VoxEU Column Industrial organisation International trade

Host-country financial development and multinational activity

Understanding how host-country financial conditions influence the global operations of multinational firms is important for encouraging FDI. Using US data, this column show that more financially developed economies have more entry by multinational affiliates and higher aggregate affiliate sales to the local market, back to the US and to third destinations, particularly in more financially vulnerable sectors. Yet at both aggregate and affiliate levels, the share of local sales in total sales is smaller, while the shares of US and third-country sales are bigger. 

Multinational companies (MNCs) account for two-thirds of international trade and provide a key channel through which capital and technology flow across borders. Evidence indicates that foreign direct investment (FDI) generates knowledge transfers to the host country through labour turnover, improved supply of intermediate inputs, and productivity spillovers to domestic firms (e.g. Javorcik 2004, Poole 2013). Multinational firms also manage increasingly complex operations, basing offshore affiliates in multiple countries and serving multiple markets from each location (e.g. Yeaple 2003, 2013, Ramondo et al. 2016). Understanding the factors that govern MNCs’ global strategy thus has important implications for the welfare gains from globalisation and for policy design in developing economies seeking to attract inbound FDI.

Key to the organisational decisions of multinational firms is how they finance the exceptionally high costs of foreign operations. Although MNC affiliates tend to be less financially constrained and more responsive to growth opportunities than domestic firms (e.g. Desai et al. 2008, Manova et al. 2015), institutional and market frictions are nevertheless relevant for their activities. Such frictions often prevent MNCs from perfectly arbitraging differences in the cost of external capital across countries (see Foley and Manova 2015 for a survey). MNCs thus raise outside finance in the host economy when possible, but only partially compensate shortfalls in local financing by accessing capital markets abroad or direct financing from the parent company.

In recent work (Bilir et al. 2019), we examine how host-country financial conditions influence the global operations of multinational firms. We exploit comprehensive data on US MNCs for 1989-2009 from the US Bureau of Economic Analysis. We show that more financially developed economies attract more multinational affiliates and support higher aggregate affiliate sales to the local market, back to the US, and to third destinations. At the level of individual affiliates, by contrast, local sales are lower, while return and third-country sales are higher. Yet at both aggregate and affiliate levels, the share of local sales in total sales is smaller, while the shares of US and third-country sales are both bigger. These effects are heightened in sectors that require more external finance for technological reasons (Rajan and Zingales 1998). The analysis uses fixed effects to account for systematic differences across country-years, sectors, and parent firms. 

We rationalise these empirical regularities with a three-country model with heterogeneous firms, imperfect capital markets in the host country, and variation in financial vulnerability across sectors. The evidence is consistent with host-country financial development shaping MNC activity through two channels – a financing effect that induces affiliate entry and expansion by improving their access to external finance, and a competition effect that reorients affiliate sales away from the local market due to increased entry by credit-constrained domestic firms.

An example

We measure financial development using the amount of bank credit to the private sector relative to GDP, as is standard in the literature. This measure captures the actual availability of external finance and reflects the strength of financial institutions that support financial contracting. 

Figure 1 illustrates how US MNC activity varies across three economies of comparable market size and distance with financial development at the 50th, 60th and 75th percentiles – Brazil in 1999, Chile in 1994, and Norway in 1989. Aggregate MNC affiliate sales (scaled by host-country market size) rise with host-country private credit. At the same time, the share of aggregate MNC sales to the local economy declines, while the shares of sales to the parent country and other destinations both rise. 

Figure 1 MNC sales shares in host countries at different levels of financial development

Note: This figure illustrates how the level and composition of aggregate MNC affiliate sales vary across three host countries at the 50th, 60th and 75th percentiles of the distribution of financial development. Financial development is measured by the ratio of private credit to GDP.

How multinationals organise and finance global operations

Table 1 demonstrates the global reach of US multinationals. In 2009, for example, 1,892 parent companies operated 14,804 affiliates in 142 countries. An average parent manages 7.38 foreign subsidiaries. The typical affiliate generates $173 million in revenues, of which 74% are earned from sales in its local market, 7% from return sales to the US, and 20% from exports to third destinations. This composition, however, varies substantially across parents, affiliates and years.

US multinationals use their global affiliate network to tap external sources of finance in multiple countries, while simultaneously reallocating financial resources internally across affiliates. Log total affiliate debt averages 9.91 (standard deviation 1.79). The mean share of affiliate liabilities held by host-country entities stands at a relatively high 63% (standard deviation 28%), while the average share held by the parent firm is 18% (standard deviation 29%). The dispersion in affiliate financing practices correlates significantly with host-country financial development. Host-country private credit as a share of GDP is positively correlated with log total affiliate debt (0.126) and with the local share of affiliate liabilities (0.022), but negatively with the parent-firm share (-0.041). 

These patterns corroborate evidence that MNC subsidiaries fund operations with locally raised external capital when host-country financial institutions are sufficiently strong. However, parent funding does not fully compensate for the shortfall in local financing in hosts with weak financial systems, such that local financial conditions influence the scale of MNC operations. As a result, MNC affiliates use less external debt if based in hosts with weaker private credit or creditor rights protection (e.g. Desai et al. 2004, Antràs et al. 2009).

Table 1 Location, sales and financing practices of multinational companies, 1989-2009

Note: This table summarises the activity US multinationals across 95 host countries and 115 industries during 1989-2009.

How host-country financial development shapes MNC activity

We develop a formal model that illustrates two channels through which host-country financial development can influence the level and composition of MNC activity. Both mechanisms are magnified in sectors that require more external finance. 

