The Impact of Financial Market Development on FDI in Developed and Emerging Countries

Catherine S F Ho and Lena C Booth

Global financial market has developed tremendously in the last two decades and has affected financial flows and the flow of international investments. With subdued global economic activities and generalized slowdown in emerging markets, countries need to manage vulnerabilities in the financial markets and rebuild resilience against potential shocks while lifting growth through the attraction of foreign investments. Sustainable macroeconomic policies must be in place coupled with financial stability to sustain global businesses. This paper examines the relations between financial market development and foreign direct investment (FDI) for the United States and Malaysia from 1981 to 2013. We divide financial market development into stock market and banking sector development. Our results show that higher stock market liquidity draws more FDI into the developed U.S., signifying higher foreign investors’ confidence and the importance of equity capital financing opportunities to foreign investors. In Malaysia, banking sector development has a significantly negative effect on FDI inflows, suggesting two possibilities: FDI is considered a substitute for financial development, or excess liquidity in the banking sector is perceived by foreign investors as having higher risk of financial fragility, hence results in lower FDI inflows.