Foreign Direct Investment and Debt Financing in Emerging Economies

The rich dynamics of capital flows is an important characteristic of business cycles in emerging market economies. In the data external debt is always procyclical, while FDI is procyclical only in normal times. We provide a microfounded rationale for this pattern by linking financial shocks to capit...

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Bibliographic Details
Published in:Journal of money, credit and banking credit and banking, 2020-06, Vol.52 (4), p.863-905
Main Authors: LUK, PAUL, ZHENG, TIANXIAO
Format: Article
Language:English
Subjects:
Business cycles
Capital
Capital movement
Debt financing
E44
Economic crisis
F41
F44
F62
FDI
financial crisis
financial frictions
Foreign investment
Market economies
Valuation
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Summary:The rich dynamics of capital flows is an important characteristic of business cycles in emerging market economies. In the data external debt is always procyclical, while FDI is procyclical only in normal times. We provide a microfounded rationale for this pattern by linking financial shocks to capital flows. For this purpose, we build a small open economy model in which firms are subject to borrowing constraints, and are either owned domestically or by foreign investors who purchase firms through FDI. During a financial crisis, the valuation gap per unit net worth between foreign and domestic investors widens, which triggers more FDI inflow. Our model produces business cycle moments consistent with empirical observations.
ISSN:0022-2879
1538-4616
DOI:10.1111/jmcb.12612