PRELIMINARY AND INCOMPLETE PLEASE DO NOT CIRCULATE

This paper empirically examines how external financial needs- measured at the sector level- and financial development at the country level interact to shape the aggregate marginal product of capital of a country (MPK) and its foreign direct investment inflows (FDI). First, following Caselli and Feyrer (2007) and using new available data we construct annual aggregate MPK for 62 developing and developed countries during 1995-2009; we use industry-level data for 36 sectors during the same period to construct an annual measure of external financial dependence for each country and assess its effects on MPK conditional on the develop-ment of the financial system. Second, we study bilateral FDI during 2001-2010 in a gravity-like framework to analyze how external financial dependence determines FDI inflows in developing countries. We find two main results: 1. Financial development seems to be a necessary condition-and certainly not a sufficient one- in order for production in financially dependent sectors to positively affect aggregate MPK and FDI of a country. We argue that the mechanism through which financial dependence affects FDI is through its effect on MPK. 2. Consistent with Caselli and Feyrer (2007), MPK is remarkably similar between capital rich and capital poor countries- sometimes even lower in the latter- and this pattern doesn’t change over time. These results taken altogether contribute to some extent explaining Lucas’s Paradox of why aggregate capitals don’t flow from capital rich to capital poor countries