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42 March 2007

HE rising economic importance of multinationalfirms has been accompanied by significant

changes in their structure and functioning. Multina-tional firms, historically characterized as webs of au-tonomous subsidiaries spread across countries, nowrepresent globally integrated production systems serv-ing worldwide customers. These changes are manifestin the rising significance of intrafirm trade and finan-cial flows for these firms. While there is extensive anal-

ysis of aggregate patterns in intrafirm flows of goods

and capital, few firm-based studies examine the work-ings of the internal markets of multinational firms,largely because of the difficulty in accessing the neces-sary data.

A number of our recent projects investigated the in-ternal markets of U.S. multinational firms. Our re-search demonstrates that internal market operationsrepresent a critical aspect of firm responses to costlyexternal finance, capital controls, and currency fluctu-ations. Our research also shows that the changing na-ture of internal markets has influenced how firmsoperate and finance themselves around the world. An

important insight emerging from this research is thatfirms use internal markets opportunistically, particu-larly in response to distortions in local markets. ThisResearch Spotlight summarizes this body of work.

Our research is based on work conducted at the U.S.Bureau of Economic Analysis (BEA) through a specialprogram that provides access to the agencys rich storeof confidential firm-level data on multinational com-panies for analytical purposes (see the box BEA Pro-gram for Outside Researchers). The firm-level data

collected in BEAs surveys of international direct in-vestment are used by BEA to produce aggregated tabu-lar data on multinational-company operations forrelease to the general public. In its benchmark and an-nual surveys of U.S. direct investment abroad, BEAcollects the most comprehensive and reliable availabledata on the activities of U.S. multinational firms.1

Several notable features of BEAs direct investmentabroad surveys distinguish them from other datasources. First, BEAs firm-level data include balance

sheets and income statements for all of a multinationalfirms affiliates, offering considerably finer firm-leveldetail than the aggregated geographic or industry seg-ment data available through public financial records.Also, aggregation in public financial statements andthe differential reporting standards of firms in differ-ent countries can hinder comparisons across firms.Second, the BEA filings provide details on intrafirmtransactions, such as intrafirm borrowing, intrafirmdividends, and intrafirm trade. Without access to suchdetailed information, previous studies were forced toinfer aspects of intrafirm transactions (such as capital

reallocations across divisions) from observed out-comes. The variety of operating information for parentcompanies and their affiliates also allows for analysisthat controls for a variety of potentially confoundingfactors.

This rich data source creates two distinct researchopportunities. First, new insights regarding financingand operating decisions can be obtained by analyzingdecisionmaking in different institutional settings. Sec-ond, examining the internal markets of multinationalfirms promises to generate new insights into how firmsstructure their worldwide operations and how policies

can impact those decisions. The remainder of this arti-cle summarizes our research on the internal markets of

1. For a discussion of the most recent data collected, see Raymond J.Mataloni Jr. and Daniel R. Yorgason, Operations of U.S. MultinationalCompanies: Preliminary Results From the 2004 Benchmark Survey, SURVEYOF CURRENT BUSINESS 86 (November 2006): 3768. For general informationon the statistics that are available on U.S. multinational firms, see RaymondJ. Mataloni Jr., A Guide to BEA Statistics on U.S. Multinational Compa-nies, SURVEY 65 (March 1995): 3855.

Research Spotlight

The Internal Markets of Multinational Firms

By Mihir A. Desai, C. Fritz Foley, and James R. Hines Jr.

T

Mihir A. Desai is an Associate Professor at Harvard Busi-ness School, C. Fritz Foley is an Assistant Professor atHarvard Business School, and James R. Hines Jr. is a Pro-

fessor of Economics at the University of Michigan. Statis-tical work for the studies described here was performed atBEA under a special program for outside researchers. (Seethe box BEA Program for Outside Researchers.) Theopinions expressed in this article represent the views ofthe authors.


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March 2007 SURVEYOFCURRENT BUSINESS 43

multinational firms in the following areas:Ownership decisionsWeak investor protection and shallow capital mar-

ketsDividend policiesCapital controls

Currency depreciations

Ownership DecisionsOne of the most fundamental decisions firms facewhen expanding abroad is whether to organize foreignoperations as joint ventures or as wholly owned affili-ates. Multinational firms frequently have the option toown 100 percent, majority, or minority shares of for-eign entities. It is widely believed that the forces of glo-balization make the use of joint ventures particularlyattractive, but this presumption rests on aspects of theownership decisions of American multinational firms

that, until recently, were not rigorously examined.The Costs of Shared Ownership: Evidence FromInternational Joint Ventures provides a comprehen-sive review of U.S. overseas affiliate activity from 1982to 1997, offering evidence that over time Americanmultinational firms have become less inclined to orga-nize their foreign operations as joint ventures. In198297, the share of all affiliates that were whollyowned increased from 72 percent to 80 percent, andthe share of minority-owned affiliates fell from 18 per-cent to 11 percent. Whole ownership affords the parent

company the ability to control the operation and des-tiny of a foreign affiliate. The growing use of wholeownership suggests an increased appetite for controlby multinational parents, one that appears to be re-lated to rising costs of employing the joint venture or-ganizational form.

