Economics of International Investment

FDI Structure

Product Markets

Physical Capital = Domestic Capital of host + Foreign Capital of Home

(Note: subscripts, d for domestic, s for foreign or subsidiary)

K = Kd + Ks

Financial Markets

Balance of Payments:


where "w" is world, ER is the exchange rate, r is the interest rate, NF is net

capital flow (in is + and out is -), and OFF is official transactions to create

the balance.

Domestic (host) Loanable Funds Market (LF):



where host household demand for LF is suppressed and government budget G

can have either a surplus (+) or a deficit (-). Crowding out and crowding in

will be analyzed in the context of the loanable funds market. Domestic or

host profit or retained earnings (Pd) can be used for the expansion of the

subsidiary or for portfolio investments in the host securities market.

The financing of any expansion (Greenfield or M/A) of a subsidiary or affiliate comes from two sources, external to the host and internal from the host market. The external source will usually consists of FDI (some from the parent Home and some from the subsidiary's profit or retained earnings) and non-FDI (portfolio flows from Home, Home bank lending from branches in host, and other international sources like IMF and WB). The internal sources are from the host financial markets. For example, for US affiliates world wide, the external was 58 percent and the internal was 42 percent for 1994. For the external, FDI was 37 percent of the 58 percent and non-FDI was 21 percent (Source: WIR 1999, Chapter VI, pp. 159-161).

Note: Physical capital equipment brought in to the affiliate in the host by the Home parent firm is recorded as a equity capital transfer-a component of FDI even though there is no actual transfer of financial resources taking place. Presumably, the real capital also shows up as an import of goods and services in the current account (Source: WIR 1999, Chapter VI, p.161).