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An Information-Based Model of Foreign Direct Investment: The Gains from Trade Revisited

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  • Assaf Razin
  • Efraim Sadka
  • Chi-Wa Yuen

Abstract

Foreign direct investment (FDI) is observed to be a predominant form of capital flows to emerging economies, especially when they are liquidity-constrained internationally during a global financial crisis. The financial aspects of FDI are the focus of the paper. We analyze the problem of channeling domestic saving into productive investment in the presence of asymmetric information between the managing owners of firms and the other portfolio stakeholders. We explore the role played by FDI in reviving equity-financed capital investment for economies plagued by such information problems. In the presence of asymmetry, the paper identifies how, however, FDI gives rise to foreign overinvestment as well as domestic undersaving. We re-examine the gains from trade argument (applied to intertemporal trade) in this case of informational-asymmetry driven FDI. We show that the gains could be sizable when the domestic credit market is either underdeveloped or failing as a result of a financial crisis. But with well-functioning domestic credit market, the gains turn into losses. Surprisingly, capital may flow into the country even though the autarkic marginal productivity of capital in the domestic economy falls short of the world rate of interest. In such a situation, capital should have efficiently flown out rather than in, and FDI is a loss-generating phenomenon.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6884.

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Date of creation: Jan 1999
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Publication status: published as Razin, Assaf, Efraim Sadka and Chi-Wa Yuen. "An Information-Based Model Of Foreign Direct Investment: The Gains From Trade Revisited," International Tax and Public Finance, 1999, v6(4,Nov), 579-596.
Handle: RePEc:nbr:nberwo:6884

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  1. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  2. Bovenberg, A.L. & Gordon, R.H., 1996. "Why is capital so immobile internationally? Possible explanation and implications for capital income taxation," Open Access publications from Tilburg University urn:nbn:nl:ui:12-73564, Tilburg University.
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  5. Barry, F & Bradley, J, 1997. ""FDI and Trade : The Irish Host-Country Experience"," Papers 97/13, College Dublin, Department of Political Economy-.
  6. Matthew D. Shapiro & Joel Slemrod, 1993. "Consumer Response to the Timing of Income: Evidence from a Change in Tax Withholding," NBER Working Papers 4344, National Bureau of Economic Research, Inc.
  7. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  8. Borensztein, E. & De Gregorio, J. & Lee, J-W., 1998. "How does foreign direct investment affect economic growth?1," Journal of International Economics, Elsevier, vol. 45(1), pages 115-135, June.
  9. Jacob Frenkel & Assaf Razin & Efraim Sadka, 1991. "International Taxation in an Integrated World," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061430, December.
  10. S. Lael Brainard, 1993. "A Simple Theory of Multinational Corporations and Trade with a Trade-Off Between Proximity and Concentration," NBER Working Papers 4269, National Bureau of Economic Research, Inc.
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  12. Razin, A. & Sadka, E. & Yuen, C.W., 1997. "Implications of the Home Bias: A Pecking Order of Capital Inflows and Corrective Taxation," Papers 32-97, Tel Aviv.
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Cited by:
  1. Soto, Marcelo, 2003. "Taxing capital flows: an empirical comparative analysis," Journal of Development Economics, Elsevier, vol. 72(1), pages 203-221, October.
  2. Jing, Chao & Kaempfer, William H. & Lowenberg, Anton D., 2003. "A public choice model of the role of multinational firms in international relations," The North American Journal of Economics and Finance, Elsevier, vol. 14(1), pages 131-144, March.
  3. Diemo Dietrich, 2002. "Investment Behaviour of Financially Constrained Multinational Corporations: Consequences for the International Transmission of Business Cycle Fluctuations," IWH Discussion Papers 165, Halle Institute for Economic Research.
  4. Buch, Claudia M. & Heinrich, Ralph P. & Schertler, Andrea, 2003. "External and Internal Financial Structures in Europe: A Corporate Finance Perspective," EIFC - Technology and Finance Working Papers 19, United Nations University, Institute for New Technologies.
  5. Selin Sayek & Laura Alfaro & Areendam Chanda & Sebnem Kalemli-Ozcan, 2003. "FDI Spillovers, Financial Markets and Economic Development," IMF Working Papers 03/186, International Monetary Fund.
  6. Assaf Razin & Efraim Sadka & Chi-Wa Yuen, 1999. "Excessive FDI flows under asymmetric information," Proceedings, Federal Reserve Bank of San Francisco, issue Sep.
  7. Assaf Razin & Efraim Sadka & Chi-Wa Yuen, 2001. "Social Benefits and Losses from FDI: Two Nontraditional Views," NBER Chapters, in: Regional and Global Capital Flows: Macroeconomic Causes and Consequences, NBER-EASE Volume 10, pages 311-332 National Bureau of Economic Research, Inc.
  8. Marcelo Soto, 2000. "Capital Flows and Growth in Developing Countries: Recent Empirical Evidence," OECD Development Centre Working Papers 160, OECD Publishing.
  9. Clemens Fuest & Bernd Huber & Søren Bo Nielsen, . "Why Is the Corporate Tax Rate Lower than the Personal Tax Rate?," EPRU Working Paper Series 00-17, Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics.
  10. Fuest, Clemens & Huber, Bernd & Nielsen, Soren B., 2003. "Why is the corporate tax rate lower than the personal tax rate?: The role of new firms," Journal of Public Economics, Elsevier, vol. 87(1), pages 157-174, January.

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