Implications of Financial Development of the South for Trade and Foreign Direct Investment from the North

• DOI: http://doi.org/10.1111/rode.12083
• Author: Larry D. Qiu,Qing Liu
• Date: 01 May 2014
• Published date: 01 May 2014

Implications of Financial Development of the

South for Trade and Foreign Direct Investment

from the North

Qing Liu and Larry D. Qiu*

Abstract

Using a North–South model of heterogeneous firms, the paper investigates the effects of the financial

development of the South on the choice of international entry mode (export vs foreign direct investment

[FDI]) of Northern firms. Such development facilitates the entry of local firms and thus intensifies product

market competition. As a result, the intensive margins, extensive margins and total sales from export or

FDI of Northern firms are all reduced. The paper provides conditions that determine whether export or

FDI is affected more significantly. The results generate empirically testable hypotheses.

1. Introduction

Financial development is an important factor that affects the activities of multina-

tional enterprises. On the one hand, the financial development of a home country

facilitates the export activities of domestic firms (Beck, 2002; Manova, 2008, 2013;

Minetti and Zhu, 2011) and outward cross-border mergers and acquisitions (Di

Giovanni, 2005). On the other hand, the financial development of the host country

affects the choice of foreign multinationals between arm’s length technology transfer

and foreign direct investment (FDI) (Antràs et al., 2009) and determines the spatial

distribution of sales from local affiliates (i.e. local sales in the host country and sales

back to the home country or to a third country) (Chor et al., 2008).1

Based on a North–South model of heterogeneous firms, this paper studies the

impact of the financial development of the South (i.e. the host country) on the choice

of international entry mode (export or foreign direct investment [FDI]) of Northern

firms. This study incorporates the financial development of the host country into a

proximity-concentration analysis of export and FDI of heterogeneous firms. Although

most FDI flows between developed countries, FDI flowing from developed to devel-

oping countries is becoming increasingly significant. The World Investment Reports

of the United Nations Conference on Trade and Development (UNCTAD) indicate

that, the average annual FDI flowing to developing countries increased eightfold from

1982–1987 to 1994–1999. As a result, developing countries attracted almost one third

of world-wide FDI flows in 1994–1999. Arguably FDI flows to developing countries

are even more important than those to developed countries: FDI inflows in 1994–1998

represented an average share of almost 10% of gross fixed capital formation in devel-

oping countries compared with the 6% in developed countries; the inward FDI stocks

* Qiu: Faculty of Business and Economics, University of Hong Kong, Hong Kong. Tel: +852-2859-1043;

E-mail: larryqiu@hku.hk. Liu: School of International Trade and Economics, University of International

Business and Economics, Beijing, P.R. China. E-mail: qliu1997@gmail.com. The authors thank the two

referees for their comments. The paper also benefitted from presentation at the IEFS China Annual

Conference, 2012. Liu also thanks the National Science Foundation of China (project no. 71302009) and

the “211 Project” of the University of International Business and Economics for their financial support.

Review of Development Economics, 18(2), 272–285, 2014

DOI:10.1111/rode.12083

© 2014 John Wiley & Sons Ltd