48 Pages Posted: 27 May 2008
Date Written: May 2007
Capital flight associated with the onset of a financial crisis in a country is often accompanied by an inflow of capital associated with foreign direct investment (FDI). Our paper provides a theoretical framework for this puzzle, and draws wider conclusions on the welfare effects of foreign takeovers. When fundamentals deteriorate, the return that can be pledged to portfolio investors is limited by the incentive constraints of the managers. Only with direct control by investors can the surplus in the project be unlocked. It is precisely during crises that there is the conjunction of the loss of control by incumbent domestic managers, and the lack of domestic capital to take over failing firms. Foreign investors can take over failing firms and capture the surplus, even though they value the assets less. Our theory is consistent with FDI inflows during financial crises being associated with the acquisition of stakes that grant control, rather than simply being acquisitions of cashflow stakes, and is also consistent with the subsequent 'flipping' of the FDI assets, where the asset is sold to investors with higher valuations once the crisis abates.
Keywords: capital flight, FDI flows, financial crises, fire sales, foreign takeovers
JEL Classification: D61, E58, G21, G28, G32
Suggested Citation: Suggested Citation
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