The Effect of Macroeconomic Instability on FDI Flows: A Gravity Estimation of the Impact of Regional Integration in the Case of Euro-Mediterranean Agreements

Abstract

In order to diversify their risks, firms facing increased demand uncertainty in their domestic market may choose to increase their investment abroad by transferring production to the more stable host economies. Using a gravity model, we test the assumption that foreign direct investment is reactive to macroeconomic instability in both source and host countries in a sample of European and MENA countries for 1985-2009. Using a gravity model form model, we show that the incidence of FDI between two countries increases with source GDP instability and with host GDP stability. We also find that although this reactivity is not conditioned by trade and investment agreements, it must be qualified with respect to the type of FDI, with North-South vertical investment being significantly affected by source country uncertainty. For the same level of cost differential, the incidence of vertical FDI thus tends to be higher when uncertainty is high than when uncertainty is low.