The Composition of International Capital Flows: Risk Sharing Through Foreign Direct Investment

Abstract:     
Evidence on international capital flows suggests that (i) foreign direct investment is less volatile than other financial flows, and that (ii) countries with lower financial ratings--and less developed countries--receive larger shares of FDI flows. We rationalize these facts in a model where international capital flows are subject to imperfect enforcement and FDI is inalienable. Inalienability means that it is not as advantageous to expropriate FDI relative to other flows. This leads to a relatively lower default premium on FDI. Hence, a financially constrained country borrows relatively more through FDI. Simultaneously, non-FDI flows respond more aggressively to changes in the country's financial constraint. The inalienability of FDI highlights its risk sharing potential.

Number of Pages in PDF File: 38

JEL Classification: F21, F34, F36

working papers series