PRTVATE portfolio flows to developing countries have increased dramatically over the past five years and constitute a potentially large source of financing for the future development needs of these countries. But there are worries about whether flows could prove ephemeral, whether funds are being channeled to productive investment, and whether financing terms are appropriate.
Private capital flows to developing countries have tripled since 1990, to over $113 billion in 1993, their highest level since the debt crisis of the early 1980s. About half of these flows are accounted for by private portfolio investment (through bonds and equities), which reached an estimated $55.8 billion in 1993. The other half is accounted for by foreign direct investment (FDI), which has been driven by the intensified pursuit of worldwide production, sourcing, and marketing strategies by multinational corporations. FDI flows have also-increased in response to the market potential offered by rising developing country incomes, liberalization in trade and investment regimes in these countries, and the telecommunications technology revolution.
As for private portfolio flows, investors have been highly selective: since 1989, more than half the flows have gone to Latin America, and five countries (Argentina, Brazil, Korea, Mexico, and Turkey) accounted for two thirds of the flows.
This dramatic increase reflects a number of developments. These include better economic “fundamentals” and growth prospects, large-scale privatization of enterprises in certain countries, opening up of equity markets to foreigners, favorable interest and equity return differentials with industrial countries, increased globalization of capital markets, and a structural shift to the private sector of the burden of generating economic growth.
The composition of capital flows to developing countries has changed over the past 20 years. In the 1970s, external financing to developing countries was channeled primarily from foreign commercial banks to governments. By the early 1980s, many countries were facing large external debts and tight external financing constraints, which led eventually to serve debt-servicing difficulties. Private financing to developing country governments all but dried up, and potential investors remained wary of lending to private borrowers in those countries. In contrast, with the recent improvement in the macroeconomic situation and the investment and regulatory climate in many developing countries, most of the financing flows in the 1990s have been extended by private lenders to private borrowers, and the source of this financing has largely shifted from banks to nonbanks through increased portfolio and direct foreign investment.
These developments hold out the promise of increased investment and growth for the recipient countries but, at the same time, raise a number of important questions: Can portfolio flows contribute in a substantive, sustained way to the financing needs of developing countries? Are the maturities and cost of funds well suited to long-term development, and are the funds being channeled to productive uses? Are new kinds of financial instruments desirable and likely to be developed? Could portfolio flows destabilize economies, and, if so, can destabilization be averted? How can the enthusiasm of industrial country investors, which is now aimed at a select number of emerging markets, be directed to a wider range of developing countries?
How big are the flows?
At the beginning of the 1990s, private international capital flows were at an all time high. Gross portfolio flows increased from about $7.5 billion in 1989 to about $55.8 billion in 1993, primarily in the form of debt instruments (bonds, certificates of deposit, and commercial paper), which rose from $4 billion in 1989 to $42.6 billion in 1993 (see charts). Although some of this represented the return to the Euro-bond markets of public sector borrowers (e.g., Czech Republic, Hungary, and Turkey) the bulk of the funds were private-to-private flows.
Investment in equities also rose, more than tripling during 1989–93 to $13.2 billion, mainly in connection with large-scale privatization programs carried out in a few Latin American countries. This growth in also reflected a sizable increase in flows to the East Asia and Pacific region, explained in part by the opening up of the equity markets in these areas to foreigners. For example, in China, firms started to list stocks on the Hong Kong exchange, and Korea has relaxed restrictions on foreign ownership.
Inflows and privatization
Foreign investors have participated in large privatization programs, especially in Latin America, through equity portfolio investment. In July 1990, Chile was the first developing country to use American Depository Receipts (ADRs) ($98 million issued in the New York Stock Exchange) for the sale of Teléfonos de Chile. In 1991, Argentina issued $364 million in Global Depository Receipts (GDRs) for the privatization of Telefónica de Argentina (see box). To date, the largest international equity issue by a developing country in conjunction with a privatization program was a $3 billion ADR issue by the Argentine state oil company, in June 1993.
Portfolio flows to developing countries have increased dramatically
P = Projected.
Source: World Bank, World Debt Tables, 1993–94.
There is also evidence that foreigners have made direct purchases of equity in newly privatized enterprises. According to the World Bank, 21 direct equity purchases were recorded during 1988–92 for a cumulative total of $4 billion, or 8.5 percent of total privatization revenues for developing countries and almost 28 percent of total foreign exchange inflows resulting from privatization transactions. Equity portfolio investment has thus proved to be attractive for directly mobilizing foreign financing for large-scale privatizations as well as indirectly through follow-up equity issues by recently privatized enterprises.
A break with the past?
There are reasons to believe, at least for those developing countries with more sophisticated capital markets and a strong track record of economic reform, that foreign portfolio flows may become a reliable source of private sector financing over the coming years.
