External capital inflows are necessary for building and supporting economic stability and growth, and in this context, there are two types of inflows, namely, foreign direct investments (FDIs) and foreign portfolio investments (FPIs).
Both foreign direct investments and foreign portfolio investments are advantageous, though they may also have their downsides, the former has an edge over the latter because, in the long run, they (FDIs) create greater stability and more sustainable multiplier effects in the host economy.
Foreign direct investments are long-term, patient and loyal capital which flows into the host economy either as new business concerns or as mergers and acquisitions of existing businesses/industrial projects in the host economy.
They provide employment opportunities for local workers, which supports aggregate demand and economic growth and development of human capital and increases market competition and efficiency as the domestic firms compete with incoming foreign enterprises.
They also enable technology transfer, generate higher tax revenue and engender foreign exchange and currency stability through a steady stream of forex inflows and boost exports, among other benefits.
Factors that attract foreign direct investment include low interest rates, robust financial markets which enable access to credit, infrastructure, especially power supply to boost production, security, a transparent and efficient judiciary, minimal bureaucratic bottlenecks, good corporate governance and reduced systemic corruption.
On the other hand, foreign portfolio investments, also known as hot money, are short-term, volatile and speculative funds which are not patient and loyal to the host economy.
They seek quick gains and can exit from the host economy at the drop of a hat if market dynamics change and their exit can sometimes be destabilising to the host economy.
The inflow of foreign portfolio investments creates liquidity and increases the velocity of trading in the stock market and creates wealth for local investors. It also helps to improve the host country’s balance of payments, strengthen the exchange rate and stimulate economic growth.
Factors that attract foreign portfolio investments include high and attractive domestic interest rates, exchange rate stability, which reduces exchange rate risks, and healthy external reserves, which engender confidence.
Others include economic growth projections, which are indicative of an expanding economy, a deep and vibrant capital market, diverse and quality asset classes, regulatory transparency, etc.
In the ongoing economic reforms, the consistent tight monetary policy (high interest rates) by the Central Bank of Nigeria (CBN) reduced inflationary pressure and attracted inflows of foreign portfolio investments, which helped to boost foreign reserves, stabilise the exchange rate and support the naira.
There was a wave of capital inflows from the United Kingdom, South Africa, Mauritius, the USA, the United Arab Emirates, France, the Netherlands and Singapore, which were mostly driven by foreign portfolio investments in money market instruments and government bonds.
Data from the National Bureau of Statistics (NBS) shows that in the first quarter (Q1) of 2025, capital inflow from the UK was USD 3.68 billion (N5.52 trillion), which accounted for 65.26 percent of total inflows for the period.
It was followed by South Africa with an inflow of USD 501.29 million, which accounted for 8.8 percent. Next was Mauritius with an inflow of USD 394.51 million (6.9 percent) and the USA with USD 368.9 million (6.54 percent).
Others are the United Arab Emirates – USD301.72 million (5.35 percent), Cayman Islands – USD114.76 million, France – USD 47.33 million, the Netherlands – USD 42.68 million and Singapore – USD 36.79 million.
The surge in foreign portfolio investments also supported total transactions at the NGX (Stock Exchange) to a seven-month record of N6.01 trillion.
As noted by the NGX, the inflows showed substantial increases in two-way transactions by foreign investors, which indicated active participation and tracking of the Nigerian market by global fund managers.
Inflows of foreign portfolio investments can boost the velocity of trading and market capitalisation, but they bear inherent risks that can disrupt and destabilise markets and economies if things go awry and the dynamics change dramatically.
In one of my previous articles titled Economy, CBN, and Capital Inflows, I noted the downsides of foreign portfolio investments and the need for caution, strategic sensitivity, and agility by authorities in the host economies regarding the potential crisis of the outflows of foreign portfolio investments.
Particularly, I highlighted the examples of the European Monetary Crisis in 1992, the Asian financial crisis in 1997 and the Mexican financial crisis in 1994.
The Mexican financial crisis in 1994 was due to the mass outflows of foreign portfolio investments due to the devaluation of the peso, the country’s currency, by the Mexican Central Bank after it had promised not to devalue it.
Foreign portfolio investors lost confidence and became sceptical and fearful and started rapid withdrawal of capital from Mexican investments and selling off shares as the Mexican Stock Exchange plummeted.
The Mexican Central Bank tried to halt the capital outflows by raising interest rates but faced another challenge of higher borrowing costs, which hindered economic growth.
Investors lost interest in purchasing new debt obligations even when it was time for the Mexican Central Bank to roll over its maturing debt obligations.
The crisis created a financial contagion known as the “Tequila Effect” throughout other financial markets in Asia and the Americas and resulted in a USD 50 billion bailout by the International Monetary Fund (IMF).
Addressing the issue, Edward M. Truman of the US Federal Reserve Board noted that developing countries were more vulnerable to shocks in today’s globalised capital markets.
He advised authorities in developing countries to pay a good deed more attention than they had in the recent past to potential shocks, both external and internal and emphasised the need for them to develop their own early warning systems.
Nwobu, a chartered stockbroker and business journalist, wrote via [email protected]. Tel: 08033021230
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