WORLD TRADE
ORGANIZATIONWT/WGTI/W/103
7 June 2001
(01-2821)
Working Group on the Relationship
between Trade and Investment
MERGER AND ACQUISITION ACTIVITY AND THE BALANCE-OF-PAYMENTS;
FOREIGN PORTFOLIO INVESTMENT
Note by the Secretariat
1. This Note has been prepared in response to a request from the Working Group for an analysis
of the balance-of-payments effects of merger and acquisition activity, to supplement
WT/WGTI/W/95, and for an analysis of portfolio flows of foreign investment, including the reasons
investors choose to invest through portfolio in vestment, the inter-relationship between FDI and
portfolio flows of foreign investment with a view to highlighting any advantages of attracting
portfolio flows in order to increase FDI, concerns that have been expressed by some Members with
regard to portfolio flows of foreign investment, a nd options that have been used in international
agreements to address such concerns.1
2. Section I of this Note covers the balance-of-payment effects of cross-border merger and
acquisition activity.
3. Section II, beginning on page 3, deals with the various aspects of foreign portfolio investment
that the Secretariat has been asked to review.
I. CROSS-BORDER MERGER AND ACQUISITION ACTIVITY AND THE BALANCE-
OF-PAYMENTS
4. Foreign direct investment (FDI) through merger and acquisition (M&A) activity is
conventionally defined as a transaction in which a foreign purchaser acquires a stake of 10 per cent ormore in an existing domestic enterprise.
2  In most instances, the stake is in practice considerably
higher than that.  UNCTAD estimates that about two-thirds of acquisitions by foreign firms in
developing countries in 1999 were majority or full (50-100 per cent) acquisitions.3
5. Inward FDI to developing countries through M&A activity increased sharply in 1996-99.
Much of it was the result of major privatization programmes in Latin America, particularly Brazil andArgentina, and foreign acquisitions of enterprises in South-East and South Asia associated with the
effects of the financial crisis.  This resulted in the share of the value of M&A activity in total FDI to
developing countries rising to more than one-third in 1997-99.
4  However, given the particular
circumstances surrounding the increase, this share may not be sustained.  In most developing
countries, M&A activity is still negligible.
                                                     
1 WT/WGTI/M/14, paras. 17-20.
2 For a review of cross-border M&A activity, see UNCTAD World Investment Report 2000,
Chapter IV.
3 Ibid, p. 99.
4 Ibid, p. 114.WT/WGTI/W/103
Page 2
6. As the Secretariat noted in WT/WGTI/W/95 (paragraph 7), analysis of the balance-of-
payments effects of FDI involves much the same ge neral factors, whether the initial capital inflow to
the host country represents greenfield investment or M&A activity.  In a static sense, it will involve an
initial capital inflow, coupled with subsequent capital  inflows (new injections of capital) and outflows
(repatriation of profits, royalties and dividends), and trade inflows (imports of capital goods andintermediate inputs associated with the initial inve stment and subsequent operations of the enterprise)
and outflows (the substitution of domestically produced goods and services for imports, as well as
exports of goods and services).
7. Beyond the initial foreign capital inflow a ssociated with M&A activity, its balance-of-
payments effects hinge largely on whether placing ownership and control of an existing enterprise in
foreign hands results in a significant change in its operations, particularly its imports and exports of
goods and services, and its imports of operating capital and exports of profits, royalties, anddividends.
8. Little can be said in a general way about the over all significance of this issue.  It is perhaps
worth noting that balance-of-payments considerations did not figure in the recent recommendations of
the UNCTAD Commission on Invest ment, Technology and Related Financial Issues on M&A
activity.
5  The Commission focused instead on the impact of M&A activity on domestic enterprise
development, employment, and competition.  With  regard to balance-of-payments effects, the
following points could be relevant, but would need to  be assessed in specific instances of FDI on a
case-by-case basis.
9. Greenfield investment and M&A activity both represent an initial injection of liquidity into a
host country's economy.  As noted in W/95, in the case of greenfield investment this may beassociated with a high initial propensity to purchase imports of machinery, equipment, and
intermediate goods and services needed for the start-up of the enterprise concerned.  A proportion of
the initial investment will then be ear-marked for this purpose, and it will not enter the host country as
an uncommitted capital inflow.
10. In the case of M&A activity, it seems less likely in general that an established enterprise will
need immediately to be re-equipped-although in specific instances this may happen – so that the initial
propensity to import stemming directly from the foreign investment will be lower than in the case of a
greenfield investment.  With less of the investment pre-committed to imports of new machinery and
equipment, the trade effects of the initial injection of capital will depend largely on the overall import
propensity of the host economy.  If the M&A activity represents a significant share of the productive
capital of the host economy in question, it may be necessary to consider the specific import propensity
of the local beneficiaries of the sale of assets;  in other words, what proportion of their spending or re-investment of the funds they receive from the sale goes on imports?
11. Again, at a general level, there is little that can be said on this point. Analysis would need
ideally to be carried out on a case-by-case basis, taking into account, inter alia , the size of the capital
inflow involved relative to the domestic monetary base, and structural and policy characteristics of the
host economy.  For example, in the case of sales in volving the privatization of state-owned assets, the
proceeds to the government may be used to reduce budget deficits or to increase fiscal expenditure,
either of which could have different effects on the balance-of-payments.  In the case of private sector
sales concluded in the context of an economy-wide financial crisis, such as happened in several Asian
                                                     
5 UNCTAD, Report of the Commission on Investment, Technology and Related Financial Issues on its
fifth session (12-16 February, 2001), "Impact of international investment flows on development:  Mergers andacquisitions – policies aimed at maximizing the positive and minimizing the possible negative impact ofinternational investment" (TD/B/48/4).  See also background material contained in TDB/COM.2/29, /26, and
/EM.7/2.WT/WGTI/W/103
Page 3
countries in the late 1990s, some of the proceeds may be expatriated for at least as long as the crisis
lasts, resulting in an offsetting capital outflow, al though it would be more appropriate to link this to
the crisis situation prevailing in the host country than to M&A activity per se.
