Taking the Bad with the Good: Volatility of Foreign Portfolio Investment and Financial Constraints of Small Firms

Abstract:     
The author examines the impact of the volatility of foreign portfolio investment on the financial constraints of small firms. Using a dataset of over 195,000 firm-year observations across 53 countries, she examines the impact of foreign portfolio investment instability on capital issuance and firm growth across countries and firm characteristics, in particular size. After controlling for the endogeneity of foreign portfolio investment instability, as well as for firm-, industry-, and country-level characteristics such as GDP growth, as well as the levels of foreign portfolio and direct investment, the author finds that the volatility of foreign portfolio investment is only significantly associated with a decreased ability to issue publicly-traded securities for small firms in years when nations are considered less creditworthy. The volatility of foreign portfolio investment only hinders the growth of small firms significantly in periods when nations are deemed less creditworthy. These results underscore both the significance of a good financial system that minimizes capital flow volatility, as well as the influence of property rights and country creditworthiness to instill confidence in foreign investors.

Keywords: foreign portfolio investment, liberalization, emerging markets, small firm

JEL Classifications: D92, F32

Working Paper Series