Portfolio Outflows and Cost of Capital

Large foreign portfolio outflows occur when overseas investors withdraw substantial funds from an economy’s shares and debt securities. They can raise the cost of capital, meaning the return that lenders and shareholders require to finance investment, by depressing security prices, weakening the currency and increasing perceived risk. The effect is not automatic: it depends on domestic demand for securities, economic conditions and the policy response.

From security sales to higher financing costs

Portfolio investors generally trade existing securities rather than withdraw money directly from firms. Nevertheless, prices in these secondary markets influence the terms on which governments and businesses can raise fresh funds.

• When foreign investors sell bonds and domestic buyers do not fully offset these sales, bond prices fall. Bond prices and yields move inversely, so the yield demanded on comparable new borrowing rises.
• Higher government bond yields can raise the benchmark against which corporate debt is priced, increasing firms’ borrowing costs.
• Equity selling can depress share valuations. Raising a given amount through a fresh share issue then requires issuing more shares, increasing dilution for existing shareholders.
• If outflows also increase perceived investment risk, shareholders demand a higher expected return, raising the firm’s cost of equity.

Currency, risk and liquidity channels

Outflows can reinforce financing pressures through the foreign-exchange market and investors’ willingness to bear risk.

• When investors convert sale proceeds into foreign currency, this puts downward pressure on the domestic currency. Expected currency depreciation can make foreign investors demand higher domestic-currency returns.
• Depreciation increases the domestic-currency burden of unhedged foreign-currency debt, potentially weakening borrowers’ balance sheets and increasing lenders’ risk premiums.
• Disorderly selling can reduce market liquidity. Investors may then require additional compensation for the difficulty of selling securities without sharply affecting their prices.
• If depreciation threatens inflation stability, monetary tightening may become necessary, adding to borrowing costs; an outflow does not automatically require a policy-rate increase.

Consequences and factors that limit the impact

Higher debt and equity financing costs can raise a firm’s weighted average cost of capital, making fewer investment projects financially viable. This can weaken capital formation and growth.

• A broad domestic investor base and deep, liquid financial markets can absorb foreign selling and limit price disruption.
• Credible macroeconomic policies and limited unhedged foreign-currency borrowing can reduce the amplification of outflows into financing stress.