FDI Contribution to Capital Flows and Investment in Capacity

The paper discusses a theory of FDI, which captures a unique feature: hands-on management standards to react in real time to a changing economic environment in the firms that FDI investors gain control. Equipped with superior managerial skills, foreign direct investors 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 higher quality, 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 the evidence: larger FDI coefficient in the domestic investment and output growth regressions relative to the equity flow coefficient, reflects a more significant role for FDI in the domestic investment process.