Interaction between Financial Decisions

and Development of Capital/ Financial Market in Host Country

Conversion of corporate capital structure is not only a matter of internal decisions as I presented in the previous chapter. There are several external factors also determining it: so it is affected basically by the development of the fi nancial and capital market. These external factors will multiply if the management has to make decisions in multinational environment. In this chapter I would like to show what kind of motives infl uences managerial decisions concerning capital structure of the multinational or foreign owned fi rms and how does the

interaction between fi nancial decisions and development of capital/ fi nancial market affect investments in host country.

Foreign direct investment (FDI) is a new source of investment in the host economy; it means FDI infl ow makes a positive impact on the capital account of the host country. FDI is not only another fi nancing source, but at the same time it may further increase the fi nancing basis for investments indirectly through activating domestic savings and channelling them to the capital market. In certain cases FDI substitutes domestic savings, and practically supplements sources of fi nancing for investments. Driffi eld, N. – Hughes, D. (2003) proved that FDI infl ows generally stimulated domestic investments. At the same time Driffi eld and Hughes found that in certain regions of the host country FDI may push domestic investors out of the capital market. The crowding out effect means that foreign fi rms aggravate the existing credit constraints and cause domestic fi rms to exit [HARRISON and MCMILLIAN (2003)]. However, Harrison et al. (2004) proved that foreign investors tended to “crowd in” domestic enterprises, they found that FDI reduces the fi nancing constraints of local fi rms, but more so for foreign owned fi rms than for domestically owned fi rms. Rutkowsky (2006) provided evidences that in Central and Eastern European countries more FDI is not likely to have signifi cant negative effects on capital markets, on the contrary, it can have positive overall effects in a host country’s capital markets, reducing fi nancial constraints for foreign-controlled fi rms without hurting domestic enterprises.

The volume and structure of the FDI depends on the local economic environment, other investment opportunities and the owners’ decision.

If investment opportunities are favourable in the host country, the volume of reinvested revenue – which is accounted for as new FDI – will grow. As regards the relation between the impact of FDI on economic growth, FDI and the trend of GDP per capita, it is often quite diffi cult to decide what the cause and what the effect is. Choe, J.I. (2003) carried out an empirical research involving 80 countries to fi nd out how FDI affects growth. In his study he also mentioned the direction of causality. His results justifi ed that although there is a positive relation between the trend of FDI and GDP, but the explanatory power of growth regarding FDI infl ow exceeded the signifi cance of the impact of FDI on GDP. Consequently, a higher FDI volume does not necessarily result in a higher growth rate, while the trend of GDP is a decisive factor for capital investments

If the profi tability of a subsidiary showed a downward trend, repatriation of dividend increases signifi cantly. If profi t repatriation starts, it will decrease the balance of the capital account, just like the repayment of credit interests. The

Klára Katona: How Components of FDI Impacted the Growth… 127

intention to repatriate also grows because of the fi nancial crises of the host countries.

Of sources of fi nancing, which could be foreign investments and credits as well, FDI is regarded as more reliable source of fi nancing than other forms of fundraising in long-term. On the one hand, it is easier and faster to receive money from foreign owners than external creditors. On the other hand economic and fi nancial crises make an impact on creditors’ and investors’ decisions. A study made by Deutsche Bundesbank (2003) pointed out that bank lending related decisions showed the highest volatility during a crisis. FDI investments proved less unpredictable. The relative independence of FDI of crisis can offset the problems caused by the drying up of other sources of fi nancing. Contessi (2012) found evidence that the industries in the Unites States that are more fi nancially vulnerable experienced signifi cant shifts in FDI equity and debt (parent’s loan) infl ows during the latest fi nancial crisis, following the changes in the cost of capital that occurred in the source economies. However, Lall – Streeten (1977) emphasized that generally FDI was more expensive than a credit, as the premium of operating risk had to be guaranteed by the expected return.

MNCs use their access to multinational fi nancial networks to fund their foreign affi liates. MNCs have strategic advantage resulting from this multinational fi nancial network. [Aggarwal et al. (2008)]. Affi liates may offset the external debt with parent debt in countries with poor institutional features and when local fi nancing is costly or not easily available. This fi nancial fl exibility is an important source of competitive advantage for MNCs and their affi liates.

Marin and Schnitzel model (2011) handles the decision on fi nancing investments as a microeconomic governance problem. They identifi ed two managerial incentive problems: the manager has to make an effort to increase the probability of success of the project, which they called the effort problem.

And the manager can hide the returns of the project, they called the repayment problem. They found that projects are fi nanced locally if the incentive problems are rather large. The larger the repayment or effort problem is, the more likely is the local bank fi nancing as opposed to global internal fi nancing. If instead, the incentive problems are moderate, global fi nancing through headquarters is preferred, leading to a capital fl ow to the host country. They also found that affi liates rely more on internal fi nancing from parents than on external fi nancing if they are located in countries with underdeveloped credit markets and weak creditor protection.

Forssbaeck and Oxelheim (2011) proved that a fi rm is more likely to engage in FDI when it has more highly valued equity, lower debt costs, a higher credit

rating, higher internal fi nancing, and when it has cross-listed its stock in a larger and more liquid equity market. Moreover, fi nancial FDI determinants are more important for fi rms with high knowledge intensity and for fi rms resident in relatively less fi nancially developed countries.

Hooper (2004) provides evidence from survey data on UK and US based multinationals and shows that companies investing in countries with high political risk have a greater preference for local sources of fi nancing than international sources of fi nancing. Kesternich and Schnitzer (2010) explore theoretically and empirically how multinational fi rms choose the capital structure of their foreign affi liates in response to different forms of political risk.

We can draw two consequences from the results of the above detailed empirical researches:

• The development of capital/fi nancial market in host country is an essential factor in understanding capital structure of the foreign and domestic fi rms as well

• Studying the individual components of FDI is more desirable than using total fl ows if the goal is to better understand the evolution of international capital fl ows.