Multinational Firms, FDI Flows and

Imperfect Capital Markets

Pol Antràs, Mihir A. Desai, and C. Fritz Foley

June 2008

Abstract

This paper examines how costly …nancial contracting and weak investor protec-
tion in‡uence the cross-border operational, …nancing and investment decisions of
…rms. We develop a model in which product developers can play a useful role in
monitoring the deployment of their technology abroad. The analysis demonstrates
that when …rms want to exploit technologies abroad, multinational …rm (MNC) ac-
tivity and foreign direct investment (FDI) ‡ows arise endogenously when monitoring
is nonveri…able and …nancial frictions exist. The mechanism generating MNC activ-
ity is not the risk of technological expropriation by local partners but the demands
of external funders who require MNC participation to ensure value maximization
by local entrepreneurs. The model demonstrates that weak investor protections
limit the scale of multinational …rm activity, increase the reliance on FDI ‡ows and
alter the decision to deploy technology through FDI as opposed to arm’s length
technology transfers. Several distinctive predictions for the impact of weak investor
protection on MNC activity and FDI ‡ows are tested and con…rmed using …rm-level
data.

Harvard University and NBER; Harvard Business School and NBER; Harvard Business School and
NBER, respectively. The statistical analysis of …rm-level data on U.S. multinational companies was
conducted at the International Investment Division, Bureau of Economic Analysis, U.S. Department of
Commerce under arrangements that maintain legal con…dentiality requirements. The views expressed
are those of the authors and do not re‡ect o¢ cial positions of the U.S. Department of Commerce. The
authors thank Robert Barro, four anonymous referees, Gita Gopinath, James Markusen, Aleh Tsyvinski,
Bill Zeile and seminar participants at Boston University, Brown University, Hitotsubashi University, MIT,
the NBER ITI program meeting, the New York Fed, Oxford, UC Berkeley, UC Boulder, Universidad de
Vigo, Universitat Pompeu Fabra, the University of Michigan, and the World Bank for helpful suggestions.
Davin Chor provided excellent research assistance.
1 Introduction
Firms globalizing their operations and the associated capital ‡ows have become major
features of the world economy. These cross-border activities and capital ‡ows span insti-
tutional settings with varying investor protections and levels of capital market develop-
ment. While the importance of institutional heterogeneity in dictating economic outcomes
has been emphasized, existing analyses typically ignore the global …rms and the capital
‡ows that are now commonplace. Investigating how global …rms make operational and
…nancing decisions in a world of heterogenous institutions promises to provide a novel
perspective on observed patterns of ‡ows and …rm activity.
This paper develops and tests a model of the operational and …nancial decisions of
…rms as they exploit their technologies in countries with di¤ering levels of investor pro-
tections. The model demonstrates that multinational …rm (MNC) activity and foreign
direct investment (FDI) arise endogenously in settings characterized by …nancial frictions.
The model generates several predictions regarding how investor protections in‡uence the
use of arm’s length technology transfers, the degree to which multinational …rm activity
is …nanced by capital ‡ows, the extent to which multinationals take ownership in foreign
projects, and the scale of multinational operations. These predictions are tested using
…rm-level data on U.S. multinational …rms.
The model considers the problem of a …rm that has developed a proprietary technology
and is seeking to deploy this technology abroad with the help of a local entrepreneur.
A variety of alternative arrangements, including an arm’s length technology transfer or
directly owning and …nancing the entity that uses it, are considered. External investors
are a potential source of funding, but they are concerned with managerial misbehavior,
particularly in settings where investor protections are weak. The central premise of the
model is that developers of technologies are particularly useful monitors for ensuring that
local entrepreneurs are pursuing value maximization. The concerns of external funders
regarding managerial misbehavior lead to optimal contracts in which the developer of the
technology is required to hold an ownership claim in the foreign project and, in certain
cases, this developer is also required to provide …nancial capital to the local entrepreneur.
As such, multinational …rms and FDI ‡ows arise endogenously in response to concerns
over managerial misbehavior and weak investor protections.1 Extending the model to
1
The experience of Disney in Japan, as documented in Misawa (2005), provides one example of the
mechanism that drives the behavior of external investors. In 1997, Disney was evaluating how to structure
a new opportunity with a local partner in Japan. Japanese banks expressed a strong preference for equity
participation by Disney over a licensing agreement in order to ensure that Disney had strong incentives
to monitor the project and ensure value maximization. The concerns of these lenders and the intuition
that Disney would have a unique ability to monitor local partners are re‡ective of the central ideas of

1
allow for a similar form of monitoring by external investors does not vitiate the primary
results. We also show that while simple revenue-sharing agreements may also provide
incentives for technology developers to monitor, this type of contract is generally not
optimal.
The characterization of multinational …rms as developers of technologies has long
been central to models explaining multinational …rm activity. In contrast to those models
that emphasize the risk of technology expropriation, the model in this paper emphasizes
…nancial frictions, a cruder form of managerial opportunism and the role of external
funders. As such, while technology is central to these other models and the model in
this paper, the mechanism generating multinational …rm activity is entirely distinct. Our
emphasis on monitoring builds on the theory presented in Holmstrom and Tirole (1997)
which captures how monitoring is critical to understanding …nancial intermediation.
Our model delivers several novel predictions about the nature of FDI and patterns
of multinational …rm activity. First, the model predicts that arm’s length technology
transfers will be more common, relative to the deployment of that technology through
a¢ liate activity, in countries where investor protections are stronger. Second, the share of
activity abroad …nanced by capital ‡ows from the multinational parent will be decreasing
in the quality of investor protections in host economies. Third, ownership shares by
multinational parents will also be decreasing in the quality of investor protections in
host economies. These predictions re‡ect the fact that monitoring by the developer of
the technology is more critical in settings where investor protections are weaker. The
model also predicts that the scale of activity based on multinational technologies in host
countries will be an increasing function of the quality of the institutional environment.
Better investor protections reduce the need for monitoring and therefore allow for a larger
scale of activity.
We test these predictions using the most comprehensive available data on the activ-
ities of U.S. multinational …rms and on arm’s length technology transfers by U.S. …rms.
These data provide details on the world wide operations of U.S. …rms, including measures
of parental ownership, …nancing and operational decisions, and information on royalty
payments and licensing fees received by U.S. …rms from una¢ liated foreign persons. The
data enable the use of parent-year …xed e¤ects that implicitly control for a variety of
unobserved attributes.
The analysis indicates that the likelihood of using arm’s length technology transfer
to serve a foreign market increases with measures of investor protections, as suggested
by the model. The predictions on parent …nancing and ownership decisions are also
the model.

2
con…rmed to be a function of the quality of investor protections and the depth of capital
markets. The model also suggests that these e¤ects should be most pronounced for
technologically advanced …rms because these …rms are most likely to be able to provide
valuable monitoring services. The empirical evidence indicates a di¤erential e¤ect for such
…rms.
Settings where ownership restrictions are liberalized provide an opportunity to test the
…nal prediction of the model. The model implies that ownership liberalizations should
have a particularly large e¤ect on multinational a¢ liate activity in countries with weak
investor protections. Our empirical analysis con…rms that a¢ liate activity increases by
larger amounts after liberalizations in countries with weaker investor protections.
This paper extends the large and growing literature on the e¤ects of investor protec-
tions and capital market development on economic outcomes to an open economy setting
where …rms make operational and …nancial decisions across borders. La Porta, Lopez-de-
Silanes, Shleifer and Vishny (1997, 1998) relate investor protections to the concentration
of ownership and the depth of capital markets. A large literature, including King and
Levine (1993), Levine and Zervos (1998), Rajan and Zingales (1998), Wurgler (2000),
and Acemoglu, Johnson and Mitton (2005), has shown that …nancial market conditions
in‡uence …rm investment behavior, economic growth and industrial structure.
By exclusively emphasizing …rms with local investment and …nancing, this literature
has neglected how cross-border, intra…rm activity responds to institutional variations.
The open economy dimensions of institutional variations have been explored, but over-
whelmingly in the context of arm’s-length cross-border lending as in Gertler and Rogo¤
(1990), Boyd and Smith (1997) and Shleifer and Wolfenzon (2002).2 In related work,
Albuquerque (2003) shows that the di¤erential alienability of FDI and portfolio in‡ows
can allow the risk of expropriation to alter the composition of capital in‡ows. In contrast
to this work, we derive the existence of multinational …rms and FDI ‡ows in response to
the possibility of opportunism by private actors. Accordingly, our empirical work employs
…rm-level data that allows us to analyze both patterns of …rm activity and …nancial ‡ows
rather than the division of aggregate capital ‡ows between FDI and portfolio ‡ows. In
short, we show that weak …nancial institutions decrease the scale of multinational …rm ac-
tivity but simultaneously increase the reliance on capital ‡ows from the parent. As such,
observed patterns of capital ‡ows re‡ect these two distinct and contradictory e¤ects. The
2
Gertler and Rogo¤ (1990) show how arms-length lending to entrepreneurs in poor countries is limited
by their inability to pledge large amounts of their own wealth. This insight is embedded into a multi-
national …rm’s production decisions in the model presented here. Our setup also relates to Shleifer and
Wolfenzon (2002), who study the interplay between investor protection and equity markets. In contrast,
Kraay et al. (2005) emphasize the role of sovereign risk in shaping the structure of world capital ‡ows.

3
empirical investigations of micro-data provided in the paper indicate that both e¤ects are
operative.3
By jointly considering the determinants of MNC activities and the ‡ows of capital
that support these activities, the paper also links two literatures –the international trade
literature on multinationals and the macroeconomic literature on capital ‡ows. Industrial
organization and international trade scholars characterize multinationals as having pro-
prietary assets and emphasize the role of market imperfections, such as transport costs
and market power, in determining patterns of multinational activity. Recent work on
multinational …rms investigates “horizontal”or “vertical”motivations4 for foreign direct
investment and explores why alternative productive arrangements, such as whole owner-
ship of foreign a¢ liates, joint ventures, exports or arm’s length contracts, are employed.5
Such analyses of multinational …rm activity typically do not consider associated capital
‡ows.6 Research on capital ‡ows typically abstracts from …rm activity and has focused
on the paradox posed by Lucas (1990) of limited capital ‡ows from rich to poor countries
in the face of large presumed rate of return di¤erentials. While Lucas (1990) emphasizes
human-capital externalities to help explain this paradox, Reinhart and Rogo¤ (2004)
3
It should be emphasized that our model abstracts from any portfolio decision by consumers and
instead focuses on the …nancing decisions of …rms. Bertaut, Griever and Tryon (2006) analyze U.S.
ownership of foreign securities and conclude that non-…nancial institutions are a fairly small fraction (less
than 10%) of overall foreign portfolio investment, and this is when including all securities such as …xed
income investments. As such, our model (unlike the one in Albuquerque (2003)) may not be particularly
well suited to interpret cross-country patterns in the composition of capital ‡ows.
4
The horizontal FDI view represents FDI as the replication of capacity in multiple locations in response
to factors such as trade costs, as in Markusen (1984), Brainard (1997), Markusen and Venables (2000), and
Helpman, Melitz and Yeaple (2004). The vertical FDI view represents FDI as the geographic distribution
of production globally in response to the opportunities a¤orded by di¤erent markets, as in Helpman
(1984) and Yeaple (2003). Caves (1996) and Markusen (2002) provide particularly useful overviews of
this literature.
5
Antràs (2003, 2005), Antràs and Helpman (2004), Desai, Foley and Hines (2004), Ethier and
Markusen (1996), Feenstra and Hanson (2005), and Grossman and Helpman (2004) analyze the de-
terminants of alternative foreign production arrangements.
6
Several studies linking levels of MNC activity and FDI ‡ows are worth noting. First, high frequency
changes in FDI capital ‡ows have been linked to relative wealth levels through real exchange rate move-
ments (as in Froot and Stein (1991) and Blonigen (1997)), broader measures of stock market wealth
(as in Klein and Rosengren (1994) and Baker, Foley and Wurgler (forthcoming)) and to credit market
conditions (as in Klein, Peek and Rosengren (2002)). Second, multinational …rms have also been shown
to opportunistically employ internal capital markets in weak institutional environments (as in Desai,
Foley and Hines (2004b)) and during currency crises (as in Aguiar and Gopinath (2005) and Desai, Foley
and Forbes (forthcoming)). These papers emphasize how heterogeneity in access to capital can interact
with multinational …rm production decisions. Marin and Schnitzer (2004) also study the …nancing deci-
sions of multinational …rms in a model that stresses managerial incentives. Their model however takes
the existence of multinational …rms as given and considers an incomplete-contracting setup in contrast
to our complete-contracting setup. The predictions from their model are quite distinct (and typically
contradictory) to the ones we develop here and show to be supported by U.S. data.

4
review subsequent research on aggregate capital ‡ows and conclude that credit market
conditions and political risk play signi…cant roles. By examining …rm behavior in a setting
with variation in investor protections, this paper attempts to unify an investigation of
multinational …rm activity and FDI ‡ows.
The rest of the paper is organized as follows. Section 2 lays out the model and generates
several predictions related to the model. Section 3 provides details on the data employed
in the analysis. Section 4 presents the results of the empirical analysis and Section 5
concludes.

