The Composition of International Capital Flows: Risk Sharing Through Foreign Direct Investment

Evidence on international capital ‡ows suggests that foreign direct investment (FDI) is less volatile than other ...nancial ‡ows. To explain this ...nding, I model international capital ‡ows under the assumptions of imperfect enforcement of ...nancial contracts and inalienability of FDI. Imperfect enforcement of contracts leads to endogenous ...nancing constraints and the pricing of default risk. Inalienability implies that it is not as advantageous to expropriate FDI relative to other ‡ows. These features combine to give a risk sharing advantage to FDI over other capital ‡ows. This risk sharing advantage of FDI translates into a lower default premium and lower sensitivity to changes in a country’s ...nancing constraint. The model o¤ers the new implication that ...nancially constrained countries should borrow relatively more through FDI. This is because FDI is harder to expropriate and not because FDI is more productive or less volatile. Using several creditworthiness and country risk ratings to measure ...nancing constraints, I present new evidence linking FDI and ...nancing constraints. Moreover, numerical simulations of the model generate stronger serial correlation for FDI than for other ‡ows into developing countries. This corroborates the view that non-FDI ‡ows are more short-term and more likely to change direction. JEL Classi...cation Numbers : F21, F34, F36.