Determinants of FPI in Developed and Developing Countries

Abstract

The pattern of capital inflows in developed and developing economies are different because of dissimilar economic and political structures. From the point of view of host country, especially the developing countries, portfolio flows are considered to play a pivotal role in bridging the saving investment gap and providing foreign exchange to finance current account deficit. While the investors of developed country invest in portfolios of different countries to diversify the risk and earn more returns, foreign portfolio investors generally go for short-term investment to reap the benefits of good economic conditions and they tend to withdraw their investments during the period of recession. This article identifies the determinants of foreign portfolio investment (FPI) in developed and developing economies. Though the movement of capital among different countries is researched in depth by existing literature, the present study adds to literature by identifying the institutional factor involving freedom index. The institutional factors aid in identifying the determinants of FPI among select developed and developing countries. This study seeks to answer, where the funds of foreign portfolio investors are headed. And also the reasons of attractiveness for FPI among different sets of countries. The sample of the study is limited to a set of 19 developed and developing counties for the period of 10 years (2004–2013). We study the determinants of FPI for a group of developed and developing countries using fixed and random effects. Additionally, we use panel generalized method of moments (GMM) suggested by Arellano and Bond (1991, The Review of Economic Studies, 58(2), 277–297). This methodology is suitable to remove the problem of endogeneity which static model is not able to capture. The results of model also incorporates persistence effect considering lagged value of dependent variable. The study empirically tests the various factors that determine the inflows of FPI and analyses their performance during different stages of the economic cycle in the last 10 years. Implicitly, in case of developed countries, it was observed that interest rate differential, trade openness, host country stock market performance and US stock market returns are significant trendsetter, while in developing countries, freedom index, interest rate differential, host country stock market performance, trade openness, US stock market returns and crisis period (2006–2008) significantly influence the inflow of FPIs. Dynamic model supports that as a group of 19 countries, portfolio investments are significantly influenced by interest rate differentials, freedom index, US stock market and host country stock market returns.