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Capital is a vital ingredient for economic growth, but since most nations cannot meet their total capital requirements from internal resources alone, they turn to foreign investors. Foreign direct investment (FDI) and foreign portfolio investment (FPI) are two of the most common routes for investors to invest in an overseas economy. FDI implies investment by foreign investors directly in the productive assets of another nation.
FPI means investing in financial assets, such as stocks and bonds of entities located in another country. FDI and FPI are similar in some respects but very different in others. As retail investors increasingly invest overseas, they should be clearly aware of the differences between FDI and FPI, since nations with a high level of FPI can encounter heightened market volatility and currency turmoil during times of uncertainty.
Imagine that you are a multi-millionaire based in the U.S. and are looking for your next investment opportunity. You are trying to decide between (a) acquiring a company that makes industrial machinery, and (b) buying a large stake in a company that makes such machinery. The former is an example of direct investment, while the latter is an example of portfolio investment.
Now, if the machinery maker were located in a foreign jurisdiction, say Mexico, and if you did invest in it, your investment would be considered an FDI. If the companies whose shares you were considering buying were also located in Mexico, your purchase of such stock or their American Depositary Receipts (ADRs) would be regarded as FPI.
Although FDI is generally restricted to large players who can afford to invest directly overseas, the average investor is quite likely to be involved in FPI, knowingly or unknowingly. Every time you buy foreign stocks or bonds, either directly or through ADRs, mutual funds, or exchange-traded funds, you are engaged in FPI.
Because capital is always in short supply and is highly mobile, foreign investors have standard criteria when evaluating the desirability of an overseas destination for FDI and FPI, which include:
Although FDI and FPI are similar in that they both involve foreign investment, there are some very fundamental differences between the two.
The first difference arises in the degree of control exercised by the foreign investor. FDI investors typically take controlling positions in domestic firms or joint ventures and are actively involved in their management. FPI investors, on the other hand, are generally passive investors who are not actively involved in the day-to-day operations and strategic plans of domestic companies, even if they have a controlling interest in them.
The second difference is that FDI investors perforce have to take a long-term approach to their investments since it can take years from the planning stage to project implementation. On the other hand, FPI investors may profess to be in for the long haul but often have a much shorter investment horizon, especially when the local economy encounters some turbulence.
This brings us to the final point. FDI investors cannot easily liquidate their assets and depart from a nation, since such assets may be very large and quite illiquid. FPI investors can exit a nation literally with a few mouse clicks, as financial assets are highly liquid and widely traded.
FDI and FPI are both important sources of funding for most economies. Foreign capital can be used to develop infrastructure, set up manufacturing facilities and service hubs, and invest in other productive assets such as machinery and equipment, which contributes to economic growth and stimulates employment.
However, FDI is obviously the route preferred by most nations for attracting foreign investment, since it is much more stable than FPI and signals long-lasting commitment. But for an economy that is just opening up, meaningful amounts of FDI may only result once overseas investors have confidence in its long-term prospects and the ability of the local government.
Though FPI is desirable as a source of investment capital, it tends to have a much higher degree of volatility than FPI. In fact, FPI is often referred to as “hot money” because of its tendency to flee at the first signs of trouble in an economy. These massive portfolio flows can exacerbate economic problems during periods of uncertainty.
As of 2020, China is the leading FDI recipient worldwide having brought in $163 billion in inflows, compared to the $134 billion attracted by the United States. This number is a significant change from 2019 when the United States had $251 billion in inflows while China received $140 billion.
FDI as a percentage of gross domestic product (GDP) is a good indicator of a nation’s appeal as a long-term investment destination. The Chinese economy is currently smaller than the U.S. economy, but FDI as a percentage of GDP is 1.31% for China as of 2019, compared with a slightly higher 1.64% for the U.S. For smaller, dynamic economies like Singapore or Cyprus, FDI as a percentage of GDP is significantly higher: 32.17% for Singapore and a whopping 103.93% for Cyprus (the highest value as of 2019).
Investors should be cautious about investing heavily in nations with high levels of FPI, and deteriorating economic fundamentals. Financial uncertainty can cause foreign investors to head for the exits, with this capital flight putting downward pressure on the domestic currency and leading to economic instability.
The Asian Crisis of 1997 remains the textbook example of such a situation. The plunge in currencies like the Indian rupee and Indonesian rupiah in the summer of 2013 is another example of the havoc caused by “hot money” outflows. In May 2013, after Federal Reserve Chair Ben Bernanke hinted at the possibility of winding down the Fed’s massive bond-buying program, foreign investors began closing out their positions in emerging markets, since the era of near-zero interest rates (the source of cheap money) appeared to be coming to an end.
Foreign portfolio managers first focused on nations like India and Indonesia, which were perceived to be more vulnerable because of their widening current account deficits and high inflation. As this hot money flowed out, the rupee sank to record lows against the U.S. dollar, forcing the Reserve Bank of India to step in and defend the currency. Although the rupee had recovered to some extent by year-end, its steep depreciation in 2013 substantially eroded returns for foreign investors who had invested in Indian financial assets.
While FDI and FPI can be sources of much-needed capital for an economy, FPI is much more volatile, and this volatility can aggravate economic problems during uncertain times. Since this volatility can have a significant negative impact on their investment portfolios, retail investors should familiarize themselves with the differences between these two key sources of foreign investment.