  • Financing effect. Host-country financial development facilitates affiliates’ use of host-country external finance, even accounting for their access to global capital markets. This stimulates MNC entry and aggregate affiliate sales.
  • Competition effect. At the same time, improvements in host-country financial conditions boost entry by credit-constrained domestic firms and intensify competition in the local market. This induces surviving MNC affiliates to sell less locally and to instead export more to the home and third-country markets.

Our regression analysis of the US Bureau of Economic Analysis data reveals three patterns consistent with these predictions.

Result 1: Financially more developed host countries attract more MNC affiliates, especially in financially more vulnerable sectors.

Comparing two industries at the 10th and 90th percentile by external finance dependence, increasing private credit availability from the 10th to 90th percentile would attract 7.8% more foreign subsidiaries in the financially more dependent industry. This result is consistent with a strong financing effect of host-country financial development on MNC entry.

Result 2: Individual MNC affiliates in financially more developed host countries sell less locally and more to their parent country and third markets, especially in financially more vulnerable sectors. Individual affiliates thus have a lower share of local sales and higher shares of return and third-country sales.

Based on an analogous 10th-90th percentile comparison as above, our estimates imply that the average affiliate in the financially more sensitive sector would sell 9.5% more to the US and 27.0% more to other destinations, but 2.2% less locally. These adjustments point to the competition effect that host-country financial development triggers.

Result 3: Aggregate MNC affiliate sales to the local market, to the parent country, to other destinations, and worldwide are higher for financially more developed host countries, especially in financially more vulnerable sectors. Nevertheless, the local share of aggregate MNC sales is lower, while the return and third-country shares are higher.

Improving financial conditions as above would boost aggregate MNC sales by 18.6% more in the financially more vulnerable industry – local, US, and third-country sales would expand by 12.8%, 37.9% and 17.3%, respectively. The differential rates at which these sales expand imply that the local sales share would fall by 2.8 percentage points more in the financially more sensitive sector, while the shares of US and third-country exports would rise by 2.1 and 0.7 percentage points. These findings illustrate the joint workings of the financing and competition effects of host-country financial development on aggregate FDI outcomes.

Policy implications

Our novel insights enrich our understanding of how multinational firms organise their global production, sales and financing operations.

First, host-country financial sector reforms can expand aggregate MNC activity through a financing effect, enabling more jobs and technological transfer. This scaling effect may well boost total capital inflows, even as individual affiliates raise more finance locally. Indeed, many countries have strengthened accounting standards and financial contract enforcement and relaxed restrictions on foreign bank entry and cross-border bank alliances, in part to attract FDI (Klein et al. 2002).

Second, host-country financial reforms can also support more entry and production by domestic firms. While multinationals may in principle crowd out local producers by raising competition (e.g., De Backer and Sleuwaegen 2003), financial reforms can instead enhance local firms’ competitiveness and trigger reallocations in affiliate sales across markets through a competition effect.

Our conclusions raise the policy relevant question whether both the scale and the composition of MNC activity matter for economic growth. While we defer a thorough assessment to future work, simple correlations in Figure 2 suggest this may indeed be the case. During 1989-2009, host countries grow faster not only when aggregate MNC sales expand more, but also when the local share of MNC sales rises faster. These patterns hold controlling for initial income and at five-year intervals.

Figure 2 Economic growth and multinational activity, 1989-2009

a) Growth in total MNC sales

b) Growth in the share of local MNC shares

Note: This figure plots the cumulative growth in GDP per capita (vertical axis) against the cumulative growth in aggregate MNC sales (Figure 2a) or in the share of aggregate MNC sales sold in the host-country market (Figure 2b), from 1989 to 2009 across 44 host countries.


Antràs, P, M A Desai and C F Foley (2009), “Multinational firms, FDI flows, and imperfect capital markets”, Quarterly Journal of Economics 124(3): 1171-1219.

Bilir, K, D Chor and K Manova (2019), “Host-country financial development and multinational activity”, European Economic Review 115: 192-220. 

De Backer, K and L Sleuwaegen (2003), “Does foreign direct investment crowd out domestic entrepreneurship?”, Review of Industrial Organization 22(1): 67-84. 

Desai, M A, C F Foley and K J Forbes (2008), “Financial constraints and growth: Multinational and local firm responses to currency depreciations”, Review of Financial Studies 21(6): 2857-2888.

Foley, F and K Manova (2015), “International trade, multinational activity, and corporate finance”, Annual Review of Economics 7: 119-146.

Javorcik, B (2004), “Does foreign direct investment increase the productivity of domestic firms? In search of spillovers through backward linkages”, American Economic Review 94(3): 605-627.

Klein, M W, J Peek and E S Rosengren (2002), “Troubled banks, impaired foreign direct investment: The role of relative access to credit”,  American Economic Review 92(3): 664-682. 

Manova, K (2013), “Credit constraints, heterogeneous firms, and international trade”, Review of Economic Studies 80: 711-744.

Manova, K, S-J Wei and Z Zhang (2015), “Firms exports and multinational activity under credit constraints”, Review of Economics and Statistics 97(3): 574-588.

Poole, J P (2013), “Knowledge transfers from multinational to domestic firms: Evidence from worker mobility”, Review of Economics and Statistics 95(2): 393-406.

Rajan, R and L Zingales (1998), “Financial dependence and growth”, American Economic Review 88(3): 559-586. 

Ramondo, N, V Rappoport and K Ruhl (2016), “Intra-firm trade and vertical fragmentation in US multinational corporations”, Journal of International Economics 98(1): 51-59. 

Yeaple, S R (2003), “The complex integration strategies of multinationals and cross country dependencies in the structure of foreign direct investment”, Journal of International Economics 60(2): 293-314.

Yeaple, S R (2013), “The multinational firm”, Annual Review of Economics 5: 193-217.

2,310 Reads