Does financial development lead to more foreign investment?

Most studies on the relationship between foreign direct investments (FDI) and financial market development focus on financial market development as a link between FDI and economic growth. However at present our disciple has no deep understanding of direct causality between FDI and financial market development, especially in emerging markets, where financial markets are in the development stage.

In a forthcoming paper in World Bank Economic Review (WBER), we document a two-way causality between FDI and stock market development indicators in selected emerging economies. When analyzing the relationship between financial market development and FDI, results depend on whether the variables used are stock market or banking sector development indicators. For banking sector development indicators, the relationship is ambiguous and inconclusive. So care is needed when analyzing the relationship between financial market development and FDI, as results may depend on whether the financial market development variables used measure development of the stock market or development of the banking sector.

In general, the literature on the relationship between FDI, financial market development, and economic growth falls into two categories. The first category finds that FDI is only efficient at spurring growth when certain conditions are met, one of which consists of a fairly developed financial sector (e.g., Alfaro et al (2004, 2010), Hermes and Lensink (2003)). The second category provides evidence that well-functioning financial sector or market liberalization—in other words, financial market development —can help spur growth (Bekaert et al (2005), Levine et al (2000), Levine and Zervos (1998), and many others).

In our study we perform an empirical assessment of direct causal relationship between FDI and financial market development using panel data from emerging markets.Our focus on emerging markets has at least four advantages:

• data are available for almost all the countries of our sample;
• the quality of institutions is less diverse in these countries than it would be in a sample that included developed markets, therefore a common explanatory variable that can link economic development and other variables in given economy (such as gross domestic product (GDP) per capita) will have less effect on the results;
• our focus on emerging economies allows us to study stock market and other financial development variables often used in the literature;
• emerging markets is the most relevant sample on which to carry this study: given that developed markets are irrelevant for our purposes, and less developed or the poorest countries may have difficulty attracting FDI even if they have a well-functioning financial sector, because their smaller market power or lack of resources make them less attractive.

We document that FDI and stock market development indicators positively impact each other simultaneously. Hence, studies involving both FDI and financial market development, especially stock market development, must account for potential problems of endogeneity. We therefore use a system of simultaneous equations to further explore the implications for the two-way link between FDI and financial market development while controlling for other factors that drive inflows of FDI and the development of financial markets.

There are several ways to explain the two-way link between FDI and stock market development in these emerging economies. On the one hand, foreign investment helps develop local stock markets by its investment spillover effects. This is because more foreign investment increases the likelihood that the affiliates of multinationals involved in FDI activities will be listed on local stock markets, since multinationals tend to hail from industrialized countries where financing through the stock market is a tradition. Furthermore, consistent with the political economy argument, one can conjecture that FDI inflows encourage the country’s political elite to adopt market-friendly regulations—especially investor protection and better governance regulations: this promotes the development of the stock market. On the other hand, a relatively well-developed stock market helps attract foreign investors, as such, a market is perceived as a sign of vitality, of openness on the part of country authorities, and of a market-friendly environment. This is especially true in emerging markets, whose stock markets are more developed than are the markets of other developing countries.

These findings suggest a key policy recommendation: Policies to attract more FDI should be accompanied by market-friendly regulations, especially stock market regulations such as mechanisms to improve governance and protect investors. This will allow countries to maximize the benefits of the spillover effects of FDI.

This article is published in collaboration with The World Bank’s Let’s Talk Development Blog. Publication does not imply endorsement of views by the World Economic Forum.

To keep up with the Agenda subscribe to our weekly newsletter.

Author: Fulbert Tchana Tchana is a Senior Economist at the World Bank in the Macroeconomic and Fiscal Management Global Practice. Issouf Soumaré is Full Professor of Finance and the Director of International Relations of the Faculty of Business Administration at Université Laval in Canada.

Image: Silhouetted workers walk in front of office towers. REUTERS/Luke MacGregor.