This article first appeared in The Edge Malaysia Weekly on October 21, 2024 - October 27, 2024

Foreign capital, as an external source of funds for investments, plays a vital role in driving economic development, especially for emerging countries where there are likely limited savings relative to the amounts required to rapidly grow their economies. This much is obvious.

There are two distinct types of foreign capital: foreign direct investment (FDI) and foreign portfolio investment (FPI). FDIs are long-term investments in assets (for example, factories, companies and infrastructure) where the foreign investor has significant control or ownership. FPI, on the other hand, is typically short-term money flows into domestic financial assets, such as stocks and bonds.

Both FDI and FPI are important sources of funds to drive domestic economic growth. FDI raises the country’s productive capacity, creates jobs and, if done right, deepens linkages in the domestic supply chain, creates and develops economic clusters, promotes technology transfer and economic complexity, and raises overall productivity and income of the people. FPI helps to develop the capital markets, allowing companies to raise capital more easily, which goes on to underpin entrepreneurship, innovation, growth and, of course, jobs creation and higher incomes.

Foreign fund flows into the equity market have been proven to have outsized impact on stock prices. Case in point: Bursa Malaysia has been a chronic underperformer for more than a decade due in part to big foreign fund outflows. And net foreign inflows have been instrumental in driving the market rally this year. As we wrote some weeks back (in our article “Institutional fund inflows fuel ringgit gains and Bursa stock prices” published in The Edge dated Sept 16, 2024), Bursa is, as a result, enjoying one of its best years in well over a decade.

Expectations of lower interest rates in the US were the key reason behind the increase in foreign inflows this year. The US dollar had been falling — and the ringgit appreciating — over this same period. Sure enough, the US Federal Reserve kicked off its interest rate downcycle with an outsized 50-basis-point cut after its meeting on Sept 18. The fund inflows reflect a rotation from developed markets (DMs), where central banks are starting to cut interest rates, to emerging markets (EMs) to capitalise on anticipated currency gains as the interest rate differential widens. In other words, the foreign fund inflows are cyclical, driven by short-term interest rate differentials. Indeed, the fund inflows appear to be tapering off or even reversed in the last few weeks as investors recalibrated their expectations of the pace of Fed interest rate cuts.

That got us thinking: Is there also a longer-term trend where foreign capital shifts from DMs to EMs? After all, the case for investing in EMs is compelling: developing countries often experience faster population growth and have favourable demographics — younger population in prime working age with higher propensity to consume compared to ageing populations in developed nations. Additionally, their per capita income growth potential is stronger due to the low base effect. At least, that’s the narrative. But what does the data say?

Chart 1 shows the total foreign capital (both FPI and FDI) flows into developed economies, including the US, UK, Germany, France, Italy, Japan, South Korea and Singapore. Since 2011, aggregate foreign investments in these countries have generally been on the rise, with notable growth in the US. In contrast, aggregate capital flows to EMs — including China, India, Brazil, Mexico, Malaysia, Thailand, the Philippines, Indonesia and Vietnam — fell to a new low in 2023 (see Chart 2). Notably, fund flows to Mexico and Brazil had been declining over time, while investments in Asean countries and India have shown cyclical patterns. Only China has seen steady increase in foreign capital inflows, at least until 2021. Since then, however, the country has also experienced a sharp contraction in foreign investments, no thanks to rising geopolitical tensions with the US. Its domestic economy is also struggling to regain traction from the slowdown triggered by the government’s clampdown on the highly leveraged property sector as well as stringent Covid-19 pandemic lockdowns.

The data evidence is quite clear. Not only is there no secular trend of capital shifting from DMs to EMs over time, but investors have, in fact, increasingly favoured DMs over EMs — despite the latter’s stronger growth prospects. Why and what does this mean for global investors and the developing economies?

To get a clearer picture, we further broke down the foreign capital flows into FDI and FPI (see Charts 3 and 4). The divergence is stark. While DMs are able to increase both FDI and FPI over time, capital flows into EMs remain predominantly in the form of FDI. Portfolio investments in both bond and equity markets are very small by comparison. We believe there are several reasons for this.

For starters, developed countries and the US, in particular, have an inherent advantage. Their currencies — the US dollar, euro, yen and British pound — are the main reserve currencies. Central banks globally hold large quantities of these currencies to stabilise their own economies and facilitate international trade. A significant portion of these reserves is held in the form of government bonds, which account for a significant share of total FPI as seen in Chart 3. The relative size of their economies also means greater scale, depth and breadth of the investing options available to investors, without having to face liquidity constraints.