2 Theoretical Framework
In this section, we develop a model of …nancing that builds on and extends the work of
Holmstrom and Tirole (1997).7 We illustrate how the model generates both multinational
activity as well as foreign direct investment ‡ows. Finally, we explore some …rm-level
empirical predictions that emerge from the model and that we take to the data in later
sections.

2.1 A Model of Financial Contracting

Environment

We consider the problem of an agent – an inventor – who is endowed with an amount

W of …nancial wealth and the technology or knowledge to produce a di¤erentiated good.
Consumers in two countries, Home and Foreign, derive utility from consuming this di¤er-
entiated good. (Appendix A.1 develops a multi-country version of the model.) The good,
however, is prohibitively costly to trade and thus servicing a particular market requires
setting up a production facility in that country. The inventor is located at Home and can-
not fully control production in Foreign. Servicing that market thus requires contracting
with a foreign agent –an entrepreneur –to manage production there. We assume that
entrepreneurs are endowed with no …nancial wealth and their outside option is normal-
ized to 0. There also exists a continuum of in…nitessimal external investors in Foreign
that have access to a technology that gives them a gross rate of return equal to 1 on
their wealth. All parties are risk neutral and are protected by limited liability. There
7
Our model generalizes the setup in Holmstrom and Tirole (1997) by allowing for diminishing returns
to investment and for variable monitoring levels. The scope of the two papers is also very distinct:
Holmstrom and Tirole (1997) study the monitoring role of banks in a closed-economy model, while our
focus is on multinational …rms.

5
are three periods, a date 0 contracting stage, a date 1 investment stage, and a date 2
production/consumption stage.

Consumer Preferences and Technology

In the main text, we focus on describing production and …nancing decisions in the Foreign
market. For that purpose, we assume that preferences and technology at Home are such
that at date 2 the inventor obtains a constant gross return > 1 for each unit of wealth
he invests in production at Home at date 1. We refer to this gross return as the inventor’s
shadow value of cash. Our assumption > 1 implies that the opportunity cost of funds is
lower for external investors than for the inventor. In Appendix A.1, this higher-than-one
value of is endogenously derived in a multi-country version of the model where consumer
preferences, technology and …nancial contracting in all countries are fully speci…ed. It is
important to note that the provision that > 1 does not imply that the e¤ective cost
of capital provided by external investors is always lower than the e¤ective cost of capital
provided by the inventor, as informational frictions may drive a wedge between returns
earned and the costs borne by the relevant parties.
We assume that Foreign preferences are such that cash ‡ows or pro…ts obtained
from the sale of the di¤erentiated good in Foreign can be expressed as a strictly in-
creasing and concave function of the quantity produced, i.e., R (q), with R0 (q) > 0 and
R00 (q) 0. We also assume the standard conditions R (0) = 0, limq!0 R0 (q) = +1, and
limq!1 R0 (q) = 0. These properties of R (q) can be derived from preferences featuring a
constant (and higher-than-one) elasticity of substitution across a continuum of di¤erenti-
ated goods produced by di¤erent …rms. In such case, the elasticity of R (q) with respect
to q is constant and given by a parameter 2 (0; 1).
Foreign production is managed by the foreign entrepreneur, who at date 1 can privately
choose to behave and enjoy no private bene…ts, or misbehave and take private bene…ts.
When the manager behaves, the project performs with probability pH , in the sense that
when an amount x is invested at date 1, project cash ‡ows at date 2 are equal to R (x) with
probability pH and 0 otherwise.8 When the manager misbehaves, the project performs
with a lower probability pL < pH and expected cash ‡ows are pL R (x). We assume that
the private bene…t a manager obtains from misbehaving is increasing in the size of the
project, and for simplicity, we specify it as being proportional to the return of the project,
i.e., BR (x). In section 2.3, we discuss how similar results obtain if private bene…ts are
8
This assumes that, when the project succeeds, each unit invested results in a unit of output (q = x),
while when the project fails, output is zero (q = 0). We shall relax the latter assumption in section 2.3
below.

6
proportional to the level of investment x.
Managerial misbehavior and the associated private bene…ts can be manifest by choos-
ing to implement the project in a way that generates perquisites for the manager or his
associates, in a way that requires less e¤ort, or in a way that is more fun or glamorous.
As described below, we will relate the ability to engage in such private bene…ts to the
level of investor protections in Foreign as well as to the extent to which the entrepreneur
is monitored. The idea is that countries with better investor protections tend to enforce
laws that limit the ability of managers to divert funds from the …rm or to enjoy private
bene…ts or perquisites. This interpretation parallels the logic in Tirole (2006, p. 359).
When investor protections are not perfectly secure, monitoring by third agents is
helpful in reducing the extent to which managers are able to divert funds or enjoy private
bene…ts. Following Holmstrom and Tirole (1997), we introduce a monitoring technology
that reduces the private bene…t of the foreign entrepreneur when he misbehaves. It is
reasonable to assume that the inventor can play a particularly useful role in monitoring
the behavior of the foreign entrepreneur because the inventor is particularly well informed
about how to manage the production of output using its technology. Intuitively, the devel-
oper of a technology is in a privileged position to determine if project failure is associated
with managerial actions or bad luck.9 We capture this in a stark way by assuming that
no other agent in the economy can productively monitor the foreign entrepreneur, though
we will discuss a more general setup in section 2.3 below. We assume that monitoring
costs are proportional to the return of the project and when the inventor incurs an ef-
fort cost CR (x) in monitoring at date 1, the private bene…t for the local entrepreneur is
multiplied by a factor (C), with 0 (C) < 0, 00 (C) > 0, (0) = , limC!1 (C) = 0,
limC!0 0 (C) = 1, and limC!1 0 (C) = 0.10 This assumption re‡ects the idea that
larger projects require e¤ort to monitor. Section 2.3 considers the possibility that e¤ort
costs are proportional to investment levels and similar results follow.
As mentioned above, the scope of private bene…ts is related to the level of investor
9
An alternative way to interpret monitoring is as follows. Suppose that the foreign entrepreneur can
produce the good under a variety (a continuum, actually) of potential techniques indexed by z 2 [0; B].
Technique 0 entails a probability of success equal to pH and a zero private bene…t. All techniques with
z > 0 are associated with a probability of success equal to pL and a private bene…t equal to z. Clearly,
all techniques with z 2 (0; B) are dominated from the point of view of the foreign entrepreneur, who
will thus e¤ectively (privately) choose either z = 0 or z = B, as assumed in the main text. Under this
interpretation, we can think of monitoring as reducing the upper bound of [0; B].
10
These conditions are su¢ cient to ensure that the optimal contract is unique and satis…es the second-
order conditions.

7
protection of the host country by an index 2 (0; 1). In particular, we specify that

B (C; ) = (1 ) (C) : (1)

Note that this formulation implies that @B ( ) =@ < 0, @B ( ) =@C < 0, and @ 2 B ( ) =@C@ =
0
(C) > 0. This formulation captures the intuition that the scope for private bene…ts
is decreasing in both investor protection and monitoring, and that monitoring has a rela-
tively larger e¤ect on private bene…ts in countries with poor legal protection of investors.
It also implies that parent monitoring substitutes for investor protection. The idea be-
hind this assumption is that both parent monitoring and investor protections constrain
managers and that parent monitoring is e¤ective even in imperfect legal environments.
This would be the case if, for example, parent monitoring during the production process
prevented misbehavior from occurring, thus eliminating any need for legal action after
improper behavior occurs.

Contracting

We consider optimal contracting between three sets of agents: the inventor, the foreign
entrepreneur and foreign external investors. At date 0, the inventor and the foreign
entrepreneur negotiate a contract that stipulates the terms under which the entrepreneur
will exploit the technology developed by the inventor. This contract includes a (possibly
negative) date-0 transfer F from the inventor to the entrepreneur, as well as the agents’
date-2 payo¤s contingent on the return of the project.11 When F > 0, the date-0 payment
represent the extent to which the inventor co…nances the project in the Foreign country.
When F < 0, this payment can be thought of as the price or upfront royalties paid for
the use of the technology, which the inventor can invest in the Home market at date 1.
The contract between the inventor and the entrepreneur also stipulates the date-1 scale
of investment x, while the managerial and monitoring e¤orts of the entrepreneur and
inventor, respectively, are unveri…able and thus cannot be part of the contract.
Also at date 0, the foreign entrepreneur and external investors sign a …nancial contract
under which the entrepreneur borrows an amount E from the external investors at date
0 in return for a date-2 payment contingent on the return of the project.
We consider an optimal contract from the point of view of the inventor and allow the
contract between the inventor and the entrepreneur to stipulate the terms of the …nancial
contract between the entrepreneur and foreign external investors. We rule out “direct”
11
For simplicity, we assume that the inventor’s date-2 return in its Home market (which is not modelled
in the main text) is not pleadgeable in Foreign.

8
…nancial contracts between the inventor and foreign external investors. This is justi…ed
in the extension of the model developed in Appendix A.1, where the inventor’s shadow
value of cash is endogenized.
Given the payo¤ structure of our setup and our assumptions of risk neutrality and
limited liability, it is straightforward to show that an optimal contract is such that all
date-2 payo¤s can be expressed as shares of the return generated by the project. All
agents obtain a payo¤ equal to zero when the project fails (that is when the return is zero),
and a positive payo¤ when the project succeeds (in which case cash ‡ows are positive).
When an agent’s share of the date-2 return is positive, this agent thus becomes an equity
holder in the entrepreneur’s production facility.12 We de…ne I and E as the equity
shares held by the inventor and external investors, respectively, with the remaining share
1 I E accruing to the foreign entrepreneur. Notice that when I is large enough,
the entrepreneur’s production facility becomes a subsidiary of the inventor’s …rm.

2.2 Optimal Contract and Empirical Predictions

We next characterize an optimal contract that induces the entrepreneur
n to behave and o
the inventor to monitor. This optimal contract is given by the tuple F~ ; ~ I ; x~; ~ E ; E;
~ C~
that solves the following program:

max I = I pH R (x) + (W F) CR (x)

F; I ;x; E ;E;C

s:t: x E+F (i)

pH E R (x) E (ii) (P1)
pH (1 E I ) R (x) 0 (iii)
(pH pL ) (1 E I ) R (x) (1 ) (C) R (x) (iv)
(pH pL ) I R (x) CR (x) (v)

The objective function represents the payo¤ of the inventor. The …rst term represents
the inventor’s dividends from the expected cash ‡ows of the foreign production facility.
The second term represents the gross return from investing his wealth W minus the date-0
transfer F in the Home market.13 The last term represents the monitoring costs.
The …rst constraint is a …nancing constraint. Since the local entrepreneur has no
wealth, his ability to invest at date 1 is limited by the sum of the external investors’
12
We focus on an interpretation of payo¤s resembling the payo¤s of an equity contract, but the model
is not rich enough to distinguish our optimal contract from a standard debt contract. Our results would
survive in a model in which agents randomized between using equity and debt contracts. In any case, we
bear this in mind in the empirical section of the paper, where we test the predictions of the model.
13
We assume throughout that W is large enough to ensure that W F 0 in equilibrium.

9
…nancing E and the co…nancing F by the inventor. The second inequality is the partici-
pation constraint of external investors, who need to earn at least an expected gross return
on their investments equal to 1. Similarly, the third inequality is the participation con-
straint of the foreign entrepreneur, given his zero outside option. The fourth inequality is
the foreign entrepreneur’s incentive compatibility constraint. This presumes that it is in
the interest of the inventor to design a contract in a way that induces the foreign entrepre-
neur to behave. In Appendix A.2, we show that this will necessarily be the case provided
that is su¢ ciently large. The …nal constraint is the inventor’s incentive compatibility
constraint: if this condition was not satis…ed, the inventor’s payo¤ would be lower when
exerting the monitoring level C~ than when not doing so.14
In the program above, constraint (iii) will never bind. Intuitively, as is standard in
incomplete information problems, the incentive compatibility constraint of the entrepre-
neur demands that this agent obtains some informational rents in equilibrium, and thus
his participation constraint is slack. Conversely, the other four constraints will bind in
equilibrium. This is intuitive for the …nancing constraint (i) and the participation con-
straint of investors (ii). It is also natural that the optimal contract from the point of view
of the inventor will seek to minimize the (incentive-compatible) equity share accruing to
the foreign entrepreneur, which explains why constraint (iv) binds.
It is perhaps less intuitive that constraint (v) also binds, indicating that the optimal
contract minimizes the equity share I allocated to the inventor. In particular, it may
appear that a large I would be attractive because it may foster a larger level of co…nancing
F at date 0, thereby encouraging investment. However, inspection of constraint (iv)
reveals that a larger I decreases the ability of the entrepreneur to borrow from external
investors, as it reduces his pleadgeable income. Overall, one can show that, for a given
level of monitoring, whether utility is transferred through an equity share or a date-0
lump-sum payment has no e¤ect on the scale of the project. In addition, it is clear from
the objective function that the inventor strictly prefers a date-0 lump-sum transfer since
he can use these funds to invest domestically and obtain a gross rate of return > 1 on
them. Hence, the minimal incentive-compatible inventor equity share I is optimal.
With these results at hand, it is immediate from constraint (v) that the optimal equity
stake held by the inventor will be given by:

~I = C~
; (2)
pH pL
14 ~ it does so by setting
Our derivation of this IC constraint assumes that if the inventor deviates from C,
C = 0 (which for large enough would lead to a violation of the entrepreneur’s incentive compatibility
constraint). This is without loss of generality because any other deviation C > 0 is dominated.

