The Contribution of FDI Flows to Domestic Investment in Capacity , and Vice Versa

This chapter provides an empirical analysis of interactions between FDI flows and domestic investment in capacity. As a motivation for the empirical analysis, I provide highlights of a new theory of FDI. The theory captures unique feature: hands-on management standards, that enable investors to react in real time to ongoing changes in the economic environment, which surrounds investors. Equipped with superior managerial skills, foreign direct investors are able to outbid portfolio investors for the top productivity firms in a domestic specialized industry, in which they have some comparative advantage in the source country. Consequently, FDI investors make investment in the domestic firm's capacity, which is both larger in size, and of higher " quality " (that is, in terms of rates of returns), than domestic investors, or foreign portfolio investors. Gains to the host country from FDI stem from the informational value of FDI, over and above the traditional capital-flow gains. 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. Likewise, domestic investment in