Determinants of FDI and FPI Volatility: An E-GARCH Approach

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Friday, April 06, 2018 /03:48PM/CBN 

Volatility in capital flows has been observed as detrimental to the macroeconomic stability of any economy and recent evidence has suggested different behavioural patterns of capital inflows. Firstly, foreign direct investment has been observed as the most stable and less volatile form of capital inflow compared to portfolio investment which has been observed to be highly volatile (Calafell, 2010; Oyejide, 2005; Rangarajan, 2000). High volatility in portfolio investment signifies large reversal of foreign capital flows which increases the risk of borrowers being faced with the risk of liquidity runs (Chang and Velasco, 1999). Such differences in the volatility of foreign direct investment and foreign portfolio investment could portray different factors influencing these inflows and thus may impact the macro-economy differently. Secondly, Aizenman
et al. (2011) noted that foreign direct investment and foreign portfolio investment are fundamentally different from each other since the former is associated with ownership and control while the latter is not. In this wise foreign direct investment is viewed as more beneficial for growth compared to portfolio investment. Also, Agenor (2003) noted that short term cross border capital flows (such as portfolio investment) are more responsive to changes in relation to the rate of returns compared to longer term capital flows which is less vulnerable to variations in short term interest rate.

Ample literatures have examined the factors underlying the volatility of capital flows (see Broto
et al., 2011; Mercado and Park, 2011; Neumann et al., 2009; Diaz-Cassou, 2006). These studies distinguished between country-specific factors (pull factors) in the host countries (such as economic fundamentals and investment opportunities) and push factors reflecting condition in the international financial market (such as World GDP, World interest rate, United State consumer price index and United State short term interest rate). Neumann et al. (2009) and Broto et al. (2011) further stressed that the determinants of the volatility of foreign direct investment and foreign portfolio investment are different. 

In spite of the growing concern on the volatility of capital inflows and their implication for macroeconomic management, previous indigenous studies have neglected this issue by failing to identify specific pull and push factors underlying foreign direct investment and portfolio investment volatility in Nigeria. Studies by Okafor (2012), Okpara
et al. (2012), Anyanwu (2011), Arbatli (2011), Obida and Abu (2010), Dinda (2009) and Nwankwo (2006) focused exclusively on the determinants of foreign direct investment only while Agarwal (2006) focused on the determinants of foreign portfolio investment in Nigeria. Furthermore, studies by Okon et al. (2012), Adegbite and Ayadi (2010), Osinubi and Amaghioyediwe (2010), Ogunkola and Jerome (2006) and Oyejide (2005) among others focused on the role of foreign direct investment in influencing growth of the host country. The paucity of knowledge on the determinants of the volatility of foreign direct investment and foreign portfolio investment constitute the gap this study intends to fill in the literature.

Understanding underlying forces behind volatility of capital flows matter for macroeconomic management and financial stability of an economy. For instance, if volatility in international capital flows react mainly to global factors, then the recipient countries are vulnerable to global shocks and are exposed to contagion effects from other economies of the world (as witnessed during the 2007/2008 US financial crisis), even if domestic policymakers maintain prudent macro-policies. In contrast, if volatility of capital flows are predominantly driven by domestic factors, policymakers are better able to manage such volatility (Jevcak
et al., 2010).

Also, the aftermath of global financial crisis of 2008-2009 which originated from the United State on developing economies like Nigeria made it evident that volatility of capital flows played key roles in shaping the performance of emerging and developing economies. Thus, without a full grasp of factors influencing the volatility of foreign direct investment and foreign portfolio investment particularly in the light of the limited ability of the domestic financial market or monetary authority in dealing with volatility in capital inflows, a comprehensive approach or appropriate policy framework to capital flows management may be elusive. Finally, the findings of this study would allow policymakers in Nigeria to hedge against the risks stemming from volatility in capital inflows while trying to maintain their access to international finance (Broto
et al., 2011).

Against the above backdrop, this study intends to address these research questions. (i) What are the drivers of volatility of foreign direct investment and foreign portfolio investment in Nigeria? (ii) Are these drivers different for volatility in foreign direct investment and foreign portfolio investment in Nigeria? The research objective of this study is “to analyse the determinants of the volatility of foreign direct investment and foreign portfolio investment in Nigeria”. In addition to the introduction, the rest of this paper is as follows: section two dealt with a review of literature while section three focused on the research methodology. In section four, the analysis and interpretation of empirical results were discussed while the conclusion and policy recommendations was the focus of section five.

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