Implications of Financial Development of the South for Trade and Foreign Direct Investment from the North

Transcription

1 Review of Development Economics, 8(2), , 204 DO:0./rode.2083 mplications of Financial Development of the South for Trade and Foreign Direct nvestment from the North Qing Liu and Larry D. Qiu* Abstract Using a North South model of heterogeneous firms, the paper investigates the effects of the financial development of the South on the choice of international entry mode (export vs foreign direct investment [FD]) of Northern firms. Such development facilitates the entry of local firms and thus intensifies product market competition. As a result, the intensive margins, extensive margins and total sales from export or FD of Northern firms are all reduced. The paper provides conditions that determine whether export or FD is affected more significantly. The results generate empirically testable hypotheses.. ntroduction Financial development is an important factor that affects the activities of multinational enterprises. On the one hand, the financial development of a home country facilitates the export activities of domestic firms (Beck, 2002; Manova, 2008, 203; Minetti and Zhu, 20) and outward cross-border mergers and acquisitions (Di Giovanni, 2005). On the other hand, the financial development of the host country affects the choice of foreign multinationals between arm s length technology transfer and foreign direct investment (FD) (Antràs et al., 2009) and determines the spatial distribution of sales from local affiliates (i.e. local sales in the host country and sales back to the home country or to a third country) (Chor et al., 2008). Based on a North South model of heterogeneous firms, this paper studies the impact of the financial development of the South (i.e. the host country) on the choice of international entry mode (export or foreign direct investment [FD]) of Northern firms. This study incorporates the financial development of the host country into a proximity-concentration analysis of export and FD of heterogeneous firms. Although most FD flows between developed countries, FD flowing from developed to developing countries is becoming increasingly significant. The World nvestment Reports of the United Nations Conference on Trade and Development (UNCTAD) indicate that, the average annual FD flowing to developing countries increased eightfold from to As a result, developing countries attracted almost one third of world-wide FD flows in Arguably FD flows to developing countries are even more important than those to developed countries: FD inflows in represented an average share of almost 0% of gross fixed capital formation in developing countries compared with the 6% in developed countries; the inward FD stocks * Qiu: Faculty of Business and Economics, University of Hong Kong, Hong Kong. Tel: ; larryqiu@hku.hk. Liu: School of nternational Trade and Economics, University of nternational Business and Economics, Beijing, P.R. China. qliu997@gmail.com. The authors thank the two referees for their comments. The paper also benefitted from presentation at the EFS China Annual Conference, 202. Liu also thanks the National Science Foundation of China (project no ) and the 2 Project of the University of nternational Business and Economics for their financial support. 204 John Wiley & Sons Ltd

2 FNANCAL DEVELOPMENT ON FD 273 of developing countries in 998 amounted to 20% of their gross domestic product (GDP) compared with the 2% in developed countries (Nunnenkamp, 2002). FD flows to emerging market economies also increased from 2.5% of these economies GDP on average in 990 to 3.7% in 2008 despite the rapid growth of their GDP (Arbatli, 20). This paper shows that financial development of the South facilitates the entry of Southern firms and thus intensifies market competition in the South and reduces the export and FD profits of Northern firms. However, the extent of reduction in export profits differs from that of reduction in FD profits and thus changes the prevalence of FD over export. The outcome depends on the firms productivity dispersion, economies of scale at the plant level, labor costs in the South and trade costs. Our paper is related to Antràs et al. (2009), which considers the financial development of the host country to investigate the choice of multinationals between arm s length technology transfer and FD. They find that the financial improvement (i.e. increased investor protection) of the host country reduces FD inflows. 2 n contrast, we compare the choice between export and FD. We find that the financial improvement (i.e. enhanced borrowing ability) of the host country reduces both trade (imports) and FD inflows. Empirical evidence indirectly supports our finding that the financial development of the host country negatively impacts FD inflows. Huang (2003) argues that China has received too much FD because Chinese domestic firms, especially private firms, are constrained by credits, which restricts their entry and thus encourages the entry of foreign firms (through FD). 3 This observation implies that improving the financial market of China would reduce FD flows to the country. This prediction can also be directly derived from our analysis. The impact of the financial development of the host country on trade and FD can also be observed in countries other than China (Figure ). Figure shows operation data on US multinational firms in 0 Asian economies (i.e. China, ndia, ndonesia, Malaysia, Pakistan, the Philippines, South Korea, Taiwan, Thailand and Vietnam) in To construct the figure, we follow Rajan and Zingales (998) to measure the financial development of a country. Two different measures of financial development are used: () the ratio of private credit by money deposit banks and other financial institutions to GDP (FD_Credit) and (2) the ratio of stock market capitalization to GDP (FD_Stock). Figure indicates that the ratio of the sales of the US subsidiaries to US exports in the 0 economies decreases as the financial development of the host country progresses. The paper is organized as follows. We describe the model in section 2 and analyze the behavior of firms in section 3. Market equilibrium is derived and the main results are presented in section 4. Section 5 concludes the paper. 2. Model Setup n our model, the world consists of two countries, the Northern country, N, and the Southern country, S. There are M + industries. One industry produces a homogeneous good z, which is taken as numeraire, whereas each of the other M industries, denoted by m =,..., M, produces a continuum of differentiated products. We refer to these differentiated products as varieties and denote a variety by v. Northern firms from the differentiated goods industries consider entering the Southern market via export or FD. Our model is an extension of the model of Helpman et al. (2004); thus most of the justifications can be found in Helpman et al. (2004). 204 John Wiley & Sons Ltd

