Financial Constraints and Productivity Gains from FDI in Emerging Markets

Policy makers in emerging market countries have provided fiscal and financial incentives for foreign firms to set up affiliates in their jurisdiction. One reason for preferential treatment for FDI is that the inflow of massive foreign capital with short investment horizon (i.e., hot money) has been criticized as the main culprit in historical episodes of currency and banking crises in emerging markets. Monetary and fiscal authorities use their policies to steer the composition of capital inflows toward more stable forms and naturally, FDI has been preferred to other types of capital flows. In addition, FDI is believed to have many positive effects, which include technology transfer and productivity enhancement in host countries. However, it turns out overall messages on the effect of FDI on productivity are ambiguous in many empirical studies. Due to heterogeneity across countries, it is difficult to find robust evidence that FDI has improved productivity in emerging markets. This raises the question of what intrinsic attributes in the host country matter for productivity enhancement, and recent research has focused on the quality of local financial markets. Along this line of research, this article examines the effect of financial constraints on productivity of domestic and FDI firms in China and explores its implications