12. It is equally difficult to draw general conclusions on likely differences in the import-intensity
and export-intensity of the operations of enterpri ses financed through greenfield investment or M&A
activity.  They will depend primarily on whether the influence of foreign management led to a
significant change in the enterprise's operations relative to the situation prevailing beforehand, and
this requires case-by-case analysis.  For example, it has been suggested by the World Bank that M&A
activity in developing countries in the 1990s broke new ground by entering into sectors that produce
non-tradeable goods and services, whereas greenfield FDI has largely been based in manufacturing.6
According to the World Bank, about half of the M&A activity in East Asia in recent years has been insuch non-tradeable industries as wholesale and retail trade, real estate, and the financial sector,particularly involving the re-capitalization of the banking industry after the financial crisis.  Taken at
face value, this could imply that foreign investment through M&A activity is likely to be less export-
oriented than FDI.  However, whether or not th ese industries remain in the non-tradeable sectors of
the economy once ownership and control has passed to foreign investors will depend upon the
management decisions those investors take.
13. As for outflows of profits and royalties, it was suggested in W/95 that in the case of
greenfield investments these are likely to be delayed until the enterprise concerned has become
productive and profitable.  In the case of M&A activity in an existing, productive and profitable
enterprise, these outflows can begin at once.  There is no obvious reason to suggest, however, that
over the long-run the outflows will be systematically higher in the case of an M&A investment than agreenfield investment.
14. In summary, while certain hypotheses can be put forward about how the likely balance-of-
payments effects of M&A activity might differ in general from the balance-of-payments effects of
greenfield investment – a lower initial propensity to import machinery and equipment, for example, or
a higher initial outflows of profits and  royalties – the empirical evidence is very thin, and the samegeneral qualifications apply that were made in W/95:  meaningful results depend largely on case-by-
case analysis, and conclusions should be drawn on the basis of the overall effects of an investment on
the balance-of-payments, not on the basis of just a select few of the trade and capital flows involved.
II. FOREIGN PORTFOLIO INVESTMENT
7
15. Foreign portfolio investment in developing countries is a more recent phenomenon generally
than FDI.  As a result it has been less well researched and analysed, and for the time being there is
little empirical work available.  The collection of data and statistics on foreign portfolio investment isalso less advanced, and in certain respects it poses greater conceptual difficulties than the collection of
data and statistics on FDI.
8
A. DEFINITION
16. Total private capital flows to developing countries comprise foreign bank lending and private
foreign investment.  Bank loans and trade finance re main important sources of external financing for
                                                     
6 World Bank, Global Development Finance 2001 (Washington D.C.), p. 36.
7 This section draws on two particular sources:  UNCTAD "Comprehensive Study of the
Interrelationship between Foreign Direct Investment  (FDI) and Foreign Portfolio Investment (FPI)",
UNCTAD/GDS/DFSB/5, June 1999;  and World Bank, Global Development Finance 2001, (Washington D.C.).
8 One of the agreed conclusions of the recen t UNCTAD Expert Meeting on foreign portfolio
investment was "given the importance of FPI, countries should increase their efforts to ensure the accurate
statistical reporting of such flows for analytical and policy-making purposes" (TD/B/COM.2/EM.6/L.1, para. 2)WT/WGTI/W/103
Page 4
many developing countries, but generally they are not classified as foreign investment and they are
excluded from consideration in this Note.
17. Foreign investment comprises FDI and foreign portfolio investment, and the most widely
used convention for differentiating between them is the IMF's Balance-of-Payments Manual .
18. The IMF's benchmark definition for FDI is based on the "lasting interest" that the investor has
in his investment in an enterprise resident in another country.9  A "lasting interest" implies the
existence of a long-term relationship between the direct investor and the enterprise, and a significant
degree of influence by the investor over the management of the enterprise, such that the benefit the
investor expects to derive from the investment goes well beyond the property income that accrues on
the capital invested.  For statistical reporting purpose s, the specific criterion used is that the foreign
investor holds 10 per cent or more of the ordinary shares or voting power of an incorporated
enterprise, or the equivalent for an unincorporated enterprise.  All subsequent equity and debttransactions between affiliated enterprises are also classified by the IMF as direct investment, as are
reinvested earnings.
19. Foreign investment involving an equity share of less than 10 per cent is classified by the IMF
as foreign portfolio investment, along with other kinds of equity securities (American depositary
receipts, mutual funds and investment trusts) and debt securities (bonds, notes, money marketinstruments and financial derivatives) that do not fall into the category of FDI.  An essential
characteristic of portfolio instruments, according to  the IMF, is that they are tradeable, so that
transactions typically take place through established capital markets (such as stock exchanges).
10
20. Depending upon the specific focus of analysis and policy-making, foreign portfolio
investment can in principle be broken down further.   One standard differentiation made is between
portfolio investment in equities and portfolio investment in debt securities, mainly bonds.  When
considering foreign portfolio investment in conjunc tion with FDI, it may be appropriate to focus on
foreign portfolio investment that is enterprise-specific, and so to separate out and exclude foreign
portfolio investment in public sector debt secu rities (i.e. government bonds, even though some of
these may be "enterprise-specific" in that they are used to finance the operations of publicly-ownedenterprises).  In some circumstances, it may be considered appropriate to make a further
differentiation so as to exclude short-term debt securities (with a maturity of less than one-year).