3 274 Qing Liu and Larry D. Qiu FD_Credit FD_Stock US FD Sales/US Exports Fitted values US FD Sales/US Exports Fitted values Figure. FD/Export vs Financial Developments This study focuses on how the financial development of the South affects the choice of Northern firms between export and FD and thus disregards the Northern market to simplify the model and analysis. The South is inhabited by a unit measure of identical consumers. A representative consumer derives the following utility from consuming z units of the homogeneous goods and x m(v) units of variety v from industry m: M M = m + m ( m ) v Ω m m= m= m U ( μ )logz μ log x ( v) dv m, where m (0, ), Ω m denotes the measure of available products in industry m and is M to be determined endogenously, and ( m= μm) and μ m are the fractions of expenditure on the homogeneous goods and the goods of industry m, respectively. The elasticity of substitution across varieties within industry m is εm = >. m The consumer maximizes his or her utility subject to the budget constraint M z+ pm() v xm() v dv E, v Ω m m= where E is the total expenditure of the consumer, assumed to be exogenously given, and p m(v) is the price of variety v in industry m. Most of the analysis focuses on a single industry; thus, to simplify notation, we omit the industry index m when such 204 John Wiley & Sons Ltd

4 omission causes no confusion. Given the above budget constraint, demand for each variety in a given industry is described as μe xv () = pv () Apv (), pv () dv v Ω where v Ω pv () ε dvis the price index of the industry and A is the industry s average consumption index, which is exogenous to any individual firm but endogenous in equilibrium. As for supply, labor is assumed to be the sole factor for production and to be inelastically supplied (in both countries). One worker in N could produce one unit of the homogeneous goods, but one worker in S could produce only w (0, ) unit of the homogeneous goods. Such limited capacity indicates the technological backwardness of the South in the homogeneous goods. Suppose that the homogeneous goods are freely traded and produced in both countries. 4 Then, the wage rate in N is normalized to one, and the wage rate in S is equal to w <. As in Melitz (2003), each of the differentiated varieties is produced by a single firm, and all industries allow free entry. To produce a differentiated variety, a firm (of either N or S) has to pay a fixed entry cost equal to f E (units of the numeraire). Upon paying the fixed cost of entry, all firms from N draw their productivity level θ from a cumulative distribution G N(θ) and all firms from S draw from G S(θ). The decision of a firm to leave the industry implies the exclusion of the firm from competition. f a Southern firm chooses to stay in the industry, it has to pay a fixed cost equal to f S (units of the numeraire) to set up a production plant. f a Northern firm stays in the industry and chooses to export to S, it pays a fixed cost f (in terms of the units of the numeraire goods) to set up its production plant at home and build a distribution channel for export. n addition, it bears an iceberg trade cost τ > (only unit of goods reaches the destination for every τ units shipped). f a Northern firm chooses to stay in the industry and makes an FD in S, it pays a fixed cost f (in terms of the units of the numeraire goods) to set up a production plant in S and a distribution channel to sell its products. The difference between f and f represents the extra fixed costs of FD compared with export, which is commonly assumed positive, that is, f > f. Southern firms are assumed never to export to or make an FD in the North. Following Chor et al. (2008) and others, we suppose that firms have to use their own capital to finance their entry cost f E and that all firms have sufficient capital to do so. However, firms have to borrow from the financial market in their country to finance all other fixed costs. The financial market is elaborated in the following section. 3. Financial Market and Firms Decision FNANCAL DEVELOPMENT ON FD 275 To investigate how the financial market of the South affects the entry modes of Northern firms, we assume that the financial market in the North is well developed and that in the South is underdeveloped. Developed Financial Market in the North and Decisions of Northern Firms To sharpen the focus of the analysis, we assume that the financial market in the North (with possible abuse of terminology) is well developed in the sense that 204 John Wiley & Sons Ltd

