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

Listed author(s):
  • Hui Tong

    (International Monetary Fund)

  • Assaf Razin

    (Cornell and Tel-Aviv Universities)

  • Itay Goldstein

    (University of Pennsylvania)

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.

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Paper provided by Society for Economic Dynamics in its series 2007 Meeting Papers with number 290.

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Date of creation: 2007
Handle: RePEc:red:sed007:290
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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  1. Razin, Assaf & Sadka, Efraim & Yuen, Chi-Wa, 1998. "A pecking order of capital inflows and international tax principles," Journal of International Economics, Elsevier, vol. 44(1), pages 45-68, February.
  2. Assaf Razin & Yona Rubinstein, 2006. "Evaluation of currency regimes: the unique role of sudden stops," Economic Policy, CEPR;CES;MSH, vol. 21(45), pages 119-152, 01.
  3. Goldstein, Itay & Razin, Assaf, 2006. "An information-based trade off between foreign direct investment and foreign portfolio investment," Journal of International Economics, Elsevier, vol. 70(1), pages 271-295, September.
  4. Albuquerque, Rui & Loayza, Norman & Serven, Luis, 2005. "World market integration through the lens of foreign direct investors," Journal of International Economics, Elsevier, vol. 66(2), pages 267-295, July.
  5. Imbens, Guido W & Angrist, Joshua D, 1994. "Identification and Estimation of Local Average Treatment Effects," Econometrica, Econometric Society, vol. 62(2), pages 467-475, March.
  6. Lane, Philip R. & Milesi-Ferretti, Gian Maria, 2007. "The external wealth of nations mark II: Revised and extended estimates of foreign assets and liabilities, 1970-2004," Journal of International Economics, Elsevier, vol. 73(2), pages 223-250, November.
  7. Albuquerque, Rui, 2003. "The composition of international capital flows: risk sharing through foreign direct investment," Journal of International Economics, Elsevier, vol. 61(2), pages 353-383, December.
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