Foreign Direct Investment and Foreign Portfolio Investment under Asymmetric Information

This paper develops a model of international capital flows when there is asymmetric information between foreign investors and domestic managers. Direct investors have a direct influence on the management, thus overcoming agency and information problems. This information advantage, however, comes at the cost of having to acquire management expertise. The tradeoff between management costs and the costs of asymmetric information consequently determines the level and composition of a country’s international capital flows. Analyzing how this tradeoff changes with economic conditions in a country, the model can qualitatively capture the experiences of many crisis countries during the 1990s. Specifically, the model can capture the rise in FDI inflows despite the reversals of foreign portfolio investment inflows during deteriorating economic conditions which has been documented in this paper for the crises that involved no sovereign default or no imposition of capital controls. Moreover, the model can also explain growing evidence on the impacts of good governance and institutional quality on the composition of a country’s capital flows, predicting a lower level of capital inflows and a larger share of FDI in countries with weaker corporate governance