10
which will be positive as long as C~ is positive. In addition, manipulation of the …rst-order
conditions of program (P1) delivers the following expression that implicitly determines
the level of monitoring (see Appendix A.2 for details)

pH pL
0
C~ = . (3)
(1 ) pH

Straightforward di¤erentiation of equation (3) together with the convexity of the function
( ) produces the following result:

Lemma 1 The amount of monitoring C~ is decreasing in both investor protection in

Foreign and in the inventor’s shadow value of cash .

The e¤ect of investor protection on monitoring is intuitive. Given our speci…cation of

the private bene…t function B ( ) in (1), the marginal bene…t from monitoring is larger,
the less developed is the …nancial system in Foreign (the lower is ). Because the marginal
cost of monitoring is independent of , C~ and are negatively correlated in the optimal
contract.
The e¤ect of the shadow value of cash on monitoring is a bit more subtle. The
intuition behind the result lies in the fact that the larger is , the larger is the opportunity
cost of remunerating the inventor through ex-post dividends rather than through an ex-
ante lump-sum transfer. Because of the tight mapping between ~ I and C~ imposed by the
incentive compatibility constraint in (v), we have that a larger is also associated with a
higher shadow cost of monitoring, and hence with a lower optimal amount of monitoring.
In light of equation (2), it is clear that our theory has implications for the share of
equity held by the inventor that relate closely to the implications for monitoring. In
particular, ~ I is proportional to the level of monitoring C~ and thus is a¤ected by the
parameters and in the same way as is monitoring. This re‡ects that equity shares
emerge in our model as incentives for the inventor to monitor the foreign entrepreneur.
As a result, we can establish that:

Proposition 1 The share of equity held by the inventor is decreasing both in investor
protection in Foreign and in the inventor’s shadow value of cash .

An immediate corollary of this result is:

Corollary 1 Suppose that a transaction is recorded as an FDI transaction only if ~ I

I . Then, there exist a threshold investor protection 2 [0; 1] such that the optimal
contract entails FDI only if < .

11
 Our theory thus predicts that the prevalence of FDI in a given country should, other
things equal, be a decreasing function of the level of investor protection in that country.
Manipulation of the …rst-order conditions of program (P1) also delivers an implicit
function of the level of investment as a function of parameters and the optimal level of
~
monitoring C:
1
R0 (~
x) = . (4)
~
(1 ) (C ) ~
pH pL C
pH 1 pH pL pH pL pH

Equation (4) implicitly de…nes the level of expected sales by the …rm, i.e., pH R (~
x). Di¤er-
entiating this equation with respect to and we obtain (see Appendix A.3 for details):

Proposition 2 Output and cash ‡ows in Foreign are increasing in investor protection
in Foreign and decreasing in the inventor’s shadow value of cash .

The intuition for the e¤ect of investor protection is straightforward. Despite the fact
that the inventor’s monitoring reduces …nancial frictions, both the foreign entrepreneur’s
compensation, as dictated by his incentive compatibility constraint (iv), and monitoring
costs are increasing in the scale of operation. In countries with weaker investor protections,
the perceived marginal cost of investment is higher, thus reducing equilibrium levels of
investment.
Using constraints (i), (ii), and (iv), one can also obtain the terms of the optimal
…nancial contract with external investors in terms of C~ and x~:

(1 ) C~ C~
~ = 1
E
pH pL pH pL
E~ = pH ~ E R (~
x) .

Finally, straightforward manipulation delivers an optimal lump-sum date-0 transfer equal

to:
pL R (~
x)
F~ = ~ (~
CR x) 0
1 x~.
(pH pL ) R (~x) x~
Depending on parameter values, the lump-sum transfer can be positive or negative and it
also varies non-monotonically with the parameters of the model. We can, however, derive
sharper predictions for the share of …nancing that is provided by the inventor. To see this,
focus on the case in which the date-0 payment F~ is positive and can be interpreted as the
level of co…nancing by the inventor. The share of investment …nanced by the inventor is
then given by
F~ pL R (~x) 1 (~
x)
= C~ , (5)
x~ (pH pL ) x~ (~
x)

12
where (x) xR0 (x) =R (x) is the elasticity of revenue to output. As mentioned above,
when preferences feature a constant elasticity of substitution across a continuum of dif-
ferentiated goods produced by di¤erent …rms, (x) is in independent of x, and R (x) can
be written as R (x) = Ax , where A > 0 and 2 (0; 1).
Notice that the …rst term in (5) is increasing in C~ and decreasing in x~ due to the
concavity of R (x). It thus follows from Lemma 1 and Proposition 2 that this …rst term
is necessarily decreasing in . As for the second term, it will increase or decrease in x~
depending on the properties of (x). In most applications, (x) will be either independent
of x or decreasing in x (e.g., when the …rm faces a linear demand function). In those
situations, the second term in (5) will also be decreasing in and we can conclude that:

Proposition 3 Provided that 0 (~ x) is su¢ ciently small, the share of inventor …nancing
in total …nancing (F~ =~
x) is decreasing in investor protection .

The intuition behind the result is that monitoring by inventors has a relatively high
marginal product in countries with weak …nancial institutions. To induce the inventor
to monitor, the optimal contract speci…es a relatively steeper payment schedule, with a
relatively higher contribution by the inventor at date 0 (a higher F~ =~
x) in anticipation of
a higher share of the cash ‡ows generated by the project at date 2 (a higher ~ I ).15
The fact that the monitoring provided by the inventor is unveri…able by third parties
is central to our theory of FDI. In particular, if monitoring was veri…able (and thus con-
tractible), the optimal contract analogous to the one described above would immediately
imply an equity share for the inventor equal to zero (see Antràs, Desai and Foley, 2007,
for details). Hence, the inventor would never choose to deploy her technology abroad
through FDI. Instead, the inventor would sell the technology to the foreign entrepreneur
in exchange for a positive lump-sum fee (and, hence, the inventor would never co…nance
the project).
In section 4, we present empirical tests of Propositions 1, 2, and 3, and Corollary 1.
Appendix A.1 shows that Propositions 1, 2, and 3 continue to hold in a multi-country
version of the model in which the statements apply to cross-sectional variation in investor
protections. Our empirical tests exploit variation in the location of a¢ liates of U.S.
multinational …rms and analyze the e¤ect of investor protections on proxies for x~, ~ I , and
F~ =~
x. We identify the inventor in the model as being a parent …rm and control for other
15
The e¤ect of the shadow value of cash on the ratio F~ =~
x is ambiguous. A larger is associated with
a lower monitoring level C~ (Lemma 1), but also with a lower level of x
~ and thus a higher ratio R (~
x) =~
x
(Proposition 2). In addition, has an additional direct negative e¤ect on the ratio. The overall e¤ect is,
in general, ambiguous.

13
parameters of the model, such as the shadow value of cash , the concavity of R (x),
the monitoring function (C) and the probabilities pH and pL by using …xed e¤ects for
each …rm in each year and controlling for a wide range of host-country variables. Because
our estimation employs parent-…rm …xed e¤ects, we are not able to test the predictions
regarding the e¤ect of in Propositions 1, 2, and 3.

2.3 Generalizations
Before proceeding to the empirical analysis, it is useful to consider the robustness of
these results to more general environments. In particular, we consider the degree to
which revenue-sharing might substitute for equity contracts, the possibility that private
bene…ts and monitoring costs may be proportional to x rather than R (x), and the e¤ects
of introducing productive monitoring by external investors. The underlying analysis is
provided in Appendix A.4.
In the model above, we assume that when the project fails it delivers a level of revenue
equal to zero. Such an assumption greatly enhances tractability but suggests that revenue-
sharing contracts may provide similar bene…ts to equity arrangements. This is problematic
because it blurs the mapping between I in the model and equity shares in the data. More
generally, however, revenue-sharing contracts are not optimal when the project delivers
a positive level of revenue in case of failure. In fact, a simple contract in which external
investors are issued secured (or risk-free) debt and the inventor and entrepreneur take
equity stakes is optimal.16 To see the intuition for this, consider the same setup as in
section 2.1 but now assume that, when the project does not perform, it yields a level
of revenue equal to R (x) 2 (0; R (x)). As is standard in moral hazard problems with
risk-neutral agents, the optimal contract calls for the agents undertaking unobservable
actions (e.g., e¤ort decisions) to be maximally punished (subject to the limited liability
constraint) whenever a failure of the project is observed. In our particular setup, this
would imply that the optimal contract yields both the inventor and the entrepreneur a
payo¤ of zero whenever a project failure is observed. The entire revenue stream R (x)
should accrue to external investors.
A straightforward way to implement such a contract is for the entrepreneur to issue
an amount of secure debt equal to R (x) to external investors and for the inventor and
entrepreneur to be equity holders. Once the debt is paid, the inventor and entrepreneur
receive a share of zero in case of project failure and a share of the amount R (x) R (x) in
16
A contract in which entrepreneur issues debt to external investors appears to have empirical validity
because most capital provided to a¢ liates from local sources takes the form of debt.

14
case of project success. The determination of their optimal shares is analogous to that in
section 2.1 with R (x) R (x) replacing R (x) (details available upon request). In this more
general setting, it is not possible to implement this optimal allocation of payo¤s across
agents through simple revenue-sharing arrangements. As such, the model can explain why
an equity-like instrument tends to dominate both …xed-fee and revenue-sharing contracts
in …nancially underdeveloped countries. Such contracts will likely entail an ine¢ ciently
low punishment to the inventor when the project does not perform well.
We next brie‡y discuss alternative formulations for the entrepreneur’s private bene…t
of misbehavior and the inventor’s private cost of monitoring. We have assumed above
that these are proportional to the revenue generated by the project in case of success. If
instead we speci…ed them as being proportional to x, then the optimal equity share ~ I
would be given by
~I = C~ x~
,
(pH pL ) R (~x)
and would also depend on x~ and the concavity of the R(~ x) function. One may thus worry
that for a su¢ ciently concave R(~x) function, it could be the case that equity stakes could
be low in low- countries on account of the low values of x~=R (~ x) in those countries.
We show in Appendix A.4, however, that our main comparative static concerning equity
shares holds as long as the elasticity of revenue with respect to output –that is (~ x)
0
x~R (~ x) – does not increase in x~ too fast. The required condition is analogous to
x) =R (~
that in Proposition 3 and is satis…ed for the case of constant price-elasticity and linear
demand functions.
We …nally consider the possibility that local external investors (e.g., banks) also pro-
vide useful monitoring, the productivity of which may also be higher in countries with
worse investor protections. In Appendix A.4, we develop an extension of the model which
incorporates monitoring by external investors that, as with the monitoring by the in-
ventor, is subject to declining marginal bene…ts. Although the optimal contract is now
more complicated, we show that the incentive compatibility constraint for the inventor
will continue to bind in equilibrium, implying that the inventor’s equity stake moves pro-
portionally with its level of monitoring. Furthermore, provided that the level of investor
protection is su¢ ciently high, the analysis remains qualitatively unaltered by the intro-
duction of local monitoring. The reason for this is that for large values of , the optimal
contract already allocates equity stakes E to external investors that are large enough to
induce them to monitor the entrepreneur.17 As a result, although certain details of the
17
When the level of investor protection is below a certain threshold, then the incentive compatibility
for external investors becomes binding, in which case the analysis becomes more complicated. Without

15
optimal contract change with the possibility of local monitoring, the comparative static
results derived in section 2.2 continue to hold in this more general model provided that
is su¢ ciently large.

