Working Paper: CEPR ID: DP3747
Authors: Itay Goldstein; Assaf Razin
Abstract: The Paper develops a model of foreign direct investments (FDI) and foreign portfolio investments. FDI is characterized by hands-on management style that enables the owner to obtain relatively refined information about the productivity of the firm. This superiority, relative to portfolio investments, comes with a cost: a firm owned by the relatively well-informed FDI investor has a low resale price because of ?lemons? type asymmetric information between the owner and potential buyers. Consequently, investors who have a higher (lower) probability of getting a liquidity shock that forces them to sell early will invest in portfolio (direct) investments. This result can explain the greater volatility of portfolio investments relative to direct investments. Motivated by empirical evidence, we show that this pattern may be weaker in developed economies that have higher levels of transparency in the capital market and better corporate governance. We also study welfare implications of the model.
Keywords: liquidity shock; informational externality; excessive volatility; capital recipient country's gains
JEL Codes: F00; F20; F30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| FDI (F23) | better management efficiency (M11) |
| higher liquidity needs (E41) | preference for portfolio investments (G11) |
| higher expected liquidity needs (E41) | greater volatility for portfolio investments (G11) |
| transparency in capital markets (G38) | reduced volatility differences between FDI and FPI (F21) |
| better management efficiency (M11) | stability of inflows (F32) |