21. Even with refinements such as these, it is important to remember that the differentiation
described above between FDI and foreign portfolio in vestment is designed for statistical reporting
purposes, for which a clear delineation is needed, and that for analytical and policy purposes the
dividing line is often not so clear-cut.  For exampl e, the terms "lasting interest" in an investment and
"significant management influence" over an enterprise are not quantifiable ex ante, and are notnecessarily associated directly with a 10 per cent equ ity threshold;  an investor with less than 10 per
cent equity share may have a lasting interest and exercise significant management control, and vice
versa.
22. For working purposes, it is useful to note that FDI and enterprise-specific foreign portfolio
investment typically involve two different kinds of investor, with different motivations andexpectations about the benefits they will derive fr om their investment.  By and large, FDI investors
are firms engaged in the production of goods and services that are motivated by expanding their
commercial activities.  Portfolio investors are either financial institutions, institutional investors (such
as pension funds, insurance companies or investment  trusts), or individuals, who are motivated by the
                                                     
9 See IMF 1993 (fifth edition) Balance-of-payments Manual,  and the OECD's 1992 (2nd edition)
Detailed Benchmark Definition of Foreign Direct Investment .
10 IMF, Coordinated Portfolio Investment Survey Guide, 1996.WT/WGTI/W/103
Page 5
financial return on their investment through capital gains or dividends, and who ex ante have no
expectation of taking a lasting interest in an enterprise nor any direct interest in managing it.11
23. As discussed later in this Note, most existing  international investment agreements (mainly
bilateral investment treaties) do not distinguish between FDI and foreign portfolio investment – they
cover both, through a comprehensive "asset-based" definition of investment.
B. THE MAGNITUDE OF FOREIGN PORTFOLIO INVESTMENT FLOWS
24. Even at the most aggregated level, data on foreign portfolio investment are not accurate, and
at more disaggregated levels their reliability deteriorates considerably.  Part of the problem is data
availability and measurement errors.  Even among OECD countries, for example, only a few
systematically record foreign portfolio equity investments separately from other foreign portfolio
investment flows, or even from FDI.12  Part of the problem also is one of concept and definitions.  For
example, the IMF notes that in recent years ther e has been an "internationalisation" of emerging
market economies' equity markets that has seen enterprises increasingly bypassing local stock
exchanges to raise capital and resorting to deposi tary receipts traded on foreign stock exchanges,
issuing initial public offerings on foreign stock exchanges, and even changing their country of
domicile so as to reduce risk premia.13  All of this adds to the difficulty of accurate data collection,
and data on foreign portfolio investment based on gross financing statistics (Annex, Table 1) showlarge discrepancies from statistics collected for balance-of-payments purposes (Table 1).
14
25. Notwithstanding the data problems, it is clear from Table 1 that private capital flows have
become a far more important source of finance for developing countries in the 1990s than official
capital flows, and that FDI and foreign portfolio investment have become more important relative to
bank lending, particularly in the emerging market economies (see also Annex, Table 2).  According toUNCTAD, in the mid-1980s international bank lending accounted for over 50 per cent of total private
capital flows to developing countries, FDI for 22 pe r cent, and foreign portfolio investment for 18 per
cent.
15  By the mid- to late-1990s, the data in Table 1 suggest that their respective shares were about
14 per cent for bank lending, 52 per cent for FDI, and 34 per cent for foreign portfolio investment.
26. FDI exceeded foreign portfolio investment (including sovereign and public bond financing) in
developing countries in all years except 1993, and in most developing countries FDI flows are a
significantly more important source of foreign financing than foreign portfolio investment flows.
According to a survey by UNCTAD, for example,  balance-of-payments data for 1990-97 show that
for two-thirds of a sample of 30 developing countries and economies in transition, FDI was on
average larger than foreign portfolio investment.16
27. By the mid-1990s, it appeared from the data that foreign portfolio bond financing was quickly
outstripping foreign portfolio equity investment in its importance as a source of foreign financing for
developing countries.  However, while both bond and equity investment flows suffered during the
years of the Asian financial crisis, equity investment flows seem to have proved the more resilient of
the two, increasing sharply in 1999 and 2000.  In cont rast to bond investment flows, they have now
                                                     
11 Even so, the distinction can blur:  for example, the time horizon of venture capital investment may be
as long as FDI and it may involve significant management control, but the primary motive of the investment is
to share in the capital gains of the equity of a local ente rprise when eventually it is listed on the stock exchange.
12 See UNCTAD, World Investment Report 1997 , p. 109, for a discussion of data problems.
13 IMF, International Capital Markets, (Washington D.C.), September 2000, pp. 72-73.
14 Ibid, p. 51.
15 TD/B/COM.2/EM.6/2, and Corr.1 of 15 April 1999.
16 Ibid, p. 8.WT/WGTI/W/103
Page 6
recovered to levels prevailing before the financial crisis, and account for around 15-20 per cent of
private capital flows to developing countries.17
Table 1
Selected net long-term resource flows to developing countries, 1991-2000
(US$ billions)
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Total 123.0 155.8 220.4 223.7 261.2 311.2 342.6 334.9 264.5 295.8
of which :
Private flows 62.1 99.3 166.8 175.7 206.1 279.3 299.8 280.3 219.2 257.2
of which :
FDI 35.7 47.1 66.6 90.0 107.0 131.5 172.6 176.8 185.4 178.0
FP1 18.5 25.2 87.6 73.4 66.9 111.7 79.2 56.5 59.9 78.1
(Equity) (7.6) (14.1) (51.0) (35.2) (36.1) ( 49.2) (30.2) (15.6) (34.5) (47.9)
(Bond) (10.9) (11.1) (36.6) (38.2) (30.8) (62.5) (49.0) (40.9) (25.4) (30.3)
Bank Lending 5.0 16.2 3.4 8.7 30.5 33.7 45.2 50.0 24.6 0.7
Source: World Bank, Global Development Finance 2001 , Table2.3.
