Determinants of Foreign Portfolio Flows in South Africa: Vector Error Correction Model (VECM) Analysis

Abstract

Over the past 10 years, South Africa has been increasing its reliance on portfolio flows compared to foreign direct investments in order to finance productive investments annually. Emanating from weak savings by both government and households. Portfolio flows have shown a positive upward trend which is stable. However, portfolio assets are liquid and volatile in nature. Subject to reversal because majority of portfolio holders are speculators who stand to gain from the short term movement in financial indicators. Therefore the portfolio maintenance behavior of investors is important in South Africa due to in impact on macroeconomic indicators like exchange rate, interest rate and inflation. Should risks exist, investors do not hesitate to internationally diversify their portfolio. South Africa being a small emerging economy with much potential for growth, endowed with a sophisticated financial market, but with uncertainties associated with its political transition to a mature democracy makes it an attractive destiny for foreign portfolio flows. It is for this reason that the determinants and their effect on portfolio flows are investigated. The primary task of the study was to analyse the effect of interest rate differentials on foreign portfolio flows. Furthermore, extend the investigation to include other domestic factors (market capitalisation and inflation) and global factors (world output and US inflation) using annually data from 1960 to 2016 from International Financial Statistics (IFS) and South African Reserve Bank (SARB). A VECM was conducted to analyse the short and long relationship between the economic variables and foreign portfolio flows. VECM outcome indicated that investors tend to follow higher paying assets as they search for higher yield in South Africa. Investors continue to view inflation as a risk factor because it weakens the spending power of individuals, affects asset prices, and thus generates portfolio outflows, resulting exchange rate depreciation. A well-managed economy and sustainable growth enhancing policies will attract initially short term foreign capital flows to the South African shores that will be followed by long term investment flows.