Diversifying sources and instruments. The sources of flows to developing countries (initially associated with the return of flight capital) have greatly expanded in the last few years. The flows now come from a variety of investors: managed funds, institutional investors (e.g., pension funds and life insurance companies), performance-oriented securities traders, and the nonresident citizens of the countries concerned. This diversity lessens the risk of a sudden and simultaneous drying up of flows, as happened in the past with commercial bank loans. Borrowing instruments have also become both more diverse and more sophisticated, implying that the future needs of developing country markets will be adequately served because financing instruments can be more closely tailored to borrowers’ needs. Foreign investors may be able to provide financing instruments that are unavailable in developing countries’ domestic capital markets. Many financial instruments can also be “synthesized” from existing instruments, which include equities, ADRs, country funds (a type of investment fund specializing in portfolio investment in one or more countries), convertible bonds, warrants, commercial paper, certificates of deposit, bonds with put and call options, floating-rate notes, and local currency instruments.
Greater risk bearing. Risk bearing by investors has increased since the 1970s, especially through investment in stocks. Unlike traditional commercial bank lending, investment in equities has the advantage of effectively matching “debt-service payments,” or dividends, with ability to pay. Furthermore, foreign investors will have an incentive to monitor the investment because they will have a real stake in the fortunes of the company as well as in the country concerned. Large equity investment may also benefit the recipient country by introducing technology transfer, management know-how, and access to export markets, all of which will improve the long-term sustainability of private capital flows.
Other benefits. As emerging markets integrate with the global economy, the cost of capital is expected to decline. For example, the increased use by Argentine entities of international capital markets has been associated with lower interest rate spreads for these borrowers. Today’s portfolio flows are expected to generate efficiency gains. In contrast with the 1970s, most of the portfolio flows now go to private borrowers who are subject to market discipline. Thus, funds are more likely to be channeled to those who are best placed to increase growth-generating, productive investment.
“Although concerns about unstable portfolio flows have not been dispelled, some observers argue that they are overstated.”
Beyond these direct gains, there are the long-term benefits of increased market-oriented flows. A well-functioning stock market should result in better resource mobilization and allocation. Indeed, country funds can improve pricing efficiency in local capital markets and help local firms mobilize domestic capital at lower costs.
But there are risks
Private-to-private flows do entail some risk because of their nature and the sheer magnitude of the flows. In addition, the maturities may be inappropriate for long-term project financing and the flows do not appear to be reaching “second-tier” borrowers, who may not have good access to domestic financing sources either.
Sustainability. Increased financial integration brings both opportunities for higher investment and growth and challenges of macroeconomic management. Because the flows are a relatively recent phenomenon, there are concerns that they could be reversed easily. (See “Surges in Capital Inflows: Boon or Curse?,” by Susan Schadler, Finance & Development, March 1994.) Whether these portfolio flows will continue in the long run depends crucially on (1) whether a stable macroeconomic environment is maintained; (2) how they are being used—for consumption (less sustainable) or domestic investment (more sustainable); (3) whether they lead to rapid export growth so as to improve future repayment capacity; and (4) whether a stable, investor-friendly economic and political environment is maintained over the long term.
Although concerns about unstable portfolio flows have not been dispelled, some observers argue that they are overstated. For example, empirical evidence shows that, although US transactions in emerging market equities are more volatile than those in other foreign equities, the volatility has been declining. Volatility of domestic stock prices has also been shown to decrease soon after market opening as more information becomes available to outside investors. Concerns about the instability of short-term flows may be similarly unwarranted. Many analysts feel that volatility associated with a particular type of capital inflow is more likely to be generated by changes in the institutional structure of a country’s financial markets than by the characteristics of any particular flow. This view is supported by studies that indicate that long-term flows are often as unpredictable as short-term flows (see reference).
Nor does the fact that these flows are mostly short term imply that they do not benefit the recipient country. The experience of the 1970s shows that although most flows were then long term, they did not benefit the country. Today, because these flows go to the private sector, they are more likely to benefit the country.
Suitability of instruments. Interest rates on foreign borrowing may be attractive (partly as a result of low international interest rates), but the maturities of most bonds and money market instruments are too short to match the financing needs of many developing country projects. Although the average maturity of new bond issues by developing countries rose from about three years to five years in 1989–92, it remains much shorter than the long-term horizon of most development projects. Greater involvement of institutional investors with longer investment horizons may, over time, alleviate this mismatch.
Lending too concentrated. Private portfolio flows have mainly been directed to a few middle-income countries in East Asia and Latin America, China, and, more recently, India. In 1993, over 80 percent of the portfolio flows through bonds to Latin America were directed to Argentina, Brazil, and Mexico (accounting for about 40 percent of the total to developing countries). In the same year, over 80 percent of bond flows to Asia went to China, Korea, and Thailand. Equity flows were similarly concentrated in 1993, with 75 percent of those going to Latin America directed to Argentina and Mexico alone and 85 percent of those to Asia directed to China and Korea alone.
A portion of these portfolio flows, representing a vote of confidence from investors, is going to those countries that have registered sustained progress since the debt crisis of the 1980s (with improved macroeconomic management, large privatization programs, price liberalization, and institutional reforms in the domestic capital markets). These efforts have contributed to economic stability and are expected to yield high economic growth rates, and, in turn, high returns to investors in the long run.
