Working Paper Series no. 579: Institutional distance and foreign direct investment

Abstract

This paper studies the link between foreign direct investment (FDI) and institutional distance. Using a heterogeneous firms framework, we develop a theoretical model to explain how institutional distance influences FDI, and it is shown that institutional distance reduces both the likelihood that a firm will invest in a foreign country and the volume of investment it will undertake. We test our model using inward and outward FDI data on OECD countries. The empirical results confirm the theory and indicate that FDI activity declines with institutional distance. In addition, we find that firms from developed economies adapt more easily to institutional distance than firms from developing economies.

Rafael Cezar and Octavio R. Escobar
December 2015

Classification JEL : F12, F23, H80, K20

Keywords : Foreign direct investment, Institutions, Heterogeneous firms, Gravity model