Financial market development in host and source countries and their effects on bilateral foreign direct investment

• DOI: http://doi.org/10.1111/twec.12884
• Author: Peter Nunnenkamp,Eric Neumayer,Julian Donaubauer
• Date: 01 March 2020
• Published date: 01 March 2020

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wileyonlinelibrary.com/journal/twec World Econ. 2020;43:534–556.

Received: 31 May 2019

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Accepted: 11 September 2019

DOI: 10.1111/twec.12884

SPECIAL ISSUE ARTICLE

Financial market development in host and source

countries and their effects on bilateral foreign direct

investment

JulianDonaubauer1

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EricNeumayer2

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PeterNunnenkamp3

1Helmut Schmidt University Hamburg, Hamburg, Germany

2London School of Economics and Political Science (LSE), London, UK

3Kiel Institute for the World Economy, Kiel, Germany

KEYWORDS

financial market development, foreign direct investment, gravity model

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INTRODUCTION

There is an emerging consensus that financial market development (FMD) increases foreign direct

investment (FDI).1 However, studies have typically addressed FMD on just one side of the source–host

pair, leaving it unclear whether what matters for FDI is only FMD in the host countries, only in the

source countries or in both host and source countries. We know of just two previous studies consider-

ing the role of financial market conditions in both host and source countries for bilateral FDI, namely

Coeurdacier, Santis, and Aviat (2009) and Desbordes and Wei (2017, p. 154) who find that "a deep

financial system in source and destination countries strongly facilitates the international expansion of

firms through FDI." Importantly, whether FMD in source and host countries functions as comple-

ments or substitutes or promotes FDI independently of each other has to our knowledge not been ana-

lysed at all. The potential conditionality between host country FMD and source country FMD is

particularly relevant for host countries that have remained on the sidelines in the global competition

for FDI, such as many developing countries, since typically they score poorly on FMD whereas many,

though by no means all, of the countries that could potentially invest in them score highly on FMD.

The differences‐in‐differences study by Desbordes and Wei (2017) is based on firm‐level data on

greenfield FDI projects in the manufacturing sector that are not freely available.2 Our analysis comple-

1 See, for example, Klein et al. (2002), Di Giovanni (2005), Antràs et al. (2009), Alfaro et al. (2009), Mohamed and

Sidiropoulos (2010), Kaur et al. (2013), Bilir et al. (2019), Buch et al. (2014) and Otchere et al. (2016).

2 These data are collected by fDi Markets (http://www.fdima rkets.com/), a fee‐based service from the Financial Times.

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduction

in any medium, provided the original work is properly cited.

© 2019 The Authors. The World Economy published by John Wiley & Sons Ltd

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DONAUBAUER Et Al.

ments and extends the work of Desbordes and Wei (2017) in several ways. First and most importantly, we

explore whether the effects of source‐ and host country FMD are conditional on each other. Second, we

use a broader measure of FMD based on a comprehensive set of financial indicators, employing the unob-

served component model suggested by Donaubauer, Meyer, and Nunnenkamp (2016a, 2016b). We regard

this broadly defined and time‐varying index as a major improvement over the existing literature, which

typically approximates financial market conditions by just bank credit and stock market capitalisation

only, whereas FMD goes well beyond these two, albeit admittedly important, aspects of developed finan-

cial markets. Third, our panel data set covers the period 2001–12 and thus a significantly longer time pe-

riod than the analysis of Desbordes and Wei (2017) which is restricted to just 4years (2003–06). Finally,

we rely on bilateral FDI stocks as officially released by UNCTAD. As discussed in more detail in Section

3, we consider this FDI measure to be most appropriate in the context of assessing the role of financial

market conditions in the global competition for external resources accessible through inward FDI.

We find positive, statistically significant and substantively important independent effects of both

source and host country FMD on FDI. When we test for conditionality between the two FMD mea-

sures, we find no evidence for it in the global sample. However, if we restrict the host countries to

developing countries, we find that source country FMD can function as a substitute for host country

FMD, and vice versa. This central finding is robust to a battery of tests, in which we employ plausible

modifications to the definition of the sample and the specification of the estimation model.

The paper proceeds as follows. Section 2 discusses the analytical background and derives our

hypotheses. Section 3 describes the methods and the data used. We present our empirical results in

Section 4 and conclude in Section 5 with what our results imply for developing host countries.

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ANALYTICAL BACKGROUND AND HYPOTHESES

As shown by Helpman, Melitz, and Yeaple (2004, p. 300), "of those firms that serve foreign markets,

only the most productive engage in FDI." Compared to serving foreign countries through exports and

other arm's length interactions, FDI involves particularly high fixed costs upfront since an affiliate

has to be established or acquired in the host country. Highly productive firms may cover these fixed

costs at least partly through internal financing. However, the availability of external financing clearly

renders it easier to cover the fixed costs of undertaking FDI. As access to external financing depends

on FMD, it is to be expected that better developed financial markets in the source country result in

higher outward FDI (Desbordes & Wei, 2017).

In a similar vein, Klein, Peek, and Rosengren (2002) advanced the so‐called "relative access to credit

hypothesis" according to which outward FDI depends on the ability of potential investors to raise exter-

nal funds. These authors highlight the role of imperfect capital markets in source countries of FDI that

may impair the availability of credit and is, thus, expected to be associated with less outward FDI, nota-

bly by bank‐dependent foreign investors. Indeed, Klein et al. (2002, p. 665) find that firms "associated

with less healthy banks" are less likely to engage in FDI. Specifically, they show that the links between

Japanese MNCs and troubled banks at home help explain the decline of Japanese FDI in the United

States in the 1990s. In a similar vein, Buch, Kesternich, Lipponer, and Schnitzer (2014) show that finan-

cially constrained German firms are less likely to undertake FDI. Analysing the determinants of M&A

deals during the 1990s, Di Giovanni (2005) finds that stock market capitalisation in the home country of

the acquiring firms is strongly and positively associated with their M&A activity abroad.

This leads to our first hypothesis:

Hypothesis 1 Better financial market development in the source country encourages outward FDI.