Differences between Portfolio and Direct Investment
Differences between Portfolio and Direct Investment

One of the most important distinctions between portfolio and direct investment to have emerged from this young era of globalization is that portfolio investment can be much more volatile. Changes in the investment conditions in a country or region can lead to dramatic swings in portfolio investment. For a country on the rise, FPI can bring about rapid development, helping an emerging economy move quickly to take advantage of economic opportunity, creating many new jobs and significant wealth. However, when a country’s economic situation takes a downturn¯sometimes just by failing to meet the expectations of international investors¯the large flow of money into a country can turn into a stampede away from it.

By contrast, because FDI implies a controlling stake in a business, and often connotes ownership of physical assets such as equipment, buildings and real estate, FDI is more difficult to pull out or sell off. Consequently, direct investors may be more committed to managing their international investments, and less likely to pull out at the first sign of trouble.

This volatility has effects beyond the specific industries in which foreign investments have been made. Because capital flows can also affect the exchange rate of a nation’s currency, a quick withdrawal of investment can lead to rapid decline in the purchasing power of a currency. Such quick withdrawals can produce widespread economic crises.

This was partly the case in the Asian economic crisis that began in 1997. Although the economic turmoil began as a result of some broader shifts in international economic policy and some serious problems within the banking and financial sectors of the affected East Asian nations, the capital flight that ensuedsome compared it to the great financial panics which took place in the United States during the 19th century significantly exacerbated the crisis.  

Example of FPI: John Yamashita, a Japanese citizen, purchases one hundred shares of stock in General Motors (GM). John now owns part of a U.S. corporation, the shares of which are part of his personal investment portfolio. John is eligible to receive dividend payments from GM, participate in shareholder decisions, or sell the stock for a profit/loss. John’s share of GM is very minor, and his chief concern is not the long-term profitability of the company but the short-term value of his stock. He might therefore sell his share quickly if the share price goes up or down significantly.

Example of FDI: Hungry Dragon Toys, a Chinese company, is sitting on a lot of cash. The company’s board of directors decides to take some of that money and purchase Cooperative Chemical, a plastics company in New Jersey. Hungry Dragon, a foreign investor, now owns a U.S. subsidiary company. Unlike John Yamashita’s small investment in GM, Hungry Dragon’s ownership of Cooperative Chemical is substantial and more likely to be long term. Hungry Dragon is unlikely to sell if the U.S. economy faces a temporary downturn. A comparison of FPI and FDI is useful to illustrate why some kinds of foreign investment tend to be more volatile than others.

 

 

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