Debt vs. Foreign Direct Investment: The Impact of Sovereign Risk on the Structure of International Capital Flows

In this paper the two standard forms of international investment in developing countries – debt and foreign direct investment (FDI) – are compared from a finance perspective. We show that the sovereign risks associated with debt finance are generally less severe than those accompanying FDI. FDI is chosen only if the foreign investor is more efficient in running the project, if the project is risky and if the foreign investor has a good outside option which deters creeping expropriation. The sovereign risk problem of FDI can be alleviated if the host country and the foreign investor form a joint venture.