Foreign Direct Investment and External Financing Conditions: Evidence from Normal and Crisis Times

• Published date: 01 October 2017
• DOI: http://doi.org/10.1111/sjoe.12192
• Date: 01 October 2017

Foreign Direct Investment and External

Financing Conditions: Evidence from

Normal and Crisis Times∗

Rodolphe Desbordes†

University of Strathclyde, Glasgow G4 0GE, UK

rodolphe.desbordes@strath.ac.uk

Shang-Jin Wei

Columbia University, New York, NY 10027, USA

shangjin.wei@columbia.edu

Abstract

In this paper, we investigate the effects that external financing conditions in source and

destination countries have on foreign direct investment (FDI) in normal and crisis times,

using a difference-in-differences approach. We find that the financial development of the

source and destination countries has a strong positive impact on the relative volume of FDI

in financially vulnerable sectors in normal times. However, during the 2008–2010 global

financial crisis, the relative volume of FDI in financially vulnerable sectors fell relatively

more in financially developed source and destination countries, most notably if these countries

experienced a credit crisis.

Keywords: Banking crisis; credit constraints; credit crisis; financial development; foreign

direct investment; global financial crisis

JEL classification:F23; O16

I. Introduction

Foreign direct investment (FDI) financial flows declined drastically during

the recent global financial crisis. According to statistics from the United

Nations Conference on Trade and Development (UNCTAD), whereas global

FDI flows increased by 35 percent in 2007, they decreased by 12 percent

in 2008 and a further 41 percent in 2009. The fact that this abrupt fall

coincided with a deterioration of credit conditions worldwide suggests that

credit constraints in source and destination countries have been one of

∗We would like to thank Celine Azemar, Luc Laeven, Stuart McIntyre, Ian Wooton, and two

anonymous referees for helpful comments and suggestions. This paper was completed while

Rodolphe Desbordes was visiting the Trade and International Integration unit (DECTI) of the

World Bank’s Development Research Group. The authors gratefully acknowledge financial

support from the Scottish Institute for Research in Economics (SIRE).

†Also affiliated with SKEMA Business School and Sciences-Po LIEPP.

©The editors of The Scandinavian Journal of Economics 2016.

Scand. J. of Economics 119(4), 1129–1166, 2017

DOI: 10.1111/sjoe.12192

the factors hindering the expansion of multinational enterprises (MNEs)

abroad. While this possibility has been evoked in various policy reports

(e.g., UNCTAD, 2010), it has yet to be investigated rigorously. This is the

aim of this paper, in which we also explore the effects of external financing

conditions on FDI in “normal” times (i.e., when financial systems are

functioning properly).

There are several channels through which a credit crisis can have an

influence on FDI.1In addition to curtailing access to external finance, it

depresses demand, reduces firms’ self-financing capabilities, and increases

uncertainty. The presence of one or several of these factors typically leads

to a fall in inward and outward FDI.2Testing directly for the impact of

a credit crisis on outward and inward FDI would amount to confounding

these different effects. To identify a potential “credit channel” impact of

the global financial crisis, we adopt a difference-in-differences approach,

where we simultaneously exploit the variation in financial vulnerability

across manufacturing sectors,3the variation in financial development across

source and destination countries, and country-specific changes in credit

conditions during the 2008–2010 period.

The intuition underlying our difference-in-differences approach is that the

ability of firms to f inance the large upfront fixed costs of engaging in FDI

with internal funds varies across sectors.4FDI in financially vulnerable

sectors is likely to be more sensitive to external finance availability, in

source and destination countries, than FDI in other sectors. This has two

implications. Holding other factors constant, in normal times, the ratio

of FDI in financially vulnerable sectors to FDI in other sectors ought

to be larger in countries characterized by high financial development in

both source and destination countries, whereas in “(credit) crisis” times,

the relative volume of FDI in financially vulnerable sectors ought to fall

1In the context of this paper, FDI is defined as the initial fixed costs incurred by a firm

expanding its activities outside the territorial boundaries of its home country through the

establishment (greenfield FDI) or the acquisition (M&A FDI) of a foreign affiliate, whatever

the sources of funds for this expansion. Because of data availability, we focus on greenfield

FDI.

2Broner et al. (2013) provide descriptive evidence that inward and outward financial FDI

flows systematically decline in countries experiencing a banking crisis.

3Following Manova (2013), we define financially vulnerable firms as f irms with high re-

quirements for external capital and/or firms with few assets that can be used as collateral.

The varying prevalence of these firms in each sector translates into sectors that differ in

their financial vulnerability.

4Engaging in FDI involves large upfront fixed costs related to market research, the modifi-

cation of products to meet foreign tastes or regulatory requirements, or the establishment of

distribution and servicing channels. Some of these costs might have to be incurred once, and

they might not apply for follow-on investments. However, crucially, each new FDI project

also involves establishing or purchasing a production facility in the destination country.

1130 FDI and external financing conditions

©The editors of The Scandinavian Journal of Economics 2016.

relatively more in deep financial systems than in shallow financial systems.

We test these two implications in this paper. By focusing on this specific

link between sector-specific financial vulnerability and country-specif ic

external financing conditions, we increase the likelihood that our results

reflect the causal impact of external financing conditions on FDI.

Variants of this difference-in-differences approach, initially suggested by

Rajan and Zingales (1998), have been used to study the impact of structural

cross-sectional differences in financial development on international trade

(Beck, 2002, 2003; Amiti and Weinstein, 2011; Manova, 2013) as well

as to investigate the detrimental financial effects of the 2008–2010 global

financial crisis on international trade (Bricongne et al., 2012; Chor and

Manova, 2012). However, this is the first study to implement it in order

to examine the influence of external financing conditions on FDI both in

normal and crisis times. This is possible because of our access to a unique

database on sector-specific real greenf ield manufacturing FDI. Using this

database, we are able to contribute to the limited literature on the causal

effects of the financial development of source and destination countries

(SFD and DFD) on FDI.5

Our empirical results indicate that external finance availability in source

and destination countries plays an important role in the international expan-

sion of firms through greenf ield FDI, especially in financially vulnerable

sectors. In normal times, defined as the period 2003–2007, SFD and DFD

have a positive influence on the relative volume of FDI in financially vul-

nerable sectors. However, during the 2008–2010 global financial crisis, the

relative volume of FDI in financially vulnerable sectors fell relatively more

in financially developed source and destination countries.6These effects are

large, statistically and economically significant, and robust to various spec-

ification tests, including controlling for economy-wide and sector-specific

output. If we take into account, in a second stage, that the degree of

tightening of credit conditions during the global financial crisis differed

across countries – some of which experienced a banking crisis – then this

reinforces our results. Finally, we find that external financing conditions

influence FDI at both the extensive (number of projects) and intensive (av-

erage size of project) margins in normal times, whereas during the global

5On the source side, Klein et al. (2002) is one of the rare papers examining this issue.

It shows that the FDI activity of Japanese firms in the United States during the Japanese

banking crisis in the 1990s was inversely correlated with the deterioration of the financial

health of their main bank, as measured by Moody’s downgrades. On the destination side,

using ingenious natural experiments, Desai et al. (2006) and Antras et al. (2009) find a

positive impact of DFD on FDI. See also Bilir et al. (2014).

6As we will show in our results, the effects of tighter credit conditions in destination

countries during the global financial crisis are not as robust as those in source countries.

Nevertheless, in a large number of cases, the coefficients on “destination” variables have the

expected sign and are statistically significant.

R. Desbordes and S-J. Wei 1131

©The editors of The Scandinavian Journal of Economics 2016.