5 276 Qing Liu and Larry D. Qiu there is no credit constraint in the North, that is, firms can borrow as much as they would like to. 5 Thus, in the North, if a Northern firm with productivity level θ serves the Southern market via export, then its marginal cost is τ/θ. Profit maximization implies a monopolistic price with a markup τ/θ. Thus, the profit of the exporting firm (with the fixed entry cost f E disregarded) is π ( ) ( ) = τ τ τ = A f Θτ B f, θ θ θ where Θ θ ε is also a measure of productivity and B A( ) ε captures the degree of market competition (as it is affected by the number of firms in the industry). f the firm chooses FD, then it will charge a price w/θ and earn a profit (ignoring the fixed entry cost f E) π ( ) ( ) f = w B f w w w = A θ θ θ Θ. As w < τ, the π curve is steeper than the π curve with regard to productivity measure Θ. Following the literature, we further assume that the FD fixed cost is much higher than the export fixed cost, such that w ε f > τ ε f. Then, we have the cutoff productivity level between FD and export as ( f f ), ( w τ ) B Θ ε () and the cutoff productivity level for exporting as Θ f τ B. (2) ε t can be easily shown that Θ <Θ. As a result, the sorting pattern for the Northern firms is as follows: firms with Θ>Θ (i.e. the most productive ones) choose FD, firms with Θ (Θ, Θ ) choose export, and the rest of the firms (i.e. the least productive ones) exit. Under-developed Financial Market in the South and Decisions of Southern Firms n the South, each staying firm wishes to borrow f S from the financial market to set up its plant for production. f a firm with productivity θ succeeds in borrowing the expected amount, it sets up its plant, starts to produce, charges a price w/θ and earns a profit (excluding the fixed entry cost f E) π S ( ) ( ) fs = w B fs w w w = A θ θ θ Θ. However, in contrast to the financial market in N, that in S is underdeveloped. Protection for lenders is imperfect in S owing to high default risk. As analyzed by Aghion et al. (2004), Chor et al. (2008) and Antràs and Caballero (2009), such imperfect protection for lenders will result in credit rationing in the following form: a firm can 204 John Wiley & Sons Ltd

