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And Foreign Portfolio Investment (FPI) UNCTAD/GDS/DFSB/5 23 June 1999 ENGLISH ONLY UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT Comprehensive Study of the Interrelationship between Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI) A staff paper prepared by the UNCTAD secretariat* __________ *This document has been reproduced without formal editing. 2 Table of contents Introduction ...............................................................3 Chapter I. Statistical issues: ...................................................3 A. Definition ........................................................4 B. Sources of data: ....................................................5 a) Host country capital flows data ..................................5 b) Mutual fund asset values .......................................7 c) Source country data on cross-border investment .....................8 C. Relative importance of FDI and FPI ....................................9 Appendix to Chapter I ................................................13 Chapter II. Determinants and development impact: ...............................15 A. Determinants .....................................................15 1.FDI determinants .............................................15 2.FPI determinants .............................................16 B. Development impact: ..............................................22 1. Role of FDI ................................................23 2. Role of FPI .................................................24 3. Volatility ..................................................24 Appendix to Chapter II ...............................................29 Chapter III. Policy implications ...............................................33 A. Foreign portfolio investment and investment agreements ..................33 B. Measures to control volatility ........................................37 C. Access to capital markets ...........................................38 Conclusions ..............................................................43 3 INTRODUCTION The pattern of capital flows to developing countries and countries in transition in the 1990s has two salient features: private flows are the major sources of capital, with FDI and FPI being the dominant components, and flows have become more subject to sharp boom-and-bust swings. The globalization of capital can bring benefits but is also full of risks. Developing countries and countries in transition are facing a policy dilemma between the need to attract external sources of finance for development, including short term finance, and the need to be selective in the types of finance in order to reduce the likely negative impact resulting from the volatility of flows. This report will analyze in detail some of the issues related to the globalization of capital, which have been raised in a companion paper.1 The purpose is to provide detailed information and analysis on new investment trends and to draw some policy conclusions, as a contribution to the current debate on the policy regimes on foreign investment. Against the background of recurrent financial crises in emerging markets, triggered by volatile short term capital flows, ongoing discussion in various forums is focusing on the appropriate speed and framework for further liberalization of investment regimes. In this context, it is felt that policy deliberations could be guided by a better understanding of the specific attributes of different types of flows, in particular foreign direct investment (FDI) and foreign portfolio investment (FPI), their characteristics, determinants and contribution to development. A first chapter will consider statistical problems related to the questions of definition, sources of data and analysis of the relative importance of the two major investment flows for developing countries. In a second chapter, a comparative analysis will be undertaken on the determinants of FDI and FPI and their likely impact on development. Policy implications for handling capital flows and foreign investment regimes will also be discussed. CHAPTER I STATISTICAL ISSUES It is important to have an accurate statistical reporting of different types of investment flows for analytical and policy-making purposes. A clear classification of different types of investment would help in this reporting: international institutions, such as the International Monetary Fund and the OECD, have developed guidelines and methodologies for such classification. The application of such methodologies in practice is not without problems. 1See Note by the UNCTAD secretariat: “Foreign Portfolio investment (FPI) and Foreign Direct Investment (FDI): Characteristics, similarities, complementarities and differences, policy implications and development impact”, TD/B/COM.2/EM.6/2, 15 April 1999. 4 A. Definition of direct and portfolio investment (a) Direct investment is the category of international investment in which a resident entity in one country obtains a lasting interest in an enterprise resident in another country. A lasting interest implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence by the investor on the management of the enterprise. The criteria used to distinguish direct investment from other types of investment is that “a direct investment is established when a resident in one economy owns 10 percent or more of the ordinary shares or voting power, for an incorporated enterprise, or the equivalent, for an unincorporated enterprise”2. All subsequent transactions between affiliated enterprises, both incorporated and unincorporated, are also classified as direct investment transactions. Direct investment is divided into equity capital, reinvested earnings, and other capital. C Equity capital comprises equity in branches, all shares in subsidiaries and associates3 (except nonparticipating, preferred shares that are treated as debt securities), and other capital contributions. Reverse investment or cross-participation transactions4 are recorded as direct investment claims and liabilities. C Reinvested earnings consist of the direct investor’s share of earnings not distributed as dividends by subsidiaries or associates and earnings of branches not remitted to the direct investor. C Other direct investment capital (or intercompany debt transactions) covers the borrowing and lending of funds between direct investors and subsidiaries, branches, and associates. (b) Portfolio investment includes investments by a resident entity in one country in the equity and debt securities of an enterprise resident in another country which seek primarily capital gains and do not necessarily reflect a significant and lasting interest in the enterprise. The category includes investments in bonds, notes, money market instruments and financial derivatives other than those included under direct investment, or in other words, investments which are both below the ten per cent rule and do not involve affiliated enterprises. In addition to securities issued by enterprises, foreigners can also purchase sovereign bonds issued by governments. According to the IMF’s 1996 Coordinated Portfolio Investment Survey Guide the essential characteristic of instruments classified as portfolio instruments is that they are traded or tradable. 2This is the definition of FDI utilized in the IMF 1993 (fifth edition) Balance of Payments Manual and that of the OECD’s 1992 (2nd edition) Detailed Benchmark Definition of Foreign Direct Investment. Although the 10 per cent criterion is specified by the IMF and OECD, a survey conducted jointly by these institutions on foreign direct investment statistics in 1997 indicated that about three-fourths of the 96 OECD and non-OECD respondent countries analyzed in the survey applied the 10 per cent rule. Many countries do not use a predetermined threshold and many non-OECD countries rely on investment approval authorities for the collection of their FDI statistics. See “Foreign Direct Investment: Survey of Implementation of Methodological Standards”, Financial Market Trends, OECD, November 1998. 3 Direct investment enterprises comprise those entities that are subsidiaries (a nonresident investor owns more than 50 percent), associates (an investor owns 50 percent or less) and branches (wholly or jointly owned unincorporated enterprises) either directly or indirectly owned by the direct investor. 4 For example, a subsidiary can have an interest in its parent company. 5 C Equity securities have been defined in the Survey as instruments and records acknowledging, after the claims of all creditors have been met, claims to the residual values of incorporated enterprises (shares, stocks, participation, American deposit receipts (ADRs), mutual funds, and investment trusts). C Debt securities include bonds and notes, money market securities (instruments such as treasury bills, commercial and finance paper, negotiable certificates of deposit with maturities of one year or less), and financial derivatives or secondary instruments, such as options. However, in the survey no guidelines or definitions were given for the recording of money market instruments and financial derivatives. B. Sources of data There exist different sources of data on cross-border investments which widely differ among themselves, according to the methodologies used. In practice, recording of portfolio investment flows can be inaccurate because of the various types of investments involved, which are channeled through various
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