The Volatility of Foreign Portfolio Investment and the Access to Finance of Small Listed Firms

• Published date: 01 August 2014
• Author: April Knill,Bong Soo Lee
• Date: 01 August 2014
• DOI: http://doi.org/10.1111/rode.12101

The Volatility of Foreign Portfolio Investment and

the Access to Finance of Small Listed Firms

April Knill and Bong Soo Lee*

Abstract

This paper examines the impact of foreign portfolio investment (FPI) volatility on the access to capital of

small listed firms. The volatility of FPI is significantly associated with decreased access to finance for small

listed firms only in years when nations are considered less “creditworthy.” Even in these times, however,

the benefits of FPI are not completely depleted. These results underscore the significance of both a good

financial system that minimizes capital flow volatility and national creditworthiness in inspiring confidence

in foreign investors.

1. Introduction

The causes of the currency crises in emerging markets during the late

1990s have been the subject of much debate—especially considering that,

before the crises, many of the Asian countries tended to have balanced

budgets and generally sound macroeconomic performance....Some

observers argue that given the generally favorable macroeconomic condi-

tion that the crises were not caused by incompatibility between fiscal and

monetary policies and exchange rate pegs, but rather by the unexpected

and self-fulfilling panics of foreign investors.

Federal Reserve Bank San Francisco: Economic Letter (2001)

The volatility of foreign portfolio investment (FPI), and not global capital flow itself,

is thought to be the limiting aspect of short-term foreign investment (Bekaert and

Harvey, 2003).1It has motivated leaders such as former Malaysian Prime Minister

Mahathir bin Mohammed to shut down country borders to foreign investment. The

extant literature contends that the volatility of capital flows can be damaging to an

economy, or that it can at least diminish the benefits derived from foreign investment

capital. Knill (2013) finds that increases in FPI can improve the access to finance of

small listed firms through a freeing up of capital when large firms access FPI directly.

If volatility of FPI increases (e.g. in times of crisis), are these benefits reduced or even

depleted? Additionally, for these small public firms who are particularly sensitive to

macroeconomic variation (Beck et al., 2005), is volatility always damaging?

* Lee: Florida State University, 251 RBB, 821 Academic Way, Tallahassee, FL 32306, USA. Tel: +1-850-

644-4713; Fax: +1-850-644-4225, E-mail: blee2@COB.fsu.edu. Knill: Florida State University, Tallahassee,

FL 32306, USA. Much of the work on this paper was completed while Knill was a doctoral student at Uni-

versity of Maryland. The authors would like to thank Vojislav Maksimovic, Lemma Senbet, Gordon Phil-

lips, Nagpurnanand Prabhala and Carmen Reinhart, Robert Marquez, Guillermo Calvo, Enrique Mendoza,

Thorsten Beck, Asli Demirgüç-Kunt, Leora Klapper, Robert Cull conference participants at the Southern

Finance Association Meetings, Infiniti Conference, and the Multinational Finance Association Meetings.

They are also grateful to an anonymous referee for his/her invaluable comments.

Review of Development Economics, 18(3), 524–542, 2014

DOI:10.1111/rode.12101

© 2014 John Wiley & Sons Ltd

This paper finds that the volatility of FPI, as defined by the standard deviation of

FPI scaled by GDP for the prior three years,2is significantly negatively associated

with small3listed firms’ access to finance only when nations are closer to crisis (i.e. less

“creditworthy”). Even in less creditworthy times, however, the positive impact of the

level of FPI on small firm access to finance surpasses the negative impact of the vola-

tility of FPI, suggesting that even in bad times, FPI remains beneficial to countries.

This result leads to policy implications supporting the allowance of this more contro-

versial capital flow.

This paper contributes to three main areas of the literature. The first is small

firm access to capital. As markets become more integrated, FPI is a potential

source of new investment capital for these financially constrained firms (Beck et al.,

2005). Information as to whether this additional source of capital for small firms

is feasible, given the information and agency environments, is useful in extending

this literature. This paper is also related to the literature on global capital flows.

As more and more countries consider reforming foreign investment policy to

enable capital market integration, this area of research becomes a resource for

many.

Lastly, this research touches on liberalization. Although not a study on liberaliza-

tion, this paper offers insight regarding the impact of FPI, a potential factor in a cou-

ntry’s investment environment. Capital market liberalization opens country borders

to foreign investment, which may ultimately broaden and deepen financial markets,

but can also open countries to the fickleness of foreign investment. Understanding

what drives the aftermath of liberalization, such as the impact of a change in FPI, may

offer insight into the debate on liberalization.

2. Weighing the Impact of Capital Flow Volatility

The Benefits of Market Integration

Research indicates that liberalization of investment regulations reduces the cost of

capital in a country through capital market integration, increases capital flows such as

FPI into the host country (Bekaert and Harvey, 2003), increases stock returns, at least

temporarily (Patro and Wald, 2005), increases the liquidity and size of markets

(Levine and Zervos, 1998), leads to an increase in the real economic growth over a

medium term (Beck et al., 2005), and decreases an economy’s capital flow depend-

ence on its current account imbalances (Kim et al., 2004). Focusing on the stock

market impact previously mentioned, the supply side of capital increases. The

increased depth of financial markets caused by the level of FPI flowing into a financial

market potentially eases the financial constraints of firms (Laeven, 2003; Harrison et

al., 2004; Knill, 2013), improves the allocation of capital (Wurgler, 2000), and is often

accompanied by improvements in the transparency of both fiscal reporting and corpo-

rate governance (Feldman and Kumar, 1995).

It is important to note that the desire of countries, and the companies domiciled

there, to “pull” (Claessens 1995). FPI into their economies motivates improvements

in corporate governance (Shinn, 2000) and investor protection/property rights

(Bekaert and Harvey, 2003).4This can lead to increased investment (Dahlquist et al.,

2003; Claessens and Laeven, 2003), triggering a cycle of investment environment

improvement. This cycle is longer term in nature and not likely to stop suddenly or

reverse based on volatility in the level of foreign investment.

VOLATILTY OF FOREIGN PORTFOLIO INVESTMENTS 525

© 2014 John Wiley & Sons Ltd