FDI Flows During Economic Crises

Abstract

Unlike other forms of capital flows, foreign direct investment (FDI) has been documented to stay stable or increase during financial crisis episodes in host countries. A key conjecture to explain this pattern has been the “fire sale” hypothesis according to which price drops following liquidity shortage in domestic firms can spur asset buyouts. In this thesis, we introduce an alternative view stemming from the theory of firm integration. During a crisis, default of an affiliate firm becomes more likely which affects the joint production problem between it and the headquarter firm. Since the optimal ownership structure depends on the default prospects of the affiliate, crisis episodes may motivate control-seeking acquisitions. We first build a single-period baseline general equilibrium model to illustrate our ideas with the framework of Antras(2003). We then present several extensions which address endogenous entry and exchange rates in this context. Subsequently, we depart from the general equilibrium setting to focus on firm problem in a dynamic setting. We conclude with empirical evidence that affiliate acquisitions form a substantial share of crisis-time acquisitions, and test the model predictions regarding the effects of the institutional environment on acquisition patterns.