FDI and Financial Development: A New Answer to an Old Question

An analysis of new evidence suggesting a critical linkage between financial development and FDI and the need for strong financial institutions across the world.
Griffin Riddler


When discussing poverty and economic growth in developing countries, the topic of foreign direct investment (FDI) often comes up. Multiple empirical studies show that FDI helps to spur economic growth and reduce poverty by increasing opportunities for wage employment and improving technology and productivity, among other factors. In “The Effects of Financial Development on Foreign Direct Investment”, Rodolphe Desbordes and Shang-Jin Wei investigate how financial development in both source and destination countries impact different varieties of FDI.

Linking FDI to Development

One case study in Senegal found that even in what was considered “a worst-case scenario” with a single multinational enterprise (MNE) controlling the entire supply chain, FDI in the agro-industry had “robust, significant, and large positive effects on income and poverty reduction” (Maertens, Colen, & Swinnen, 2011). Researchers in Bolivia likewise determined that “FDI inflows enhance economic growth and reduce poverty” (Nunnenkamp, Schweickert, & Wiebelt, 2007). Deng Xiaoping famously opened China to FDI as part of his larger economic reforms, hoping to use foreign capital to kick the Chinese economy into high gear. Clearly, both economists and policy makers view FDI as another tool in the quest to boost growth and reduce poverty around the world.

A Literature Review of Financial Development and FDI

When studying FDI, researchers noticed something rather obvious: the level of FDI flows dropped worldwide in 2008 and 2009, the same time period as the global financial crisis. As FDI is reliant upon external financing from banks and other institutions, it made sense that financial development should affect FDI levels. However, until recently, studies into the effects of financial development, whether it be in source countries (SFD) or destination countries (DFD), on FDI have been stymied by shortcomings in the research design.

The authors of this working paper, Desbordes and Wei, identified three key problems with previous studies. First, by using balance of payments (BOP), other studies do not include external financing from within destination countries which prevents a proper comparison of DFD to SFD. This is compounded by a risk of bias due to imprecise estimates of control variables and country fixed effects. That, in turn, makes it very difficult to definitively show that financial development has long-run effects on FDI.

Finally, the studies that do attempt to limit omitted variable bias through the use of restricted data sets thereby limit the scope of their findings. The results: the vast majority of studies do not cover the total effects of SFD and DFD on FDI. These shortcomings drove Desbordes and Wei to construct a differences-in-differences model which utilized “variations in both country-specific financial development and sector-specific financial vulnerability” (Desbordes & Wei, 2017) to determine the impacts of both SFD and DFD.

Building a Model

After briefly postulating that SFD and DFD have net positive effects on FDI, whether a direct “external finance effect” or indirect effects on overall production, Desbordes and Wei established their definitions of the different types and margins of FDI that they measured. The different types roughly group into two categories, initial investment, represented by greenfield FDI and M&A FDI, and expansion FDI. For those unfamiliar with the first two terms, greenfield simply means establishing an entirely new foreign branch of the enterprise, while M&A is the acquisition of an extant firm in the destination country. As for the margins, the paper measures two kinds: the extensive margin, or the number of FDI projects in a given sector, and the intensive margin, or the average size of said projects.

The data used in “The Effects of Financial Development on Foreign Direct Investment” comes from two sources. Desbordes and Wei use the fDI Markets database complied by the Financial Times to measure greenfield and expansion FDI. The data does not distinguish between sources of external financing, making it superior to BOP measurements, and allows for the breakdown of FDI by sector. For M&A FDI flows, not included in the fDI Markets data, the authors use the Zephyr database, which includes comprehensive measurements of cross-border M&A deals by country and sector since 2003.

Desbordes and Wei, in an attempt to isolate the causal effects of SFD and DFD, created a model focusing on the interactions between SFD or DFD and a specific sector’s financial vulnerability (FV). In the first exponential regression, SFD and DFD were measured as the private credit to GDP ratio at time t-1, while country-pair and sector fixed effects were measured at time t, with FV (fraction of capital expenditures not financed by cash flows from operations) remaining a time-invariant measure. The coefficients of the interaction terms, β1 and β2, find the total effects of financial development on the different types of FDI.

FDIijst = exp(β1[ln(SFDit−1) · FVs] + β2[ln(DFDjt−1) · FVs] + αijt + αstijst

The next piece of the model expanded upon the first regression by controlling for the pre-sample size of the manufacturing sectors in both countries. This change meant that now the coefficients only captured the direct effects of SFD and DFD on FDI. (β1γ1) and (β2γ2) therefore represented the indirect effects on FDI, which the authors predicted to be positive. For both regressions, Desbordes and Wei restricted sample data to the period of 2003 to 2006 in order to avoid spillover effects from the financial crises that started in 2007.

FDIijst = exp(γ1[ln(SFDit−1) · FVs] + γ2[ln(DFDjt−1) · FVs] + γ3ln(Yis) + γ4ln(Yjs) + αijt + αstijst

Results and Conclusions


As shown by Table 1, the regressions run on the first model show that even with a variety of control variables, the results are unchanged: across all countries, DFD and SFD are found to have significant positive effects on FDI. These results show a conclusive link between financial development and bilateral FDI, but the first set of regressions only measures the total effects.


Table 2 shows the differences-in-differences approach the authors took to measure the indirect effects of financial development. In column (3), the differences shown at the bottom are those measurements: SFD and DFD appear to have both positive direct and indirect effects on FDI. Columns (5), (7), and (9) detail the effects of financial development on the extensive (5 & 7) and intensive (9) margins of FDI. Overall, SFD and DFD have net positive effects on greenfield FDI, with the primary driving mechanism being a strong effect on the average size of FDI projects.


Table 3, a series of regressions involving expansion FDI, tells a different story. While both SFD and DFD have significant positives effects on expansion FDI, where those effects occur differs for the different sources. The vast majority of SFD’s effects (~75%) translate into an increased presence of FDI (more projects), while DFD tends to lead to greater average size of said projects. In addition, the total effects of financial development on expansion FDI are only 66-75% the size of the effects on greenfield FDI.


The final form of FDI, M&A, is shown to be strongly and positively affected by SFD and DFD, at an even higher level than greenfield or expansion FDI. In summary, the results of all three models lead to the validation of the authors’ hypothesis that SFD and DFD have both direct and indirect impacts on all forms of FDI.


This paper makes one thing absolutely clear: countries wishing to attract FDI or spur an international expansion of their own MNEs must implement policies designed to secure the financial sector. The global financial crisis showed that, as FDI flows across the world plummeted due to instable credit markets. Developing countries in particular should include financial development in their growth strategies: by creating financial institutions with a strong foundation, they can attract more FDI to their nation and spur faster growth and reductions in poverty.


Desbordes, R., & Wei, S.-J. (2017). The Effects of Financial Development on Foreign Direct Investment. Cambridge: National Bureau of Economic Research.

Maertens, M., Colen, L., & Swinnen, J. F. (2011). Globalisation and poverty in Senegal: a worst case scenario? European Review of Agricultural Economics, 38(1), 31-54.

Nunnenkamp, P., Schweickert, R., & Wiebelt, M. (2007). Distributional Effects of FDI: How the Interaction of FDI and Economic Policy Affects Poor Households in Bolivia. Development Policy Review, 25(4), 429-450.

Cover image courtesy of: http://www.investopedia.com/video/play/foreign-direct-investment/