Notes : Long-term resource flows have a maturity of one-year or more.  Inflows of debt (bonds and bank
lending) are net of amortization payments, and FDI is net of disinvestment.  Figures for bond financing include
sovereign, public, and private bond issues;  the IMF cal culates that in 1998-99 private bond issues accounted for
about 31 per cent of the total.18
Table 2
Net long-term resource flows of FDI and portfolio equity investment
to developing countries, by region : 1998-1999
(US$ billions)
All
developing
countriesE. Asia and
PacificEurope and
Central AsiaLatin America
and CaribbeanMiddle East
and N. AfricaSouth Asia Sub-Saharan
Africa
FDI (net)
1998 185.4 56.0 26.5 90.4 1.5 3.1 7.9
1999 178.0 58.0 28.8 76.2 4.5 3.2 7.3
Portfolio
equity flows
1998 34.5 21.1 3.5 3.9 0.7 1.3 3.9
1999 47.9 28.6 5.5 9.9 0.9 2.1 0.8
Source: World Bank, Global Development Finance 2001 .
                                                     
17 See World Bank, op cit , p. 46;  15 per cent based on capital market commitments, and 18 per cent
based on net long-term resource flows.
18 Ibid, p. 53.WT/WGTI/W/103
Page 7
28. For the time being, foreign portfolio investment is even more heavily concentrated in just a
few developing countries than is FDI, primarily in upper-middle-income countries which have well
developed capital markets and which are associated with sound macro-economic policies and
relatively high growth rates.  Using data from Table 1, Table 2 shows the distribution by region of net
long-term resource flows of FDI and portfolio equity  investment to developing countries in 1998 and
1999.  In fact, the distribution of equity investment flows may be even more concentrated than these
figures would suggest, and the World Bank finds th at in 2000, 85 per cent of total portfolio equity
investment flows to developing countries was accounted for by just four countries:  Brazil, China,
Mexico and Turkey.19
C. THE DETERMINANTS OF FOREIGN PORTFOLIO INVESTMENT
29. The determinants of foreign portfolio investment  are less well researched than those of FDI.20
Nonetheless, the principal motivations of foreign portfolio investment are considered to be
expectations of high yields (capital gains and/or interest and dividends) and reduced risk through
portfolio diversification.  As noted earlier, this contrasts with the motivation behind FDI, which is
considered to lie primarily in a desire to expand the parent company's commercial activities.
30. The increase in foreign portfolio investment in developing countries in the 1990s, particularly
the emerging market economies, is attributed to a number of factors:  the liberalization of financialmarkets internationally, which has allowed capital to move more freely and cheaply between
countries;  sustained high growth rates, sounder economic fundamentals, and the liberalization of
capital markets in many emerging market economies;  favourable international macroeconomic
conditions, marked by low interest rates and ample liquidity in the industrialized countries;  the
institutionalization of savings in the industrialized countries, and the increase in professional assetmanagement which has helped reduce operating costs for financial transactions;  and progress in
communications and information technology, which has allowed cheaper, quicker and more accurate
processing of information by asset managers on a much wider range of countries and companies than
in the past.
31. On the basis of these developments, it is believed that portfolio investors based in the
industrialized countries have been more willing to invest in developing countries and economies in
transition.  In addition, in the 1990s portfolio investors have been encouraged to do so, in order to
diversify their portfolios and help increase the risk-adjusted returns on their investments.
21
32. Once a decision has been taken to invest in emerging markets as a group, specific country
determinants will influence the actual allocation of funds.  UNCTAD suggests that individual host
country determinants of foreign portfolio investment fall into two groups: economic determinants and
policy/regulatory determinants.22
33. Economic determinants are a reflection of the general health of the economy, the potential for
firms to earn profits, and the potential to obtain a high return on fixed income investment.  According
                                                     
19 Ibid, p. 47.
20 For a discussion, see John H. Dunning and John R. Dilyard "Towards a general paradigm of foreign
direct and foreign portfolio investment", and Mira Wilkins "Two literatures, two story-lines:  is a general
paradigm of foreign portfolio and foreign direct investment feasible?", Transnational Corporations , Vol.8 No.1,
April 1999.
21 See UNCTAD/GDS/DFSB/5 (23 June 1999), pp. 18-22, for a description of the extension of the
single market capital asset pricing model to include investment in emerging markets as a strategy to lower therisk-adjusted returns of an investment portfolio, and for a discussion of why there are doubts that this strategyhas worked in practice.
22 Ibid, p. 16-18.WT/WGTI/W/103
Page 8
to UNCTAD, investors will typically focus on the following factors23:  high economic growth rate;
exchange rate stability;  macroeconomic stability;  level of foreign exchange reserves;  health of
domestic banking system;  stock and bond market liquidity;  and real interest rates.  Some of these
factors (e.g., stock market liquidity) will be of more importance to equity investors, and others (e.g.,
real interest rates) to fixed income investors.
34. The main policy and regulatory determinants, according to UNCTAD's survey, are:  ease of
repatriating dividends and capital;  domestic capital gains tax;  stock and bond market regulation;
quality of domestic accounting and disclosure standards;  speed and reliability of the settlement
system;  availability of domestic custodians and brokers;  and degree of investor rights protection.
UNCTAD states that these are factors over which host  governments have the most direct control, and
that while it is not possible to isolate any single factor as being the most important, some tend to carry
more weight than others.  For example, the degree of investor rights protection and the ease ofrepatriating dividends and capital are often cited as being watched closely by potential investors, as
are efforts that are being made in emerging markets to meet higher standards of corporate governance.
D. FDI 
AND FOREIGN PORTFOLIO INVESTMENT
35. FDI and foreign portfolio investment display several elements of complementarity, both in a
direct commercial sense and in terms of the advant ages that the host country derives from attracting
foreign investment.
