Debt v. Foreign Direct Investment: The Impact of Sovereign Risk on the Structure of International Capital Flows

Abstract

The paper compares the two standard forms of international investment in developing countries, debt and foreign direct investment (FDI), from a finance perspective. The sovereign risks associated with debt finance are shown to be generally less severe than the ones that come with FDI. FDI is chosen only if the foreign investor is more efficient in running the project, if the project is risky, and if the foreign investor has a good outside option which deters creeping expropriation. The sovereign risk problem of FDI can be alleviated if the host country and the foreign investor form a joint venture.

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