KYKLOS, Vol. 54 – 2001 – Fasc.

1, 89–114

The Determinants of Foreign Direct Investment:

Sensitivity Analyses of Cross-Country Regressions

Avik Chakrabarti*

I. INTRODUCTION

Over the last decade, the changing global economic and political environment
has led to a renewed interest in Foreign Direct Investment (FDI). First, there has
been a rapid and steady growth in global FDI flows since the late 1980s. Ag-
gregate net inflows of FDI (in current US dollars) increased nearly six times
from $ 53 billion in 1985 to $ 315 billion in 1996. Second, there was a sudden
appearance of a large volume of FDI into the U.S., between 1985 and 1987: ag-
gregate net inflows of FDI (in current US dollars) increased nearly three times
from $ 20 billion to $ 58 billion over the three year period 1. Finally, during most
of the 1980s, the majority of the developing economies were effectively shut
out of the international capital markets following the borrowing binge of the
1970s and the break down of normal financial relations in 1982–1983 (the so-
called ‘debt-overhang’). This financial constraint, particularly severe for the
heavily indebted countries, quickly translated into a sharp decline in investment
and growth rates in these economies. This resulted in the growing importance
of FDI as a relatively reliable source of capital flows for the LDCs.
With this backdrop it is not at all surprising that a vast empirical literature
has developed around the issue of determining the forces attracting FDI. Most
of these studies have used cross-country regressions to search for empirical
linkages between FDI and a variety of economic variables. The literature is not
only extensive but controversial as well.
The lack of a consensus over the conclusions reached by the wide range of
empirical studies as to the relative importance and the direction of impact of

* Assistant Professor, University of Wisconsin, Address: 17 425 W. River Birch Dr. #208, Brook-
field, WI 53 045. E-Mail: chakra@csd.uwm.edu.
1. Source: World Development Report (1998).

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 AVIK CHAKRABARTI

the potential determinants of FDI can be explained, to some extent, in terms

of the wide differences in perspectives, methodologies, sample-selection and
analytical tools 2. On top of the heterogeneity in approaches, these empirical
studies, like many others in different fields of economics, rather unfortunately,
form examples of ‘measurement without theory’: variables are searched for
that show a significant influence on FDI, and the results are explained ex post.
The absence of a consensus on a theoretical framework to guide empirical
work on FDI is rather conspicuous 3. This has resulted in a diverse and some-
what unwieldy literature where most investigators have considered only a
small number of explanatory variables at a time in an attempt to establish a sta-
tistically significant relationship between inbound FDI and a particular varia-
ble or a set of variables of interest. Moreover, none of these studies meaning-
fully control, consciously or otherwise, for all the variables analyzed by early
researchers as potential candidates explaining FDI. A wide range of variables
have been studied and observed to be significantly correlated with FDI in dif-
ferent directions in different studies 4. All this not only points to obvious statis-
tical and conceptual weaknesses prevalent in the empirical literature on the de-
terminants of FDI, but also leaves the motivated reader rather perplexed, at the
end, as to the confidence that should placed in the findings of any particular
study.
It, therefore, becomes imperative to examine whether one can have any con-
fidence and, if so, how much confidence in the conclusions reached by the
cross-country FDI regressions. To that end I first use a variant of Leamer’s
(1983, 1985) Extreme Bound Analysis (EBA) to determine which coefficients
of the explanatory variables studied in the existing cross-country studies 5 on
the determinants of FDI are ‘robust’ and which are ‘fragile’ to small changes
in the conditioning information set. Earlier applications of this sensitivity anal-
ysis may be found in the literature on growth (Levine and Renelt 1992), savings
(Mireaux and King 1984), industry concentration (Cooley 1982), and money
demand (Cooley and Le Roy 1981). Second, I rank the ‘fragile’ coefficients in

2. See Gastanaga, Nugent, and Pashamova (1998) and Chakrabarti (1999).

3. See Chakrabarti (1998 a, chapter 1) and Choi (1999).
4. From the substantial empirical literature on the determinants of FDI it is difficult, if not impos-
sible, to discern a conventional wisdom. Table 1 is only suggestive of how confusing the evi-
dence is. The table presents the observed effect of 8 potential determinants of FDI that have re-
ceived the most attention in the literature. See Chakrabarti (1998 a, chapter 2) for a review of the
literature.
5. In this paper I do not intend to comment on the relatively few studies that have analyzed firm-
level data on multinationals. Some of the data these studies have used are proprietary.

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 THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT

terms of their likelihood of being correlated with FDI by assigning each of

them a level of confidence, following Sala-i-Martin’s (1997) 6 work on growth.
Section II motivates and explains the methodology used in the sensitivity
analyses. Section III discusses the role of the explanatory variables used in the
EBA. This Section may also been structured as a review of the relevant litera-
ture referred to in Table 1. Section IV describes the data and estimation tech-
nique used in the sensitivity analyses. Section V presents the results. Section VI
summarizes the conclusions of the paper.

