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more heavily on debt flows and bank loans than among countries that relay on FDI
as a source of capital (Gaston and Wei, 2005). In general, mainstream literature on
financial globalization maintains that when financial liberalization translates into
foreign debts (as happens when the current account balance presents a deficit) it
does generate the greatest risk. Foreign debt flows can also lead to inefficient
capital allocation if domestic banks are poorly supervised. In addition, moral
hazard can emerge if debts are implicitly guaranteed by governments and/or
international financial institutions. Finally, short-term bank loans are found to be
pro-cyclical: i.e. they tend to increase during booms and rapidly decrease during
slowdowns (World Bank, 2000) 11 . In a nutshell, the pro-cyclical and highly volatile
nature of these flows can magnify the adverse impact of negative shocks on
economic growth if financial liberalization does not go hand in hand with local
industrial development.
Let us now take a micro-economic perspective. If domestic investments need
other assets, other than ‘cheap capital’, to face domestic competition and enter
highly competitive markets, a government should also look at the collateral costs
and benefits that foreign investments bring about in the real sector of the economy.
Let’s first distinguish between equity (portfolio) investments (which do not imply
control over the management) and FDI (which do). Although the former would be
normally considered more ‘market oriented’ than the latter, a thorough examination
seems appropriate. Equity market liberalization, by making shares of local firms
available to foreigners, can be considered in principle to have a positive effect on
growth (Bekaert, Harvey and Lundbad, 2005). Industries that become more
dependent on external finance also appear to grow faster in countries that present a
higher stock market capitalization 12 . Moreover, foreign investors tend to demand
higher governance standards, which are considered to have a positive impact on
profitability, efficiency and various measures of operative performance. Yet,
portfolio equity flows are also more unstable and prone to reversal than FDI flows.
In general, recent studies show that the composition of inflows seem to have a
strong predictive power for currency crashes. In particular, the share of FDI in a
country’s total capital inflow is negatively associated with the probability of a
currency crises. Another important composition effect relates to the maturity
structure of external debt. The grater the share of short-term debt, the more likely is
a crisis to take place. To the extent that shorter debts can be proxied by portfolio
investments and longer debts by FDI, we have a case in favor of FDI versus
portfolio investments. So in the end, a trade-off appears between portfolio
investments and FDI to mirror a parallel trade-off between market flexibility and
industrial stability.
11 The currency denomination of external debt is also important. A higher share of foreign debt
denominated in foreign currency is currently associated, by the most prominent rating institutions,
with a higher probability of a crisis.
12 For a recent study on the effect of FDI, foreign loans and portfolio flows on domestic investment
see Mileva (2008).
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