Journal Issue
Working Paper Summaries (WP/94/1 - WP/94/76)

Working Paper Summaries 94/44: Information Externalities Affecting the Dynamic Pattern of Foreign Direct Investment: The Case of China

International Monetary Fund
Published Date:
August 1994
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Why doesn’t capital flow from rich to poor countries? This important question illustrates the inadequacy of the neo-classical theory of trade and growth in explaining the pattern of foreign direct investment (FDI). This paper shows that the dynamic pattern of FDI in developing countries, despite government policies to actively promote it, has shown a sluggish increase initially, followed by a period of considerable fluctuation, before reaching the stage of rapid growth. Some countries, however, remain at the stage of small-scale FDI and their economies have not taken off. This paper addresses why China’s open-door policy, which attracted many potential investors, did not actually realize large-scale FDI in the early 1980s, and why the pattern of foreign investment has shown discontinuity over the period.

The purpose of this paper is to provide an explanation for this pattern of FDI, through recourse to two concepts. The first is the searching process carried out by individual investors, and the second is the information externalities of investors in the aggregate; this refers to the information transmission mechanism from pioneer investors to potential investors. In developing countries, foreign investors often take a wait-and-see attitude because the investment environment is generally highly uncertain. The degree of uncertainty may decline to a large extent if more information, based on the actual performance of the initial investors, becomes available. In the absence of incentives to be the first to initiate projects, information about the investment environment is revealed slowly. This information revealing process is delayed further because investors not only need to find profitable projects, but also face high search costs owing to the dearth of reliable information. As a result, host countries may end up without any capital inflow.

The second objective of the paper is to consider policies that may help to shift the economies in developing countries from small-scale FDI to rapidly expanding FDI. Third parties, such as international organizations and governments in source countries, can play a crucial role in promoting the disclosure of information by initiating or financing joint ventures. Foreign investors with greater information about the investment environment are able to allocate their resources to achieve optimal returns. In addition, by promoting this process, governments in developing countries would be able to adjust their policies before facing stagnant investment inflows and the associated operational problems that inhibit new inflows. Thus, the role of information in such an environment is to provide signals to potential investors about the profitability of a given market, as well as to host country governments to enable them to make earlier policy adjustments that would attract the needed FDI.

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