Honors Capstone Project
Date of Submission
Capstone Prize Winner
Won Capstone Funding
Business | International Economics | Labor Economics | Other Economics | Public Economics
Sovereign debt has been a central political issue in Latin American nations for many years, especially considering the region’s long history of defaults and restructurings. Finding ways to grow sustainably at manageable levels of indebtedness has certainly been a challenge, especially with the large number of factors that play into how a nation finances itself and its growth. One of these factors, foreign direct investment (FDI), has attracted significant attention after countries became more politically stable and protective of investor interests in the early 1990s. As a result, inflows of FDI have grown at record levels reaching over $112 billion in 2010, up from around $30 billion in 1995 (World Bank, 2011).
This project sets out to explore a possible relationship between sustainable growth in Latin America and the high levels of foreign direct investment entering the region, especially within the past twenty years. In order to do so, it examines the causality between the ratio of total debt to gross domestic product (GDP), and three different measures for FDI. The first measure is based on the nominal inflows of FDI into a country, the second and third are indexes based on extraordinary quarters of FDI inflow, either significant quarter on quarter (QoQ) growth or large aggregated individual FDI transactions per quarter.
Regressions suggest that there is an inverse relationship between nominal FDI and the natural logarithm of the debt to GDP ratio. To reduce the debt to GDP ratio from 29% (current average for the South American and Caribbean regions) to 21% about an $2.34 billion increase in FDI inflows is required. This relationship could be explained through increases in tax revenue from transactions. Another plausible mechanism is the improvement of market sentiment on the economic wellbeing of a nation from seeing significant monetary commitments from foreign firms to a country. This may reduce interest rates at which a country rolls over its debt making it less burdensome to sustain. These findings, however, are not supported by a relationship between debt to GDP and the two indexes of extraordinary FDI transactions. This could be attributed to a lagged effect, as only announcement dates of transactions are being considered in an effort to gage whether market sentiment surrounding meaningful FDI events is largely affecting the economy.
Further research could examine large transactions more closely and their effect on generic 10-year bond rates for a country to see whether investment aids perception on a country’s creditworthiness. Another method could include a similar study in regions such as south-east Asia, which has also seen significant inflows of foreign capital over the past decade.
Fuentes, Oriana I., "The Effects of Foreign Direct Investment on Sovereign Debt Sustainability in Latin America" (2012). Honors Capstone Projects - All. 188.
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