NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Channeling Domestic Savings into Productive Investment Under Asymmetric Information: The Essential Role of Foreign Direct Investment

Assaf Razin, Efraim Sadka, Chi-Wa Yuen

NBER Working Paper No. 6338
Issued in December 1997
NBER Program(s):   IFM   PE

Foreign direct investment (FDI) is observed to be a predominant form of capital flows to low and middle income countries with insufficiently developed capital markets. This paper analyzes the problem of channeling domestic savings into productive investment in the presence of asymmetric information between the managing owners of firms and other portfolio stakeholders. We emphasize the crucial role played by FDI in sustaining equity-financed capital investment for economies plagued by such information problems. Similar problems also exist for foreign portfolio debt flows. The paper identifies how, in the presence of information asymmetry, different capital market structures may lead to foreign over- or under-investment and to domestic under- or over-saving, and thus to inefficient equilibria. We show how corrective tax-subsidy policies consisting of taxes on corporate income and the capital incomes of both residents and nonresidents can restore efficiency.

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Document Object Identifier (DOI): 10.3386/w6338

Published: European Economic Review (May 1998).

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