Restrictions on outward portfolio investment and domestic equity markets

Governments sometimes impose restrictions on local investors which effectively prevent them from purchasing overseas equities. Reasons for doing this, from the government's point of view, would include increasing the availability of risk capital to local companies and lowering its costs. The paper analyses this argument in terms of modern portfolio theory. It is shown that, under certain circumstances, domestic equities and overseas equities may be complements rather than substitutes. In this case the effect of the restrictions would be to lower prices on the domestic stock exchange and to raise the cost of risk capital to local companies. Indications are given of the circumstances in which this effect is likely to occur. Policy makers who are not aware of the risk‐spreading motives which underly much international portfolio investment in equities are likely to overstimate the benefits to local industry from forcing local equity investors to keep their funds at home.