Liquidity, Institutional Quality and the Composition of International Equity Flows

37 Pages Posted: 8 Feb 2010

See all articles by Itay Goldstein

Itay Goldstein

University of Pennsylvania - The Wharton School - Finance Department

Assaf Razin

Tel Aviv University - Eitan Berglas School of Economics; National Bureau of Economic Research (NBER); CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

Hui Tong

International Monetary Fund (IMF)

Date Written: February 2010

Abstract

FDI investors control the management of the firms, whereas FPI investors delegate decisions to managers. Therefore, direct investors are more informed than portfolio investors about the prospects of projects. This information enables them to manage their projects more efficiently. However, if investors need to sell their investments before maturity because of liquidity shocks, the liquidation price they can get will be lower when buyers know that they have more information on investment projects. In this paper we examine the choice between Foreign Direct Investment and Foreign Portfolio Investment at the level of the source country. Based on the Goldstein and Razin model, we predict that (1) source countries with higher expectation of future liquidity problems export relatively more FPI than FDI, and (2) this effect strengthens as the source country's capital market transparency worsens. To test these hypotheses, we examine the variation of FPI relative to FDI for source countries from 1985 to 2004. Our key variable is the predicted severity of liquidity shock, as proxied by episodes of economy-wide sales of external assets. Consistent with our theory, we find that the predicted liquidity shock has a strong effect on the composition of foreign equity investment. Furthermore, greater capital market opacity in the source country strengthens the effect of the liquidity shock.

Suggested Citation

Goldstein, Itay and Razin, Assaf and Tong, Hui, Liquidity, Institutional Quality and the Composition of International Equity Flows (February 2010). NBER Working Paper No. w15727. Available at SSRN: https://ssrn.com/abstract=1548805

Itay Goldstein (Contact Author)

University of Pennsylvania - The Wharton School - Finance Department ( email )

The Wharton School
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Assaf Razin

Tel Aviv University - Eitan Berglas School of Economics ( email )

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Ramat Aviv, Tel Aviv, 69978
Israel
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+972 3 640 9908 (Fax)

National Bureau of Economic Research (NBER) ( email )

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CESifo (Center for Economic Studies and Ifo Institute)

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Germany

HOME PAGE: http://www.CESifo.de

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Hui Tong

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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