We identify three sources of rising costs to joint ven-tures by analyzing the factors that influence ownershipshares. First, joint ventures limit a firms ability tostructure its worldwide operations in a tax-efficientmanner. This is the inevitable byproduct of divided in-terests, as joint venture partners are concerned with lo-cal profits while multinational parents are concernedwith the profits of their global operations. Second, theattractiveness of transferring intellectual property tooverseas operations is reduced by the prospect of po-tential appropriation of that technology by jointventure partners. Third, the desire to decentralize

worldwide production through greater intrafirm tradecreates the potential for conflict with local partnersover sourcing decisions and transfer pricing. Becausemultinational firms increasingly rely on worldwide taxplanning, global technology transfer, and productiondecentralization, they face growing incentives to avoidsharing ownership with local partners.

Wholly owned foreign affiliates of U.S. companieshave considerably greater financial and commercialties to their U.S. parent companies than do partiallyowned foreign affiliates. However, this cross-sectionalevidence that whole ownership is associated with closecoordination of parent and affiliate activity does notprove that ownership decisions are functions of coor-dination costs. Another possibility is that both owner-ship and operational decisions are responses to otherunmeasured factors. In distinguishing these two inter-pretations of the same evidence, we identify exogenouschanges in ownership levels and trace their effects onintrafirm transactions. By principles of symmetry (im-plied by the theory of the firm), any effects of owner-ship on intrafirm transactions should be mirrored byequal effects of intrafirm transactions on ownershipdecisions. Our analysis examines two changes in gov-ernment policy that affected the relative costs of shar-

ing ownershipthe liberalization of foreignownership restrictions and tax penalties on joint ven-tures featured in the U.S. Tax Reform Act of 1986. Ourresults indicate that affiliates operating in liberalizingcountries and firms whose joint ventures would besubject to tax penalties after 1986 both engaged ingreater intrafirm transactions after the reforms.

These reactions imply that the increased desire tocoordinate parent and affiliate trade, technology trans-fers, and tax planning that has been evident over the

BEA Program for Outside Researchers

Recognizing that some research requires data at amore detailed level than that provided in its publiclydisseminated tabulations, the Bureau of EconomicAnalysis maintains a program that permits outsideresearchers to work on site as unpaid special swornemployees of BEA for the purpose of conducting ana-lytical and statistical studies using the microdata thatit collects under the International Investment andTrade in Services Survey Act.

This work is conducted under strict guidelines andprocedures that protect the confidentiality of com-pany-specific data, as required by law. Because theprogram exists for the express purpose of advancingscientific knowledge and because of legal require-ments that limit the use of the data to analytical andstatistical purposes, appointment to special-sworn-employee status under this program is limited toresearchers. Appointments are not extended to per-sons affiliated with organizations that collect taxes,enforce regulations, or make policy.


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44 Research Spotlight March 2007

Percent

External borrowing to assets ratioBorrowing from parents to assets ratio

Chart 1. Relationship Between Creditor Rightsand Types of Affiliate Borrowing, 1994Chart 1. Relationship Between Creditor Rightsand Types of Affiliate Borrowing, 1994

50

40

30

20

10

0Creditor rights index

equal to zero

Creditor rights indexequal to four

60

NOTE. This chart presents the median debt ratios for affil iates in countries with a creditor rights indexof zero or four. The ratio of borrowing from U.S. parents to assets is the ratio of net current liabilitiesand long-term debt borrowed from U.S. parents to total assets, as measured in the 1994 benchmarksurvey. External borrowing to assets is the ratio of current liabilities and long-term debt borrowedfrom nonparent sources to total assets, as measured in the 1994 benchmark survey. The creditorrights index is from Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and RobertVishny, Law and Finance, Journal of Political Economy106 (1998): 1,1131,155.

last 20 years contributed to the rising appetite for con-trol over worldwide operations. Our estimates implythat between one-fifth and three-fifths of the decline inthe use of partial ownership by multinational firmsover the sample period is attributable to the increasedimportance of intrafirm transactions. These findings

indicate that the forces of globalization have dimin-ished rather than accelerated the use of shared owner-ship.