Table 1
How Confusing Is the Evidence?

POTENTIAL DETER- OBSERVED EFFECT ON FDI IN DIFFERENT STUDIES

MINANTS OF FDI
POSITIVE NEGATIVE INSIGNIFICANT
1. MARKET SIZE Bandera & White (1968)
Schmitz & Bieri (1975)
Swedenborg (1979)
Lunn (1980)
Dunning (1980)
Root & Ahmed (1979)
Kravis & Lipsey (1982)
Nigh (1985)
Schneider & Frey (1985)
Culem (1988)
Papanastassiou &
Pearce (1990)
Wheeler & Mody (1992)
Sader (1993)
Tsai (1994)
Shamsuddin (1994)
Billington (1999)
Pistoresi (2000)
2. LABOR COST Caves (1974) Goldsbrough (1979) Owen (1982)
Swedenborg (1979) Saunders (1982) Gupta (1983)
Nankani (1979) Flamm (1984) Lucas (1990)
Wheeler & Mody (1992) Schneider & Frey Rolfe and White
(1985) (1991)
Culem (1988) Sader (1993)
Shamsuddin (1994) Tsai (1994)
Pistoresi (2000)

6. Sala-i-Martin (1997) used confidence levels in his analysis of the growth literature to propose a
test for robustness of explanatory variables that is alternative to Leamer’s (1985) EBA. I find it
meaningful to use Leamer’s EBA to identify whether (qualitatively) an estimated coefficient is
robust and Sala-i-Martin’s approach to determine how much (quantitative) confidence one
should have even when an estimated coefficient is labeled ‘fragile’ by the EBA.

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 AVIK CHAKRABARTI

POTENTIAL DETER- OBSERVED EFFECT ON FDI IN DIFFERENT STUDIES

MINANTS OF FDI
POSITIVE NEGATIVE INSIGNIFICANT
3. TRADE BARRIER Schmitz & Bieri (1972) Culem (1988) Beaurdeau (1986)
Lunn (1980) Blonigen & Feenstra
(1996)
4. GROWTH RATE Bandera & White (1968) Nigh (1988)
Lunn (1980) Tsai (1994)
Schneider & Frey
(1985)
Culem (1988)
Billington (1999)
5. OPENNESS Kravis & Lipsey (1982) Schmitz & Bieri
Culem (1988) (1972)
Edwards (1990) Wheeler & Mody
Pistoresi (2000) (1992)
6. TRADE DEFICIT Culem (1988) Torissi (1985)
Tsai (1994) Schneider & Frey
Shamsuddin (1994) (1985)
Hein (1992)
Dollar (1992)
Lucas (1993)
Pistoresi (2000)
7. EXCHANGE RATE Edwards (1990) Caves (1988) Calderon-Rossell
Contractor (1990) (1985)
Froot & Stein (1991) Sader (1991)
Blonigen (1995) Blonigen (1997)
Blonigen & Feenstra Tuman and Emmert
(1996) (1999)
8. TAX Swenson (1994) Hartman (1984) Wheeler & Mody
Grubert and Mutti (1992)
(1991) Jackson & Markowski
Hines & Rice (1994) (1995)
Loree & Guisinger Yulin & Reed (1995)
(1995) Porcano & Price
Guisinger (1995) (1996)
Cassou (1997)
Kemsley (1998)
Barrel and Pain (1998)
Billington (1999)

II. METHODOLOGY

This Section motivates and explains the use of a variant of EBA and the cumu-
lative distribution function to provide evidence on the sensitivity of past find-

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 THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT

ings on the determinants of FDI to small alterations in the conditioning infor-

mation set.
Economic theories, in general, and those on the determinants of FDI, in par-
ticular, do not generate a complete specification of which variables are to be
held constant when statistical tests are performed on the relation between a de-
pendent variable and the independent variables of primary interest. Thus, many
candidate regressions may have equal theoretical status, but the estimated co-
efficients on the variables of interest in these regressions may depend impor-
tantly on the conditioning set of information. The EBA tests the robustness of
such coefficient estimates to alterations in the conditioning information set.
The logic runs as follows. Suppose a regression involves a set of variables
that are always kept in the equation (the free variables) and some others that the
researcher feels comfortable experimenting with (the doubtful variables). Nor-
mally, this experimentation is limited to a small subset of the possible models
that could have been estimated. Instead a meaningful analysis should consider
a whole range of models in each of which the free variables and any one linear
combination of the doubtful variables are included. If it turns out that infer-
ences about issues of interest are essentially the same, in the sense that the es-
timates fall within a reasonable range 7, for all choices of the linear combina-
tions of the doubtful variables, then there need be no debate. If, on the other
hand, the range turns out to be too wide 8 then it must be admitted that the in-
ferences are too fragile to be useful 9. The intuition for considering all linear
combinations of the doubtful variables is that this represents all (linear) con-
straints that can be imposed, the most familiar constraint obviously being the
exclusion of a variable by setting its coefficient to zero.
In that spirit, a large number of variables and their statistical relationships
with FDI are first studied, variables that have been the focus of attention in a
broad collection of works on the determinants of FDI. A particular statistical
relationship between FDI and a variable of interest is regarded as robust if it re-
mains statistically significant with the same sign when the conditioning infor-
mation set is subjected to changes. A common feature of most cross-section

