Do foreign portfolio capital flows affect domestic investment? Evidence from Brazil

• Author: Tiago R. Loncan,João F. Caldeira,Jefferson A. Colombo
• Date: 01 April 2019
• Published date: 01 April 2019
• DOI: http://doi.org/10.1002/ijfe.1695

Received: 9 March 2018 Revised: 24 July 2018 Accepted: 10 September 2018

DOI: 10.1002/ijfe.1695

RESEARCH ARTICLE

Do foreign portfolio capital flows affect domestic

investment? Evidence from Brazil

Jefferson A. Colombo1Tiago R. Loncan2João F. Caldeira3

1The COPPEAD Graduate School of

Business - Federal University of Rio de

Janeiro, Brazil

2Department of Accounting & Finance,

University of Strathclyde, Glasgow,United

Kingdom

3Department of Economics, Universidade

Federal do Rio Grande do Sul & CNPq,

Porto Alegre, Brazil

Correspondence

Jefferson A. Colombo, The COPPEAD

Graduate School of Business, Rio de

Janeiro-RJ, 21941-918, Brazil.

Email: jefferson.colombo@coppead.ufrj.br

Funding information

CAPES, Grant/AwardNumber:

99999.003202/2014-3 (Jefferson A.

Colombo); CNPq, Grant/AwardNumber:

309899/2015-0 and 430192/2016-9 (João

F. Caldeira)

JEL Classification: E22; E44; F62

Abstract

Although there are several direct and indirect theoretical channels through

which foreign capital flows may affect domestic investment, empirical evidence

remains inconclusive. In this paper,we employ a VARX framework to assess the

impact of equity foreign portfolio investment (EFPI) on domestic investment

growth, employing monthly series for the Brazilian economy. Our results sug-

gest that EFPI played a nonnegligible role in explaining aggregate investment

fluctuations, but only before the 2008 global financial crisis. After the crisis, a

period marked first by a shift in economic policy in 2008–2009, with substantial

increases in government intervention, followed by deterioration in the institu-

tional outlook and political stability in 2014–2015, mostly against the backdrop

of the Petrobrascorruption scandal, unexpected shocks to EFPI no longer led any

real effects on investment growth. Although, in general, our results vouch for

beneficial effects of equity capital flows on investment, this virtuous relationship

is likely disturbed by interventionist policies and political unrest.

KEYWORDS

aggregate investment,emerging markets, financial integration, foreign portfolio capital flows, global

financial crisis, government interventionism

1INTRODUCTION

Developing countries have long struggled with insuffi-

cient capital to finance investments. A promising agenda

to tackle the problem was advocated by the International

Monetary Fund (IMF) and the World Bank in the late

1980s, in series of policy prescriptions set forth by the

so-called Washington Consensus. Developing countries

were advised to implement capital account liberalizations,

allowing foreign equity capital to flow in, thus promot-

ing integration with global equity markets and financing

new capital stock with foreign funds. However, as noted

by Aizenman, Pinto, and Radziwill (2007), such recipes for

growth eventually became the single most controversial

policy prescription, and concerning fostering investments,

for most of emerging markets, there is no evidence of

a growth bonus associated with increasing the financing

share of foreign funds. In line with this view, Bekaert,

Harvey, Kiguel, and Wang (2016) note that, despite volu-

minous research on the subject, whether financial global-

ization produces beneficial real economic effects remains

controversial. In this paper, we provide novel evidence to

this important debate, by investigating whether foreign

portfolio capital flows stimulate investment, using Brazil

as a case study.

Foreign equity capital flows allegedly reduce the cost

of equity capital in developing markets for the interplay

of four main factors: improved risk sharing among local

and foreign investors, alleviation of financial constraints

as more foreign capital becomes available, increased stock

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856 COLOMBO ET AL.

market liquidity, and adoption of better corporate gover-

nance practices by local firms to attract more sophisticated

foreign shareholders. In theory, as emerging countries

move from financial autarky and become more open to

cross-border finance, physical investment should increase

accordingly, as a lower cost of equity capital expands the

portfolio of positive net present value investments in the

economy (Bekaert, Harvey, & Lundblad, 2005; Chari &

Henry, 2004; Henry, 2000; Levine & Zervos, 1998; Stulz,

2005).

