Foreign Capital flows internationally as a factor of production for the sake of suitable investments and as aids to the less developed countries. With the globalization of financial market, private capital has now been moving around the world in search of highest returns.
Capital moves across the borders of countries more easily than labour. The growth in the flow of foreign capital has become possible only because investment policies in the western countries have changed to allow higher investments, including portfolio investments abroad. The structural adjustments, following economic reforms, reduction in budget deficits, restructuring of public sector, relaxation of trade and exchange controls etc., have created a favourable climate for capital inflows into many developing countries.
Foreign Capital Inflow may broadly be classified into three types:
1. Portfolio investment by foreign institutional investors.
2. Direct foreign investments.
3. Capital raised by domestic companies through euro-issues
Foreign Institutional Investment means investment made by foreign institutions such as pension fund, mutual funds, investment trust, assets management companies and other specified institutions. Securities traded on the domestic primary and secondary market include shares, debentures and other securities specified by the government. These are regarded as portfolioinvestment since they do not grant them any managerial control. These institutions investors make such investment not with a purpose of acquiring any managerial control companies but with the object of securing portfolio diversification. If investments are made with the object of acquiring managerial control, they are treated as foreign direct investments. Portfolio Investment refers to investment made in securities of different companies and in different countries is made to diversify the portfolio of investment to secure higher returns at the same time minimizing risks. The investment made by foreign institutional investors thus becomes portfolio investment.
The investors make investment in securities of different companies in the same country and in different countries and thus diversify their securities portfolio as Investments with no doubt brings returns, in which there are risks associated with every investment. Prudent investors know that diversifying their investment across industries leads to lower level of risk for a given level of expected return. The broader the diversification, the more stable the return and the more diffusion of the risks
The advantages of diversification of portfolio of domestic securities are limited because all companies in a country are more or less subject to the same cyclical economic fluctuations.
Through international diversification that is, by diversifying investment in securities of companies in different countries, investors can achieve a better trade off between return and risk. Country risk and foreign
exchange risk, like business risk can be diversifies by holding securities of different countries denominated in different currencies. The benefit of international diversification will increase if the securities portfolio covers not only equities but also bonds. The easiest way to investing abroad is to buy shares in an international diversified mutual fund.
Direct Foreign Investments (DFI)
Direct foreign investment is referred to as any flow of lending to, or purchase of ownership in a foreign enterprise that is largely owned by the residents of the investing company. The most distinguishing feature of DFI is the exercise of control over decision-making in an enterprise located in one country by investors located in another country. While individuals or partnerships may make such investment, most of them are made by enterprise. It is important for clarification to note the main difference between portfolio investment and direct investment. In direct, investment the investor retains control over the invested capital. Direct Investment and management go together. With portfolio investment, no such control is exercised. However, the n Investor lends the capital in order to get a return on it, but has no control over the use of capital.
Direct investment is much more than just a capital movement. It is accompanied by inputs of managerial skill, trade secrets, technology, right to use brand names and instructions about which markets to pursue and which to avoid. The classical examples of FDI is a multinational enterprise starting a foreign subsidy with 100% equity ownership or acquire more than 50% equity in a domestic company, such that to have control over managerial decisions.
Short-Term Capital Flows
Apart from the long-term capital flows in the forms of direct investments and portfolio n Investments abroad there is a flow of capital among nations for a short period as well. These flows take the forms of export credit and loans, Imports debts, banks deposits, and commercial papers held abroad, foreign currency holdings and obligations. The difference between long term and short term capital flow is on the basis of instruments rather than the intentions of the n investor Also, the determinant of these flows depends on the type of flow. In order to explain their determinants, it is proper to divide the short-term flow into three categories such as trade capital, arbitrage and speculative.
Trade Capital Exports and imports are negotiated both on down payments, as well as on credits. When down payments are made, bank deposits in exporting country’s currency increase while those in importing countries currency decrease. In the case of transactions on credits, accounts receivable /payables increase. Since these accounts are usually payable within one year they are included in short term capital flows. The volume of trade capital obviously varies directly with the magnitude of merchandise trade, and the credit relationships between trading partners.
Under arbitrage, individuals and institutions buy one currency and resell with the sole objective of making profits without taking any risk. The opportunities for such profits arise due to two factors, which states that spot exchange rates are not quite consistent in all the worldwide markets, and secondly, the difference between spot rates and forward rates is not always c onsistent with the interest rate differentials in different markets.
Speculative flows of capital take place across countries with the sole objective of making money through deliberate understanding of foreign exchange risk. Since the breakdown of the Britton Woods system in 1971, exchange rates have been fluctuating widely, which had given rise to significant speculative flows of capital. Speculators buy currencies, which they expect to appreciate and sell those, which they expect to depreciate. These transactions are of course, subject to government regulations. The magnitude of speculative flows depends directly on the variability of exchange rates, and the ability and attitudes of speculator towards risks.