Weak Investor Protection andShallow Capital Markets

Capital market conditions differ markedly around theworld. Some countries offer legal protections and sup-portive regulation that produce liquid capital marketsof the type found in the United States, whereas othershave legal structures or regulatory policies that pro-duce extremely shallow capital markets. These differ-

ences influence the capital structure choices that firmsmake. Empirical attempts to study these issues face sig-nificant challenges. Recent efforts using cross-countrysamples of local firms exploit the rich variation that in-ternational comparisons offer, but these efforts havefaced problems associated with nonstandardized mea-surement across countries and limited statistical powerbecause of small sample sizes. An alternative approachis to analyze the financing choices of local affiliates ofmultinational firms. This approach affords the pros-pect of comparing the financing decisions of affiliatesof the same multinational firm operating in differentinstitutional settings. Furthermore, an analysis of mul-tinational firm responses to capital market conditionsilluminates the workings of internal capital markets, asmultinational firms may be able to substitute internalcapital reallocations for external financing when it ismost costly.

In A Multinational Perspective on Capital Struc-ture Choice and Internal Capital Markets, we studyBEAs firm-level data and find that both the level andthe composition of leverage of multinational affiliatesare strongly influenced by capital market conditions.Analysis of these data illuminates the mechanisms bywhich weak capital markets affect external and internal

financing choices. Our findings indicate that interestrates paid by U.S.-owned affiliates are significantlyhigher in countries with underdeveloped credit mar-kets and weak creditor rights. This interest-rate differ-ence very likely reflects the default premium thatlenders demand in countries where legal institutionsmake it difficult or costly to use bankruptcy proce-dures to recover unpaid loans and the price premiumpaid for capital in countries with thin capital markets.In addition, the difference between the costs of bor-

rowing from external lenders and parent companies islarger for affiliates in these weaker institutional envi-ronments. In response to these differences, multina-tional firms borrow less from external sources andmore from internal sources in settings with weak creditmarkets. These differences are manifest in a simple

comparison of the internal and external borrowing de-cisions of affiliates in countries where creditor rightsare very weak and very strong (chart 1). Regressionanalysis indicates that greater internal borrowing off-sets approximately three-quarters of the reduction inexternal borrowing arising from adverse local creditmarket conditions.

The tests in our paper control for other determi-nants of financing choices, including political risk, in-flation, and tax rates. Greater political risk is associatedwith higher affiliate leverage. Higher inflation is associ-ated with more external borrowing and less internal

borrowing. Finally, higher corporate tax rates are asso-ciated with higher leverage. The analysis also revealsthat borrowing from parent companies responds moresharply to tax rate differences than borrowing from ex-ternal sources, suggesting that firms are better able toexploit internal capital markets than external capitalmarkets when structuring optimal financing in re-sponse to tax differences.

In general, we found that firms use internal capitalmarkets opportunistically when external finance iscostly and when there are tax planning opportunities.


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are particularly attractive to firms that would face highcosts of raising funds externally. The analysis also re-veals that financially constrained parents in industrieswith attractive investment opportunities are particu-larly likely to receive dividends from foreign affiliates.Hence, it seems that dividend payments from foreign

affiliates are often used to satisfy parent company cashneeds.

Finally, dividend payments from foreign affiliatesappear to play a role in monitoring the activities of for-eign managers. Regular dividend payments can restrictthe financial discretion of foreign managers, mitigatingwhatever agency problems may exist within firms.Conflicts of interest between managers of foreign affil-iates and managers of parent companies are likely to bemost pronounced when the parent company ownsonly a fractional share of the affiliate, as other ownersmay be tempted to transact with the affiliate at non-

market prices. Consequently, parent companies haveincentives to require steady flows of dividend pay-ments in order to limit the scope of potential malfea-sance by foreign affiliates. Indeed, the evidenceindicates that regularized dividend payments are mostcommon when affiliates are partially owned, evenwhen such payments are explicitly tax penalized. Thisfinding suggests that at least some of the regularizationof dividend repatriations is a consequence of controlconsiderations inside the firm.

The foreign affiliates of U.S. multinational corpora-tions follow well-defined repatriation policies featur-ing gradual adjustment of payouts to target ratios thatdepend on current earnings and the tax costs of repa-triating dividends. In addition to taxation, costly exter-nal finance and agency problemsmotivations thatare typically emphasized with respect to arms-lengthfinancing decisionsalso appear to influence the in-ternal capital markets of multinational firms.

