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The Current State and Determinants of Foreign Portfolio Investment[17-08]
Author(s)
Hansoo Kim
The date
05 April 2017
Publications
Capital and Financial Markets
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Recently, foreign portfolio investment has increased at a rapid pace. As compared to 2001, outstanding portfolio investment quadrupled to $48.5 trillion in 2014 to account for about 62% of global GDP. High-income, developed countries form major investor countries as high-income OECD member nations hold over 90% of portfolio investment. Those countries also are popular destinations of portfolio investment. About 86% of outstanding portfolio investment is held in assets in high-income economies, whereas emerging markets account for a low, albeit recently increasing, proportion.
As of the end of 2014, outstanding portfolio investment in equity securities is estimated to reach $22 trillion, about 46% of total outstanding portfolio investment. Foreign portfolio investment in equities has grown rapidly at a CAGR of 11% since 2001, with the growth being more evident among high-income, developed countries. Meanwhile, a bias toward home equities has been observed everywhere. Whereas European investors tend to show a low home bias, Japan and Korea are found to have a higher home bias.
Korea’s outward portfolio investment has been growing more rapidly than that of developed countries. As of the end of 2015, outstanding portfolio investment by investors resident in Korea stood at $235.9 billion, over a 30-fold increase from the 2001 level. Since the global financial crisis, the public sector has led the expansion of Korean residents’ portfolio investment. As of 2014, almost 68% of Korea’s international equity investment was held by the public sector such as pension funds, whereas the private sector’s portfolio investment has dwindled significantly since the global financial crisis. It is found that about 68% of portfolio investment by Korean residents is allocated in high-income regions, with a relatively high share being invested in the US and China.
Such a geographical pattern in portfolio investment demonstrates that friction factors across economies still linger despite the rapid progress in globalization. By analyzing the determinant of international equity investment, this study explored what factors could explain international equity investment. For empirical analysis, I first estimated the gravity model with variables used as a proxy for information and transaction costs in the existing literature to find out whether those variables remain significant in our extended global sample. Then, the impacts the innate nature of investor and investee countries have on international equity investment were estimated, with the focus on structural factors such as population ageing, growing pension funds, etc. Also analyzed was the determinant of risk diversification, one of the important positive functions of international equity investment. Lastly, I explored how those determinants are different across regions and countries.
Similar to the existing literature, the global sample used in this study revealed that the major determinants to international equity investment, such as such as economic, social, and cultural correlations between investor and investee countries, their financial market openness and liquidity, investment returns and risk diversification in investment destinations, etc., hold a statistical significance and move in the same direction as expected. Moreover, it was estimated that the demographic structure and the share of pension fund assets in investor countries are important factors behind foreign portfolio investment. This suggests an expansion of international equity investment by Korea, currently facing a rapid progress in population ageing and pension fund growth.
It was found in the regional sample that determinants of foreign portfolio investment have differences in their statistical significance and direction across investor countries’ income levels and geographical locations. Especially, international equity investment for the purpose of risk diversification was found only in high-income regions and major developed countries, whereas, contrary to expectations, the risk diversification factor appeared to have a positive correlation in some low-income regions.
Korea’s fast increase in international equity investment is expected to continue going forward. Accordingly, Korea should take the followings into account so as to fully realizing the benefits of international equity investment in the long run. First, it is necessary to induce private sector investors to hold international equity investment for a longer term. Investing in international equities seeking short-term profits could lead to a herding toward a specific region, which appears to undermine the intended effect of risk diversification among Korean investors. This requires any policy effort related to foreign portfolio investment to induce a long-term, well-diversified investment.
As Korea’s recent growth in international equity investment has been driven by the public sector, policy measures are necessary to leverage the growth to improve private sector capabilities for foreign portfolio investment. In this regard, it is worth considering the case of Singapore’s sovereign wealth fund selects an overseas external manager under the condition that the external manager employees Singaporean staff, with the aim to nurture private sector capabilities. Improving capabilities of private sector financial institutions is not only an important precondition to the growth of portfolio investment, but also a crucial element helping realize the positive function of risk diversification via international equity investment. Hence, it appears that the government should facilitate international equity investment seeking to simultaneously achieve the dual goals of capability improvement in domestic financial institutions and advancement in the financial markets.
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