The effect of information frictions on FDI persistence

Abstract

We examine the extent to which firms' familiarity with the investment environment and efficiency of financial markets of the host economies reduce information frictions and in turn affect persistence of FDI. In a simple model of firm learning, we derive the optimal investment equation and estimate it using panel data on bilateral FDI flows. We find that the persistence of FDI is higher when firms invest in developing economies, in distant economies, in economies that are dissimilar to their home country, and when financial markets are less efficient. We interpret the results in the context of our model that when a firm is unfamiliar with the investment environment and financial markets play a limited role in providing information, it is unable to process information from recent signals about its productivity, and is therefore more reliant on its past performance in making future FDI decisions, which raises the persistence of its FDI. Therefore, FDI's apparent stability is not necessarily a positive signal for the host economy as it can result from information frictions.