Optimal Exit Costs of Foreign Direct Investment

Abstract

This paper examines the optimal policy on exit costs of foreign direct investment for a host country considering the impact of varying income level and host country’s risk aversion against volatile FDI flows. Based on a dynamic model about the impact of the exit costs on FDI inflows and capital formation, we demonstrate that a host country should determine the exit cost considering two counterbalancing factors, that is, facilitating higher FDI inflows and reducing volatility of FDI inflows. When a host country is less vulnerable to volatility with inelastic risk aversion against FDI volatility, it is optimal for the host country with a negative income shock to take a more aggressive approach to induce FDI inflows by lowering exit costs. However, if the host country is more vulnerable to volatility with elastic risk aversion, the host country is advised to take a conservative approach by increasing exit costs to reduce FDI volatility. These findings, supported by the OECD data on 42 countries’ exits costs, implicate that developing countries are recommended to lower exit costs to induce higher FDI inflows when they are not highly vulnerable to volatility shocks.