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

This paper examines the impact of the volatility of foreign portfolio investment on the financial constraints of small firms. Utilizing a dataset of over 195,000 firm-year observations across 53 countries, I examine 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-, industryand country-level characteristics such as GDP growth as well as the levels of foreign portfolio and direct investment, I find 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.’ Importantly, the volatility of foreign portfolio investment also 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. JEL Classification: D92, F32