Foreign Portfolio Equity Investments, Financial Liberalization, and Economic Development

Reform of local capital markets and relaxation of capital controls to attract foreign portfolio investments (FPIs) has become an integral part of development strategy. The proximity of market openings and large, sudden shifts in international capital flows gave credence to the notion that the liberalization was the primary culprit in precipitating the recent Asian crisis. Hence, this paper reassesses the benefits and costs of FPIs from the perspective of the recipients. Specifically, it discusses the various FPI contributions and presents empirical evidence regarding the relationship between FPIs and market development, degree of capital market integration, cost of capital, cross‐market correlation and market volatility. It is clear that the evidence on benefits of FPIs is strong, whereas the policy concerns regarding resource mobilization, market comovements, contagion, and volatility are largely unwarranted. The authors make some policy suggestions regarding preconditions for capital market openings, market regulation, and liberalization sequencing.