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Foreign Investment Routes:


By Elvis Picardo, CFA | Updated January 29, 2014AAA |
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 to supply capital. Foreign direct investment (FDI) and foreign
portfolio investment (FPI) are two of the most common routes for overseas
investors to invest in an economy. FDI implies investment by foreign investors
directly in the productive assets of another nation. FPI means investing by
investors 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
Examples of FDI and FPI
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 or companies 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 as FDI. As well, 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. The cumulative figures for FPI are huge. According to the
Investment Company Institute, for the week ended December 23, 2013, domestic
equity mutual funds had inflows of $254 million, while foreign equity funds
attracted six times that amount, or $1.53 billion.
Evaluating Attractiveness for FDI / 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:
Economic factors the strength of the economy, GDP growth trends,
infrastructure, inflation, currency risk, foreign exchange controls etc.
Political factors political stability, governments business philosophy, track
record, and so on.
Incentives for foreign investors taxation levels, tax incentives, property
rights, etc.
Other factors education and skills of the labor force, business
opportunities, local competition etc.
FDI versus FPI
Although FDI and FPI are similar in that they both originate from foreign
investors, 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.
Which 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 have an advantage here in that they can exit a nation
literally with a few mouse clicks, as financial assets are highly liquid and widely
FDI and FPI Pros and Cons
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 to an economy. 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.
Recent Trends
The United States and China are the worlds biggest recipients of FDI, with China
surpassing the U.S. in this regard in 2011. The U.S. had FDI net inflows of
US$259.34 billion in 2010, while China had FDI net inflows of $243.70 billion that

year. In 2011, China surpassed the U.S. ($280.07 billion vs. $252.54 billion in
FDI) and maintained that lead in 2012 ($253.47 billion vs. 203.79 billion).
FDI as a percentage of GDP is a good indicator of a nations appeal as a longterm investment destination. Given that the Chinese economy is currently smaller
than the U.S. economy, FDI as a percentage of GDP was 3.1% for China in 2012,
compared with 1.3% for the U.S. For smaller, dynamic economies like Singapore
and Luxembourg, FDI as a percentage of GDP is significantly higher 20.6% for
Singapore (FDI of $56.65 billion in 2012) and a whopping 50.5% for Luxembourg
(FDI of $27.88 billion in 2012).
Portfolio equity flows totaled $776 billion in 2012, compared with $1.5 trillion in
total FDI for that year. The U.S. was the biggest recipient of portfolio equity in
2012, with $232 billion, followed by Ireland with $105.4 billion. China had portfolio
equity inflows of only $29.9 billion in 2012.
Cautionary Signs for Investors
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 recent example of the havoc caused by hot money outflows.
In May 2013, after Federal Reserve chairman Ben Bernanke hinted at the
possibility of winding down the Feds 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.
The Bottom Line
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.

Read more: Foreign Investment Routes: The FDI And

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