# **1 Introduction**

In recent years, much attention has been devoted to the role that financial development plays in promoting economic development.<sup>1</sup> Research typically finds that a deep and well-functioning financial system is a key determinant of economic growth (Rajan and Zingales, 1998; Levine, 2005). In the absence of easy access to external finance, firms with limited internal funds have to forsake profitable investment opportunities which require large fixed and variable costs to be incurred early in the production cycle.

These unfulfilled opportunities can reside in foreign markets. The large upfront fixed costs associated with exporting can be an insurmountable obstacle for financially vulnerable firms when the external finance premium is large.<sup>2</sup> Indeed, a large body of empirical research shows that the volume of exports of firms belonging to financially vulnerable sectors is highly sensitive to the level of source countries’ financial development (SFD).<sup>3</sup> Foreign direct investment (FDI) requires even larger upfront fixed costs because a new foreign affiliate must be established or acquired.<sup>4</sup> Hence, on the source side, higher financial development can also be expected to foster FDI, with a disproportionate positive impact on FDI in financially vulnerable sectors. On the destination side, the influence of higher financial development on FDI is ambiguous on theoretical grounds. While a positive access to external finance effect is still likely to exist, several channels have been identified through which higher destination countries’ financial development (DFD) could reduce FDI (Antras et al., 2009; Ju and Wei, 2010; Bilir et al., 2013). Nevertheless, the limited and non sector-specific empirical evidence available points towards an overall positive impact of both higher SFD and DFD on FDI (Klein et al., 2002; Desai et al., 2006; Antras et al., 2009).<sup>5</sup>

> 1The World Economic Forum (World Economic Forum, 2012) defines financial development in its 2012 _Financial Development Report_ as “the factors, policies, and institutions that lead to effective financial intermediation and markets, as well as deep and broad access to capital and financial services” (p.3). Two common measures of financial development are the ratio of stock market capitalisation to GDP and the ratio of private credit provided by financial institutions to GDP. They are used as proxy for access to external equity financing and access to debt financing, respectively.

> 2Following Manova (2013), we define financially vulnerable firms as firms with high requirements for external capital and/or firms with few assets that can be used as collateral. The varying prevalence of these firms in each sector translates into sectors which differ in their financial vulnerability.

> 3See for example Beck (2002, 2003), Amiti and Weinstein (2011), or Manova (2013).

> 4For this paper, FDI is defined as the initial fixed costs incurred by a firm expanding its activities outside the territorial boundaries of its home country through the establishment (greenfield FDI) or the acquisition (M&A FDI) of a foreign affiliate, whatever the sources of funds for this expansion. These funds may be internal or external to the firm and originate from related or unrelated parties located in the home country, the destination country, or in a third country.

> 5Empirical investigation of the impact of higher SFD and/or DFD on greenfield or M&A FDI can also be found in Hausmann and

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