36. Most FDI involves various foreign financial transactions over and above the initial
investment.  Examples are equity capital contributions made by the parent company subsequent to the
initial investment, and intercompany debt transactions, involving borrowing and lending between the
parent company and its subsidiaries.  If capital markets are well-developed in the host country, FDIwill have the choice of conducting at least some of these financial transactions at arms-length, through
local markets for equity and debt securities, rather  than solely on the basis of the subsidiary-parent
company relationship.  This can create a risk, that by competing for scarce capital to support its
operations FDI will crowd-out domestic enterprises in the host country from local capital markets.
Access to foreign portfolio investment flows can help reduce that risk.
37. Like FDI, foreign portfolio investment supplements domestic savings in developing countries,
and provides for a higher rate of capital formation to support growth and development than would
otherwise be possible.  Foreign portfolio investment does not bring with it the management know-
how, technology, and intangible assets that are associ ated with FDI.  However, nor does it involve any
loss of control of ownership.  Its potential benefits for developing countries are generally considered
to lie in its contribution to adding liquidity to domestic capital markets, increasing their efficiency,
and raising financial and corporate standards.  These contribute to enhancing the businessenvironment in recipient countries.
24
38. By injecting liquidity, foreign portfolio investment helps to increase the availability of
financing for local enterprises and to reduce the cost  of capital, which increases their competitiveness.
Inter alia, this can assist the start-up and expansion of locally-owned enterprises that establish
backward and forward linkage activities related to the operations of FDI, as well as locally-owned
enterprises that compete directly with FDI for a share of the domestic market.
                                                     
23 Based on the results of an UNCTAD questionnaire reproduced in UNCTAD/GDS/DFSB/5.
24 See UNCTAD, Expert Meeting on Portfolio Investment Flows and Foreign Direct Investment,
Commission on Investment, Technology, and Related Financial Issues , "Foreign Portfolio Investment and
Foreign Direct Investment:  Characteristics, Sim ilarities, Complementarities and Differences, Policy
Implications and Development Impact", TD/B/COM.2/EM.6/L.1, July 1999, pp. 7-12.WT/WGTI/W/103
Page 9
39. As liquidity increases, capital market turnover also increases and price volatility is likely to be
reduced, thus attracting more investors and encouraging firms to use capital markets to raise funds
through issues of financial instruments.  Foreign portfolio investment can help improve the standards
of local capital markets, as foreign investors generally demand high quality information, transparency,
and disclosure, as well as legal protection for minority shareholders and bondholders, and theydemand adequate market and trading regulations.  Foreign portfolio investment can also encourage
the development of other financial intermediaries and ancillary services in recipient countries, such as
investment management and financial advisory services, accounting, auditing, and market information
services, and credit rating agencies.  This can help strengthen the financial infrastructure, increase
transparency in financial transactions, deepen the process of financial intermediation, and improve
corporate governance.
40. More generally, by contributing to the development of a better domestic business
environment in the host country, particularly the development of the local financial infrastructure and
the deepening of capital markets, foreign portfolio  investment can help attract new FDI, including
through M&A activity.
E. C
ONCERNS OF HOST COUNTRIES
41. According to UNCTAD, the main concern of  recipient countries is the potentially
destabilizing effects of volatile foreign portfolio in vestment flows.  The main concern of low income
developing countries, on the other hand, is th eir limited access to flows of foreign portfolio
investment, as well as FDI.25
42. From an accounting point of view, foreign portfolio investment represents both a foreign asset
(the initial capital inflow) and a foreign liability (the periodic payment of dividends and interest, andthe eventual repatriation of the original capital).  It is difficult to say anything at a general level about
how assets and liabilities will evolve over time, since their relationship is dependent in part on the
overall growth and development of the host economy,  but in normal circumstances there is no prima
facie reason to believe that foreign portfolio investment need become an unsustainable burden on a
recipient country's balance-of-payments situation.  For example, the initial capital inflow may be usedto generate a future stream of foreign exchange earnings that is well in excess of the financial
liabilities associated with it, and even if the origin al investment instrument matures or is sold on the
domestic capital market at some point, the proceeds may be re-invested in the recipient country rather
than being repatriated.
43. In general, equity investments may pose less of a potential burden on the recipient country's
balance-of-payments than bond (debt) instruments.  Equity investments do not mature and are
therefore not subject to redemption;  they are priced in domestic currency terms as long as they areissued and traded on the domestic stock market, so that the foreign investor shares in any exchange
rate risk which may occur;  and they are subject not only to possible capital gains but also losses,
depending on the performance of the domestic enterprise , so that the foreign investor shares in the
operating risk too.  In contrast, debt securities do mature, they typically have a fixed payment due at
maturity which is independent of the commercial fortunes of borrower, and they may be denominatedin foreign currency.
44. It has been suggested in addition that while equity holders can withdraw their funds in the
event of a domestic financial crisis, this can be done typically only by incurring large capital losses, so
that equity investments may be less prone to contri buting to capital flight.  However, evidence on this
point appears to be mixed.  The World Bank notes, for example, that in the three financial crises ofthe 1990s – Mexico, East Asia and Russia – mutual funds (which represent some of the most
                                                     
25 Ibid, Agreed Conclusions, pp. 1-3WT/WGTI/W/103
Page 10
significant investments in emerging markets) with drew large sums of money and contributed to the
loss of liquidity, but the World Bank also cites a study that draws opposite conclusions from the
available empirical evidence.26
45. Separately, UNCTAD has suggested that different degrees of potential volatility can be
associated with different kinds of foreign portfolio equity investment.27  The least volatile seem to be
venture capital investments;  investments placed through large institutional investors (i.e. through
country funds) seem to be less volatile than investments made directly through the local stock market;
also, closed-end investment funds seem to be less volatile than open-end investment funds.  The
highest degree of volatility is associated with direct portfolio equity investments in the local stock
market managed by retail investors, who tend to invest more speculatively.  UNCTAD notes that the
issue of volatility does not arise in the case of investment flows in the secondary market for depositary
receipts, since the trading activity is conducted on foreign exchanges and does not affect the flow offunds in and out of the local stock market.
