Why Do Emerging Economies Import Direct Investment and Export Savings? A Story of Financial Underdevelopment∗

The net foreign asset positions (NFAP) of developing countries and emerging markets tend to be short equity and either short or long debt, while most industrial nations are long equity and short debt. This paper proposes that financial system inefficiencies associated with underdeveloped financial markets can explain this difference in the NFAPs. Financial system imperfections typically found in emerging markets and developing countries raise the cost of debt financing for domestic firms. This in turn leads to three distinct effects; a greater need for firms to precautionary save, increased vulnerability to foreign multinationals buy-outs, and a drastic limitation on the purchase of foreign firms. We extend a small open economy framework to study the financing decisions of firms operating under financial frictions. In equilibrium, we can obtain a large negative net equity position and a smaller negative net debt position as a result of incremental financing decisions of the firms, rationalizing the observed NFAP in most non-industrial economies. JEL Codes: F41, F21, F23, G15