6 borrow only up to a fraction, λ (0, ), of its expected net sales, which is λθw B for firm θ in our model. 6 A larger λ represents a more developed financial market. Thus, we have λ = for the financial market in N. Therefore, firms with productivity level θ, orθ, such that λθw B < f S can not borrow a sufficient amount and thus leave the industry. Firms with Θ Θ S, where Θ S f w B FNANCAL DEVELOPMENT ON FD 277 S, (3) λ can obtain sufficient credits and eventually enter the product market. 4. Equilibrium and Comparative Static Analysis n any differentiated goods market in the South, there are three types of firms: the exporters from N with productivity Θ (Θ, Θ ), the FD firms from N with productivity Θ>Θ, and the local firms with productivity Θ>Θ S. Thus, the set of the industry s varieties available in the market, Ω, is determined. As the exporters charge τ/θ, the FD firms charge w/θ, and the local firms charge w/θ, the price index of the industry is obtained as v Ω Θ τ w w p( v) dv = dgn( ) dgn( ) ( ) Θ θ + ( ) Θ θ + Θ Θ ΘS ( ) ΘdG S ( θ). Following Helpman et al. (2004), we assume that a firm s productivity is drawn from a Pareto distribution with shape parameter k and lower bound b, that is, b k G( θ), for θ b > 0, where /k is positively correlated with the productivity θ dispersion within an industry. With any given productivity distribution, the sales distribution is also a Pareto distribution with shape parameter k (ε ). As argued by Helpman et al. (2004), it is reasonable and realistic to assume k > (ε ). n our model, the distribution parameters (k, b) are (, b N) for the North and (k S, b S) for the South. For convenience, we introduce the following function and = ( ) bki i k Vi( Θ) xdgi( x) Θ ( ε = ) Θ k ( ε ) i k, i = N, S. Note that V i ( Θ) < 0. We can then rewrite the price index as pv ( ) ε dv= ε { τ ε [ VN( Θ) VN( Θ)] + w ε [ VN( Θ) + VS( Θ S)] } v Ω B = τ ( μ ) E V ( Θ ) + ( w τ ) V ( Θ ) + w V ( Θ ). N N S S (4) The equilibrium levels of Θ, Θ, Θ S, and B are determined by conditions () (4). Note that once B is uniquely determined, the other three variables, Θ, Θ and Θ S, are also uniquely determined by () (3), respectively. Substituting () (3) into equation (4) yields an equation with only one unknown, which is B. We can also observe that 204 John Wiley & Sons Ltd

7 278 Qing Liu and Larry D. Qiu V i(θ) is a decreasing function of Θ and Θ, Θ and Θ S are all decreasing functions of B; thus, V N(Θ ), V N(Θ ) and V N(Θ S) are all increasing functions of B. Thus, the lefthand side of equation (4) strictly increases in B, whereas the right-hand side strictly decreases, indicating that B is uniquely determined. Our first question is how the financial development of the South, represented by an increase in λ, affects the Northern firms as well as the Southern firms at the margins, that is, at the cutoff productivity levels Θ, Θ, and Θ S, respectively. The results are given in Lemma. Lemma. The financial development of the South reduces B and Θ S and Θ : but raises Θ dθs dθ dθ < 0, < 0, > 0, and > 0. Proof. See Appendix. The above results are intuitive. The financial development of the South most directly affects the Southern firms: further developing the financial market in the South enables more Southern firms to obtain sufficient credits to enter the market ( Θ S/ λ < 0). This induced entry intensifies market competition (/ Θ S < 0) and indirectly affects the Northern firms: the profits of exporters and FD firms all drop. Exporters with a productivity level only slightly above the cutoff make no profit and thus leave the industry ( Θ / > 0). Note that a decrease in price index in the South brings a larger negative impact on firm revenue from FD than from export because FD has a larger production owing to a smaller marginal cost (enjoying a lower wage rate and avoiding the variable export cost). As a result, FD profits drop more significantly than export profits and thus cause firms with productivity Θ just above the cutoff to switch from FD to export ( Θ / > 0). Of course, the changes in Θ, Θ and Θ S feed back to the market competition and affect B in return. However, this second-order effect is dominated by the first-order effect that we have just discussed. Our next question is how the financial development of the South influences the two extensive margins of the North: the export extensive margin, which is the total number of exporters M, and the FD extensive margin, which is the total number of FD firms M. Given that M = GN = bn ( Θ ) Θ ε, we know that dm / < 0 because dθ / > 0 according to Lemma. From kn M = GN GN = bn bn ( Θ ) ( Θ ) Θ Θ, we notice that how the export extensive margin changes is less obvious because some exporters exit whereas some firms switch from FD to export. We can prove that the export extensive margin also shrinks. An interesting question is then whether the export extensive margin is affected more badly than the FD extensive margin. The answer to this question depends on a number of conditions as stated in Proposition. kn Proposition. The financial development of the South reduces both the export and FD extensive margins of the North, albeit to different degrees: 204 John Wiley & Sons Ltd

