An Information-Based Model of Foreign Direct Investment: The Gains from Trade Revisited

Abstract

The financial aspects of Foreign direct investment (FDI) are the focus of this paper. The gains from trade argument (applied to intertemporal trade) is re-examined in this case of informational-asymmetry-driven FDI. FDI is observed to be a predominant form of capital flows to emerging economies, especially when they are liquidity-constrained internationally during a global financial crisis. We analyze the problem of channelling domestic savings into productive investment in the presence of asymmetric information between the managing owners of firms and portfolio stakeholders. We explore the role played by FDI in reviving equity-financed capital investment for economies plagued by such information problems. In the presence of information asymmetry, the paper identifies how FDI gives rise to foreign overinvestment as well as domestic undersaving. We show that the gains from trade could be sizable when the domestic credit market is either under-developed or failing as a result of a financial crisis. But with a well-functioning domestic credit market, the gains turn into losses. Surprisingly, capital may flow into the country even when the autarkic marginal productivity of capital in the domestic economy falls short of the world rate of interest. In such a situation, capital should have efficiently flown out rather than in, and FDI becomes a social loss-generating phenomenon.