46. There are well-established reasons to expect foreign portfolio investment in general to be
more variable and footloose than FDI, and the data support that conclusion.  For example, UNCTAD
has calculated that the relative variance of foreign portfolio equity flows is four times higher than that
of FDI.
28  Separately, UNCTAD found from a survey of 29 countries for the period 1990-98 that the
values of the coefficients of variation were high est for the category "other investment" (primarily
bank loans) in 16 countries, they are the highest for foreign portfolio investment in 9 countries, and
for FDI in only 4 countries, of which two were Kuwait and Saudi Arabia whose results were clearly
skewed by the effects of the gulf war.29  Comparing the coefficients of variation of portfolio equity
securities and portfolio debt securities, UNCTAD found that debt securities were more variable thanequity securities in 19 cases out of 29.
47. The fact that foreign portfolio investment is found to be more variable than FDI, because
portfolio investors generally have a shorter time horizon and are able to liquidate their investments
more easily, does not necessarily imply that it is inherently "volatile".  The difference between
variability and volatility is in practice mainly one of degree, but volatility carries with it also thenotion of large, more frequent, and unpredictable changes in the volume of capital inflows and
outflows.  Clearly, when this happens, it can destabilize the domestic investment environment and be
highly detrimental to growth, development and macroeconomic management in the host country.
30
Sudden and significant changes in foreign investment can undercut monetary, fiscal and exchange ratepolicies.  They can also affect the availability of finance, and consequential changes in its cost and in
asset prices, which makes investment planning difficult.  Large capital inflows create excess liquidity
in the domestic financial system, which can encourage asset bubbles and increase speculativeinvestments, while outflows drain liquidity from the system and can threaten the viability of otherwise
perfectly sound investments.
48. It is not coincidental that the 1990s saw emerging market economies register a sharp increase
in inflows of foreign portfolio investment, and some of these economies experience serious financial
crises.  Clearly, the behaviour of foreign portfolio investors contributed to both the timing and theamplitude of the financial crises.  At the same time, it would be simplistic to draw the conclusion that
                                                     
26 World Bank, Global Development Finance 2001, p. 47 and footnote 12.
27 UNCTAD World Investment Report 1997, p. 111.
28 Ibid.
29 UNCTAD/GDS/DFSB/5, p. 26.
30 For an analysis of the causes and effects of portfolio investment volatility, see UNCTAD: “The
Growth of Domestic Capital Markets, Particularly in Developing Countries, and Its Relationship with Foreign
Portfolio Investment” (TD/B/COM.2/EM.4/2, 19 March 1998) and “Foreign Portfolio Investment: Implicationsfor the Growth of Emerging Capital markets” (UNCTAD/GDS/GFSB/4, 9 September 1998), and World Bank
Global Development Finance 2001, pp. 71-76.WT/WGTI/W/103
Page 11
financial crisis is an inevitable consequence of allowing increased flows of foreign portfolio
investment.  By and large, it seems likely that most categories of foreign portfolio investors (other
than perhaps those operating at the most speculative end of the market) are as averse to volatile capital
market conditions as are the governments and private enterprises of recipient countries, and that both
have an equal interest in seeing regulatory m easures taken, and policies put in place, to limit
volatility.31
F. FOREIGN PORTFOLIO INVESTMENT IN INTERNATIONAL INVESTMENT AGREEMENTS
49. While examples exist of bilateral investment treaties which apply only to foreign direct
investment32 such treaties typically use a more comprehensive, "asset-based" definition  which states
that "investment means every kind of asset" including traditional property rights, rights in companies,
claims to money and titles to performance, intellectual property rights, and concessions and similar
rights.33 Examples of this definition can be found in several submissions to the Working Group.34 This
"asset-based" definition of investment covers portfoli o investment in an item which includes debt and
equity security interests in companies and which does not make the treatment of equity securities as
investment dependant upon whether equity holdings confer a controlling interest on the foreign
investor.35 Though it has been suggested that the broad definition of investment must be seen in the
light of the fact that in most such treaties bind ing obligations are limited to the post-establishment
treatment and protection of investment, a similarly broad definition, including portfolio investment,
appears in bilateral investment treaties that provide for application of non-discrimination obligations
to the pre-establishment phase.
50. Notwithstanding the inclusion of portfolio investment in the broad, asset-based definition of
investment, bilateral investment treaties are not designed as instruments aimed at the removal ofimpediments to cross-border portfolio capital flows.  In this respect, such treaties differ from
instruments aimed at the liberalization of capit al movements between residents and non-residents,
such as the OECD Code of Liberalization of Ca pital Movements. One important obvious difference
between bilateral investment treaties and international instruments aimed at the liberalization of
capital movements is that bilateral investment treaties do not impose obligations upon countries withrespect to outward investments by their own investor s.  In addition, most bilateral investment treaties
do not provide for obligations regarding the admission of inward foreign investment.
36
51. Virtually all bilateral investment treaties contain provisions that guarantee the right of transfer
of funds related to covered investments.  Such provisions normally specify the kinds of transfers that
benefit from this right, the type of currency in which the transfer is guaranteed, the timing of the
                                                     
31 For a discussion of policy options to address volatility, see World Bank op cit  and
UNCTAD/GDS/DFSB/5, pp. 38-39.
32 See, for example, UNCTAD, Bilateral Investment Treaties in the Mid-1990s , p. 33 (referring to the
definition of investment in the bilateral investment treaty between Denmark and Lithuania as "every kind ofasset connected with economic activities acquired for the purpose of establishing lasting economic relations
between an investor and an enterprise").
