SMU ECONOMICS & STATISTICS WORKING PAPER SERIES Paper No. 10-2008
We present evidence that the level of financial development in FDI recipient countries systematically aects the spatial distribution of multinational corporations' (MNCs) sales. Using detailed proprietary survey data collected by the Bureau of Economic Analysis (BEA) on US multinational activity abroad, we find that stronger financial development in the host country has a negative effect on the share of MNC affiliate sales that remain in the host country, indicating a reduced propensity towards horizontal FDI. Conversely, the share of affiliate sales that is re-exported to third-country destinations increases, suggesting an increased propensity towards export-platform FDI. We provide a three-country model with heterogenous firms that rationalizes these observations: More financially developed host countries foster entry by domestic firms, making the local market more competitive for MNC products. This leads MNCs to orient their affiliates away from servicing the local market towards third-country markets instead.