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

40 Pages Posted: 18 Feb 2000 Last revised: 29 Dec 2014

Rui A. Albuquerque

Boston College, Carroll School of Management; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Date Written: September 27, 2002

Abstract

Evidence on international capital flows suggests that foreign direct investment (FDI) is less volatile than other financial flows. To explain this finding, I model international capital flows under the assumptions of imperfect enforcement of financial contracts and inalienability of FDI. Imperfect enforcement of contracts leads to endogenous financing constraints and the pricing of default risk. Inalienability implies that it is not as advantageous to expropriate FDI relative to other flows. These features combine to give a risk sharing advantage to FDI over other capital flows. This risk sharing advantage of FDI translates into a lower default premium and lower sensitivity to changes in a country’s financing constraint.

The model offers the new implication that financially constrained countries should borrow relatively more through FDI. This is because FDI is harder to expropriate and not because FDI is more productive or less volatile. Using several creditworthiness and country risk ratings to measure financing constraints, I present new evidence linking FDI and financing constraints. Moreover, numerical simulations of the model generate stronger serial correlation for FDI than for other flows into developing countries. This corroborates the view that non-FDI flows are more short-term and more likely to change direction.

Keywords: Foreign direct investment, intangible assets, volatility, risk sharing, imperfect enforcement, financing constraints, default risk, country risk

JEL Classification: F21, F34, F36

Suggested Citation

Albuquerque, Rui A., The Composition of International Capital Flows: Risk Sharing Through Foreign Direct Investment (September 27, 2002). Journal of International Economics, Vol. 61, 2003. Available at SSRN: https://ssrn.com/abstract=206071 or http://dx.doi.org/10.2139/ssrn.206071

Rui A. Albuquerque (Contact Author)

Boston College, Carroll School of Management ( email )

140 Commonwealth Avenue
Chustnut Hill, MA 02467-3808
United States

HOME PAGE: http://ruialbuquerque.webs.com

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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