Although theories justifying increased investmentunder

greater financial openness are reasonably sound, in prac-

tice, the story is more complicated. Instead, foreign port-

folio capital is often blamed for disrupting local financial

markets, for its short-termed nature exacerbates volatility

and instability,actually hindering new investment because

firms are reluctant in expanding their capital stocks when

they do not trust foreign capital will stay long (Singh

& Weisse, 1998; Stiglitz, 2000). In fact, recent empirical

evidence shows that during periods of financial instabil-

ity, like in the 2008 global financial crisis, foreign equity

investors reallocated massive quantities of portfolio cap-

itals from emerging economies to advanced economies

(Fratzscher, 2012). As adjusting capital stocks is costly,

uncertainty about equity valuations caused by foreign cap-

ital sudden reversals might actually discourage new invest-

ment. Also, portfolio investment may harm the economy

for its procyclicality, as it increases when economies are

booming but rapidly retreats when economies are slowing,

for overheating exchange rates and for inducing bubbles

in real estate and financial asset prices (Aizenman & Pas-

richa, 2013). Moreover, empirical evidence strongly sug-

gests that institutional quality plays an important role too,

working as a catalyst channelling all the aforementioned

benefits from capital flows to real variables, such as eco-

nomic growth, investment, and productivity (AyhanKose,

Prasad, & Taylor, 2011; Bekaert, Harvey,& Lundblad, 2011;

Slesman, Baharumshah, & Wohar, 2015).

The Brazilian experience is an exciting story to study.

Like many emerging markets, Brazil experienced a surge

in foreign capital flows in the 1990s (Cardoso & Gold-

fajn, 1998). More recently,in years 2009/2010, increases in

capital flows raised concerns related to financial stability

and exchange rate overheating, to which Brazil responded

with several capital controls on equity and fixed income

investments (Chamon & Garcia, 2016; Jinjarak, Noy, &

Zheng, 2013). Moreover,Brazilian private firms long suffer

from credit constraints, relying heavily on internally gen-

erated cash flows to finance investments (Terra, 2003). As

a response to the 2008 financial crisis, the Brazilian gov-

ernment has sharply increased the supply of subsidized

credit from state-owned banks (mainly through BNDES)

to the private sector, especially for large firms, a policy of

betting on so-called national champions firms, hoping to

give a boost to investment. Nevertheless, as of the present

moment, there is no evidence this policy has produced

any stimulus on investment, but it has notably contributed

to the deterioration of fiscal deficits. Together with this

dramatic shift in economic philosophy, political risk in

Brazil has escalated to severe levels, against the backdrop

of the Petrobras scandal, which, together with the accusa-

tions of fiscal fraud, has led to the impeachment of former

President Dilma Rousseff, in August 2016.

As the Brazilian economy faces the toughest recession

of its modern history, much triggered by the aforemen-

tioned events, the country urgently needs alternatives to

stimulate investment and deliver growth to make its way

out of this crisis. In theory, foreign portfolio capitals offer

a promising channel to finance expansions of private capi-

tal stock. Although there is evidence showing that foreign

capitals increase equity valuations and decrease the cost of

capital in Brazil (Loncan & Caldeira, 2015; Reis, Meurer,

& Silva, 2010; Sanvicente, 2014; Tabak, 2003), the crucial

question whether foreign capital benefits are channelled

to the real economy and play any role in financing new

investments remains to be investigated. In our paper, we

address this relevant question, contributing to an impor-

tant and unsettled debate on the effects of foreign capital

flows on domestic investment in emerging markets, pre-

viously examined in Bosworth and Collins (1999), Henry

(2000), Laeven (2002), Bekaert et al. (2005), Aizenman

et al. (2007), and Chari and Blair Henry (2008), among oth-

ers. We accord novel evidence from a major destination

of capital flows such as Brazil, exploiting a granular and

wide monthly dataset spanning from 1996 till 2015. This

is an interesting period to study: The economy has expe-

rienced not only mixed cycles, such as surges in capital

flows and growth, but also recessions, mostly triggered by

troubled shifts in economic philosophy and politics after

the great financial crisis (GFC) and in more recent periods,

which have gone against the best practices in capital flows

management almost by design.

Our first step in modelling the relation between foreign

capital and aggregate investment is to construct a monthly

estimate of the Brazilian quarterly gross capital formation

series. We do that for two main reasons. First, because we

have monthly information available on the main compo-

nents of the quarterly aggregate investment, following the

most recent guidelines of the System of National Accounts

2008 (United Nations, 2009). Second, all other macroeco-

nomic variables we use in the models are available on a

monthly basis, including foreign equity capital flows. In

doing this monthly interpolation of the quarterly invest-

ment series, we do not change the properties of the original

series, and we significantly increase the number of degrees

of freedom in our models, which allows us to enhance the