Challenges in the Era of Globalization - iaabd

Challenges in the Era of Globalization
Edited by Emmanuel Obuah
because their activities can lead to more stock market liquidity, better price discovery, and an increase in
the capitalization of the domestic stock market. One of the arguments for foreign portfolio investment is
its ability to promote local capital market development (see UNIDO, 1996). Foreign portfolio investors
also provide capital to investee countries. Most African countries have a grave need for this capital to
foster economic growth and development. Foreign portfolio investors can therefore contribute to these
markets becoming giants and useful for economic growth.
Another school of thought posits that the activities of foreign portfolio investors are harmful for the
domestic stock market. This is because these investments can be subject to very sharp reversals and may
be crisis prone. Some of the arguments against foreign portfolio investments in the Hamao and Mei
(2001) paper include: (1) trading by foreign investors tends to increase market volatility more than trading
by domestic investors; (2) foreign investors have more sophisticated investment technology than do their
domestic counterparts, causing domestic investors to “lose out” to foreign ones; and (3) foreign investors
tend to make investment decisions on the basis of short-term gains rather than long-term fundamentals,
such as corporate dividend growth. Grabel (1996) argues that portfolio investments have two main
negative effects which are mutually reinforcing; they exacerbate the constraints on policy autonomy and
increase the vulnerability of the economy to risk, financial volatility and crisis. Foreign portfolio investors
also have a low commitment to the country of investment and can exit the investment at the slight hint of
trouble. Foreign portfolio investors usually have high hopes of achieving good returns. If these returns
are not being met they are likely to pull their funds out and invest the funds in another country where they
believe returns will be higher. Another serious charge against foreign portfolio investors is that they tend
to exhibit a herding behaviour which can aggravate a crisis. Once a few foreign investors start pulling out
of the country, others are likely to follow leading to a contagion.
Despite some evidence that portfolio investments can have a negative effect on countries with very open
capital accounts, World Bank and IMF economists who celebrate openness have not called for capital
controls and attribute the so called tequila effect to unsound macroeconomic policies (see Grabel, 1996).
Singh and Weisse (1998) note that portfolio investments had proved to be a double edged sword. The
arguments presented so far implies that foreign portfolio investments can have both a positive and
negative impact on the recipient country. Few studies, especially in the African context, have examined
the effects of foreign portfolio investments on the continent. Despite the fact that foreign portfolio
investors have become important for stock markets in Africa, there is a dearth of literature on the
determinants of foreign equity portfolio investment flows into African stock markets. In this paper, we
investigate empirically the determinants of foreign equity portfolio investment flows into African stock
markets. The rest of this paper is structured as follows: in Section 2 we review the pertinent literature on
foreign portfolio investments and stock markets; in Section 3 we detail the methodology employed for the
study; in Section 4 we present our empirical findings; and finally in Section 5 we conclude the paper.
Brief Review of the Literature
There are various kinds of foreign capital flows. These are foreign direct investment (FDI), foreign
portfolio investment (FPI) and debt flows. The composition of capital flows has been changing over the
past few decades. Capital flows used to be dominated by debt flows in the 1970s. In the 1990’s the
dominant form of capital flows to developing countries was portfolio investments (see Borthworths and
Collins, 1999; Singh and Weisse, 1998). However, after the Asian Financial crisis, countries believed that
foreign portfolio investments were risky and could be potentially destabilizing. Foreign direct investments
therefore tended to dominate capital flows after the Asian financial crisis (see Fernandez-Arias and
Hausmann, 2001). Capital flows also seem to differ according to whether the country is developed or
developing. Developed countries tend to attract more foreign portfolio investments whilst developing
countries tend to attract more foreign direct investments. Goldstein and Razin (2006) develop a
theoretical model based on asymmetric information that explains the empirical results on the behaviour of
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