3 Data and Descriptive Statistics

The empirical work presented in section 4 is based on the most comprehensive available
data on the activities of U.S. multinational …rms and on arm’s length technology transfers
by U.S. …rms. The Bureau of Economic Analysis (BEA) annual survey of U.S. Direct
Investment Abroad from 1982 through 1999 provides a panel of data on the …nancial and
operating characteristics of U.S. …rms operating abroad. U.S. direct investment abroad is
de…ned as the direct or indirect ownership or control by a single U.S. legal entity of at least
ten percent of the voting securities of an incorporated foreign business enterprise or the
equivalent interest in an unincorporated foreign business enterprise. A U.S. multinational
entity is the combination of a single U.S. legal entity that has made the direct investment,
called the U.S. parent, and at least one foreign business enterprise, called the foreign
a¢ liate.18 The most extensive data for the period examined in this study are available for
1982, 1989, 1994, and 1999 when BEA conducted Benchmark Surveys. Accordingly, the
analysis is restricted to benchmark years except when the annual frequency of the data is
critical –in the analysis of scale in section 4.3 that uses the liberalizations of ownership
restrictions.
In order to analyze arm’s length technology transfers, measures of royalty payments,
licensing fees, and other payments for intangible assets received by U.S. …rms from unaf-
…liated foreign persons are drawn from the results of BEA’s annual BE-93 survey. This
survey requires that all …rms receiving payments above certain thresholds to report, re-
gardless of whether the …rm is a multinational.19 Table I provides descriptive statistics
for the variables used in the analysis employing the benchmark year data (Panel A) and
analysis employing the full panel (Panel B).
Implementing empirical tests requires mapping the variables of the model to reasonable
proxies in the data. In order to investigate the choice of an inventor to engage in arm’s
imposing particular functional forms on the monitoring functions, it becomes impossible to derive sharp
comparative static results (see Appendix A.4).
18
Coverage and methods of the BEA survey are described in Desai, Foley and Hines (2002). The survey
covers all countries and industries, classifying a¢ liates into industries that are roughly equivalent to three
digit SIC code industries. As a result of con…dentiality assurances and penalties for noncompliance, BEA
believes that coverage is close to complete and levels of accuracy are high.
19
Because these data have been collected since 1986, data used in the analysis of arm’s length technology
transfers cover only 1989, 1994, and 1999.

16
length technology transfer or FDI (Corollary 1), the analysis uses a dummy variable that
is equal to one if a U.S. …rm receives an arm’s length royalty payment from a country in
a given year and zero if that …rm only serves the country through a¢ liate activity in a
particular year. For Proposition 3’s predictions on the share of inventor …nancing in total
…nancing (F~ =~x) a variable is de…ned as the ratio of the sum of parent provided and equity
debt to a¢ liate assets. Speci…cally, this share is the ratio of the sum of parent provided
equity and net borrowing by a¢ liates from the parent to a¢ liate assets.20 Proposition 1
considers the determinants of the share of equity held by the inventor, I , and this variable
is measured in the data as the share of a¢ liate equity owned by the multinational parent.
The log of a¢ liate sales is used to test Proposition 2’s predictions on the scale of a¢ liate
activity.
Table I also provides descriptive statistics for a number of other variables. Two mea-
sures of investor protections and capital market development are used in the analysis
below. As the model emphasizes the decisions of local lenders, the …rst measure is cred-
itor rights. This measure is drawn from Djankov, McLiesh, and Shleifer (2007), which
extends the sample studied in La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998) to
cover a broader sample of countries over the 1982-1999 period on an annual basis. Cred-
itor rights is an index taking values between 0 and 4 and measures the extent to which
the legal system constrains managers from diverting value away from creditors (as a large
does in the model).21 The second measure is the annual ratio of private credit provided
by deposit money banks and other …nancial institutions to GDP, and it is drawn from
Beck, Demirguc-Kunt, and Levine (1999). This measure has the advantage of being an
objective, continuous measure of the lending environment which captures the willingness
of lenders to provide credit in response to investor protections.22
20
In the model, we have interpreted all sources of …nancing as equity …nancing, but as explained in
footnote 12, our setup is not rich enough to distinguish equity …nancing from debt …nancing. Hence, our
empirical tests of Proposition 5 include both.
21
Speci…cally, the measure is an index formed by adding 1 when: (1) the country imposes restrictions,
such as creditors’consent or minimum dividends to …le for reorganization; (2) secured creditors are able to
gain possession of their security once the reorganization petition has been approved (no automatic stay);
(3) secured creditors are ranked …rst in the distribution of the proceeds that result from the disposition
of the assets of a bankrupt …rm; and (4) the debtor does not retain the administration of its property
pending the resolution of the reorganization.
22
It is possible to employ a measure of shareholder rights to measure investor protections. Creditor
rights and private credit are used to measure investor protections for several reasons. First, shareholder
rights are only available for a single year near the end of our sample. Second, in our data, there is
very little local ownership of a¢ liate equity, but a¢ liates do make extensive use of debt borrowed from
local sources. As such, using creditor rights and private credit allows us to capitalize on some time series
variation in investor protections and more closely corresponds empirically to the …nancing choices of
a¢ liates.

17
 Measures of capital market development are correlated with other measures of eco-
nomic and institutional development that could a¤ect the outcome studied in ways not
considered in the model. Therefore, the regressions control for several measures of eco-
nomic and institutional variation that might otherwise obscure the analysis. The baseline
speci…cations include controls for FDI ownership restrictions, human capital development,
the log of GDP, the log of GDP per capita, and corporate tax rates. A number of coun-
tries impose restrictions on the extent to which foreign …rms can own local ones. Shatz
(2000) documents these restrictions using two distinct measures that capture restrictions
on green…eld FDI and cross-border mergers and acquisition activity. The FDI ownership
restriction dummy used below is equal to one if either of these measures is below three
and zero otherwise.
Countries with more human capital, with more economic activity, or with a higher
level of economic development may be more able to use technology obtained through an
arm’s length transfer, and a¢ liates in these countries may exhibit distinctive …nancing
patterns that re‡ect the quality of local entrepreneurs as opposed to …nancial market
conditions. To address these possibilities, the speci…cations include workforce schooling,
which measures the average schooling years in the population over 25 years old and is
provided in Barro and Lee (2000). Data on the log of GDP and the log of GDP per
capita come from the World Development Indicators. Firms could avoid local production
or alter their …nancing patterns in response to tax considerations. Corporate tax rates are
imputed from the BEA data by taking the median tax rate paid by a¢ liates that report
positive net income in a particular country and year.
Several other controls appear in additional speci…cations. Firms might chose to deploy
technology through a¢ liate activity as opposed to through an arm’s length transfer, and
they might select higher levels of ownership if they fear expropriation by local entrepre-
neurs (see, for instance, Ethier and Markusen, 1986 for a theoretical treatment). Ginarte
and Park (1997) provide a measure of the strength of patent protections, and the Index
of Economic Freedom provides a measure of more general property rights. Rule of law
is an assessment of the strength and impartiality of a country’s legal system, and it is
drawn from the International Country Risk Guide (ICRG). Additionally, …rms might fear
expropriation by foreign governments and might limit foreign activity and make more
extensive use of local …nancing in response. The ICRG also provides an index of the
risk of outright con…scation or forced nationalization faced by foreign investors. For this
measures, higher values indicate lower risks.23
23
Some country-level measures of economic and institutional development are highly correlated. The
multicollinearity of these variables might cause the standard errors of our key estimates to be large.

18
 Since the BEA data are a panel measuring activity of individual …rms in di¤erent
countries, they allow for the inclusion of e¤ects for each …rm in each year, which we refer
to as parent-year …xed e¤ects. These …xed e¤ects help control for other parameters of the
model that are likely to be speci…c to particular …rms at particular points in time, such
as the shadow value of cash , the concavity of R (x), the monitoring function (C) and
the probabilities pH and pL . The inclusion of these …xed e¤ects imply that the e¤ects
of investor protections are identi…ed o¤ of within …rm variation in the characteristics of
countries in which the …rm is active.
While the comprehensive data on multinational …rms and arm’s length technology
transfers does o¤er a number of advantages, it is worth noting one signi…cant oversight.
Neither the model nor the empirical work considers situations in which a …rm neither
invests in nor transfers technology to a particular location.

4 Empirical Results
Each of the analyses below is comprised of a descriptive …gure and …rm-level regressions.
The …gures provide a transparent and intuitive perspective on the predictions, and the
regressions allow for a full set of controls and subtler tests emphasizing the role of tech-
nology intensity. The predictions on the use of arm’s length technology transfers and
the …nancing and ownership of foreign a¢ liates are investigated by pooling cross-sections
from the benchmark years. Investigating the e¤ect on scale requires an alternative setup
as controlling for the many unobservable characteristics that might determine …rm size
is problematic. Fortunately, the model provides a stark prediction with respect to scale
that can be tested by analyzing responses to the easing of ownership restrictions.

4.1 Arm’s Length Technology Transfer Decisions

Figure I provides a preliminary perspective on the extent to which …rms deploy technology
through arm’s length transfers relative to direct ownership, across di¤erent quintiles of
the private credit measure of investor protections. The propensity to use arm’s length
technology transfer is computed at the country-year level as the ratio of the number of
…rms that receive a royalty payment from an una¢ liated foreign person to the number
of …rms that either receive such an arm’s length royalty or have an a¢ liate. The average
arm’s length royalty share is 0.11 for the lowest private credit quintile of observations
while it is 0.27 for the highest quintile. As predicted by the theory, …rms appear to make
However, these coe¢ cient estimates remain unbiased.

19
greater use of arm’s length technology transfers, relative to direct ownership, to access
countries with more developed capital markets.
Table II further explores arm’s length technology transfers through speci…cations that
include various controls and incorporate subtler tests. The dependent variable in these
tests, the Arm’s Length Technology Transfer Dummy, is de…ned for country-year pairs
in which a …rm either has an a¢ liate or receives a royalty payment from an una¢ liated
foreign person. The dummy is equal to one if the …rm receives a royalty payment from an
una¢ liated foreign person, and it is otherwise equal to zero. The inclusion of parent-year
…xed e¤ects controls for a variety of unobservable …rm characteristics that might otherwise
con‡ate the analysis. All speci…cations presented in the table also include a measure of the
existence of foreign ownership restrictions, workforce schooling, the log of GDP, the log
of GDP per capita, and host country tax rates.24 Standard errors are heteroskedasticity-
consistent and are clustered at the country-year level. These speci…cations are linear
probability models and are used in order to allow for both parent-year …xed e¤ects and
for clustering of standard errors at the country-year level.25
The coe¢ cient on creditor rights in column 1 is positive and signi…cant, a¢ rming the
prediction of Corollary 1 that …rms are more likely to serve countries with higher levels of
investor protections through arm’s length technology transfer as opposed to only through
a foreign a¢ liate. The results also indicate that …rms are more likely to engage in arm’s
length technology transfer as opposed to just a¢ liate activity in countries that have a
more educated workforce and that have higher corporate tax rates.
The predictions of the model relate to credit market development, but the measure of
creditor rights may be correlated with more general variation in the institutional environ-
ment. The speci…cation presented in column 2 includes additional proxies for the quality
of other host country institutions including indices of patent protections, property rights,
the strength and impartiality of the overall legal system, and the risk of expropriation as
control variables. The coe¢ cient on creditor rights remains positive and signi…cant with
the inclusion of these additional controls, implying that capital market conditions play
an economically signi…cant role relative to other host country institutions. The e¤ect of
a one standard deviation change in creditor rights is approximately one and a half times
as large as the e¤ect of a one standard deviation change in patent protections, which is
24
In order for the estimated e¤ects of capital market conditions to be unbiased in this and the subsequent
tests, these country characteristics must be exogenous to …rm decisions to use arm’s length technology
transfers as opposed to FDI, and …rm …nancing and ownership decisions.
25
Given the limited time dimension of our dataset, our linear speci…cation avoids the incidental para-
meter problem inherent in the estimation of a large number of …xed e¤ects. As a robustness check, these
speci…cations have been run as conditional logit speci…cations. The resulting coe¢ cients on the measures
of …nancial development are of the same sign and statistical signi…cance as those presented in Table II.

20
also positive and signi…cant in explaining the use of arm’s length technology transfer.
The speci…cation presented in column 3 provides a more subtle test of the model and
the particular mechanism that gives rise to FDI as opposed to arm’s length technology
transfer. The model implies that the relative value of monitoring should be more pro-
nounced for …rms that conduct more research and development (R&D) because these
…rms are more likely to be deploying novel technologies that require the unique monitor-
ing ability of parents. Alternatively, …rms with limited technological capabilities are less
likely to be important to external funders as monitors, and the e¤ects of capital market
development on the choice to serve a country through arm’s length technology transfer or
a¢ liate activity should be less pronounced for these kinds of …rms.
The speci…cation presented in Column 3 uses the log of parent R&D as a proxy for
the degree to which …rms are technologically advanced. Since this speci…cation includes
parent-year …xed e¤ects, this variable does not enter on its own, but it is interacted with
creditor rights.26 The positive coe¢ cient on the interaction term is consistent with the
prediction that the value of creating incentives to monitor through ownership in countries
with weak …nancial development is highest for technologically advanced …rms.
The speci…cations presented in columns 4-6 of Table II repeat those presented in
columns 1-3 replacing creditor rights with private credit as a measure of …nancial devel-
opment. The positive and signi…cant coe¢ cients on private credit in columns 4 and 5
are consistent with the …ndings in columns 1 and 2 and illustrate that countries with
higher levels of …nancial development are more likely to be served through arm’s length
technology transfers as opposed to just a¢ liate activity. The positive and signi…cant co-
e¢ cient on private credit interacted with the log of parent R&D presented in column 6
indicates that the e¤ects of capital markets are most pronounced for …rms that are R&D
intensive.27

4.2 The Financing and Ownership of Foreign A¢ liates

The analysis presented in Figure II and Table III investigates if …nancing and ownership
decisions re‡ect the dynamics emphasized in the model. As depicted in Figure II, parent
26
If the measure of parent technology intensity were included on its own, its coe¢ cient would be subject
to endogeneity concerns. Because parent characteristics are absorbed by the parent/year …xed e¤ects,
the coe¢ cient on this interaction term picks up how the e¤ect of capital market conditions varies across
…rms. The sample used in this speci…cation and the speci…cation in column 6 includes only multinational
…rms because R&D expenditures are only available in the BEA data for these …rms.
27
When running these speci…cations as conditional logit speci…cations, the resulting coe¢ cients on
these interaction terms are of the same sign and statistical signi…cance as those in the Table II, except for
the interaction of creditor rights and the log of parent R&D. The coe¢ cient on this variable is positive,
but it is not statistically di¤erent from zero at conventional levels.

