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Ebook How Does Country Risk Matter for Foreign Direct Investment?

Foreign direct investment (FDI) is widely viewed as beneficial for growth and job creation in the destination countries as it finances domestic investment and can be a vehicle for productivity growth through the use and dissemination of advanced production techniques and management skills. Compared with short-term credits and portfolio investments, FDI is much more stable and resilient to changes in economic environment. For these reasons, countries have tried to attract FDI. Therefore, the really important question is what countries can do to attract more of inward FDI.

Many theoretical and empirical studies have suggested various factors that influence location choices of investment by multinational enterprises (MNEs). Some are firm level characteristics while others are country-level characteristics, which in turn can be either host country characteristics or home country characteristics. For instance, Helpman, Melitz and Yeaple (2004) suggest that a firm’s relative productivity plays a major role in the MNEs’ investment decision-making process because only more productive firms can earn enough operating profits to recoup the high sunk costs of investing in a foreign country. Yeaple (2009) further extends this insight to propose theoretically that countries with a more favorable investment environment attract a larger number of MNEs.

Using cross-sectional data on outward FDI from the U.S., Yeaple (2009) empirically confirms that countries with better investment environments attract more U.S. MNEs. Hayakawa, Lee, and Park (2010) confirm this finding: using a firm-level database of outward FDI from Japan, Korea, and Taiwan, they show that host countries with better environments for FDI, in terms of larger market size and smaller fixed entry costs, attract more foreign investors. Thus, the quality of a host country’s investment environment is very important in attracting FDI. They also examine the role of home country characteristics in FDI by showing that firms from home countries with higher wages are more likely to invest abroad.

This paper focuses on host country characteristics. This is an interesting topic, as while virtually all countries now compete vigorously for FDI inflows, the distribution of those inflows is far from uniform. While some countries pull in enormous amounts of FDI inflows, other countries such as those in Sub-Saharan Africa lag far behind. Therefore, it is important for FDI-seeking policymakers to have a good grasp of the underlying drivers of the MNEs’ location decisions in order to attract inward FDI.

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