An Information-Based Model of Foreign Direct Investment: the Gains from Trade Revisited
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 savings 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 information asymmetry, the paper identifies how, however, FDI gives rise to foreign overinvestment as well as domestic undersaving.
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