The Effects of Financial Development on Foreign Direct Investment
This paper examines how financial development influences foreign direct investment. The direct and indirect sector-specific effects that source countries' financial development and destination countries' financial development can have on foreign direct investment are first identified in a conceptual framework. The presence and relative strength of these various channels of influence at the different margins of foreign direct investment are then empirically investigated using unique and underexploited sector-specific bilateral panel data on greenfield foreign direct investment over the period 2003-2006. Causality is established by applying a difference-in-differences approach that exploits the variation in financial vulnerability across manufacturing sectors. The overall effects of higher source countries' financial development and destination countries' financial development on the relative volume of bilateral foreign direct investment in financially vulnerable sectors are large, positive, and complementary. These effects appear to operate mainly at the intensive margin rather than at the extensive margin of foreign direct investment. There is also evidence of direct and indirect effects of financial development. The key findings are robust to the use of data on the number of bilateral Mergers\&Acquisitions transactions. Overall, the empirical results unambiguously indicate that a sophisticated and well-functioning financial system in source and destination countries greatly facilitates the international expansion of firms through foreign direct investment, especially in financially vulnerable sectors.
Summary: | This paper examines how financial
development influences foreign direct investment. The direct
and indirect sector-specific effects that source
countries' financial development and destination
countries' financial development can have on foreign
direct investment are first identified in a conceptual
framework. The presence and relative strength of these
various channels of influence at the different margins of
foreign direct investment are then empirically investigated
using unique and underexploited sector-specific bilateral
panel data on greenfield foreign direct investment over the
period 2003-2006. Causality is established by applying a
difference-in-differences approach that exploits the
variation in financial vulnerability across manufacturing
sectors. The overall effects of higher source
countries' financial development and destination
countries' financial development on the relative volume
of bilateral foreign direct investment in financially
vulnerable sectors are large, positive, and complementary.
These effects appear to operate mainly at the intensive
margin rather than at the extensive margin of foreign direct
investment. There is also evidence of direct and indirect
effects of financial development. The key findings are
robust to the use of data on the number of bilateral
Mergers\&Acquisitions transactions. Overall, the
empirical results unambiguously indicate that a
sophisticated and well-functioning financial system in
source and destination countries greatly facilitates the
international expansion of firms through foreign direct
investment, especially in financially vulnerable sectors. |
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