The effects of financial development on foreign direct investment

https://doi.org/10.1016/j.jdeveco.2017.02.008Get rights and content

Highlights

  • We investigate the various effects of financial development on FDI.

  • These effects can be direct or indirect, positive or negative.

  • We exploit sector-specific financial vulnerability to establish causality.

  • We look at different types and margins of real manufacturing FDI.

  • Financial development in both home and host countries strongly promotes FDI.

Abstract

This paper empirically investigates the various effects that source and destination countries’ financial development (SFD and DFD respectively) have on foreign direct investment (FDI). We establish causality by exploiting variations in both country-specific financial development and sector-specific financial vulnerability. This approach is made possible by our use of detailed databases on real manufacturing FDI projects worldwide. We find that both SFD and DFD have a large positive influence on greenfield, expansion, and mergers & acquisitions FDI, by directly increasing access to external finance and indirectly promoting manufacturing activity. The overall economic impacts of SFD and DFD tend to be similar but their direct and indirect effects vary across margins and types of FDI.

Introduction

Many countries actively seek to attract foreign direct investment (FDI) because they believe that multinational enterprises will contribute to economic growth by creating new job opportunities, increasing capital accumulation, and raising total factor productivity. Indeed, a large body of empirical evidence shows that FDI tends to generate net gains for both home and host countries.1 The growth-enhancing effects of FDI flows have motivated a thorough investigation of their determinants. Robust push and pull factors are market size, cultural and physical proximity, relative labour market endowments, and corporate tax rates (Eicher et al., 2012, Blonigen and Piger, 2014). Financial development should certainly be added to this list.2 FDI flows strongly grew during the period 2003-2007 but experienced an abrupt decline the two following years.3 The fact that the tight external financing conditions resulting from the global financial crisis have been partly blamed for this fall (UNCTAD, 2010) suggests that access to external finance is an important determinant of FDI. We investigate this issue, by providing a comprehensive and causal exploration of the various effects that source and destination countries' financial development (SFD and DFD respectively) have on FDI.

We are not the first cross-country study to look at the effects of financial development on FDI.4 However previous research broadly suffers from three key shortcomings: inadequate measurement of FDI, absence of causal identification, and limited scope.

The majority of studies have used easily available balance of payments (BOP) FDI data, aggregated at the country-level. Unfortunately, these data can potentially provide an incomplete picture of the international expansion of multinational enterprises (MNEs) because they only include the funds which have been provided by parent companies in the forms of equity capital, intercompany debt, or reinvested earnings.5 The external funds raised in host countries are notably ignored. This omission complicates the investigation of the impacts of SFD and DFD on the foreign expansion of firms, and may possibly lead to erroneous conclusions; if SFD and DFD are substitutes, high investment in new or existing foreign affiliates can occur despite observing low BOP inward FDI.6

To a certain extent, this measurement issue disappears when studies use data on cross-border M&A. However, this does not solve the problem of causal identification. Financial development is likely to be correlated with other country attributes which can influence FDI, such as overall institutional quality, human capital, natural resources, capital controls liberalisation, or foreign ownership restrictions. Even with a large number of control variables, the risk of an omitted variable bias remains and multicollinearity may become an issue. Some studies have included country fixed effects, controlling in that way for any time-invariant factor potentially correlated with financial development. As discussed by Coeurdacier et al. (2009), this strategy may not be fruitful. Measures of financial development often exhibit low time-series variation, generating imprecise estimates, and relying on time-series variation to identify the parameters does not necessarily lead to the estimation of the relationship of interest if permanent and transitory changes in financial development have very different effects on FDI.7 Overall, without a proper identification strategy, it is nearly impossible to establish that SFD and DFD are long-run causal determinants of FDI.

As a way of circumventing a potential omitted variable, a few studies use confidential firm-level data from a single source country (Japan or the United States) and rely on ingenious natural experiments to identify the causal effects of SFD on the occurrence of Japanese FDI (Klein et al., 2002) or of DFD on the sales or capital expenditures of U.S. foreign affiliates (Desai et al., 2006, Antras et al., 2009). The estimated effects are largely positive. However, these studies are confined to specific events and specific source countries. They also do not cover how the effects of SFD and DFD can diverge with the nature of the FDI project (greenfield, M&A, or expansion) or across margins of FDI (occurrence and number of FDI projects vs. average size of the projects).8 Finally, they do not explore in a comprehensive manner the direct and indirect effects that SFD and DFD can have on FDI. While the vast majority of existing studies have stressed how financial development can increase FDI by improving access to external finance, SFD and DFD may also have indirect and not necessarily positive impacts on FDI, by promoting overall economic activity in source and destination sectors.

In response to these various gaps in the literature, we use comprehensive and under-exploited data on real manufacturing FDI projects during the period 2003-2006 to investigate the various effects of financial development on bilateral FDI in a difference-in-differences approach, where we exploit variations in both country-specific financial development and sector-specific financial vulnerability. In doing so, we can make a substantial contribution to the existing literature. Our data provide us with a worldwide coverage of source and destination countries and allow us to look at the impacts of both SFD and DFD on FDI. We have the opportunity to investigate how various types of real FDI (greenfield, expansion, M&A) at different margins (extensive or intensive) respond to financial development. By focusing on the relationship between sector-specific dependence on external finance and financial development, our identification approach, which is novel in the context of bilateral FDI, increases the likelihood that we identify causal effects.9 The intuition is that engaging in FDI involves substantial upfront fixed costs that financially vulnerable firms (i.e. firms with high requirements for external capital) will struggle to finance without easy access to external finance (Buch et al., 2009). Hence, causal effects of SFD and DFD can be isolated by looking at whether financial development has a disproportionate impact on FDI in more financially vulnerable manufacturing sectors. Finally, to a certain extent, we are able to decompose the total effects of SFD and DFD into the direct and indirect effects suggested by our integrative literature review.

