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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.

Suggested Citation

  • Assaf Razin & Efraim Sadka & Chi-Wa Yuen, 1999. "An Information-Based Model of Foreign Direct Investment: The Gains from Trade Revisited," NBER Working Papers 6884, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:6884
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    References listed on IDEAS

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    1. 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.
    2. Barry, Frank & Bradley, John, 1997. "FDI and Trade: The Irish Host-Country Experience," Economic Journal, Royal Economic Society, vol. 107(445), pages 1798-1811, November.
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    6. 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.
    7. Shapiro, Matthew D & Slemrod, Joel, 1995. "Consumer Response to the Timing of Income: Evidence from a Change in Tax Withholding," American Economic Review, American Economic Association, vol. 85(1), pages 274-283, March.
    8. Linda S. Goldberg & Michael W. Klein, 1996. "Foreign direct investment, trade, and real exchange rate linkages in developing countries," Proceedings, Federal Reserve Bank of San Francisco, pages 73-100.
    9. 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.
    10. 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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    Cited by:

    1. Assaf Razin & Efraim Sadka & Chi-Wa Yuen, 1999. "Excessive FDI flows under asymmetric information," Proceedings, Federal Reserve Bank of San Francisco, issue Sep.
    2. 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.
    3. 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.
    4. 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.
    5. Karolyi, G. Andrew & Ng, David T. & Prasad, Eswar, 2015. "The Coming Wave: Where Do Emerging Market Investors Put Their Money?," IZA Discussion Papers 9405, Institute for the Study of Labor (IZA).
    6. Diemo Dietrich, 2004. "Financing FDI into Developing Economies and the International Transmission of Business Cycle Fluctuations," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 140(IV), pages 449-481, December.
    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, "undated". "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. Soto, Marcelo, 2003. "Taxing capital flows: an empirical comparative analysis," Journal of Development Economics, Elsevier, vol. 72(1), pages 203-221, October.
    11. repec:zbw:iwhdps:165 is not listed on IDEAS

    More about this item

    JEL classification:

    • F10 - International Economics - - Trade - - - General
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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