Debt and foreign direct investment in a small developing economy

Debt plays an important role as a source of investment for a small developing country. However, over accumulation of debt may be one of the reasons leading a country to a financial crisis. Foreign direct investment is, therefore, a good alternative to debt because foreign investors share the risk with the country.;This study examined a small developing country and a foreign investor's decisions on determining the optimal debt and foreign direct investment levels when an effect of debt on the country's vulnerability to crisis was taken into account. This study was conducted on the assumption that (1) the probability of the country having a crisis increases with debt level; and (2) the country and the foreign investor are risk-neutral. At some (exogenous) share of foreign ownership of equity, multiple equilibria occur: a high debt-low foreign direct investment equilibrium and a low debt-high foreign direct investment equilibrium. The existence of multiple equilibria raises a question on the conventional viewpoint that a country with high debt-low foreign direct investment could increase foreign direct investment by increasing the maximum legal share of foreign equity ownership.;This study argues that even at a high share of foreign equity ownership, the country might not be able to move to the low debt-high foreign direct investment equilibrium because it is trapped at the high debt-low foreign direct investment equilibrium.;The implication was that the country needs a policy in addition to the foreign ownership policy to push the country to the low debt-high foreign direct investment equilibrium. Furthermore, the study shows that a low debt-high foreign direct investment equilibrium can exist at a low fraction of foreign ownership. This suggests that a small country need not necessarily offer a very high share of foreign ownership to reach low debt-high foreign direct investment equilibrium.