Get clear on direct vs portfolio investment

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Let’s turn to the Balance of Payments (BoP). This is the record of transactions (money coming into Australia; funds leaving Australia) between Australia and the rest of the world. 

The BoP is divided into two accounts: the  Current Account and the Capital and Financial Account (KAFA). We’ll focus on the KAFA.

(Why is the abbreviation for the Capital and Financial Account KAFA? Because the symbol for capital is ‘K’. Not ‘C’. C is for consumption).

The KAFA itself is divided into the Capital Account (the KA part) and the Financial Account (the FA part). 

So many abbreviations.

Anyway, let’s stay with the FA part of the KAFA.

The FA has five main components:

  • Direct investment

  • Portfolio investment

  • Financial derivatives

  • Reserve assets

  • Other investment.

For this post, we’ll focus on direct and portfolio investment. 

“The key here is the 10 per cent figure. Less than 10 per cent — think portfolio investment. Above 10 per cent — think direct investment.”

Portfolio investment

Think about an investment portfolio. This typically involves an individual holding a mix of investments, all of which are relatively small. The same logic applies here.

Portfolio investment involves an individual or a firm buying shares in an existing business. The size of this investment is less than 10 per cent of existing shares in the company.

An example? An American investor purchases A$1,000 worth of Telstra shares. The value (market capitalisation) of Telstra is A$42 billion as of November 2019. Clearly, this small investment is much less than 10 per cent of the value of the business!

Direct investment

This is all about creating totally new investment or buying more than 10 per cent of shares in an existing company. 

So, we might see an Australian company buy more than 10 per cent of shares in an American company (this is also sometimes referred to as the Australian company taking a controlling stake in the US business). We could also see a foreign company start a subsidiary business in Australia (an Australian offshoot of its foreign operations; essentially the creation of a new business in Australia).

The key here is the 10 per cent figure. Less than 10 per cent — think portfolio investment. Above 10 per cent — think direct investment.