International equity financial inflows play a major role in the growth of the capital markets of developing and developed countries. International equity flow is in the form of two important foreign investments; foreign direct and foreign portfolio investments. These investments are crucial for a country's economic growth. We will discuss both these terms in the following section.
Foreign Direct Investment
This is the kind of investment in which residents of one country invest in a firm present in another country and acquire a joint venture with the foreign firm. The International Monetary Fund's Balance of Payments Manual defines FDI as "an investment that is made to acquire a lasting interest in an enterprise operating in an economy other than that of the investor, the investor's purpose being to have an effective voice in the management of the enterprise". When a direct investment is made by an entity based in one country into another entity that is based in another country, it helps to enhance globalization and cut trade barriers. Countries with limited means get financial support from wealthier countries and thereby, the private sector of the host country is benefited.
The United States is the biggest recipient of such investments. The importance of such an investment is clear from China's economic growth because exports and investments made by companies or entities of other countries in China are the main ingredients for China's high economic growth. For example, the US builds several companies in India and obtains certain percentage of ownership of the domestic firm of the host country. By doing so, it easily taps the Indian market.
Foreign Portfolio Investment
This is a type of investment in financial securities such as bonds, debentures, stocks, warrants, options, domestic mutual funds, etc., with an intent to get financial gain. An important feature of FPI is that it can offer equity finance (money obtained from the investors in return for the stocks issued) for the company. Some of the factors affecting FPI are tax rates, interest rates and exchange rates. FPI reduces the foreign exchange gap for developing countries or least developed countries (LDCs), thus making imports of highly necessary products with least trade barriers.
FDI Vs. FPI
The major point of difference between FDI and FPI is that direct investors gain interest in the ownership (maximum 10%) by controlling the domestic firm, but portfolio investors do not have any managerial control or securities control over the firm in which they invested.
- FDI is a long-term process wherein the investor reflects a long-lasting and controlling interest in the firm, while FPI is a short-term process.
- FDI is a direct investment in buildings, technologies, equipment and machinery belonging to the firm of a host country (foreign firm), while FPI is an indirect investment in the foreign firm by simply buying the stocks of the company and not getting involved in any major activities of the firm.
- The investors of FPI are not interested in the management control of the firm in which they invest as it is a short-term investment plan.
- Bigger loss or risk is involved in making of FPI as foreign shareholders cannot sue the domestic stock exchange or the public entity in which they invested their money.
- Direct investors are more informed about the changes in the prospects of the project as compared to portfolio investors.
- It is easy to sell off the shares in FPI as compared to direct investments made by an entity from one country in another country. In other words, FPI is more volatile than FDI.
- FPI investors are more vulnerable to liquidity shocks than companies or entities that make direct investments in foreign countries. This forces many FPI investors to liquidate their investment at a faster rate.
- The probability of withdrawal of FPI is greater than that of FDI.
Unlike other developing countries, India is more benefited by indirect investments than direct investments by other countries. But there are serious issues concerning FPI because of its uncertainty and volatile nature. Finally, the outline of FDI and FPI is that they help to strengthen domestic capital markets and economic potential of a country which has proper regulatory structure.