Risk, financial stability and FDI

Abstract

All Foreign Direct Investment (FDI) involves risk. Augmenting the international finance literature, we assess the effects of financial system risk on FDI trends through considering both origin and host country effects. Motivated by the sovereign debt crisis and based on a dataset including bilateral FDI holdings, this paper investigates the implications of sovereign and bank-related risk on FDI in the Eurozone. Strikingly, we find that in terms of banking risk, it is only that encountered in the country of origin that has an impact on FDI choices. However, we find that sovereign risk, in both origin and host countries, have effects. As a corollary, we suggest that although poor financial discipline by host governments has been widely blamed as the primary factor likely to frighten off overseas investors, it is amongst FDI supplying nations that the effects of sovereign yields seem most pronounced. Policymakers in countries seeking to attract FDI should not only be attentive to domestic conditions, but also be aware of the financing environment that multinational enterprises (MNEs) encounter in their home countries and how this might impact on their choices.