FIW – Working Paper Financial Frictions , Foreign Direct Investment , and Growth

This paper assesses the role of nancial frictions and Foreign Direct Investment (FDI) on an economys growth rate, business cycle volatility, and rmscapital structure. We gauge these e¤ects within the Financial Accelerator framework, where entrepreneurs can establish a¢ liates of local rms abroad through Foreign Direct Investment. Model simulations suggest that in the presence of credit market imperfections FDI is associated with faster growth, less leverage, and lower aggregate volatility. These features are consistent with the macroeconomic dynamics of the more globally integrated economies over the last three decades. JEL Classi cation: F43; E32; G32. Keywords: Output volatility; Foreign Direct Investment; International Diversi cation; Capital Structure. Author age: 34 years old. Correspondence: Luis San Vicente Portes, Montclair State University, Upper Montclair, NJ, 07043. Email: PortesL@mail.montclair. edu. 1 Introduction Over the last three decades the more globally integrated economies have exhibited faster growth, lower rm leverage, and a moderation in their business cycles. These trends have been observed in both emerging and developed economies. Our objective is to assess the extent to which greater nancial integration, in the form of Foreign Direct Investment (FDI), can explain them. For this purpose we work with a uni ed theoretical model that predicts the three observations as rms and countries engage in larger foreign operations. Using an extension of Bernanke et al. (1999) Financial Accelerator framework, in which rms are able to diversify internationally in the form of FDI, we nd that not only aggregate volatility declines, but also countries exhibit faster growth and a decrease in rmsleverage. These results highlight the e¤ect of greater international nancial integration in the presence of credit market frictions. This work relates to three strands of the literature and tries to identify a common theoretical thread between them. The rst branch concerns the e¤ect of greater openness on growth; the second refers to rms nancing behavior upon nancial liberalization; and the third involves the moderation in aggregate volatility around the world. While a large part of the debate on the link between openness and growth concentrates on whether greater openness is the outcome of better institutions, the consensus is that openness is associated to faster growth. At the rm level, studies have also shown that multinational corporations tend to grow faster relative to domestic rms, as foreign and domestic capital spending are positively associated generating a feedback e¤ect. Furthermore, it has been observed that the expansion of U.S. multinationals have led to a shift towards more capital-intensive production of the parent rm. By working within a theoretical model we are able to show that larger FDI allows countries and rms to grow faster regardless of the institutional environment. This nding does not involve technological transfers nor spillovers usually associated with multinational corporations.1 Another branch of the literature that relates to this work concerns the e¤ect of internationalization on rms nancing choices. Schmukler and Vesperoni (2004) study how access to international capital markets a¤ects rmscapital structure in developing countries. Based on rm level data from emerging market economies in East Asia and Latin America they nd that the debt to equity ratios tend to decline after 1For di¤erent views on openness and growth see Rodriguez and Rodrik (2000), Rodrik (2005), and Dollar and Kraay (2001; 2005). In terms of nancial openness, Tornell et al. (2004) show that nancial liberalization leads to larger growth. Razin (2002) and Desai et al. (2005a and 2005b) document the positive e¤ect of FDI on domestic growth and capital accumulation. Lipsey (2002) shows that the expansion of U.S. multinationals have led to more capital-intensive production for the parent rm.