Portfolio Investments: Case for and against | Economics

Portfolio investment is that form of flow of foreign capital in which the foreign investors have only the ownership capital. The management and control of capital remains in the hands of host country. The LDC’s have developed a strong preference for the portfolio investment in view of serious dangers inherent in the foreign direct investment. The portfolio investment, in fact, signifies borrowings by a country from the other countries or the international lending institutions.

The portfolio investment or foreign loans permit the host country the freedom to control the use of foreign capital and the income generated from it. The foreign loans may be tied to a specific project or programme. The untied loans can be used by the borrowing countries for the balance of payments adjustments or some other specified purposes. The latter is required to make the repayment of loan and interest thereon as stipulated by an agreement between it and the lending country.

The portfolio investment in India rose from 4 million dollars in 1991-92 to the peak level of 3.82 billion dollars in 1994-95. In 2001-02, the portfolio investments in India stood at the level of U.S. $ 20.2 billion. Between 2003-04 and 2007-08, the inflows of the portfolio investment increased sharply from US $ 12.5 billion to US $ 27.43 billion. In the year 2010-11, portfolio investments stood at 23.8 billion dollars. The net portfolio investment declined to US $ 21.0 billion in 2013-14.

Case for Portfolio Investments:

The main arguments in support of portfolio investments are as follows:

(i) Economical:

When foreign capital is obtained in the form of foreign direct investment, the investors receive profit or return on equities. Generally the rate of return on foreign direct investment is quite high. In contrast, the rate of interest on borrowings from foreign countries or multilateral lending agencies is very low. Therefore portfolio investment is more economical from the point of view of the borrowing country.

(ii) Proper Direction of Capital:

In case of foreign direct investments, the capital utilisation is governed by the consideration of maximum possible rate of profit or return. In certain sectors or industries, the degree of risk may be high and the rate of return low. The foreign direct investments will not be forthcoming in those industries or sectors even though they require a high priority. The loans can be utilised in accordance with the economic and social priorities and it is possible to realize the goal of economic planning through portfolio investments.

(iii) Certainty about Payment:

In the case of foreign borrowings, the repayments of loans and interest thereon, have to be made at the stipulated time. There is complete certainty and definiteness about it. On the opposite, there is much uncertainty about repatriation of capital and remittance of profits in the case of foreign direct investments.

(iv) No Exploitation of Domestic Economy:

When there are foreign direct investments, the foreign entrepreneurs exploit labour, raw materials and markets of the host country for their vested interests. No such exploitation of domestic economy can be possible in case of foreign loan as the control of capital is vested in the host country.

(v) Suited for Developing Public Sector:

In LDC’s, the public sector plays a vital role in the process of economic transformation. Some of the heavy and capital goods industries, in which risk prospect is high and private domestic and foreign investment is not forthcoming, have to be started in the public sector. The capital for setting up projects in the public sector can be obtained in the form of foreign portfolio investment which is well-suited for the development of public sector.

(vi) Indigenous Management and Control:

While in case of foreign direct investments the ownership, control and management of capital remains in the hands of foreigners, the domestic investors and entrepreneurs retain the control and management of loans obtained from the foreign sources.

(vii) No Fear of Emergence of Monopolies:

The foreign direct investments often result in the concentration of industrial control in the hands of foreign entrepreneurs and consequent emergence of oligopolies or monopolies which exploit the economies of the host countries. There can be no fear of emergence of monopolies in the case of portfolio investments.

(viii) No Fear of Political Domination:

The foreign direct investments sometimes lead to the loss of autonomy in economic and political decision­ making. In the case of portfolio investment, on the opposite, the use of borrowed funds is to be made by the host country in accordance with its own priorities so that the latter retain the independence of action.

There is little possibility that the lending countries can assume economic and political dominance in the borrowing countries. However, the enforcement of conditionality’s by the lending countries and multilateral agencies for earning eligibility to secure loans and for the use of funds cannot be ruled out in this form of transfer of capital.

Case against Portfolio Investments:

The main arguments against the portfolio investments are as follows:

(i) Burden of Interest:

In case of foreign direct investment, the equity-holders receive dividends in the year when the business concerns earn profits. No dividend payments are made in the event of losses. On the contrary, the borrowing country is saddled with a continuous heavy burden of interest payment in the case of portfolio investments.

(ii) No Benefit of Advanced Technology:

When a LDC obtains direct investments from abroad, it gets the benefit of not only the foreign capital but also the latest machinery, equipment and technical know-how. In case of portfolio investments, only loans become available. The host country does not get the benefit of advanced foreign technology.

(iii) Uneconomical Use:

The direct investments invariably get employed in those activities wherefrom the maximum return is expected. On the contrary, the foreign loans are likely to be used in high-risk and low-profit sectors. Sometimes the foreign loan capital is dissipated in financing consumption or to meet defence needs. Thus the portfolio investments can be utilised in an uneconomical way. This problem can, however, be overcome if the loans are tied to specific project or programme.

(iv) Less Pressure for Domestic Resource Mobilisation:

The steady and higher rate of growth requires that developing countries should make forceful efforts towards domestic resource mobilisation for development. But when the loans from external sources can be obtained on easy terms, there is less pressure to mobilise the resources for development from within the home country. It may discourage domestic saving and investment and neutralise partly the foreign capital.

(v) Government Extravagance:

When long term funds can be raised by the government on very low rates of interest, there is fear of extravagance on the part of governments in the LDC’s. The funds may be misutilised on conspicuous consumption, construction of hotels, restaurants, sports studio etc. Such spending is likely to have adverse effect on the process of growth. There can be no such misuse of funds in the case of foreign direct investments.

(vi) Difficulty during Depression:

The foreign loans pose problem for the borrowing countries in the times of depression. As the country has low exchange earnings, the debt servicing becomes difficult. Such a situation does not arise in the case of foreign direct investments.

(vii) Reverse Capital Flow:

The loans from foreign countries and the multilateral lending institutions are supposed to supplement the resources available for financing development. The experience of India during the nineties, however, showed that there was a reverse flow of capital from India. According to the World Development Report issued by the World Bank in 1999, the disbursement of development aid to India during 1994-99 period was $ 2636 million.

The payment made by India to the lenders by way of debt servicing amounted to $ 4703 million. Thus there was a net outflow or reverse capital flow of the magnitude of $ 2067 million. Even in the 2008-09, the country experienced a net outflow of portfolio investment of the magnitude of US $ 11.3 billion. Such a situation is likely to have a very depressing effect upon the BOP situation and development process.

(viii) Influenced by Political Reasons:

The foreign loans are forthcoming in a greater measure for such countries which have a closer political alignment with the lending countries. Those countries which attempt to follow an independent political line of action are unable to get hold of foreign loan capital.

(ix) Foreign Interference:

The lending countries insist upon the particular uses of loans. They also stipulate the mode of resource mobilisation for the repayment of foreign loans. Thus the portfolio investments generally result in the interference in the economic and political policies of the borrowing countries.

Despite these shortcomings, the LDC’s have greater preference for the portfolio investments over the foreign direct investments.