, it produces the revenue stream necessary to cover future capital outflows. The above theory combined with the empirical evidence for developing countries has resulted in the conventional wisdom that switching from short-term to long-term capital flows may reduce the probability of currency crises.
But is the conventional wisdom unassailable? A potential criticism of the conventional view regarding differing degrees of stability of various capital flows is that it fails to take into account the complex interactions between FDI and other flows. Examining each flow individually, particularly during short periods of time (such as year-to-year variations), may be an unreliable indicator of the degree of risk of various classes of flow, and could even be highly misleading. Capital that flows in under the guise of FDI, could flow out under another guise. Contrary to popular belief, FDI is not quite ‘bolted down’, although the physical assets it finances are. Foreign investors can use the physical assets as collateral to obtain loans from banks and can then place the funds abroad. In other words, the foreign direct investor may hedge the firm’s FDI exposure by borrowing domestically and then taking short-term capital out of the country. Hence, a firm may be doing one thing with its assets and a different thing with the manner in which it finances them.
Actually, the distinction between portfolio and FDI flows in the balance of payments can be somewhat arbitrary. Small differences in equity ownership, which may serve to reclassify financial flows, are unlikely to represent substantially different investment horizons. This is especially relevant in view of the fact that an increasing share of FDI is in the form of M&As (that is, ownership stake of over 10%) in recent years and is usually the reason for the increase in FDI immediately after a crisis as foreign investors purchase assets on fire sales. This is an important but often overlooked point. If a foreign entity undertakes a cross-border acquisition of less than 10%, it is regarded as FDI flows. The Chinese sovereign wealth fund (SWF) purchasing a 9.9% stake in the largest US private equity firm, Blackstone Group, is an example. Therefore, this investment enters the balance of payments as FDI flows from China to the US. If the Chinese had purchased a stake of above 10%, the transaction would have been categorised as FDI. This and other investments by foreign SWFs in the US have tended in recent times to be less than 10% so that they are not categorised as FDI and therefore do not need to undergo the evaluation by Committee on Foreign Investment in the United States (CFIUS).
Given this marginal difference between the two, it is rather curious to expect the two categories of investment flows to be such different beasts. Do small differences in equity ownership represent substantially different investment horizons? A potential danger is that policy measures designed to encourage FDI (and discourage portfolio flows) may yield little gain in terms of enhanced financial stability. Given the growing interconnections between FDI and ‘mobile capital’, there is clearly a need for a deeper analysis of this issue.
The author is associate professor, School of Public Policy at George Mason University, Virginia