Effect of volatility of development aid on volatility of foreign direct investment inflows

Abstract

PurposeThis paper aims to examine the effect of development aid volatility on foreign direct investment (FDI) volatility in aid recipient countries.Design/methodology/approachThe empirical analysis has relied on a sample of 117 countries over the period 1981–2016 and used the two-step system generalized methods of moments (GMM) approach.FindingsThe findings indicate that development aid volatility exerts a positive and significant effect on FDI volatility, with the magnitude of this positive effect rising as countries’ real per capita income increases. Furthermore, development aid volatility is non-linearly related to FDI volatility, as additional rises in the degree of development aid volatility further amplify FDI volatility.Research limitations/implicationsThese outcomes highlight that volatility of development aid inflows enhances the volatility of FDI inflows. Thus, the enhancement of the aid coordination system between donor-countries and recipient-countries would not only help mitigate the volatility of aid – which reduces the macroeconomic effectiveness of aid – but also stabilizes FDI inflows to developing countries.Practical implicationsA limitation of the present paper is its reliance on aggregate FDI inflows to perform the analysis. Availability of data on greenfield FDI inflows and cross-border mergers and acquisitions FDI inflows over a long-time-period would provide an opportunity to conduct an in-depth analysis of the volatility of development aid on FDI inflows volatility. Furthermore, it could be interesting to investigate in the future (if data is available) the extent to which aid coordination systems between donor-countries and recipient-countries versus recipient-countries’ domestic factors contribute to explaining the dynamics of FDI inflows volatility in recipient-countries of these two types of capital flows.Originality/valueTo the best of the authors’ knowledge, this topic has not been addressed in the literature.