Summary:
Since 2015, alongside the continual growth of China's Foreign Portfolio Investment (FPI) assets, there has been a greater share directed toward bond and equity assets in developing economies with high macroeconomic risks. Concurrently, China's Economic Policy Uncertainty (EPU) Index, as documented by Baker et al. (2016), rose sharply from 166 in January 2015 to 852 in June 2019, largely due to domestic and international factors such as the China-US economic and trade consultayions and real estate market volatility. Although the index later declined, it remained relatively high at 513 by December 2022. This raises a crucial question: Is the observed shift in China's FPI assets closely correlated with rising economic policy uncertainty？ This study investigates the effects of economic policy uncertainty in source countries on its FPI positions and their geographic distribution. Using data on equity and bond FPI positions from 22 source countries and 91 destination countries, drawn from the CPIS database covering the period 2001 to 2019. Economic policy uncertainty in source countries is measured using the Economic Policy Uncertainty Index (Baker et al., 2016), while country risks in destination countries are assessed using indicators from the EIU Country Risk Model. To enrich the empirical analysis, the study incorporates an interaction term between the source country's economic policy uncertainty and the destination country risks into a gravity model framework, which is designed to address cross-border financial asset transactions. The empirical findings reveal that FPI generally rises in response to increasing economic policy uncertainty in the source country. Specifically, a 1% rise in economic policy uncertainty leads to a 1.245% increase in equity FPI (standardized by GDP) and a 0.691% increase in bond FPI. However, when the interaction term between the source country's economic policy uncertainty and the destination country risks is introduced, the regression results show that the coefficient for the destination country risks is significantly negative, while the interaction term's coefficient is significantly positive. This suggests that as the source country's economic policy uncertainty increases, investors become less risk-averse toward the macroeconomic risks in the destination countries for FPI. These results remain robust across various tests, including those using valuation-adjusted FPI data, different measures of destination country risks, and addressing potential endogeneity issues. In further analysis, the study explores the differential effects of various forms of uncertainties—namely, the source country's economic policy uncertainty, systemic banking crises, information asymmetry between the source and destination countries, and global financial market uncertainty—on FPI. The results indicate that only an increase in the source country's economic policy uncertainty correlates with a higher proportion of FPI and a greater allocation to destination countries with elevated risks. The contributions of this study can be summarized in three key areas. First, while prior research has primarily examined whether the source country's economic policy uncertainty affects the overall scale of international investment or how destination risks impact investment inflows, without considering how changes in the source country's economic policy uncertainty shape investors' attitudes toward destination risks. This study finds that increases in the source country's economic policy uncertainty significantly raise investors' tolerance for macroeconomic risks in destination countries. In other words, although international investors generally avoid high-risk destinations, their level of risk aversion fluctuates in response to changes in the source country's economic policy uncertainty. Second, existing research has rarely examined how uncertainty influences financial asset allocation, with most studies focusing on bank loans. However, Foreign Direct Investment (FDI) and bank loans are closely tied to productive investment, whereas cross-border securities investment (FPI) is primarily a financial asset. Thus, the impact of economic policy uncertainty on FPI differs from that on other forms of capital. This study provides empirical evidence on how the source country's economic policy uncertainty affects FPI. Third, traditional gravity models used to analyze bilateral financial asset transactions tend to emphasize source country, destination country, and bilateral variables, often overlooking the interaction between source and destination factors. By introducing interaction terms between source and destination country factors, this study expands the analytical framework of gravity model, demonstrating that the geographical distribution of financial assets is indeed shaped by the interaction between source and destination country factors.
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