Debt versus Foreign Direct Investment: The Impact of Sovereing Risk on the Structure of Capital Flows to Developing Countries

In this paper we compare the two standard forms of international investments in developing countries, debt and foreign direct investment, form a finance perspective. It is shown that the sovereign risks associated with debt finance are generally less severe than the ones which come with FDI. FDI is chosen only if the foreign investor is more efficient in running the project, if the project is risky and if the foreign investor has a good outside option which deters creeping expropriation. We show furhtermore that the host country and the foreign investor may benefit from forming a joint venture.