Capital ControlsCountries concerned about the economic instabilitythat may be associated with exposure to world capitalmarkets are often tempted to impose controls onshort-term international capital movements. These

controls can take many forms, and their effect on eco-nomic growth and firm performance is hotly debated.Countries imposing capital controls are typically alsoeager to attract foreign direct investment, but the po-tential inconsistency of attempting to control capitalmovements while also attracting inbound foreign di-rect investment has hitherto received limited attention.

Capital Controls, Liberalizations, and Foreign Di-rect Investment analyzes the effects of capital controls

on the operations of the foreign affiliates of U.S. multi-national firms. Evidence indicates that foreign affiliateslocated in countries imposing capital controls faceborrowing rates that average 5.25 percentage pointsmore than those faced by other affiliates of the samemultinational parent companies.

Multinational firms operating in countries withcapital controls have incentives to use their internalproduct and capital markets to mitigate the effects ofcapital controls by limiting local profits that are subjectto such controls. Similar incentives are created by hightax rates, and it is possible to compare the effects ofcapital controls with the effects of high income taxrates. Our results indicate that multinational firms dis-tort their reported profitability and their dividend re-patriations in order to mitigate the impact of capitalcontrols. Affiliates in countries imposing capital con-trols have 5.2-percent lower reported profit rates than

comparable affiliates in countries without capital con-trols, reflecting in part trade and financing practicesthat reallocate income within a firm. The distortions toreported profitability are comparable with those thatstem from a 27-percent difference in corporate taxrates. Dividend repatriations are also regularized to fa-cilitate the extraction of profits from countries impos-ing capital controls.

Evidence of the impact of removing capital controlsis consistent with the comparisons of foreign affiliateslocated in countries with and without capital controls.U.S.-owned foreign affiliates in countries with capitalcontrols experience 6.9-percent faster annual growthof property, plant, and equipment investment after theliberalization of controls, indicating that capital con-trols impose significant burdens on foreign investors.There is, however, no discernible effect of the imposi-tion or removal of capital controls on the volatility ofaffiliate profitability or the volatility of affiliate growthrates. Hence, it appears that capital controls are re-sponsible for slow growth of U.S.-owned affiliates, andlocal reported profit rates significantly below those re-ported elsewhere.

Currency Depreciations

Settings where investment opportunities and financialconstraints move in identifiable ways provide valuableopportunities to study the impact of financial con-straints on firm growth. Because firms typically incursome costs in local currency terms, currency deprecia-tions are hypothesized to provide improved invest-ment opportunities. Firms differ, however, in theiraccess to financial resources at the time of the depreci-ation. A comparison of the investment responses to


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March 2007 SURVEYOFCURRENT BUSINESS 47

Percent

AffiliatesLocal firms

Chart 3. Asset Growth of Local Firms andAffiliates of Multinationals After Currency CrisesChart 3. Asset Growth of Local Firms andAffiliates of Multinationals After Currency Crises

25

20

15

10

5

02 years before

depreciation

Year of and 2 yearsafter depreciation

NOTE.The two bars represent the average of the annual median asset growth rates for local firms andmultinational affiliates. The first pair of bars are averages for the 2 years prior to a currency cr isis. Thesecond pair of bars are averages for the year of, the year after, and 2 years following a cr isis.

currency depreciations by firms with differential accessto financial resources can illustrate the degree to whichfinancial constraints can limit growth. This compari-son, given its setting, can also help explain why hy-pothesized benefits of depreciations are often notmanifest.

In the paper Financial Constraints and Growth:Multinational and Local Firm Responses to CurrencyDepreciations, the effects of sharp currency deprecia-tions on the behavior of U.S.-owned affiliates and localfirms in the tradable sectors of emerging markets arecompared.5 The differential response of local firms andmultinational affiliates is manifest in the simple com-parison provided in chart 3. In this chart, the bars rep-resent annual growth rates in assets in the year prior toa sharp depreciation and subsequent years for localfirms and multinational affiliates. This basic differencebetween local firms and multinational affiliates is ro-

bust. Regression analysis demonstrates that U.S.-owned affiliates increase sales 5.4 percent, and assets7.5 percent, more than local firms after currency de-preciations. The improved relative performance ofU.S.-owned affiliates is even more striking in invest-ment. Capital expenditures are 34.5 percent higher forU.S.-owned firms than for local firms in the aftermathof large currency depreciations. Our analysis investi-gates the sources of this distinctive performance, with

5. Unlike the other papers described in this spotlight, this paper was writ-ten by Mihir A. Desai, C. Fritz Foley, and Kristin J. Forbes. The other paperswere written by Mihir A. Desai, C. Fritz Foley, and James R. Hines Jr. See

the references.

particular emphasis on the possible role of differentialoperating exposures and financing capabilities.

