How are foreign direct investment (FDI) flows and patterns of multinational firm (MNC) activity determined in a world with frictions in financial contracting and variations in institutional environments? As developers of technologies, MNCs have long been characterized as having comparative advantage in monitoring the deployment of their technology. The model shows that, in a setting of non-contractible monitoring and financial frictions, this comparative advantage endogenously gives rise to MNC activity and FDI flows. The mechanism generating MNC activity is not the risk of technological expropriation by local partners but the demands of external funders who require MNC participation to ensure value maximization by local entrepreneurs. The model delivers distinctive predictions for the impact of weak institutions on patterns of MNC activity and FDI flows, with weak institutional environments limiting the scale of multinational firm activity but increasing the share of that activity that is financed by multinational parents through FDI flows. In addition to accounting for distinctions between patterns of MNC activity and FDI flows, the model can help explain substantial two-way FDI flows between countries with high levels of financial development and small and unbalanced FDI flows between countries with different levels of financial development. The main predictions of the model are tested and confirmed using firm-level data on U.S. outbound FDI
FDI, Multinationals, Financial Constraints, Capital Structure
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