8 (i) dm / < 0 and dm / < 0; (ii) dm / dm / > 0 if w is high, τ is low, f is high, and is large; and dm / dm / < 0 otherwise. Proof. See Appendix. Part (ii) of Proposition indicates that the financial development of the South more severely affects the export extensive margin than the FD extensive margin when the South s wage rate is high, its trade cost is low, its FD fixed cost is high and its industry productivity dispersion is low. The intuition is as follows. First, when is large, the industry productivity dispersion is small and there are not many firms taking FD. The number of firms around the cutoff productivity level Θ is also small. As a result, when the financial development of the South shifts up Θ, only a few firms switch from FD to export. n contrast, with the small productivity dispersion, the number of firms around the cutoff productivity level Θ is large and so the increase of Θ owing to the financial development of the South will result in a large number of Northern firms quitting export. Thus, the number of FD firms is less significantly reduced than that of exporters (i.e. dm / dm / > 0). The same intuition holds for the results in the opposite case, i.e. when is small. Let us now turn to other conditions in Proposition (ii). For a given productivity distribution, when labor cost w is high, trade cost (tariff) τ is low in S, orf is much higher than f, Θ is significantly higher than Θ. This observation implies that FD firms are less likely to be found at the right-most end of the productivity distribution than exporters. Thus, increased Θ does not increase the number of firms that switch from FD to export, but increased Θ causes many exporters to halt operations. As a result, the decrease in M is smaller than that in in M. The financial development of the South reduces not only the number of exporters and FD firms from the North, but also the sales of each remaining Northern firm (i.e. the intensive margin) because the product market competition intensifies. For an exporter, its sales from export are Q = Θτ (B/ ). For an FD firm, its sales are Q = Θw (B/ ). t is straightforward to obtain dq / < 0, dq / < 0, and dq / dq / < 0. The latter inequality, together with the finding that FD firms are more productive than exporters, indicates that the intensive margin of FD firms more significantly declines than that of exporters. Therefore, if the FD extensive margin more significantly declines than the export extensive margin, the total FD sales more substantially decline than the total export sales. The only question is whether this relation is consistent, which is examined below. The total sales of exports from N to S in an industry and those of FD firms in the same industry are given by, respectively TQ TQ Θ B τ B = Θτ dg ( θ) = [ V ( Θ ) V ( Θ )], Θ N N N B w B dg ( θ) = V ( Θ ). = Θw N N Θ We have the following results. FNANCAL DEVELOPMENT ON FD 279 Proposition 2. The financial development of the South reduces the sales of both Northern exporters and Northern FD firms in the South, albeit to different degrees: 204 John Wiley & Sons Ltd

9 280 Qing Liu and Larry D. Qiu (i) dtq / < 0, dtq / < 0; (ii) dtq / dtq / > 0 if w is high, τ is low, f is high, and is large; dtq / dtq / < 0 otherwise. Proof. See Appendix. The intuition behind Proposition 2(i) is simple. ncreased market competition reduces each firm s sales. Since the number of exporters and that of FD firms are reduced (Proposition ), the total sales of export and that of FD must decline. Proposition 2(ii) says that the FD sales drop less than export sales when wage is high, trade cost is low and the firms productivity dispersion is small. Notice that the conditions are qualitatively the same as those in Proposition (ii). This is not surprising as we have pointed out earlier that since the productivity distribution is Pareto, the sales distribution is also Pareto (with different parameter values). Therefore, the same intuition behind Proposition (ii) also applies to Proposition 2(ii). Propositions and 2 together have a clear empirical implication: when applying the model to the case with many host countries, we should expect that countries with higher wages and lower trade barriers will see that in the high productivity-dispersion industries, the Northern FD to their countries will be reduced less significantly than the Northern export to their countries after they improve their financial development. These findings provide a rough rationalization of FD in China and the FD/export pattern of the ten Asian economies in Figure. Given that these economies had low labor costs and poorly developed financial markets in , our model predicts that the prevalence of FD declines with the financial development of the host country. This prediction is supported by the findings As the expected profit of all firms prior to entry is zero owing to the free entry condition, the South s welfare is equal to the consumption of goods in all industries. Since welfare from the numeraire good is fixed and all differentiated industries are symmetric, we can just analyze the consumption of goods in one differentiated goods industry, which is μ W x v dv μ ε log ( ) log p v dv E v ( ) μ Ω v Ω ε μ ( ) = log μe. B = = ( ) ( ) Lemma indicates that / < 0, therefore, we have dw/ > 0. That is, financial market improvement in the South unambiguously increases the South s welfare. Clearly, the underlying intuition for this result comes from consumers love of variety. Note that consumer s income is fixed (equal to the total wage payment), so there is no wealth effect from financial market improvement. However, the varieties available for consumption are increased: although some foreign firms exit the market, more domestic firms enter the market; and thus, the total number of varieties increases. 5. Concluding Remarks This paper examines the effects of Southern countries financial development on Northern firms choice of entry mode between export and FD. mproving financial development in the South facilitates the entry of Southern firms into the market and 204 John Wiley & Sons Ltd

