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The Effect of Capital Controlson Foreign Direct Investment Decisions Under Country Risk with Intangible Assets

  • Kinga Z. Elo
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    This paper examines how capital controls affect FDI decisions and how the impact of these restrictive measures varies with different levels of country risk. We construct a model of firms' FDI decisions, broadly in Dunning's "eclectic theory" framework, using "real options" to emphasize economic uncertainty and country risk. Numerical results of the model take the form of "quality statistics" that uncover the underlying dynamics hidden in the aggregate data that is responsible for the low performance of recent empirical studies. We find that increasing levels of capital controls reduce the life-span of FDI investments at each level of country risk and foreign investors' willingness towards risk sharing increases. We reveal a significant interaction between capital control and country risk, resulting in a nonlinear relationship between these and the volatility and volume statistics. We estimate a standard cross-sectional model that provides strong support for our theoretical findings.

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    Paper provided by International Monetary Fund in its series IMF Working Papers with number 07/79.

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    Length: 62
    Date of creation: 01 Apr 2007
    Date of revision:
    Handle: RePEc:imf:imfwpa:07/79
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    1. Montiel, Peter & Reinhart, Carmen M., 1999. "Do capital controls and macroeconomic policies influence the volume and composition of capital flows? Evidence from the 1990s," Journal of International Money and Finance, Elsevier, vol. 18(4), pages 619-635, August.
    2. Badi H. Baltagi & Chihwa Kao, 2000. "Nonstationary Panels, Cointegration in Panels and Dynamic Panels: A Survey," Center for Policy Research Working Papers 16, Center for Policy Research, Maxwell School, Syracuse University.
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    6. Ricardo Hausmann & Eduardo Fernández-Arias, 2000. "Foreign Direct Investment: Good Cholesterol?," Research Department Publications 4203, Inter-American Development Bank, Research Department.
    7. Mary Kathryn Campion & Rebecca M. Neumann, 2003. "Compositional Effects of Capital Controls - Theory and Evidence," The World Economy, Wiley Blackwell, vol. 26(7), pages 957-973, 07.
    8. Kose, Ayhan & Prasad, Eswar & Rogoff, Kenneth & Wei, Shang-Jin, 2004. "Financial Globalization, Growth and Volatility in Developing Countries," CEPR Discussion Papers 4772, C.E.P.R. Discussion Papers.
    9. Hull, John C & White, Alan D, 1987. " The Pricing of Options on Assets with Stochastic Volatilities," Journal of Finance, American Finance Association, vol. 42(2), pages 281-300, June.
    10. Michael P. Dooley & Peter Isard, 1978. "Capital controls, political risk and interest disparities," International Finance Discussion Papers 125, Board of Governors of the Federal Reserve System (U.S.).
    11. Jean J Boddewyn, 1983. "Foreign and Domestic Divestment and Investment Decisions: Like or Unlike?," Journal of International Business Studies, Palgrave Macmillan, vol. 14(3), pages 23-35, September.
    12. Aizenman, Joshua & Marion, Nancy P. & Marion, Nancy P., 1993. "Macroeconomic uncertainty and private investment," Economics Letters, Elsevier, vol. 41(2), pages 207-210.
    13. Asiedu, Elizabeth & Lien, Donald, 2004. "Capital Controls and Foreign Direct Investment," World Development, Elsevier, vol. 32(3), pages 479-490, March.
    14. Black, Fischer, 1974. "International capital market equilibrium with investment barriers," Journal of Financial Economics, Elsevier, vol. 1(4), pages 337-352, December.
    15. Classens, S. & Dooley, M.P. & Warner, A., 1995. "Portfolio Capital Flows: Hot or Cold," Papers 501, Harvard - Institute for International Development.
    16. Eswar Prasad & Qing Wang & Thomas Rumbaugh, 2005. "Putting the Cart Before the Horse? Capital Account Liberalization and Exchange Rate Flexibility in China," IMF Policy Discussion Papers 05/1, International Monetary Fund.
    17. Rui Albuquerque, 2004. "The Composition of International Capital Flows: Risk Sharing Through Foreign Direct Investment," International Finance 0405004, EconWPA.
    18. Hartwell, Christopher A., 2001. "The case against capital controls: financial flows, crises, and the flip side of the free-trade argument," MPRA Paper 40263, University Library of Munich, Germany.
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