Cross-Border Investment

More transparency needed to encourage cross-border investment

New research shows that the availability of information is crucial in determining external portfolio investment flows. Two leading economists, Richard Portes of London Business School and Hélène Rey of the London School of Economics, find that ‘the more information foreign investors have about a given market, the more they trade in that market’. These and other significant conclusions appear in a paper on the determinants of cross-border investment flows recently published by the Centre for Economic Policy Research. 

The authors’ starting point is the fact that investors in one country invest less abroad than normal portfolio allocation models seem to justify. This is the ‘home bias puzzle’ in international finance. One explanation is that investors prefer to invest at home because it is the place they know best. 

The authors find that the existing research is on the whole unconvincing, partly because of the lack of data available in this area. They therefore look to see if there are other, hitherto unacknowledged, forces at work in determining cross-border portfolio investment flows. These go beyond the size of a country and its stock market capitalisation, the importance of which has been recognised by specialists in the area. Portes and Rey introduce phenomena such as the level of telephone traffic between countries, the number of banks from one country to be found in another, the effectiveness of judicial systems, the sharing of a language and so on. They even look at the frequency with which newspapers in one country report on events in others. (Italians appear more interested in France than they are in Germany, while Switzerland occupies more column inches in Germany than elsewhere.) These factors all play a part in directing cross-border investment.

Geographical distance between one country and another emerges as an important element in determining portfolio investment flows. This again can be a reflection of the crucial role of information. Among obstacles to inward investment is information asymmetry, as for example when insider trading is common on a local stock market. 

When all these factors are put together they explain 70% of the gross flows that actually take place. They are more important, it seems, than the returns that might be expected from different markets. The authors find some similarity between the factors governing goods trade and investment flows. 

The results should have important implications for policy. If governments wish to attract investment to their countries, ‘they should consider measures to improve transparency, reduce insider trading, encourage entry of foreign financial institutions, and communicate to the foreign press information relevant to the financial markets’.

Notes for Editors:

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The Authors:
Richard Portes is Professor of Economics at London Business School, President of CEPR and is currently visiting Haas School of Business, University of California at Berkeley.

Hélène Rey is Lecturer in Economics at London School of Economics and a Research Affiliate in CEPR’s International Macroeconomics research programme.