FDI Contribution to Capital Flows and Investment in Capacity

The paper surveys a theory of FDI, which captures a unique feature: hands-on management standards, that enable investors to react in real time to a changing economic environment. Equipped with superior managerial skills, foreign direct investors are able to outbid portfolio investors for the top productivity firms in a particular industry in which they have specialized in the source country. Consequently, FDI investors would make investment, both larger, and of higher quality (namely, with large rates of returns), than the domestic investors. The theory can explain both two-way FDI flows among developed countries, and one-way FDI flows from developed to developing countries. Gains to the host country from FDI stem from the informational value of FDI. The predictions of the theory are consistent with evidence from panel data: larger FDI coefficients in the domestic investment and output growth regressions relative to the portfolio equity flow and international loan coefficients, reflect a more significant role for FDI in the domestic investment process than other types of capital inflows.