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Channeling Domestic Savings into Productive Investment Under Asymmetric Information: The Essential Role of Foreign Direct Investment

  • Assaf Razin
  • Efraim Sadka
  • Chi-Wa Yuen

Foreign direct investment (FDI) is observed to be a predominant form of capital flows to low and middle income countries with insufficiently developed capital markets. This paper analyzes the problem of channeling domestic savings into productive investment in the presence of asymmetric information between the managing owners of firms and other portfolio stakeholders. We emphasize the crucial role played by FDI in sustaining equity-financed capital investment for economies plagued by such information problems. Similar problems also exist for foreign portfolio debt flows. The paper identifies how, in the presence of information asymmetry, different capital market structures may lead to foreign over- or under-investment and to domestic under- or over-saving, and thus to inefficient equilibria. We show how corrective tax-subsidy policies consisting of taxes on corporate income and the capital incomes of both residents and nonresidents can restore efficiency.

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File URL: http://www.nber.org/papers/w6338.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6338.

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Date of creation: Dec 1997
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Publication status: published as European Economic Review (May 1998).
Handle: RePEc:nbr:nberwo:6338
Note: IFM PE
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  1. Zhaohui Chen & Mohsin S. Khan, 1997. "Patterns of Capital Flows to Emerging Markets; A Theoretical Perspective," IMF Working Papers 97/13, International Monetary Fund.
  2. Frenkel, Jacob & Razin, Assaf & Sadka, Efraim, 1992. "International taxation in an integrated world," MPRA Paper 23266, University Library of Munich, Germany.
  3. Gordon, R.H. & Bovenberg, A.L., 1994. "Why Is Capital So Immobile Internationally?: Possible Explanations and Implications for Capital Income Taxation," Working Papers 358, Research Seminar in International Economics, University of Michigan.
  4. Razin, A & Sadka, E & Yuen, C-W, 1997. "A Pecking Order of Capital Inflows and International Tax Principles," Papers 12-97, Tel Aviv - the Sackler Institute of Economic Studies.
  5. Bovenberg, A.L. & Gordon, R.H., 1996. "Why is capital so immobile internationally? Possible explanation and implications for capital income taxation," Other publications TiSEM 6a131c21-fd9a-4d83-8d9a-7, Tilburg University, School of Economics and Management.
  6. Bester, Helmut, 1985. "Screening vs. Rationing in Credit Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 75(4), pages 850-55, September.
  7. Akerlof, George A, 1970. "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, MIT Press, vol. 84(3), pages 488-500, August.
  8. 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.
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