10 FNANCAL DEVELOPMENT ON FD 28 thus intensifies market competition. As a result, both export and FD from the North become less profitable. This reduces the export and FD intensive as well as extensive margins. However, the financial market improvement of the South more adversely affects Northern export than it does Northern FD when the South s wage rate is high, its trade cost is low, its FD fixed cost is high and its industry productivity dispersion is low. There is a large literature on the determination of FD inflows, especially in developing countries. Some recent studies (e.g. Campos and Kinoshita, 2008; Arbatli, 20) start to explore the roles of new explanatory variables such as the host country s financial development level and other macroeconomic factors. The present study finds that studying FD inflows is important, but examining the impact of macroeconomic factors on both FD and export is more important because multinationals need to know their options in relation to changes in market conditions, such as the financial development of the host country. Appendix Proof of Lemma From (4), we have dθ dθ dθ S = + +. Θ Θ Θ From the expressions of Θ, Θ, and Θ S, we have and dθ Θ Θ dθ Θ Θ = =, = =, B B dθs ΘS ΘS ΘS ΘS = λ + B = λ. B Substituting dθ /, dθ /, and dθ S/ into /, weget ΘS ΘS λ =. Θ Θ ΘS B B B Θ Θ Θ C Because V (Θ) < 0, w < τ, from the expression of B, we have / Θ > 0, / Θ > 0, / Θ S > 0. Therefore, /<0. t is straightforward that S dθ Θ = >0, B and 204 John Wiley & Sons Ltd

11 282 Qing Liu and Larry D. Qiu dθ Θ >0. B For Θ S, we have dθs Θ Θ + + ΘC B Θ B Θ =. λ Θ Θ ΘS B Θ B Θ B Θ S As / Θ > 0, / Θ > 0 and / Θ S > 0, we have dθ S/ < 0. Proof of Proposition First, dm knb = ( ε) B Θ Θ < 0, because ε >, Θ >Θ, and / < 0. Second, Next, dm knb = Θ < 0. ( ε) B dm dm knb = ( ε) B Θ 2Θ. As ε >, / < 0, we have sign dm k dm N ε ε ( sign ) = Θ 2 Θ. Note that Θ 2Θ kn τ ( f f ) = 2 w ( ) τ f ε, [τ (f f )/(w τ )f ] > (because Θ >Θ ), and > (ε ). Thus, when w is k high, τ is low, f is high, and is large, we have 2 [ τ ε ( ε ( f ) τ ε ) ] ε f w f > that is, (dm /) (dm /) > 0; otherwise, (dm /) (dm /) < 0., 204 John Wiley & Sons Ltd

12 FNANCAL DEVELOPMENT ON FD 283 Proof to Proposition 2 First, for the total export sales, dtq τ τ = [ VN( Θ) VN( Θ) ] + B VN ( Θ) Θ + d B V N ( Θ Θ ) λ B ( kn + 2 τ ) = [ VN( Θ) VN( Θ) ] < 0, because k + 2 ε > 0, V ( Θ ) V ( Θ ) > 0 N N N (as V i ( Θ) < 0 and Θ <Θ ), and / < 0. For total FD sales, dtq w w k w V N BV ( N + 2 ) = ( Θ ) N( Θ) Θ ε = V B As For the difference, we have dtq N ( Θ) < 0. dtq ( k + 2 ) τ ε w ε = [( + ) VN( Θ) τ ε VN( Θ)]. N ( τ + w ) VN( Θ) τ = τ V ( Θ ) N ( ) ε + w ( w τ ) f τ ε τ ( ) f f = +( ) kn ε+ w w f ( ) τ τ ( f f ) with ε >,τ > w, ε +> 0 and 0 < [(w τ )f ]/[τ (f f )] < owing to Θ >Θ ; then, when w is high, τ is low, f is high, and is large, we will have k ε+ ( τ + w ) N ( w τ ) f τ τ ( ) <. f f n this case, we have ε+, dtq dtq >0. The inequality is reversed if the conditions do not hold altogether. References Aghion, Philippe, Peter Howitt, and David Mayer-Foulkes, The Effect of Financial Development on Convergence: Theory and Evidence, Quarterly Journal of Economics 20 (2004): John Wiley & Sons Ltd