Portfolio flows are also going to countries in which investors expect to make high short-term returns as they seek to take advantage of temporary profit opportunities that may arise from inconsistent macroeconomic policies. In these countries, interest rates are high as a result of the tensions created by a tight monetary policy pursued in conjunction with loose fiscal policy and doubts about the credibility of government policies. Portfolio flows that are motivated by “good” economic fundamentals in an environment characterized by consistent macroeconomic policies should be more sustainable than those motivated by inappropriate policies and a lack of progress in structural reforms.
What countries can do
To continue to attract portfolio flows, developing countries need to provide a favorable macroeconomic and regulatory climate for investors. At the macroeconomic level, this means pursuing sound financial policies and correcting structural problems, such as excessive government intervention, labor market distortions, and inefficient tax and trade policies. Sound domestic policies are also important to mitigate the appreciation of the real exchange rate that often accompanies large capital inflows.
At the sectoral level, governments need to establish an appropriate institutional framework to channel the increased flows. The choice of intermediary—the banking system or the stock market—is pivotal because the intermediary affects the final uses of the funds and the possible negative effects on the economy when funds are withdrawn. In addition, many countries need to improve prudential and supervisory functions as well as government regulation of the financial sector. Others, particularly in Eastern Europe, may have to create financial structures from scratch. In general, countries can benefit from the portfolio inflows only if they have a healthy and properly regulated banking system.
As countries get the macroeconomic fundamentals right, the amount of portfolio flows and consequent benefit—a lower cost of capital—will increasingly depend on whether they have their microeconomic fundamentals right too: few regulatory barriers, proper taxation, and ease of access by foreign investors.
Foremost, they need to continue lowering barriers to portfolio investment—legal hurdles, poor credit ratings, high and variable inflation, limits on the size of emerging stock markets, the absence of a solid regulatory and accounting framework and investor protection, inadequate clearing and settlement procedures, lack of modern communications, and too few country funds or internationally listed securities. Empirical evidence shows that these barriers raise the risk-adjusted cost of capital. Some barriers—for example, poor credit ratings—obviously cannot be removed overnight. In addition, portfolio flows to developing countries depend not only on domestic regulations but also on industrial country regulations. Thus, developing countries can benefit only if industrial countries relax some of the uneconomic and severe restrictions on the composition of assets that pension funds and other institutional investors can hold abroad.
Some domestic barriers can be removed fairly easily, and developing countries should concentrate on these. They can, for example, harmonize the taxation of capital gains and dividends with that in industrial countries. Empirical evidence indicates that taxes that are not thus harmonized raise the risk-adjusted cost of capital in developing countries. Developing countries can also adopt investor safeguards relatively easily, especially if they rely on regulations adopted and enforced by market participants.
The action that would bring the most immediate results would be to reduce restrictions on access by foreigners (e.g., ownership restrictions, remittance restrictions, other foreign exchange restrictions, and restrictions on capital structure) so as to lower the cost of capital in these markets. Many developing countries have initially allowed only restricted access, for example, by limiting foreign ownership. Such access barriers are an important component of overall barriers and have a negative effect on stock performance.
To date, foreigners have been allowed to purchase stocks irrespective of risk properties. However, allowing them to buy “blue-chip” firms (firms that are already transnationals) does not significantly decrease the cost of capital for the firm itself and has few positive spillover effects on the rest of the market. In contrast, in the case of stocks of small and medium-size firms, foreign investment can lead to a sharing of some of the risk and can lower the risk-adjusted cost of capital for these firms.
The prospects for continued, substantial portfolio flows to developing countries are favorable. Emerging markets generally offer good economic performance and, because they are still underweighted in the portfolios of industrial country investors, they are likely to continue to attract investors for some time to come.
It must be recognized, however, that some of these private flows can be volatile, that their volume to some countries is unlikely to be maintained at prevailing levels, and that they can place upward pressure on exchange rates and thus erode export competitiveness. There is also a risk of a reversal of these inflows if investment conditions in industrial countries become more favorable. Sustaining these private capital flows in the long term calls for maintaining a stable economy and an investor-friendly environment where developing country exports continue to grow rapidly.
American Depository Receipts (ADRs) are equity-based financial securities that are denominated in US dollars. They are publicly traded in the US securities exchanges (NYSE, AMEX, NASDAQ) and are backed by a trust containing shares of non-US corporations. Global Depository Receipts (GDRs) are similar to ADRs except that they are offered in the US private placement market (under SEC Rule 144A) as well as in stock markets other than in the United States. GDRs can be traded in several currencies.
This article draws on papers presented at a conference held in Washington in September 1993. The proceedings are provided in Portfolio Investment in Developing Countries, by Stijn Claessens, Michael Dooley, and Andrew Warner, in Claessens and Gooptu (editors) World Bank Discussion Paper No. 228, December 1993, available from the World Bank.