21
…rms provide …nancing that averages 45% of a¢ liate assets in countries in the lowest
quintile of private credit but 38% of a¢ liate assets in countries from the highest quintile
of private credit.28 Table III presents the results of more detailed tests of this relation.
In addition to a variety of country-level controls, …xed e¤ects for each parent in each year
control for di¤erences across …rms. The negative and signi…cant coe¢ cient on creditor
rights in column 1 indicates that the share of a¢ liate assets …nanced by the parent is higher
in countries that do not provide creditors with extensive legal protections. This result
is consistent with the prediction contained in Proposition 3, and the pattern depicted in
Figure II.
The speci…cation in column 2 includes the set of other institutional variables also used
in Table II to ensure that proxies for …nancial development are not proxying for some
other kind of institutional development. In addition, this speci…cation also controls for
a¢ liate characteristics that the corporate …nance literature suggests might in‡uence the
availability of external capital. Harris and Raviv (1991) and Rajan and Zingales (1995)
…nd that larger …rms and …rms with higher levels of tangible assets are more able to
obtain external debt. Two proxies for a¢ liate size— the log of a¢ liate sales and the log
of a¢ liate employment— and a proxy for the tangibility of a¢ liate assets— the ratio of
a¢ liate net property, plant and equipment to a¢ liate assets— are included.29
In the speci…cation in column 2, the -0.0164 coe¢ cient on creditor rights implies that
the share of a¢ liate assets …nanced by the a¢ liate’s parent is 0.0327, or 7.9% of its mean
value, higher for a¢ liates in countries in the 25th percentile of creditor rights relative
to the 75th percentile of creditor rights. The negative and signi…cant coe¢ cient on FDI
ownership restrictions is consistent with the hypothesis that such restrictions limit parent
capital provisions, and the negative and signi…cant coe¢ cient on the log of GDP suggests
that a¢ liates located in smaller markets are more reliant on their parents for capital.
When a¢ liates borrow, they primarily borrow from external sources, and Desai, Foley
and Hines (2004b) shows that a¢ liates borrow more in high tax jurisdictions. These
facts could explain the negative coe¢ cient on the corporate tax rate in explaining the
share of assets …nanced by the parent.30 Previous theoretical work stressing how concerns
28
More speci…cally, the values displayed in this chart are computed by …rst taking average shares of
a¢ liate assets …nanced by parents for each country in each year. These shares are de…ned as the ratio of
the sum of net borrowing from the parent and parent equity provisions (including both paid-in-capital
and retained earnings) to a¢ liate assets. The bars display medians of the country level averages for each
quintile of private credit.
29
The a¢ liate controls included in this speci…cation as well as those in columns 3, 5, and 6 of Table III
and columns 2, 3, 5, and 6 of Table IV are potentially endogenous. It is comforting that their inclusion
does not typically have a material impact on the estimated e¤ects of capital market conditions.
30
The model’s predictions relate to overall parent capital provision. As such, these speci…cations di¤er
from the analysis in Desai, Foley and Hines (2004b) where only borrowing decisions are analyzed.

22
over technology expropriation might give rise to multinational activity does not make
clear predictions concerning the share of a¢ liate assets …nanced by the parent, but it is
worth noting that the indices of patent protection and property rights are negative in the
speci…cation in column 2. None of the unreported coe¢ cients on a¢ liate characteristics
are signi…cant.
If parent …nancing creates incentives for monitoring and the e¤ects of monitoring are
strongest for …rms with more technology, then the e¤ects documented in column 2 should
be most pronounced for R&D intensive …rms. The speci…cation in column 3 tests for
a di¤erential e¤ect of creditor rights on …nancing by including creditor rights interacted
with the log of parent R&D. The negative and signi…cant coe¢ cient on this interaction
term indicates that more technologically advanced …rms …nance a higher share of a¢ liate
assets in countries with weak credit markets. This …nding is not implied by many other
intuitions for why investor protections might a¤ect parental …nancing provisions.
The speci…cations presented in columns 4-6 of Table III repeat the analysis presented
in columns 1-3 substituting measures of private credit for creditor rights. In columns 4
and 5, the coe¢ cient on private credit is negative, and it is signi…cant in column 4 but
only marginally signi…cant in column 5. In the speci…cation in column 6, the interaction
of private credit and the log of parent R&D is signi…cant. The results obtained when using
private credit are also consistent with the prediction of Proposition 3 and with Figure II.
The model also predicts that multinational parents should hold larger ownership stakes
in a¢ liates located in countries with weak investor protections. Table IV presents results
of using the share of a¢ liate equity owned by the parent as the dependent variable in
speci…cations that are similar to those presented in Table III. Although parent equity
shares are bounded between 0 and 1, and there is a large grouping of a¢ liates with equity
that is 100% owned by a single parent …rm, the speci…cations presented in Table IV
are ordinary least squares models that include parent-year …xed e¤ects and that allow
standard errors to be clustered at the country-year level.31 In the speci…cations presented
in columns 1, 2, 4, and 5, the proxy for credit market development is negative and
signi…cant. Parent companies own higher shares of a¢ liate equity when a¢ liates are
located in countries where protections extended to creditors are weaker and private credit
is scarcer, as predicted by the model. In the speci…cations presented in columns 3 and
6, the negative and signi…cant coe¢ cients on the interaction terms indicate that these
results are also more pronounced for technologically advanced …rms.
31
Wholly-owned a¢ liate comprise 77.2% of all observations. These results are robust to using an
alternative estimation technique. Conditional logit speci…cations that use a dependent variable that is
equal to one for wholly owned a¢ liates and zero for partially owned a¢ liates yield similar results.

23
 The results in Table IV also indicate that equity ownership shares are lower in coun-
tries with ownership restrictions and countries with higher corporate tax rates. If equity
ownership decisions placed strong emphasis on the protection of technology and ownership
substituted for weak patent protections, the coe¢ cient on the Patent Protections variable
should be negative and signi…cant. While the estimated coe¢ cient is negative, it is only
marginally signi…cant in some speci…cations.
The results presented in Tables II, III, and IV are robust to a number of concerns.
First, it is possible that the estimates of coe¢ cients on capital market conditions in-
teracted with the log of parent R&D may re‡ect the e¤ect of similar interactions with
alternative institutional variables. In order to consider this possibility, it is useful to con-
sider the inclusion of other interaction terms. For example, when the log of parent R&D
interacted with the rule of law index is included in the speci…cations presented in columns
3 and 6 of the three tables, the interactions that include proxies for capital market de-
velopment remain signi…cant in all of the tests. When the log of parent R&D interacted
with the patent protection index is included in these speci…cations, the interactions fea-
turing proxies for credit market development remain signi…cant in all of the tests except
for the one in column 3 of Table II. As such, it appears that the role of R&D intensity
is most pronounced through the channel emphasized in the model, through interactions
with capital market conditions.
It may also be the case that the share of a¢ liate assets …nanced by the parent and
parent ownership levels are lower for older a¢ liates and these a¢ liates may be more
prevalent in countries with better investor protections. Including proxies for a¢ liate age
in the speci…cations presented in the speci…cations presented in Tables III and IV does
not a¤ect the results of interest.32 Similarly, the model does not explicitly consider the
possibility that a …rm exploits its technology through trade as opposed to through FDI
or arm’s length technology transfers. To consider if trade channels could a¤ect the main
…ndings, the log of parent exports to una¢ liated foreign persons in each country and year
is included as a control in each of the speci…cations. The magnitude and signi…cance of
the coe¢ cients on the proxies for capital market conditions and the interactions of these
proxies and the log of parent R&D are not materially changed. Finally, contractual forms
that are speci…c to the natural resources sector could a¤ect some of the results. Removing
observations of …rms in this sector reduces the signi…cance of the results on the e¤ects of
private credit in speci…cations presented in column 5 of Table II and Table III, but does
not materially change any of the other results on the e¤ects of capital market conditions
32
The proxies for age are the number of years since an a¢ liate …rst reported data to BEA and a dummy
equal to one if the a¢ liate …rst reported in 1982 and zero otherwise.

24
in Tables II, III, and IV.33

4.3 The Scale of Multinational Activity

The model predicts that multinational activity will be of a larger scale in countries with
stronger investor protections. Because there are many theories for the determinants of
FDI activity, using speci…cations similar to those presented in Tables II, III, and IV to
explore scale is problematic as it is di¢ cult to include a set of controls su¢ ciently extensive
to distinguish between alternative theories.34
Fortunately, a subtler prediction of the model allows for tests of scale e¤ects. Speci…-
cally, the model suggests that the response to the liberalizations of ownership restrictions
should be larger in host countries with weak investor protections. The intuition for this
prediction is that in countries with weak investor protections, ownership restrictions are
more likely to bind because ownership is most critical for maximizing the value of the en-
terprise in these settings. As such, the relaxation of an ownership constraint should have
muted e¤ects for a¢ liates in countries with deep capital markets and more pronounced
e¤ects for a¢ liates in countries with weaker investor protections.35
Figure III illustrates how the scale of multinational activity changes around the time of
ownership liberalizations in countries with di¤erent levels of capital market development.
Liberalizations are de…ned as the …rst year in which the FDI ownership restriction dummy
described above changes from 1 to 0.36 The lines trace out an index that is computed by
33
Firms in BEA industries 101-148 and 291-299 are dropped from the sample. The coe¢ cient on private
credit in column 5 of Table II, when estimated using the reduced sample, is 0.0292, and it has a t-statistic
of 1.92. The coe¢ cient on private credit in column 5 of Table III, when estimated using the reduced
sample, is -0.0351, and it has a t-statistic of 1.62.
34
Appendix Table I in Antràs, Desai, and Foley (2007) presents the results of such an exercise. Although
the coe¢ cients on both the creditor rights variables and private credit variables are usually positive in
explaining the log of a¢ liate sales, as Proposition 2 predicts, none of the coe¢ cients on these variables
is signi…cant.
35
This prediction can in fact be explicitly derived from the model. In particular, one can envision an
ownership restriction as an additional constraint to program (P1) requiring that I I for some foreign
ownership cap I 2 R. One can then show (details available upon request) that (i) for large enough ,
this constraint will not bind and thus a removal of the constraint will have no e¤ects on a¢ liate activity;
(ii) when the constraint binds, the level of a¢ liate activity x is lower than in the absence of the constraint;
and (iii) a marginal increase in I (i.e., a relaxation of the restriction) increases x by more, the lower is
. Hence, the response of a¢ liate activity to a removal of ownership restrictions will be relatively larger
in countries with relatively weaker investor protections.
36
The countries experiencing a liberalization are Argentina (1990), Australia (1987), Colombia (1992),
Ecuador (1991), Finland (1990), Honduras (1993), Japan (1993), Malaysia (1987), Mexico (1990), Norway
(1995), Peru (1992), Philippines (1992), Portugal (1987), Sweden (1992), Trinidad and Tobago (1994),
and Venezuela (1990). Since control variables measuring the development of institutions other than credit
markets do not vary much (if at all) through time and are unavailable for six of the sixteen reforming
countries, these controls are not included in the analysis of liberalizations. The a¢ liate …xed e¤ects

25
calculating the ratio of aggregate a¢ liate sales in a particular country and year to the
value of aggregate a¢ liate sales in that country in the year of liberalization. The line
demarcated by squares (triangles) plots the average of this index across countries that
have a measure of private credit in the year prior to the liberalization that is equal to or
less than (above) the median private credit of liberalizing countries. The lines indicate
that a¢ liate activity increases by a larger margin in countries with low levels of private
credit following liberalizations.
The speci…cations presented in Table V investigate if these di¤erential e¤ects are
robust. The dependent variable in columns 1 and 2 is the log value of a¢ liate sales,
and the sample consists of the full panel from 1982 to 1999. Given the limited data
requirements of these speci…cations (relative to the variables investigated in Tables II, III
and IV) and the desire to investigate changes within a¢ liates, the full panel provides a
more appropriate setting for these tests. These speci…cations include a¢ liate and year
…xed e¤ects and the standard errors are clustered at the country level. The sample
includes all countries so a¢ liate activity in countries that do not liberalize helps identify
the year e¤ects and the coe¢ cients on the income variables. The results are robust to
using a sample drawn only from reforming countries.
The speci…cations in columns 1 and 2 include controls for log GDP, log GDP per
capita and the post-liberalization dummy. The coe¢ cient on log GDP per capita is
positive and signi…cant indicating that rising incomes are associated with larger levels of
a¢ liate activity. The coe¢ cient of interest in column 1 is the coe¢ cient on the interaction
of the post-liberalization dummy and a dummy that is equal to one if the country has a
value of the creditor rights index in the year before liberalization that is equal to or less
that the median value for liberalizing countries. The positive and signi…cant coe¢ cient
indicates that a¢ liates in weak creditor rights countries grow quickly after liberalizations.
The coe¢ cient on the post-liberalization dummy on its own indicates that the e¤ect
of liberalizations is negligible and statistically insigni…cant for a¢ liates in high creditor
rights countries. In column 2, these same results are obtained when the measure of
private credit is used as the proxy for …nancial development. At the a¢ liate level, the
model’s predictions regarding how the scale of activity relates to capital market depth are
validated using tests that, through the use of a¢ liate …xed e¤ects and the emphasis on
the interaction term, are di¢ cult to reconcile with alternative theories.
It is possible that the results presented in columns 1 and 2 inaccurately capture the
e¤ects of the liberalizations because they only measure activity on the intensive margin
and fail to capture responses on the extensive margin. Entry or exit might accompany
implicitly control for time invariant country characteristics so this is unlike to pose a signi…cant problem.