13 284 Qing Liu and Larry D. Qiu Antràs, P. and R.J. Caballero, Trade and Capital Flows: A Financial Frictions Perspective, Journal of Political Economy 7 (2009): Antràs, P., M.A. Desai, and F. Foley, Multinational Firms, FD Flows, and mperfect Capital Markets, Quarterly Journal of Economics 24 (2009):7 29. Arbatli, Elif, Economic Policies and FD nflows to Emerging Market Economies, MF working paper /92 (20). Beck, T. Financial Development and nternational Trade. s There a Link? Journal of nternational Economics 57 (2002):07 3. Campos, Nauro F. and Yuko Kinoshita, Foreign Direct nvestment and Structural Reforms: Evidence from Eastern Europe and Latin America, MF working paper 08/26 (2008). Caporale, G. M., P. Howells, and A. M. Soliman, Endogenous Growth Models and Stock Market Development: Evidence from Four Countries, Review of Development Economics 9 (2005): Chor, D., F. Foley, and K. Manova, Host Country Financial Development and MNC Activity, Stanford University, Memio (2008). Di Giovanni, J., What Drives Capital Flows? The Case of Cross-border M&A Activity and Financial Deepening, Journal of nternational Economics 65 (2005): Helpman, E., M. Melitz, and S. Yeaple, Export versus FD with Heterogeneous Firms, American Economic Review 94 (2004): Huang, Y., Selling China, Cambridge: Cambridge University Press (2003). Manova, K., Credit Constraints, Equity Market Liberalizations and nternational Trade, Journal of nternational Economics 76 (2008):33 47., Credit Constraints, Heterogeneous Firms, and nternational Trade, Review of Economic Studies 80 (203):7 44. Melitz, M., The mpact of Trade on Aggregate ndustry Productivity and ntra-industry Reallocations, Econometrica 7 (2003): Minetti, Raoul and Susan Zhu, Credit Constraints and Firm Export: Microeconomic Evidence from taly, Journal of nternational Economics 83 (20): Nunnenkamp, Peter, Foreign Direct nvestment in Developing Countries: What Economists (Don t) Know and What Policymakers Should (Not) Do! Kiel nstitute of World Economics, Germany, working paper 026 (2002).s Qiu, L.D., Credit Rationing and Pattern of New Product Trade, Journal of Economic ntegration 4 (999): Rajan, R. and L. Zingales, Financial Dependence and Growth, American Economic Review 88 (998): Notes. Qiu (999) examines how credit rationing in both the home and foreign countries affects the pattern of intra-industry trade in new products. Other studies have investigated the relationship between financial development and economic growth (e.g. Rajan and Zingales, 998; Caporale et al., 2005). 2. Antràs et al. (2009) find that financial improvement alleviates the concern of external funders about the misbehavior of managers in implementing projects and thus reduces the requirement for the monitoring services of technology owners (multi-national enterprises, MNEs). This finding implies reduced shareholding (i.e. decreased FD inflows) by MNEs in projects. 3. According to Huang (2003), there are several reasons why Chinese private firms are credit constrained: for example, limited resource availability and political pecking order against private firms in allocating resources. 4. This can be justified by assuming that demand for homogeneous goods and/or the labor supply are sufficiently large in each country. 204 John Wiley & Sons Ltd

14 FNANCAL DEVELOPMENT ON FD This is the same assumption made by Chor et al. (2008). 6. Antràs and Caballero (2009) do not take a particular stance on the underlying reason why the financial market is not perfect. There could be many possibilities, for example, institutional imperfect protections for lenders, borrowers moral hazard or limited commitments, or problem of adverse selection. Chor et al. (2008), who follow Aghion et al. (2004), model financial development from the perspective of lender protection. Qiu (999) considers credit rationing in a model of international trade in which credit rationing arises from asymmetric information and adverse selection. 204 John Wiley & Sons Ltd