Systemic Liquidity and the Composition of Foreign Investment: Theory and Empirical Evidence

Foreign direct investors are more informed than foreign portfolio investors regarding changes in the prospects of their projects. This inside information, acquired through rigorous monitoring of management, enables foreign direct investors to manage their firms more efficiently. Having better information, however, comes at a cost. If projects can be liquidated prematurely because of liquidity shocks, the price foreign direct investors get is lower than the price foreign portfolio investors could obtain. This is due to the asymmetry of information between buyers and sellers in the capital market. We develop a theory of the effect of aggregate, and idiosyncratic liquidity shocks on the composition of foreign investment. We also demonstrate how capital market transparency affects the composition of foreign investment. A key prediction of the theory is that source countries with higher probability of aggregate liquidity crises will export relatively more FPI and less FDI. To test this hypothesis, we apply a dynamic panel model to examine the variation of FPI relative to FDI for 140 source countries from 1990 to 2004. Our key variable is the probability, estimated from a Probit model, of liquidity shocks, as proxied by episodes of economy wide sales of external assets. It turns out that liquidity shocks have strong effects on the composition of foreign investment, as predicted by our model. Moreover, higher opacity (the inverse of transparency) in the source country accelerates the effect of the probability of liquidity shock on FPI/FDI. We repeat this analysis using real interest rate hikes, or big real exchange rate depreciation, as an alternative indicator of a liquidity crisis, and get similar results.