26
liberalizations and might amplify or dampen these results. Figure III suggests this is
not the case because it is constructed using data aggregated to the country level. The
speci…cations provided in columns 3 and 4 employ a dependent variable that is the log
value of the aggregate value of all sales of U.S. multinational a¢ liates within a country-
year cell. These speci…cations substitute country …xed e¤ects for a¢ liate …xed e¤ects but
are otherwise similar to the regressions provided in columns 1 and 2.
In column 3, the coe¢ cient on the interaction term including the creditor rights vari-
able is again positive and signi…cant indicating that incorporating activity on the extensive
margin does not appear to contradict the earlier result. In column 4, the coe¢ cient on
the interaction term is again positive and signi…cant. Taken together, the results suggest
that the scale of activity is positively related to the quality of investor protections and
capital market development, and these results persist when incorporating the e¤ects of
entry and exit.

5 Conclusion
E¤orts to understand patterns of multinational …rm activity have typically emphasized
aspects of technology expropriation rather than the constraints imposed by weak investor
protections and shallow capital markets. In the prior literature, multinational …rms arise
because of the risk of a partner expropriating a proprietary technology. In the model
presented in this paper, the exploitation of technology is central to understanding multi-
national …rm activity, but the critical constraint is the nature of capital market devel-
opment and investor protections in host countries. Entrepreneurs must raise capital to
fund projects, and external investors are aware of the possibility that these entrepreneurs
might behave opportunistically. Inventors can alleviate …nancial frictions because they
have privileged knowledge of their technology and can thus play a role in monitoring entre-
preneurs. As a result, multinational …rm activity and capital ‡ows arise endogenously to
ensure that monitoring occurs. External investors demand higher levels of multinational
parent …rm …nancial participation in countries with weak investor protections.
By placing …nancial frictions at the center of understanding patterns of activity and
‡ows, the model delivers novel predictions about the use of arm’s length technology trans-
fers and about the …nancial and investment decisions of multinational …rms that are vali-
dated in …rm-level analysis. The use of arm’s length technology transfers is more common
in countries with strong investor protections and deep capital markets. Previous …ndings
that FDI ‡ows to developing countries are limited re‡ect two opposing forces. Weak in-
vestor protections and shallow capital markets limit the e¢ cient scale of enterprise but

27
also result in greater parent provision of capital and more parent ownership of a¢ liate
equity. The e¤ects of the institutional setting are more pronounced for R&D intensive
…rms as parental monitoring is particularly valuable for the investments of these …rms. By
jointly considering operational and …nancial decisions, the theory and empirics provide
an integrated explanation for patterns of MNC activity and FDI ‡ows that have typically
been considered separately.
Further consideration of the role of …nancial frictions on multinational …rm activity
along several dimensions may prove fruitful. First, the model presented e¤ectively rules
out exports to unrelated parties as a means of serving foreign markets. Incorporating the
tradeo¤ between exports and production abroad in a world with …nancial frictions may
yield additional predictions that would help explain the choice between exporting and
FDI. Second, exploring the implications of …nancial frictions for intra…rm trade may help
explain how the demands of external funders in weak institutional environments a¤ect the
fragmentation of production processes across borders. Finally, the central role of foreign
ownership in reducing diversion may lead to signi…cant variation in the relative competi-
tiveness of local and foreign …rms that re‡ects the institutional environment emphasized
in this paper.

28
A Appendix
A.1 The Shadow Cost of Cash
In the main text, we have treated the shadow value of cash as exogenous. In this Appendix
we brie‡y illustrate how to endogenize it and show how it relates to characteristics of the Home
country and in particular to its level of investor protection.
For this purpose, we generalize the setup described in section 2.1 and consider the situation
in which there are J 1 Foreign countries, each associated with a level of …nancial development
j and a cash ‡ow function Rj xj .37 The inventor contracts with each of J 1 foreign
entrepreneurs and, as a result of the optimal contracting described above, has an amount of
P ~j
cash equal to W j6=H F to invest in the Home country.
Preferences and technology at Home are such that the cash ‡ows obtained from the sale of
the di¤erentiated good at Home can be expressed as a strictly increasing and concave function
of the quantity produced, RH (q), satisfying the same properties as the cash ‡ow function in
other countries. Home production is managed by the inventor, who can also privately choose
to behave or misbehave, with consequences identical to those discussed above: if the inventor
behaves, the project performs with probability pH , but if he misbehaves, the project performs
with a lower probability pL . In the latter case, however, the inventor obtains a private bene…t
equal to a fraction 1 H of cash ‡ows, where H is an index of investor protection at Home.

The inventor sells domestic cash ‡ow rights to a continuum of external investors at Home,
who can obtain a rate of return equal to one in an alternative investment opportunity.38 We
consider an optimal …nancial contract between the inventor and external investors in which the
inventor is granted the ability to make take-it-or-leave-it o¤ers, just as in the main text. The
optimal contract speci…es the scale of operation xH , the amount of cash Wx that the inventor
invests in the project, the share of equity H E sold to external investors, and the amount of cash
H
E provided by external investors.
Taking the contracts signed with foreign individuals as given, an optimal …nancial contract
with
n external investors
o at Home that induces the inventor to behave is given by the tuple
H
x H ~ ~
~ ; Wx ; E ; E~ H that solves the following program:

P j P
max I = j6=H I pH C j Rj xj + pH 1 H
E RH xH + W j6=H F~ j Wx
H
xH ;Wx ; E ;E
H

s:t: xH E H + Wx
P ~j
Wx W j6=H F
H H
pH ER xH EH
H
(pH pL ) 1 E RH xH 1 H RH xH
(P2)
37
With some abuse of notation we use J to denote both the number of countries as well as the set of
these countries.
38
For simplicity, we assume that the inventor cannot pleadge foreign cash ‡ow rights to its external
investors.

29
 It is straightforward to show that provided that H is low enough (i.e, provided that …nancial
frictions at Home are large enough), all constraints in program (P2) will bind in equilibrium,
and the pro…ts of the entrepreneur can be expressed
0 1
X X
I = j
I pH C j Rj xj + b @W F~ j A (A1)
j6=H
j6=H

where
1 H
^= (pH pL )
> 1.
1 H ~H
x
pH pL 1 pH RH (~
xH )

Notice that the resulting pro…t function (A1) is closely related to that considered in program
(P2) in section 2.2, where ^ now replaces . There are however two important di¤erences
between the two pro…t functions.
First, the formulation in (A1) considers the case in which the inventor obtains cash ‡ow
from the exploitation of the technology in multiple countries. Nevertheless, notice that for a
given ^ , the pro…t function features separability between these di¤erent sources of dividends.
As a result, for a given ^ , the optimal contract with the entrepreneur and external investors in
each country j is as described in section 2.2.39 Hence, Propositions 1, 2, and 3 continue to apply
and their statements not only apply to changes in the parameter , but also to cross-sectional
(cross-country) variation in investor protection. In this sense, the tests performed in section 4
are well de…ned.
The second important di¤erence between the pro…t function in (A1) and in program (P2) is
that the shadow value of cash ^ is in fact endogenous, in the sense that it is a function of the
scale of operation at Home xH , which in turn will depend on the optimal contracts in the other
J countries through the date-0 transfers F~ j for j 6= H (as is clear from program (P2)). Hence, ^
will in general be a function of the vector of country investor protections 1 ; :::; J 1 ; H .

Notice, however, that for large enough J, the e¤ect of a particular investor protection level
j (j 6= H) on the overall shadow value of cash ^ will tend to be negligible, and thus the

comparative static results in section 2.2 will continue to apply.

To sum up, this Appendix has illustrated that a higher-than-one shadow value of cash can
easily be rationalized in a simple extension of our initial partial-equilibrium model, in which not
only foreign entrepreneurs, but also the inventor faces …nancial constraints. We have seen that
endogenizing the shadow value of cash may a¤ect the solution of the optimal contract in subtle
ways, but that if the number of host countries in which the inventor exploits his technology is
large enough, the comparative static results in section 2.2 remain qualitatively valid.
39
Notice also that when ^ > 1, the inventor is …nancially constrained at Home, in the sense that external
investors at Home are only willing to lend to him a multiple of his pleadgeable income (wealth plus date-
0 payments). If external investors were to lend a larger amount, the inventor’s incentive compatibility
constraint would be violated. The same would of course apply to external investors in foreign countries.
This helps rationalize our assumption in section 2.1 that the inventor does not sign bilateral …nancial
contracts with external investors in host countries.

30
A.2 Characterization of the Optimal Contract
Let us start by writing the Lagrangian corresponding to program (P1). Letting k denote the
multiplier corresponding to correspond to constraint k = 1; 2; 4; 5 (remember constraint (iii)
cannot bind), we have

L = I pH R (x) + (W F) CR (x) + 1 (E +F x) + 2 (pH E R (x) E)

C
+ 4 ((pH pL ) (1 E I) (1 ) (C)) + 5 I .
(pH pL )

The …rst-order conditions of this program (apart from the standard complementarity slackness
conditions) are:

@L
= + 1 =0
@F
@L
= pH R (~
x) 4 (pH pL ) + 5 =0
@ I
@L
= ~ I pH R0 (~
x) ~ 0 (~
CR x) 1 + ~
2 pH E R
0
(~
x) = 0 (A2)
@x
@L
= 2 pH R (~
x) 4 (pH pL ) = 0
@ E
@L
= 1 2 =0
@E
@L 5
= R (~
x) 4 (1 ) 0
C~ = 0. (A3)
@C (pH pL )

Straightforward manipulation of these conditions delivers

1 = = >0
2
pH pH
4 = 2 R (~
x) = R (~
x) > 0
p H pL pH pL
5 = ( 1) pH R (~
x) > 0;

from which we conclude that all constraints bind, as claimed in the main text.
The fact that 5 > 1 immediately implies that constraint (v) binds and we have ~ I =
~ (pH pL ), as indicated in equation (2). Next, plugging the values of the multipliers in (A3)
C=
yields
0 ~ p H pL
C = ,
(1 ) pH

as claimed in equation (3) in the main text. Next, plugging the multipliers and ~ I into (A2)
yields
1
R0 (~
x) = ,
(1 ) (C~) pH pL ~
C
pH 1 pH pL pH pL pH

which corresponds to equation (4) in the main text.

31
 Setting the constraints to equality, we can also compute the total payo¤ obtained by the
inventor:
~I = W + R (~
x)
0
x
~ . (A4)
R (~x)
This expression can be used to analyze when it is optimal for the inventor to implement good
behavior. To do so, consider the optimal contract that implements bad behavior. It is clear
that in this case the inventor has no incentive to exert monitoring e¤ort. It is also immediate
that even when the entrepreneur does not obtain any share of the cash ‡ows, her participation
L L
constraint will be satis…ed, and thus we have that ~ I + ~ E = 1. The program de…ning the
optimal contract can then be written as

max I = I pL R (x) + (W F)
F; I ;x;E

s:t: x E+F (i) (P1L )

pL (1 I ) R (x) E (ii)
I 0 (iii)
Following the same steps as before, we …nd that all three constraints will bind, and hence
L
C~ L = ~ I = 0. Furthermore, the optimal level of investment is given by

~L = 1;
pL R 0 x

while the overall payo¤ obtained by the inventor equals:

!
~L = W + R x ~L
~L
x . (A5)
xL )
R0 (~

Comparing equations (A4) and (A5) we see that ~ I > ~ L if and only if

R (~x) R x ~L
x
~> ~L .
x
R0 (~
x) xL )
R0 (~

But since RR(x)

0 (x) x is strictly increasing in x whenever R00 (x) < 0, we can conclude that good
behavior will be implemented whenever

x ~L .
~>x

Note also that x ~ is increasing in ~L is

(this is formally proved in Appendix A.3), while x
independent of . Furthermore, when ! 1, it is necessarily the case that x ~ > xL
~ . Hence,
there exists a threshold over which it is optimal to implement good behavior.

