Foreign portfolio investment and market stability

Abstract

Until recently, many Asian countries including Malaysia have attracted impressively large inflows of foreign financial capital. Though inevitable as a country liberalises its capital markets and financial sector, the cost and benefits and more importantly, the ability to buffer against the potentially destabilising effects of volatile portfolio flows, have received widespread international attention following the contagion effects of the July 2 Thai baht devaluation and the spillover of Hong Kong stock market crash to the world's major markets in October this year. The 1997 East Asian financial crisis, currently being played out, is yet another episode in the history of international capital flows which show strong tendency to oscillate between boom and crisis, amplified by changes in investors' perceptions that are not fully justified by the underlying fundamentals. There is little doubt that sustained portfolio investment inflows increase the recipient country's financing capacity. However, the vagaries of the portfolio flows need not much an introduction as the Asean and East Asian economies are presently experiencing the economic consequences of a reversal.' Countries that have large stocks of foreign portfolio investment are therefore highly vulnerable to the "portfolio switching" activities of international investors moving from one market to another in search of higher gains. Evidence of the inverse relationship between total portfolio flows to Asian emerging stock markets and those in Latin America lends support to the adverse side-effects of increased integration of global capital markets. Several econometric studies have also suggested that cyclical external factors account for some 30-50% of the variation in private capital flows to developing countries.