Pecking order of international Capital Flows Assaf Razin and Efraim Sadka

First period Second period Stage 1: planning Stage 2: implementation realizes K FDIors step in Managers make finance and investment decision Owners make investment rule F(K 0 )

Rigid investment rule dictates the manager to take either one of three possible courses of action, once becomes known to her: Portfolio-equity finance new capital investment, so as to augment the stock of capital to a predetermined level of K E ; Not to invest at all; Debt-finance new capital investment, so as to augment the stock of capital of the firm to a predetermined level of K D.

Foreign Direct Investment At the end of the planning stage, when is not yet known, FDI investors step in. Employing their skimming technology they can outbid all other investors for the top productivity firms. Owners of a firm do not know the productivity level. But she can infer from the signal that her firm was “raided”, belong to the top group.

Foreign Direct Investment

Portfolio Equity Flows

Debt Flows

Which firms do not make new investment?

The capital flows structure of the economy There are low productivity firms which finance their investment by equity; There are medium-low productivity firms which do not invest; There are medium-high productivity firms which finance their new investment by debt issue; There are high productivity firms, pre- screen by foreign direct investors, and sold to them.

The Investment Rule

Determinants of Capital Flows

Gains from FDI

Constrained Efficiency