32
A.3 Proofs of Comparative Static Results
The comparative statics in Lemma 1 simply follow from the fact that the right-hand side of
equation (3) is increasing in and , while the left-hand is decreasing in C~ (given the convexity
of ( )).
The statements of Proposition 1 directly follow from Lemma 1 because ~ I is proportional to
~
C.
Consider next the comparative statics in Proposition 2. For that purpose, let

(1 ) C~ pH pL C~
F ; ; C~ ( ; ) = + ,
pH pL pH pL pH

so that h i
pH R0 (~
x) 1 F ; ; C~ ( ; ) = 1.

Using equation (3), we can establish that:

dF ( ) C~ (1 ) 0
C~ dC~ pH pL 1 dC~ C~
= + + = < 0;
d pH pL pH pL d pH pL pH d pH pL

dF ( ) (1 ) 0
C~ dC~ pH pL 1 dC~ pL C~ pL C~
= + + 2 = 2 > 0.
d pH pL d pH pL pH d (pH pL ) pH (pH pL ) pH

From inspection of (4) and the concavity of R ( ), it is then clear that x

~ is increasing in and
decreasing in .
Finally, the statements in Proposition 3 follow from the discussion in the main text and the
fact that R (~x) =~
x is decreasing in x
~, and thus decreasing in and increasing in .

A.4 Generalizations
In this Appendix, we provide more details on the generalizations outlined in section 2.3.
Consider …rst the case in which the entrepreneur’s private bene…t and the inventor’s private
cost of monitoring are proportional to x rather than to R (x). Following the same steps as in
the formulation in the main text, we …nd that the optimal C^ and x ^ are now given by

p H pL
0
C^ =
pH (1 )

and
( pH pL ) C^ pH (1 ) C^
0
pH R (^
x) = 1 + + . (A6)
(pH pL ) pH pL

Straightforward di¤erentiation indicates that both C^ and x

^ continue to be decreasing in , as

33
in our paper. Next note that we can use equation (A6) to write

^ C^ x
^ pH C^ x ^R0 (^
x) C^
I = =
(pH pL ) R (^
x) (pH pL ) R (^ x) pH R0 (^x)
2 3 1
pH ^R0 (^
x x) 4 1 ( p H pL ) pH (1 ) C^
= + + 5 .
(pH pL ) R (^x) C^ (pH pL ) (pH pL ) C^

It is straightforward to see that the last term continues to be an increasing function of C^

and is thus decreasing in . This implies that the only way that ^ I could be increasing in
would be if the elasticity of revenue to output –that is (^ x) x ^R0 (^
x) =R (^ x) –was su¢ ciently
increasing in x ^. For a constant-elasticity function, R (x) = Ax , we have (^ x) = for all x ^
^
and thus I continues to be decreasing in for any level of concavity of the R (x) function.
Remember that the revenue function will be isoelastic whenever the …rm faces a demand with
constant price-elasticity. If the …rm where to face a linear demand function, then we would have
that (^ x) would be decreasing in x ^, hence reinforcing the result that ^ I is decreasing in .
We next consider the case in which (local) external investors can also serve a monitoring
role. In particular, if external investors exert an unveri…able e¤ort cost M R (x), the private
bene…t is now:
B (C; M ; ) = (1 ) ( (C) + (M )) :

with ( ) satisfying similar the same properties as ( ) above, namely, 0 (M ) < 0, 00 (M ) >
0, (0) = , limM !1 (M ) = 0, limM !0 0 (M ) = 1, and limM !1 0 (M ) = 0. Be-
cause local monitoring is not veri…able, the program that determines the optimal contract will
need to include a new incentive compatibility constraint for external investors. In particu-
lar, an optimal contract
n o that induces the entrepreneur to behave is now given by the tuple
^; ^ E ; E;
F^ ; ^ I ; x ^ C;
^ M
^ that solves a program analogous to (P1) but with constraints (ii) and
(iv) now given by :

pH E R (x) M R (x) E (ii)

(pH pL ) (1 E I) (1 ) ( (C) + (M )) (iv)

and with the additional constraint

E M= (pH pL ) (vi) .

Manipulating the …rst-order conditions of this new program, we obtain that:

5 =( 1) pH R0 (^
x) + 6;

which immediately implies that constraint (v) continues to bind even in the case with local mon-
itoring. Consequently, inventor (or parent …rm) equity shares continues to move proportionately
with the amount of monitoring undertaken by the inventor.

34
 Furthermore, provided that the level of investor protection is su¢ ciently high, the analysis
in the main text goes through essentially unaltered. The reason for this is that in such a case
constraint (vi) is not binding ( 6 = 0) and we obtain that C^ and M ^ being determined by:

pH pL
0
C^ = , (A7)
(1 ) pH

which is identical to (3), and

0 ^ = (pH
M
pL )
. (A8)
(1 ) pH

From the convexity of the monitoring functions, we thus obtain that both C^ and M ^ are decreasing
functions of . Furthermore, manipulating the …rst-order conditions it can also be easily shown
that (i) the investment levels (and thus) sale revenue continue to be increasing in , and (ii) the
ratio F^ =b
x is still increasing in provided that (^ x) does not increase in x ^ too quickly, just as
in the main text (details available upon request).
0 ^ ^ ), and if the functions
0 (M
Note that equations (A7) and (A8) also imply that (C) >
^ > C.
( ) and ( ) are su¢ ciently similar we will have M ^ Intuitively, a disproportionate amount
of local monitoring may be optimal because it is “cheaper”, since external investors have a lower
shadow cost of getting remunerated through equity shares. Still, as long as the equilibrium
level of M^ is su¢ ciently low (or is su¢ ciently high), the above analysis suggests that inventor
equity shares comoves with investor protection in the same manner than in our simpler model
with only inventor monitoring.
For low enough values of , however, the above optimal contract leads to M ^ > (pH pL ) bE ,
which violates constraint (vi). In such a case, we have 6 > 0. Manipulating the …rst-order
conditions, one can show that C^ and M ^ are implicitly de…ned by the system:

1 + (1 ) 0 ^
M
=
1 + (1 ) 0
C^

pH pL C^ ^
M = (1 ) C^ + ^
M .

Unfortunately, without imposing particular functional forms for the functions ( ) and ( ), it
becomes impossible to characterize how C^ (and thus ^ I ) vary with .

35
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39
 0.30
Arm's Length Technology Transfer Share

0.25

0.20

0.15

0.10

0.05

0.00
1 2 3 4 5

Private Credit Quintile

Figure I
Arm's Length Technology Transfer Versus Direct Investment

Note: Arm's Length Technology Transfer Share is the ratio of the number of firms that receive a royalty from an unaffiliated
foreign person to the sum of the number of such firms and those firms that have an affiliate in a particular country and year.
These shares are averaged by quintiles of private credit. Private credit varies by year and is the ratio of private credit lent by
deposit money banks to GDP, as provided in Beck et. al. (1999). Higher number quintiles relate to higher values of private
credit.
 0.50

0.45

0.40
Median Parent Financing Share

0.35

0.30

0.25

0.20

0.15

0.10

0.05

0.00
1 2 3 4 5

Private Credit Quintile

Figure II
Parent Financing of Affiliate Assets
Note: Parent financing share is the ratio of the sum of net borrowing from the parent and parent equity provisions
to affiliate assets. The bars display medians of the country level average shares for each quintile of private credit.
Private credit is the ratio of private credit lent by deposit money banks to GDP, as provided in Beck et. al. (1999).
Higher number quintiles relate to higher values of private credit.
 2.5
Sales Level Indexed to Year of Liberalization

2.0
Low Private Credit Countries

1.5

High Private Credit Countries

1.0

0.5

0.0
-4 -3 -2 -1 0 1 2 3 4
Year Relative to Liberalization

Figure III
Liberalizations and Multinational Firm Growth
Note: The two lines correspond to averages of an index computed at the country level as the ratio of aggregate affiliate sales in
a given year to the level of sales in the year of the liberalization. Countries are split into two samples at the median level of
private credit. Private credit is the ratio of private credit lent by deposit money banks to GDP, as provided in Beck et. al.
(1999).
 Table I
Descriptive Statistics
Standard
Mean Deviation
Panel A: Benchmark Year Data for Tables II-V
Multinational Firm Variables
Arm's Length Technology Transfer Dummy 0.2552 0.4360
Share of Affiliate Assets Financed by Parent 0.4146 0.3267
Share of Affiliate Equity Owned by Parent 0.8991 0.2195
Log of Affiliate Sales 9.9024 1.7218
Log of Affiliate Employment 4.7601 1.6060
Affiliate Net PPE/Assets 0.2355 0.2264
Log of Parent R&D 9.0580 4.3927
Country Variables
Creditor Rights 2.1415 1.2100
Private Credit 0.7536 0.3891
FDI Ownership Restrictions 0.2247 0.4174
Workforce Schooling 8.1385 2.1739
Log of GDP 26.8002 1.4252
Log of GDP per Capita 9.3995 1.1019
Corporate Tax Rate 0.3488 0.1060
Patent Protections 3.2287 0.8480
Property Rights 4.3767 0.8378
Rule of Law 9.3207 1.4088
Risk of Expropriation 5.1398 1.2731
Panel B: Annual Data for Table IV
Log of Affiliate Sales 10.1285 2.1426
Log of Aggregate Affiliate Sales 15.7572 1.7018
Notes: Panel A provides descriptive statistics for data drawn from the benchmark year survey and used in the analysis presented in Tables II-V. Arm's
Length Technology Transfer Dummy is defined for country-year pairs in which a parent has an affiliate or from which a parent receives a royalty
payment from an unaffiliated foreign person. This dummy is equal to one if the parent receives a royalty payment from an unaffiliated foreign person,
and it is otherwise equal to zero. Share of Affiliate Assets Financed by Parents is the ratio of parent provided equity and net parent lending to total
affiliate assets. Share of Affiliate Equity Ownership is the equity ownership of the multinational parent. Affiliate Net PPE/Assets is the ratio of
affiliate net property plant and equipment to affiliate assets. Creditor Rights is an index of the strength of creditor rights developed in Djankov,
McLiesh, and Shleifer (2007); higher levels of the measure indicate stronger legal protections. Private Credit is the ratio of private credit lent by deposit
money banks to GDP, as provided in Beck et. al. (1999). FDI Ownership Restrictions is a dummy equal to zero if two measures of restrictions
on foreign ownership as measured by Shatz (2000) are above 3 on a scale of 1 to 5 and one otherwise. Workforce Schooling is the average schooling
years in the population over 25 years old provided in Barro and Lee (2000). Corporate Tax Rate is the median effective tax rate paid by affiliates in a
particular country and year. Patent Protections is an index of the strength of patent rights provided in Ginarte and Park (1997). Property Rights is an
index of the strength of property rights drawn from the 1996 Index of Economic Freedom . Rule of Law is an assessment of the strength and
impartiality of a country's overall legal system drawn from the International Country Risk Guide. Risk of Expropriation is an index of the risk of
outright confiscation or forced nationalization of private enterprise, and it is also drawn from the International Country Risk Guide; higher values of this
index reflect lower risks. Panel B provides descriptive statistics for annual data covering the 1982-1999 period that are used in the analysis presented in
Table IV. Log of Aggregate Affiliate Sales is the log of affiliate sales summed across affiliates in a particular country and year.
 Table II
Arm's Length Technology Transfer Versus Direct Investment

Dependent Variable: Arm's Length Technology Transfer Dummy

(1) (2) (3) (4) (5) (6)
Creditor Rights 0.0086 0.0131 0.0023
(0.0022) (0.0026) (0.0039)
Creditor Rights*Log of Parent 0.0016
R&D (0.0005)
Private Credit 0.0273 0.0295 -0.0606
(0.0129) (0.0147) (0.0133)
Private Credit*Log of Parent 0.0117
R&D (0.0020)
FDI Ownership Restrictions 0.0098 0.0063 0.0079 -0.0001 0.0017 0.0020
(0.0089) (0.0085) (0.0094) (0.0093) (0.0087) (0.0097)
Workforce Schooling 0.0069 0.0122 0.0134 0.0066 0.0097 0.0103
(0.0019) (0.0018) (0.0020) (0.0025) (0.0021) (0.0024)
Log of GDP 0.0238 0.0239 0.0268 0.0212 0.0216 0.0243
(0.0032) (0.0033) (0.0038) (0.0031) (0.0035) (0.0039)
Log of GDP per Capita -0.0148 -0.0129 -0.0144 -0.0179 -0.0182 -0.0223
(0.0039) (0.0058) (0.0066) (0.0047) (0.0067) (0.0077)
Corporate Tax Rate 0.1239 0.1583 0.1777 0.1367 0.1363 0.1588
(0.0435) (0.0413) (0.0453) (0.0434) (0.0393) (0.0438)
Patent Protections 0.0124 0.0127 0.0155 0.0158
(0.0046) (0.0052) (0.0057) (0.0066)
Property Rights -0.0227 -0.0254 -0.0095 -0.0086
(0.0061) (0.0067) (0.0057) (0.0066)
Rule of Law -0.0013 -0.0022 -0.0025 -0.0040
(0.0039) (0.0043) (0.0043) (0.0046)
Risk of Expropriation -0.0076 -0.0080 -0.0082 -0.0080
(0.0044) (0.0049) (0.0050) (0.0055)
Constant -0.3780 -0.3569 -0.5162 -0.2839 -0.2638 -0.3923
(0.0840) (0.0822) (0.0979) (0.0807) (0.0843) (0.0968)

