Channeling Domestic Savings into Productive Investment Under Asymmetric Information: The Essential Role of Foreign Direct Investment
CEPR Discussion Paper Series No. 1837
Posted: 8 Oct 1998
Date Written: March 1998
Foreign direct investment (FDI) is observed to be a predominant form of capital flows to low- and middle-income countries with insufficiently developed capital markets. This paper analyzes the problem of channeling domestic savings into productive investment, in the presence of asymmetric information between the managing owners of firms and other portfolio stakeholders. We emphasize the crucial role played by FDI in sustaining equity-financed capital investment for economies plagued by such information problems. The paper identifies how, in the presence of information asymmetry, different capital market structures may lead to foreign over- or under-investment and to domestic under- or over-saving, and thus to inefficient equilibria. We show how corrective tax-subsidy policies, consisting of taxes on corporate income and the capital incomes of both residents and non-residents, can restore efficiency.
JEL Classification: F21, F35, H25, H30
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