Equally important, DMs have well-established economic and political institutions, financial systems and robust regulatory and legal frameworks underpinning the rule of law, strong governance as well as private property rights protection, among others. Their capital markets are highly developed, transparent and efficient environments in which investors can operate confidently. There is less risk of arbitrary government interventions and corruption.

In contrast, emerging countries tend to score lower on the Corruption Perceptions Index (Chart 5), indicating that practices such as bribery, nepotism and state capture as well as the misappropriation of funds are more prevalent. There is lower transparency and good governance is not assured.

For portfolio investments, these risks are a much bigger concern, given their shorter-term investment horizons. For example, Asean as a whole has huge growth potential, but member countries have very diverse economies (at differing stages of development), political system of governance, fiscal-monetary policies and laws. Foreign investors are simply passive investors with little control over the underlying business-assets and as such, short-term risks are hard to assess and control. Transparency and good governance become more critical factors for portfolio investors. FDIs, on the other hand, are long term in nature. And since the foreign investors have control or ownership of the underlying businesses, they can better manage-mitigate these risks over time. Thus, we saw during the golden age for globalisation in the past four decades, multinational corporations invested heavily in EMs, profiting from cheap and readily available labour. (This trend may be reversing, notably post-pandemic, with greater concerns for supply chain resilience and deglobalisation, geopolitical factors and the impact from technological advancements such as robotics and artificial intelligence). As noted in Chart 2, China had accounted for the lion’s share of foreign capital flows into EMs over the past decade — but investments have contracted steeply since 2021.

The above-mentioned are all valid reasons why many portfolio investors continue to favour DMs. That said, Singapore possesses all the positive attributes as a developed country — strong public institutions and good governance, low corruption, transparent and business-friendly rules and processes, robust legal framework and rule of law, efficient financial system, stable political environment and strong currency. It gets a huge share of the FDI destined for Asean. Yet, its equity market too is failing to attract portfolio capital. Why?

Some weeks back, we wrote about how the US capital markets keep attracting more investments, which underpin its economic dynamism and growth (“Without good stories, stock liquidity and speculation, cheap stock markets will stay cheap”, published in The Edge dated Sept 30, 2024). Demand for US-dollar assets (thanks to the US dollar status as the primary reserve and trade settlement currency) underpins capital inflows into its markets. The resulting high liquidity drives up stock valuations, and higher valuations attract other exciting and high-quality companies to list there. This, in turn, draws even more capital inflows. US companies benefit from lower cost of capital, which they leverage on to expand globally and invest in research and development, further strengthening their technological leaderships. Advanced technologies lead to greater productivity and create high-skilled jobs, thus attracting a more educated and capable workforce, which fuels further innovation and reinforcing their competitive edge. The stronger growth prospects make these companies comparatively more attractive. It is a self-reinforcing virtuous cycle — at the expense of other stock markets (not only EMs but also other DMs), which have seen their share diminish over time. For investors, this suggests that US stocks may well continue to outperform for the foreseeable future.

Stock market operators and regulators in the rest of the world are growing increasingly concerned that their capital markets are being marginalised. Many are actively undertaking reforms to make themselves more attractive to global investors and improve market valuations. We have written quite a few articles on this subject, suggested various measures that could be implemented and highlighted some of the actions taken by the Tokyo Stock Exchange that have worked well for the Japanese equity market. Singapore set up a task force in August to come up with ways to revitalise the Singapore Exchange. Time will tell if the SGX and other EMs can break out of the vicious cycle that they are currently trapped in. We will revert to this topic again in more detail, given its implications and consequences to global economic development and income-wealth disparities. This is especially so as “rich” nations increasingly run deficits that need to be funded. Will global inequalities get progressively worse?

The Malaysian Portfolio gained 0.7% for the week ended Oct 16, performing better than the benchmark FBM KLCI, which fell 0.1%. IOI Properties Group (8.5%), KSL Holdings (1.7%) and United Plantations (1.5%) were the top gainers while the biggest losers were Insas Bhd – Warrants C (-4.8%) and LPI Capital (-1.1%). Last week’s gains boosted total portfolio returns to 201.9% since inception. This portfolio is outperforming the FBM KLCI, which is down 10.8% over the same period, by a long, long way.

Meanwhile, the Absolute Returns Portfolio gained 1.1%, raising total returns since inception to 14.2%. The top gainers were Airbus (+6%), D R Horton (+3.9%) and CRH (+3.1%). Tencent Holdings (-4.2%), Itochu (-1.2%) and OCBC (-0.1%) were the three losing stocks for the week.

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views  to influence readers to buy/sell stocks. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

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