An information-based model of foreign direct investment: The gains from trade revisited

Foreign direct investment (FDI) is observed to be a predominant form of cap ital flows to emerging economies, especially when they are liquidity-constr ained internationally during a global financial crisis. The financial aspec ts of FDI are the focus of this paper. We analyze the problem of channellin g domestic savings into productive investment in the presence of asymmetric information between the managing owners of firms and other portfolio stake holders. We explore the role played by FDI in reviving equity-financed capi tal investment for economies plagued by such information problems. In the p resence of information asymmetry, the paper identifies, however, how FDI gi ves rise to foreign overinvestment as well as domestic undersaving. The gai ns from trade argument (applied to intertemporal trade) is re-examined in t his case of informational-asymmetry-driven FDI. We show that the gains coul d be sizable when the domestic credit market is either under-developed or f ailing as a result of a financial crisis. But with a well-functioning domes tic credit market, the gains turn into losses. Surprisingly, capital may fl ow 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 is a social loss-generating phenomenon.