A fundamental question in international economics is why and how firms engage in foreign direct investment (FDI). Two broad motives for undertaking such investments have been identified -- one related to trade frictions and the second one related to the value of exercising corporate control. The trade literature focuses on the importance of economies of scale, trade barriers, and cross-border differences in production costs as the reasons for firms becoming multinational (see, among others, Brainard 1997; and Helpman et al. 2004). The finance literature, on the other hand, stresses the role of corporate control and the differences in the returns to private investment as drivers of FDI. Aside from being of enduring interest to international economists, the answer to this question has wider implications for growth, investment and technological convergence across countries. Given that 54% of the total FDI inflows in 2013 was destined for developing countries (UNCTAD, 2014), these issues are especially pertinent for those countries.
Financial liquidity and FDI
In a recent paper, we show that the ability of foreign acquirers to provide financial liquidity to targets based in emerging-market economies is a key determinant of foreign mergers and acquisitions (M&A) (Alquist et al. 2014a). By financial liquidity, we mean the sum of internal funds and credit available from external sources. This channel provides a unified explanation for the distribution of M&A-based FDI across both industries and countries. It also explains the size of the acquirer’s stake in the target.
This paper is a follow-up to Alquist et al. (2014b) that examined the behavior of foreign M&A in emerging markets during periods of financial stress. In the earlier paper, we found that foreign acquisitions are more likely during emerging-market liquidity crises. Our more recent work shows that financial liquidity is a key driver of emerging-market M&A during non-crisis periods as well.
Financial liquidity as a driver of FDI to emerging-market economies is an intuitively appealing idea. The inability of firms to access liquid financial markets has been shown to be an impediment to the growth prospects of firms (Levine 2005) and their ability to export (Berman and Héricourt 2010). This argument applies with particular force to firms located in emerging-market economies where local financial markets are underdeveloped. According to the World Bank Enterprise Surveys, up to 46% and 34% of South Asian and Latin American firms in different size categories reported difficulties in obtaining their desired levels of credit (WBES 2013). The lack of access to credit in these countries makes illiquid, and hence undervalued, local firms attractive acquisition targets for more liquid firms that are based in developed markets.
What do firm-level credit constraints imply for M&A-based FDI at the industry level? To answer this question, we use a theoretical model and two indicators to measure financial liquidity -- the industry’s dependence on external sources of finance and the tangibility of the assets it uses in production. Asset tangibility refers to the ease with which the productive assets of a firm can be pledged as collateral. Under this definition, physical plant and equipment are more tangible assets than proprietary software. Consistent with economic intuition, our model predicts that FDI is more likely in industries that are more reliant on external finance and that have fewer tangible assets. The firms in such industries are more financially constrained and are more likely to be undervalued. The model suggests that by improving the ability of a target to pledge its assets, domestic financial development makes foreign M&A less likely across all sectors, especially in the sectors that are more dependent on external finance.
Financial liquidity and ownership structure
Our theory of liquidity-driven FDI also makes two additional predictions about the size of the ownership stake bought by the foreign acquirer. The stake is higher in industries that are more reliant on external finance and lower in those industries with more tangible assets. To provide the target’s owner with an incentive to accept co-ownership, the foreign acquirer offers her a stake just large enough to induce her to accept the offer. The domestic target values the option of retaining full ownership more when it is not liquidity constrained and can invest optimally on its own. For this reason, we expect to see that smaller foreign stakes are acquired in sectors less dependent on external finance and that own more tangible assets.
Liquidity matters for foreign M&A in emerging markets
We test these predictions using a data set of foreign and domestic M&A in the manufacturing sector of fifteen emerging-market economies between the years 1990 and 2007. Consistent with the theory, we find that firms in sectors dependent on external finance and in sectors with lower asset tangibility are more likely to be targets of foreign acquisitions. The effects are economically large. Our estimates suggest that the likelihood of being the target of a foreign acquisition for a firm in the sector most dependent on external finance (instruments) is 18.5 percentage points higher than that in the least dependent sector (tobacco). We also find that domestic financial development reduces the advantage foreign firms have in acquiring targets in external finance dependent sectors.
In addition, the evidence shows that conditional on entry, larger foreign ownership stakes are more likely in external finance dependent sectors, just as the model predicts. A firm in the sector most dependent on external finance is likely to have a foreign ownership stake that is 36.7 percentage points higher than that of a firm in the least dependent sector. In contrast to foreign acquisitions, the ownership structure chosen by domestic acquiring firms is insensitive to the industry liquidity proxies. This is exactly what we expect to find. The average difference in financial liquidity between an acquirer and a target that are both based in an emerging market should be smaller than that between a developed-market acquirer and an emerging-market target.
The inclusion of sector-level controls—such as measures of scale economies, the presence of tariffs, and cross-country differences in productivity levels and capital, R&D, and advertising intensity—in the regression analysis enables us to compare the predictions of existing models of FDI with those generated by our model. The regression estimates suggest that the financial-liquidity channel is at least as economically significant as the other channels and often more so.
This research has implications for investment, growth, and the international diffusion of technology in countries that lack well-developed financial markets. For example, sectors with higher levels of external finance dependence and fewer tangible assets are more likely to be the recipients of liquidity-driven FDI when foreign ownership rules are relaxed. Because there are usually large and persistent increases in productivity, investment, and wages in the targets acquired by foreign firms (e.g., Arnold and Javorcik 2009), such sectors are the ones most likely to receive the direct benefits of the international diffusion of technology and management practices through multinational corporations. On the other hand, because larger foreign stakes, as well as full foreign ownership, are more common in such sectors, the indirect benefits of technology spillovers through backward linkages to domestic firms (e.g., Javorcik 2004) are likely to be lower in the sectors that are the most dependent on external finance and that have the lowest levels of asset tangibility.
Our findings provide a new perspective on the importance of financial liquidity as a determinant of FDI flows into emerging-market economies. Taking account of this motive for foreign acquisitions has wide-ranging implications for the developing countries that now receive the bulk of these flows.
Note: Parts of the paper were written while Alquist was at the Bank of Canada. Tesar is currently on leave at the Council of Economic Advisers. The views expressed in the paper represent the authors' own and not those of the Council of Economic Advisers, the Bank of Canada, or Kings Peak Asset Management.
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