The Effects of Financial Development on Foreign Direct Investment

53 Pages Posted: 20 Apr 2016

See all articles by Rodolphe Desbordes

Rodolphe Desbordes

SKEMA Business School

Shang-Jin Wei

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: October 1, 2014

Abstract

This paper examines how financial development influences foreign direct investment. The direct and indirect sector-specific effects that source countries' financial development and destination countries' financial development can have on foreign direct investment are first identified in a conceptual framework. The presence and relative strength of these various channels of influence at the different margins of foreign direct investment are then empirically investigated using unique and underexploited sector-specific bilateral panel data on greenfield foreign direct investment over the period 2003-2006. Causality is established by applying a difference-in-differences approach that exploits the variation in financial vulnerability across manufacturing sectors. The overall effects of higher source countries' financial development and destination countries' financial development on the relative volume of bilateral foreign direct investment in financially vulnerable sectors are large, positive, and complementary. These effects appear to operate mainly at the intensive margin rather than at the extensive margin of foreign direct investment. There is also evidence of direct and indirect effects of financial development. The key findings are robust to the use of data on the number of bilateral Mergers\&Acquisitions transactions. Overall, the empirical results unambiguously indicate that a sophisticated and well-functioning financial system in source and destination countries greatly facilitates the international expansion of firms through foreign direct investment, especially in financially vulnerable sectors.

Keywords: Private Sector Economics, Marketing, Private Sector Development Law

Suggested Citation

Desbordes, Rodolphe and Wei, Shang-Jin, The Effects of Financial Development on Foreign Direct Investment (October 1, 2014). World Bank Policy Research Working Paper No. 7065, Available at SSRN: https://ssrn.com/abstract=2513121

Rodolphe Desbordes

SKEMA Business School ( email )

Lille
France

Shang-Jin Wei

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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