33 The scope of the definition is sometimes limited by provisions stating that covered investments must
be made in accordance with the domestic law of the host state.   See e.g., "Bilateral, regional, plurilateral andmultilateral agreements", Note by the Secretariat, 26 January 1998, para. 6, and Communication from India,WT/WGTI/W/71, 13 April 1999, para. 4.
34 Communication from Japan, WT/WGTI/W/92, 24 October 2000, para. 7. See also communication
from India, WT/WGTI/W/71, 13 April 1999, para. 4, and communication    from Australia, WT/WGTI/W/80,16 June 1999, para. 1.
35 See, for example, Rudolf Dolzer and Margrete Stevens, Bilateral Investment Treaties  (1995), p. 28;
UNCTAD, Bilateral Investment Treaties in the Mid-1990s (1998), p. 33 and UNCTAD, Scope and Definition
(1999),  p. 19.
36 See, UNCTAD, Transfer of Funds  (2000), pp. 28-29.WT/WGTI/W/103
Page 12
transfer and the applicable exchange rate.37  As discussed in a recent UNCTAD study, the main kinds
of transfers covered by these provisions are: (i ) the outward transfer of amounts derived from or
associated with protected investments;38  (ii)  the outward transfer of amounts arising from a host
country's performance of other investor protection obligations under an agreement;  and (iii) the
inward transfer of amounts to be invested by a foreign investor.39 These provisions are often qualified
by exceptions and limitations, notably in respect of taxation, reporting requirements in relation to
currency transfers, adjudicatory proceedings and enforcement of creditor rights. In some cases,
provision has been made for limitations of the right of free transfer on account of balance-of-
payments problems.40  It would appear, however, that this is not typical. A detailed analysis of 335
bilateral investment treaties found that about one fifth of the treaties dealt with balance-of-payments
problems in provisions that allowed for the transfer of large sums in instalments extending over a
period of between three to five years.41 Another source states that "[o] nly  few recent BITs contain a
clause admitting the right of a contracting party to restrict the transfer of any payment connected with
a covered investment in exceptional financial or economic circumstances affecting its balance-of-
payments."42 The recent UNCTAD study on Transfer of Funds notes that "only a very small
proportion of the nearly 1,800 bilateral investment treaties in existence specifically allow for
temporary balance-of-payments derogation".43
52. It should be noted that bilateral investment treaties concluded by Chile contain provisions that
permit the parties not to allow the transfer of capital during a period of one year after the date of entry.
Similarly, the investment provisions of the Canada-Chile Free Trade Agreement contain an annex in
which Chile reserves the right to take certain measures "for the purposes of preserving the stability of
its currency". These pertain, inter alia , to the maintenance by Chile of requirements that transfers of
proceeds from the sale or liquidation of an investment not take place until the expiry of specified
periods of time and the application by Chile of a reserve requirement on investment from Canada,
other than foreign direct investment, and on foreign credits relating to an investment.
53. Among the regional investment agreements that are similar in scope and content to bilateral
investment treaties, only a small number contain safeguard clauses for balance-of-payments problems.Prominent examples are the NAFTA and the Treaty on Free Trade between Colombia, Mexico and
Venezuela. 
44
54. Questions pertaining to the possible adverse balance-of-payments or financial implications of
certain kinds of investment flows have been addressed more explicitly in the context of international
rules on the liberalization of capital movements. Thus, for example, Article 7(c) of the OECD Code of
Liberalization of Capital Movements provides that:
                                                     
37 See, generally, UNCTAD, Bilateral Investment Treaties in the Mid-1990s,  (1998), pp. 75-81; and
UNCTAD, Transfers of Funds  (2000), pp. 30-38.
38 This category comprises returns on investment;  pr oceeds from the sale or liquidation of all or any
part of the investment;  payment under a contract including a loan agreement;  and earnings and other
remuneration of personnel engaged from abroad in connection with an investment.
39 This includes transfers made to develop and maintain an existing investment and, in the case of
agreements that contain requirements regarding the admission of investment, transfers made for the purposes ofmaking an investment.
40 UNCTAD, Bilateral Investment Treaties in the Mid-1990s  (1998), p. 79.
41 Mohammed Khalil, "Treatment of Foreign Investment in Bilateral Investment Treaties," Foreign
Investment Law Journal-ICSID Review , Vol.7, No.2, Fall 1992, pp. 339-383, pp. 360-361.
42 Giorgio Sacerdoti, Bilateral Treaties and Mu ltilateral Instruments on Investment Protection ( 1997),
p. 363.
43 UNCTAD, Transfer of Funds  (2000), p. 36.
44 UNCTAD, Transfer of Funds (2000), p. 37  and OAS Trade Unit, Investment Agreem ents in the
Western Hemisphere:  A Compendium , (1997), p. 12.WT/WGTI/W/103
Page 13
"If the overall balance-of-payments of a Member develops adversely at a rate and in
circumstances, including the state of its monetary reserves, which it considers serious,
that member may temporarily suspend the application of measures of
liberalisation…"
Article 7(b) of the Code provides that:"If any measures of liberalisation take n or maintained in accordance with the
provisions of Article 2(a) result in serious economic and financial disturbances in the
Member states concerned, that member may withdraw those measures."
55. In addition, the Code provides that Members may lodge reservations when a new item is
added to the list of capital movements covered by the Code, and when an obligation relating to an
item is extended or begins to apply to a Member.  The Code also provides that in respect of certain
transactions included in a "List B" members may reintroduce restrictions at any time. The coverage ofthis List B is currently limited to financial opera tions of a short-term nature. According to the
UNCTAD study on Transfer of Funds this "generous treatment of these transactions is attributable to
their potentially adverse impact on the macroeconomic and balance-of-payments stability of OECD
members."