Our empirical results unambiguously indicate that a deep financial system in source and destination countries strongly facilitates the international expansion of firms through FDI. The total effects of SFD and DFD on relative greenfield FDI in financially vulnerable manufacturing sectors, as well as on the overall level of aggregate greenfield FDI, are positive, statistically significant, economically large, and complementary. SFD and DFD have net positive effects on new greenfield FDI by directly increasing access to external finance and indirectly promoting manufacturing activity in source and destination countries. This direct impact of financial development accounts for most of the total effects of SFD and DFD and primarily operates at the intensive margin through its positive contribution to the average size of FDI projects. Expansion FDI and M&A FDI are also positively influenced by greater SFD and DFD but not necessarily in the same way as greenfield FDI. For example, SFD matters much less for expansion FDI than for greenfield FDI at the intensive margin, while M&A FDI is more responsive than the two other FDI types to the direct effects of SFD and DFD at the extensive margin. Lastly, the overall economic impacts of SFD and DFD on FDI are comparatively similar. These results substantially expand existing research on FDI. In common with the few studies which have investigated in a causal manner some of the effects of SFD or DFD on FDI, we find a positive effect of financial development on the expansion of MNEs. However, we reach this conclusion by very different means,10 and our findings yield novel insights.

Our research has implications for our understanding of both the effects of FDI on economic growth and the functioning of MNEs' internal capital markets. Many studies have stressed that a well-developed financial system is crucial for local firms to benefit from foreign technology spillovers (Hermes and Lensink, 2003, Alfaro et al., 2004, Alfaro et al., 2009, Alfaro et al., 2010) while other studies have highlighted positive links between the domestic and foreign activities of firms (Desai et al., 2005, Desai et al., 2009, Herzer, 2010, Navaretti et al., 2010). We show that SFD and DFD promote outward and inward FDI, thereby contributing indirectly to economic growth in source and destination countries. Highlighting the role of external finance in the expansion of MNEs also helps to understand the sources and limitations of their internal capital markets. The financial advantage that foreign firms tend to enjoy over local firms (Desai et al., 2004b, Desai et al., 2008, Alfaro and Chen, 2012) is related to their home countries' financial depth and, beyond short-term horizons, MNEs cannot fully bypass restricted local access to external finance by making use of foreign sources of funds.

Finally, our study is related to works investigating the effects of credit constraints on international trade. The positive effect of SFD on the volume of exports of firms belonging to financially vulnerable sectors is well documented.11 Expansion through FDI involves much higher fixed costs than exports (Buch et al., 2010), and therefore our results are fully in agreement with those of the trade literature.

The rest of the paper proceeds as follows. In Section 2, we review the various effects that SFD and DFD are likely to have on FDI. In Section 3, we describe our FDI data. and introduce our difference-in-differences models. In Section 4, we describe our variables of interest and the estimation methods. We also provide some stylized facts. In Section 5, we present our empirical results. Finally, we conclude in Section 6.

Section snippets

The various effects of financial development on FDI

In this section, we examine in an integrative literature review the various structural effects that SFD and DFD may have on FDI.12

Greenfield and M&A bilateral FDI data

Our bilateral FDI data need to meet three requirements. First, they must be available for a relatively large number of manufacturing sectors. Second, they must reflect the fixed costs involved with the expansion of firms abroad. Third, values of these costs must be inclusive, in the sense that all sources of funds are accounted for.

Our greenfield and expansion FDI data come from the fDi Markets database compiled by fDi Intelligence, a division of the Financial Times.25

Financial development

Our main measure of financial development (SFDit1;DFDjt1) is the domestic credit allocated to the private sector by banks and other financial intermediaries, normalized by GDP. This financial development measure, which reflects the actual use of external debt financing in the economy, has been extensively used in the growth, finance, and international trade literature (Levine, 2005). Data come from Beck et al. (2009). We lag this variable by one year to reduce any potential simultaneity bias

The overall effects of financial development on greenfield FDI

Our initial results are presented in Table 1. In column (1), we estimate model 1 by pooled Poisson QMLE. We omit the time-varying country-pair fixed effects, but, in addition to the financial development variables, we control for source and destination income and income per capita, bilateral distance, contiguity, language similarity, colonial links, time zone difference, source and destination institutional quality, and source and destination human capital stock.48

Conclusion

We investigated in this paper the various structural effects of financial development on foreign direct investment (FDI). We show that source and destination countries’ financial development jointly promote FDI by directly increasing access to external finance and indirectly supporting overall economic activity. Governments wishing to facilitate the internationalization of their firms and to attract foreign multinational enterprises (MNEs) should thus implement measures to improve access to

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    We would like to thank Celine Azemar, Loe Franssen, Stuart McIntyre, Ian Wooton, and two anonymous referees for helpful comments and suggestions. The authors gratefully acknowledge financial support from the Scottish Institute for Research in Economics (SIRE).

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