Differential changes in investment opportunitiescould give rise to distinctive investment opportunitiesfor local firms and multinational affiliates. For exam-ple, multinational affiliates may export more of their

output to countries with undepreciated currencies. Inorder to consider this possibility, we compared multi-national and local firms with similar product and in-put market exposures. We also computed measures ofthe operating exposures of firms in order to investigatewhether differences in operating exposures explain dif-ferences in the behavior of U.S.-owned affiliates andlocal firms.

Our tests offered little evidence that the relativegrowth of multinational affiliates after sharp currencydepreciations can be traced to differential investmentopportunities. Multinational affiliates that are more

reliant on exports prior to depreciations increase in-vestment by larger amounts, but affiliates that exclu-sively serve the local market increase investment byconsiderably more than local firms. Large differencesin the investment responses of affiliates and local firmspersist after including measures of operating exposureas controls.

Given the evidence on the opportunistic use of in-ternal capital markets by multinational firms discussedabove, it is possible that a superior ability to overcomefinancing constraints is the reason for the better post-depreciation performance of U.S.-owned affiliates.Tests reveal that financing constraints play a decisiverole in explaining the differential investment responseof multinational affiliates and local firms. Followingcurrency depreciations, the leverage of local firms in-creases more than the leverage of multinational affili-ates, in part reflecting the tendency of local firms toborrow in foreign currency terms. Local firms with themost leverage and with the shortest term debt reduceinvestment the most. The examination of the internalcapital markets of multinationals shows that multina-tional parents provide additional financing in responseto sharp currency depreciations. These results indicatethat multinational firms overcome the negative conse-

quences of large depreciations by avoiding the financialconstraints that handicap local firms.

In addition to offering a test of how financial con-straints influence investment, this evidence illustratesan effect of foreign direct investment not previouslyemphasized. The internal capital markets of multina-tional firms allow their affiliates to expand output aftersevere currency depreciations, precisely when econo-mies are fragile and prone to severe economic contrac-


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tions. As a consequence, multinational affiliates maybe able to mitigate some of the aggregate effects of cur-rency crises. This analysis does not consider the long-run distributional consequences of the differential im-pact of currency crises on multinational affiliates. In-creased multinational activity during crises may help

support local firms through spillover effects, such asincreased demand for local inputs or improved accessto technology or trade credit. However, multinationalscould also use crises to expand at the expense of localfirms with potentially persistent effects. While the in-ternal capital markets of multinational firms appear tomitigate the contractionary output effects of severecurrency depreciations, the longer term effects on localfirms remain an open question.

ConclusionThe data collected by BEA in its surveys of interna-

tional direct investment provide a unique window onthe internal markets of U.S. multinational firms.

Our analyses of BEAs firm-level data reveal that theincreased importance of internal capital markets hasreduced the use of joint ventures; that multinationalfirms respond opportunistically to cross-country dif-

ferences in capital markets, capital controls, and taxes;that the set of factors that influence dividend payoutsby U.S.-owned foreign affiliates are similar to thosethat influence dividends paid to external shareholders;and that multinationals access their internal capitalmarkets to overcome financial constraints associatedwith currency depreciations.

As more firms expand their global activities, BEAswork in collecting these data will become even morecritical to policymakers, business leaders, and othersseeking to make informed policy decisions and busi-ness choices.

References

Mihir A. Desai, C. Fritz Foley and Kristen J. Forbes.Financial Constraints and Growth: Multinational andLocal Firm Responses to Currency DepreciationsReview of Financial Studies(forthcoming).

Mihir A. Desai, C. Fritz Foley and James R. Hines Jr.Capital Controls, Liberalizations, and Foreign DirectInvestment, Review of Financial Studies 19, no. 4(Winter 2006): 1,4331,464.

. The Costs of Shared Ownership: EvidenceFrom International Joint Ventures, Journal of Finan-cial Economics73, no. 2 (August 2004): 323374.

. Dividend Policy Inside the MultinationalFirm, Financial Management(forthcoming).

. A Multinational Perspective on CapitalStructure Choice and Internal Capital Markets, Jour-nal of Finance59, no. 6 (December 2004): 2,4512,488.

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