Parent-Year Fixed Effects? Y Y Y Y Y Y

No. of Obs. 37,314 36,029 30,954 34,583 33,922 29,238
R-Squared 0.7628 0.7645 0.6061 0.7598 0.7624 0.6105
Notes: The dependent variable, the Arm's Length Technology Transfer Dummy, is defined for country-year pairs in which a parent has an affiliate or
from which a parent receives a royalty payment from an unaffiliated foreign person. This dummy is equal to one if the parent receives a royalty
payment from an unaffiliated foreign person, and it is otherwise equal to zero. Creditor Rights is an index of the strength of creditor rights developed
in Djankov, McLiesh, and Shleifer (2007); higher levels of the measure indicate stronger legal protections. Private credit is the ratio of private credit
lent by deposit money banks to GDP, as provided in Beck et. al. (1999). FDI Ownership Restrictions is a dummy equal to zero if two measures of
restrictions on foreign ownership as measured by Shatz (2000) are above 3 on a scale of 1 to 5 and one otherwise. Workforce Schooling is the average
schooling years in the population over 25 years old provided in Barro and Lee (2000). Corporate Tax Rate is the median effective tax rate paid by
affiliates in a particular country and year. Patent Protections is an index of the strength of patent rights provided in Ginarte and Park (1997). Property
Rights is an index of the strength of property rights drawn from the 1996 Index of Economic Freedom . Rule of Law is an assessment of the strength
and impartiality of a country's overall legal system drawn from the International Country Risk Guide. Risk of Expropriation is an index of the risk of
outright confiscation or forced nationalization of private enterprise, and it is also drawn from the International Country Risk Guide; higher values of
this index reflect lower risks. Each specification is an OLS specification that includes parent-year fixed effects. Heteroskedasticity consistent standard
errors that correct for clustering at the country-year level appear in parentheses.
 Table III
Parent Financing Decisions

Dependent Variable: Share of Affiliate Assets Financed by Parent

(1) (2) (3) (4) (5) (6)
Creditor Rights -0.0166 -0.0164 -0.0080
(0.0054) (0.0051) (0.0055)
Creditor Rights*Log of Parent -0.0010
R&D (0.0003)
Private Credit -0.0632 -0.0384 -0.0084
(0.0195) (0.0215) (0.0220)
Private Credit*Log of Parent -0.0031
R&D (0.0012)
FDI Ownership Restrictions -0.0406 -0.0426 -0.0426 -0.0323 -0.0358 -0.0358
(0.0146) (0.0154) (0.0155) (0.0171) (0.0160) (0.0162)
Workforce Schooling 0.0200 0.0110 0.0114 0.0199 0.0151 0.0157
(0.0057) (0.0042) (0.0043) (0.0060) (0.0048) (0.0049)
Log of GDP -0.0224 -0.0180 -0.0180 -0.0157 -0.0148 -0.0148
(0.0055) (0.0070) (0.0071) (0.0062) (0.0084) (0.0085)
Log of GDP per Capita -0.0327 -0.0066 -0.0072 -0.0285 0.0027 0.0030
(0.0112) (0.0153) (0.0154) (0.0136) (0.0167) (0.0169)
Corporate Tax Rate -0.1288 -0.2135 -0.2061 -0.1135 -0.1803 -0.1731
(0.0776) (0.0763) (0.0764) (0.0743) (0.0742) (0.0745)
Patent Protections -0.0392 -0.0388 -0.0434 -0.0436
(0.0113) (0.0114) (0.0119) (0.0120)
Property Rights 0.0112 0.0110 -0.0096 -0.0113
(0.0112) (0.0115) (0.0103) (0.0106)
Rule of Law 0.0059 0.0062 0.0065 0.0068
(0.0078) (0.0079) (0.0080) (0.0080)
Risk of Expropriation 0.0010 0.0007 0.0009 0.0003
(0.0090) (0.0091) (0.0092) (0.0094)
Constant 1.2571 0.9710 0.9728 1.0444 0.8389 0.8330
(0.1083) (0.1420) (0.1435) (0.1479) (0.1868) (0.1906)

Parent-Year Fixed Effects? Y Y Y Y Y Y

Affiliate Controls? N Y Y N Y Y
No. of Obs. 51,060 41,232 40,297 48,183 38,911 38,016
R-Squared 0.3013 0.3105 0.3071 0.3076 0.3167 0.3134
Notes: The dependent variable is the ratio of parent provided equity and net parent lending to total assets. Creditor Rights is an index of the strength of
creditor rights developed in Djankov, McLiesh, and Shleifer (2007); higher levels of the measure indicate stronger legal protections. Private credit is
the ratio of private credit lent by deposit money banks to GDP, as provided in Beck et. al. (1999). FDI Ownership Restrictions is a dummy equal to
zero if two measures of restrictions on foreign ownership as measured by Shatz (2000) are above 3 on a scale of 1 to 5 and one otherwise. Workforce
Schooling is the average schooling years in the population over 25 years old provided in Barro and Lee (2000). Corporate Tax Rate is the median
effective tax rate paid by affiliates in a particular country and year. Patent Protections is an index of the strength of patent rights provided in Ginarte
and Park (1997). Property Rights is an index of the strength of property rights drawn from the 1996 Index of Economic Freedom . Rule of Law is an
assessment of the strength and impartiality of a country's overall legal system drawn from the International Country Risk Guide. Risk of Expropriation
is an index of the risk of outright confiscation or forced nationalization of private enterprise, and it is also drawn from the International Country Risk
Guide; higher values of this index reflect lower risks. Each specification is an OLS specification that includes parent-year fixed effects. As affiliate
controls, the specifications presented in columns 2, 3, 5, and 6 include the log of affiliate sales, the log of affiliate employment, and affiliate net
PPE/assets. Affiliate Net PPE/Assets is the ratio of affiliate net property plant and equipment to affiliate assets. Heteroskedasticity consistent standard
errors that correct for clustering at the country-year level appear in parentheses.
 Table IV
Parent Ownership Decisions

Dependent Variable: Share of Affiliate Equity Owned by Parent

(1) (2) (3) (4) (5) (6)
Creditor Rights -0.0091 -0.0101 -0.0010
(0.0028) (0.0035) (0.0031)
Creditor Rights*Log of Parent -0.0010
R&D (0.0003)
Private Credit -0.0506 -0.0481 0.0078
(0.0135) (0.0174) (0.0144)
Private Credit*Log of Parent -0.0057
R&D (0.0009)
FDI Ownership Restrictions -0.0728 -0.0637 -0.0611 -0.0622 -0.0560 -0.0529
(0.0126) (0.0133) (0.0134) (0.0117) (0.0122) (0.0122)
Workforce Schooling 0.0005 -0.0049 -0.0044 0.0007 -0.0030 -0.0026
(0.0024) (0.0024) (0.0025) (0.0026) (0.0026) (0.0026)
Log of GDP -0.0157 -0.0116 -0.0116 -0.0110 -0.0079 -0.0079
(0.0037) (0.0046) (0.0045) (0.0035) (0.0046) (0.0046)
Log of GDP per Capita 0.0309 0.0358 0.0363 0.0381 0.0402 0.0416
(0.0064) (0.0132) (0.0132) (0.0078) (0.0143) (0.0144)
Corporate Tax Rate -0.2633 -0.3456 -0.3391 -0.2778 -0.3249 -0.3179
(0.0638) (0.0712) (0.0700) (0.0584) (0.0582) (0.0564)
Patent Protections -0.0142 -0.0137 -0.0127 -0.0122
(0.0073) (0.0072) (0.0078) (0.0077)
Property Rights 0.0055 0.0044 0.0000 -0.0014
(0.0072) (0.0075) (0.0071) (0.0072)
Rule of Law 0.0005 0.0012 0.0009 0.0017
(0.0061) (0.0061) (0.0061) (0.0060)
Risk of Expropriation 0.0054 0.0050 0.0069 0.0059
(0.0068) (0.0068) (0.0066) (0.0067)
Constant 1.1593 1.0774 1.0675 0.9833 0.9356 0.9159
(0.1006) (0.1147) (0.1121) (0.0947) (0.1055) (0.1018)

Parent-Year Fixed Effects? Y Y Y Y Y Y

Affiliate Controls? N Y Y N Y Y
No. of Obs. 51,320 41,436 40,498 48,422 39,096 38,198
R-Squared 0.3974 0.4250 0.4184 0.3998 0.4275 0.4217
Notes: The dependent variable is the share of affiliate equity owned by the affiliate's parent. Creditor Rights is an index of the strength of creditor
rights developed in Djankov, McLiesh, and Shleifer (2007); higher levels of the measure indicate stronger legal protections. Private credit is the ratio of
private credit lent by deposit money banks to GDP, as provided in Beck et. al. (1999). FDI Ownership Restrictions is a dummy equal to zero if two
measures of restrictions on foreign ownership as measured by Shatz (2000) are above 3 on a scale of 1 to 5 and one otherwise. Workforce Schooling is
the average schooling years in the population over 25 years old provided in Barro and Lee (2000). Corporate Tax Rate is the median effective tax rate
paid by affiliates in a particular country and year. Patent Protections is an index of the strength of patent rights provided in Ginarte and Park (1997).
Property Rights is an index of the strength of property rights drawn from the 1996 Index of Economic Freedom . Rule of Law is an assessment of the
strength and impartiality of a country's overall legal system drawn from theInternational Country Risk Guide. Risk of Expropriation is an index of
the risk of outright confiscation or forced nationalization of private enterprise, and it is also drawn from the International Country Risk Guide; higher
values of this index reflect lower risks. Each specification is an OLS specification that includes parent-year fixed effects. As affiliate controls, the
specifications presented in columns 2, 3, 5, and 6 include the log of affiliate sales, the log of affiliate employment, and affiliate net PPE/assets. Affiliate
Net PPE/Assets is the ratio of affiliate net property plant and equipment to affiliate assets. Heteroskedasticity consistent standard errors that correct for
clustering at the country-year level appear in parentheses.
 Table V

Liberalizations and Multinational Firm Scale

Log of Aggregate Affiliate

Dependent Variable: Log of Affiliate Sales
Sales
(1) (2) (3) (4)
Post Liberalization Dummy 0.0016 -0.0073 -0.0633 -0.1049
(0.0684) (0.0712) (0.1230) (0.1262)

Post Liberalization Dummy * Low 0.3011 0.3682

Creditor Rights Dummy (0.0827) (0.1552)

Post Liberalization Dummy * Low 0.2947 0.3812

Private Credit Dummy (0.0899) (0.1769)

Log of GDP 0.3886 0.3409 -0.0786 -0.1351

(0.3888) (0.3960) (0.7833) (0.7040)

Log of GDP per Capita 1.3675 1.4488 2.6620 2.8376

(0.3720) (0.3867) (0.5425) (0.6192)

Constant -13.5818 -13.0613 -4.7847 -4.9033

(9.2414) (9.2484) (22.1876) (20.0397)

Affiliate and Year Fixed Effects? Y Y N N

Country and Year Fixed Effects? N N Y Y

No. of Obs. 180,796 181,103 827 845

R-Squared 0.8035 0.8040 0.9243 0.9251
Notes: The dependent variable in the first two columns is the log of affiliate sales, and the dependent variable in the last two columns is
the log of affiliate sales aggregated across affiliates in a particular country. The data are annual data covering the 1982-1999 period.
The Post Liberalization Dummy is equal to one for the sixteen countries that liberalize their ownership restrictions in the year of and
years following liberalization of foreign ownership restrictions. The Low Creditor Rights Dummy is equal to one for observations
related to countries with below median levels of creditor rights among liberalizing countries measured in the year prior to liberalization
and zero otherwise. The Low Private Credit Dummy is equal to one for observations related to countries with below median levels of
private credit among liberalizing countries measured in the year prior to liberalization and zero otherwise. Creditor Rights is an index
of the strength of creditor rights developed in Djankov, McLiesh, and Shleifer (2007). Private credit is the ratio of private credit lent
by deposit money banks to GDP, as provided in Beck et. al. (1999). The first two specifications are OLS specifications that include
affiliate and year fixed effects, and the last two are OLS specifications that include country and year fixed effects. Heteroskedasticity
consistent standard errors that correct for clustering at the country level appear in parentheses.