Of particular interest is the effect FDI has on local
capital markets. The rationale advanced by some policy
makers that foreign investment can add to scarce
capital for new investment in developing countries is
based on the assumption that foreign investors who establish
new enterprises in local markets bring in additional
capital with them. But Kindleberger (1969),
Graham and Krugman (1991), and Lipsey (2002) show
that investors often fail to fully transfer capital upon
taking control of a foreign company, tending instead
to finance an important share of their investment in
the local market.9 Increasing volatility in exchange
rates, moreover, has prompted many foreign investors
to hedge by borrowing from local capital markets,
which can exacerbate financing constraints on domestic
firms by effectively crowding them out of domestic
capital markets. This latter effect has been tested by
Harrison and McMillan (2003) and Harrison et al.
(2004) using an Euler equation approach combined
with a generalized method of moment estimation.
The former, a country case study that analyzed the behavior
of mostly French multinationals operating in
Cote d’Ivoire, found that, in a context characterized
by market imperfections and rationed access to credit,
foreign investors did, indeed, crowd domestic enterprises
out of local credit markets. On the other hand,
the latter, which examined company-level data across
a panel of countries that varied in the strength of their
credit markets, found that the amount of credit available
to domestically owned firms increased with foreign
investment. These contrasting results point to
the important role played by policy complementarities
such as strong financial institutions, which are discussed
at length in the following section.