Sovereign Risk, FDI Spillovers, and Growth

This paper studies the effect of sovereign risk on capital flows from rich to poor nations in the context of a two‐country model, where Foreign Direct Investment (FDI) creates positive externalities in domestic production. We show that if externalities are large, a developing country never expropriates foreign assets, and behaves as under perfect enforcement of foreigners' property rights, jumping to the steady state in one period. If externalities are absent, a developing country always expropriates foreign assets and, then, there are no capital flows in equilibrium, as occurs in autarky. If externalities are of a medium size, our model can account for scarce capital flows from rich to poor nations, as well as other key features of the data, such as rising‐over‐time patterns of foreign capital and FDI in developing countries. In addition, the model offers an economic rationale for the FDI restrictions observed across nations.