Financial development and FDI flows: evidence from advanced economies

Foreign direct investment (FDI) has grown dramatically as a major form of international capital transfer over the past decades. This rapid growth in cross border investment has to a large part been due to the reduction in trade and investment barriers, the harmonization and mutual recognition of regulation and the removal of domestic impediments through reform and privatization (see OECD, 2001). Amongst the numerous FDI determinants studied in the literature, the development and depth of the financial sector has gained importance during the last decade. According to the Paradox of Finance hypothesis, despite the fact that Multinational Corporations (MNCs) are not locally financially constrained their affiliates interact significantly with the domestic financial system. Hence, a deep and efficient financial system should act as a pull factor for FDI flows. Using up-to-date FDI data for advanced and emerging economies, this research explores the role of previously unavailable financial variables in attracting FDI flows. The results show that fostering an efficient financial sector with diversified funding sources for enterprises contributes to increased participation by Multinational Corporations in the host economy. This insightful policy implication for advanced economies is that the restructuring of the financial system can contribute to economic recovery through the FDI channel as well. Finally, the results highlight the importance for the full implementation of the Banking Union and the Capital Markets Union in the EU.