45
56. Similarly,  liberalization of capital movements within the context of the European Community
has also been accompanied by certain safeguards regarding certain kinds of capital movements. Thus,
the Council Directive adopted in June 1988 on the liberalisation of capital movements  by 1 July 1990
allowed for the application of restrictions of limited duration in respect of capital movements
identified in an annex to that Directive "whe re short-term capital movements of exceptional
magnitude impose severe strains on foreign-exchange markets and lead to serious disturbances in theconduct of a Member State's monetary and exchange rate policies, being reflected in particular in
substantial variations in domestic liquidity…."
46.
                                                     
45 UNCTAD, Transfer of Funds  (2000), p. 22.
46 Council Directive 88/361/EEC, OJ No L 178, 8.7.1988, p. 6.WT/WGTI/W/103
Page 14
ANNEX
Table 1
Capital market commitments
to developing countries by type of flow, 1991-2000
(US$ billions)
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Total 76.9 80.1 115.7 135.5 173.3 236.4 315.8 189.5 185.5 236.4
of which :
Bond issuance 11.0 20.1 50.1 45.7 52.6 97.6 114.3 73.0 70.3 77.2
Bank lending 61.3 54.0 57.5 72.8 112.7 125.2 179.1 107.8 94.0 124.4
Equity placement 4.6 6.0 8.1 17.0 8.0 13.7 22.4 8.6 21.1 34.8
of which, China 0.0 0.7 1.9 2.6 0.9 2.1 9.4 1.1 3.3 21.2
Source: World Bank, Global Development Finance 2001 , Table2.6.
Note: For bond and equity flows, commitments typically translate almost immediately into disbursements;
however, for bank lending, commitments are often disbursed over more than a year.WT/WGTI/W/103
Page 15
Table 2
Net Private Capital Flows to Emerging Markets, 1992-99
(US$ billions)
1992 1993 1994 1995 1996 1997 1998 1999
Emerging markets
Total net private capital inflows
Net foreign direct investmentNet portfolio investmentBank loans and other112.6
35.4
56.121.0172.1
59.4
84.428.3136.3
84.0
109.6
-57.3226.9
92.6
36.997.4215.9
113.2
77.824.9147.6
138.6
52.9
-44.075.1
143.3
8.5
-76.780.5
149.8
23.3
-92.5
Africa
Total net private capital inflows
Net foreign direct investment
Net portfolio investmentBank loans and other-4.0
0.6
1.8
-6.4-1.8
1.9
1.0
-4.72.9
2.3
2.0
-1.410.9
2.2
1.47.37.5
4.8
1.31.416.7
7.4
3.75.611.5
5.2
4.32.014.8
9.5
4.40.9
Asia
Total net private capital inflows
Net foreign direct investment
Net portfolio investment
Bank loans and other20.8
15.7
9.0
-3.957.4
33.9
21.8
1.763.6
47.1
11.8
4.7104.9
46.6
14.2
44.1104.1
53.1
12.9
38.1-1.4
55.5
3.5
-60.4-42.6
58.3
-17.9
-82.9-27.0
49.9
-5.6
-71.3
Five crisis-affected Asian countries1
Total net private capital inflows
Net foreign direct investmentNet portfolio investment
Bank loans and other29.0
7.3
6.4
15.331.8
7.6
17.2
7.036.1
8.8
9.9
17.474.2
7.5
17.4
49.265.8
8.4
20.3
37.1-20.4
10.3
12.9
-43.6-25.6
8.6
-6.0
-28.2-24.6
10.2
6.3
-41.1
Europe
Total net private capital inflows
Net foreign direct investmentNet portfolio investment
Bank loans and other6.5
5.1
2.3
-0.827.4
6.7
12.4
8.41.8
6.1
21.5
-25.848.8
14.6
14.6
19.726.7
14.4
19.6
-7.432.2
20.3
23.3
-11.416.3
21.7
0.7
-6.118.0
24.2
6.6
-12.8
Middle East
Total net private capital inflows
Net foreign direct investmentNet portfolio investmentBank loans and other33.7
0.2
12.720.822.3
3.5
5.1
13.618.6
5.4
7.65.69.1
4.6
3.80.85.6
1.4
3.01.214.6
2.3
3.39.019.9
2.0
6.7
11.220.6
2.6
7.3
10.8
Western Hemisphere
Total net private capital inflows
Net foreign direct investmentNet portfolio investmentBank loans and other55.6
13.9
30.311.466.8
13.4
44.0
9.449.4
23.1
66.7
-40.453.1
24.7
3.0
25.572.1
39.5
41.0
-8.485.5
53.1
19.213.270.0
56.1
14.7
-0.854.1
63.6
10.6
-20.1
Current account
Emerging markets
AfricaAsiaEuropeMiddle East
Western Hemisphere-72.7
-10.0
3.6
-6.6
-25.1
-34.5-110.3
-11.2
-13.2-14.5-25.4
-46.0-73.8
-11.5
-4.4
5.8
-11.5
-52.2-112.5
-16.5
-50.4
-3.1-5.7
-36.8-96.0
-7.0
-38.5-20.0
7.8
-38.3-77.4
-7.4
18.0
-29.4
5.4
-64.1-49.5
-20.0
114.9
-23.6-32.2
-88.621.5
-16.8
103.1
-6.6-4.1
-54.2
As percent of emerging markets' GDP
Direct investmentPortfolio investmentBank loans and other0.7
1.10.41.0
1.50.51.4
1.9
-1.01.4
0.61.51.6
1.10.41.9
0.7
-0.62.1
0.1
-1.12.1
0.3
-1.3
Source: IMF, International Capital Markets , September 2000.
1Indonesia, Korea, Malaysia, Philippines, and Thailand.
__________