7. The reasonable range, for instance, may be defined by a confidence interval around some bench-
mark estimate.
8. The range would be too wide if, for instance, it extends beyond the limits of a confidence inter-
val.
9. In Bayesian terms, the ‘extreme bounds’ are applicable when the prior distribution for a subset
of coefficients is located at the origin but is otherwise unspecified, and the prior distribution for
the other coefficients is ‘diffuse’. A sensitivity analysis is then performed to determine if fea-
tures of the posterior distribution depend importantly on the way the partially defined prior dis-
tribution is fully specified.

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 AVIK CHAKRABARTI

FDI regressions (at least all the studies listed in Table 1), one that somewhat
simplifies the application of EBA in the present context, is that the explanatory
variables have been entered independently and linearly. Thus the EBA uses
equations of the form:

Y = α + βX + γ I + δZ + ε

where Y stands for net FDI; X represents the set of explanatory variables (free
variables) that have been relatively less controversial, i.e., that have come out
with the same sign and significance of their coefficient estimates, individually
or in group, despite being included in major (mostly cited) cross-country re-
gressions of FDI; I is the variable of interest in each EBA; Z is a subset of var-
iables (doubtful variables) chosen from a pool of explanatory variables identi-
fied from a wide range of past studies as other potentially important candidates
that ‘need to be controlled’ for in cross-country FDI regressions 10. The EBA
then involves alterations in the subset of Z-variables that are included in the re-
gression, to find the widest range of coefficient estimates on the variables of in-
terest, I. In particular, a variable (I) that has been the focus of past empirical
studies on the determinants of FDI is chosen and a ‘base’ regression is run that
includes only the X-variables and the I-variable. Then the regression results are
computed for all possible linear combinations of up to three Z-variables. The
extreme upper bound (EUB) is defined by the group of Z-variables that pro-
duces the maximum value in terms of the estimated coefficient (γ ) of the I-var-
iable plus two standard deviations. The extreme lower bound (ELB) is defined
by the group of Z-variables that produces the minimum value in terms of ‘the
estimated coefficient (γ ), of the I-variable, minus two standard deviations’ 11.
The degree of confidence one can have in the partial correlation between the Y
and I variables can be inferred from the extreme bounds on the coefficient γ. If
γ does not remain significant (at 95% level of confidence) or if the coefficient
changes sign at the extreme bound, then one has reason to lack confidence in
the relationship between Y and I because alterations in the conditioning infor-
mation set change the statistical inferences that one draws regarding the Y-I re-
lationship. In such a case the result is regarded as ‘fragile’ in the sense that
there is not enough independent variation in the variable of interest to explain

10. Note that there can be, and are in the EBA, overllaps between the set of X-variables and the set
of I-variables, as well as between the set of Z-variables and the set of I-variables. The distinc-
tion is made only for expositional convenience.
11. Note that a point estimate of the EUB and the ELB, though may be less restrictive, is less ap-
propriate. Using point estimates of the extreme bounds does not alter any of the conclusions of
the paper. See Chakrabarti (1998 a, chapter 1).

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 THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT

cross-country differences in FDI 12. If, on the other hand, the coefficient re-
mains significant and of the same sign at the extreme bounds, then one can
maintain a fair amount of confidence in the partial correlation. In such a case
the result is regarded as ‘robust’ 13.
Once each variable of interest is classified as either ‘robust’ or ‘fragile’ I look
at the entire distribution of the coefficients of these explanatory variables in or-
der to rank them in terms of their relative likelihood of being correlated with
FDI. Suppose i1 % of the density function for the estimates of the coefficient of
an explanatory variable I1 lies to the right or left of zero and i2 % of the coeffi-
cient of an explanatory variable I2 lies to the right or left of zero then I1 is more
likely to be correlated with the dependent variable than is I2 if i1 > i2. Let F(0) =
max (CDF(0), 1 – CDF(0)) represent the larger of the two areas to the right and
left of 0 under the density function where CDF stands for the cumulative distri-
bution function for each of the point estimates (obtained from alternative com-
binations of the Z-variables) of the coefficient of an explanatory variable.
In order to compute F(0) I calculate the weighted mean and standard devia-
tion of the distribution of the point estimates of the coefficient of each variable
of interest. For each combination ( j) of Z-variables, I compute the likelihood
(Lj), the point estimate γ j, and the standard deviation σj. I then construct the es-
timated mean (γ) and standard deviation (σ) using the following definitions:

γ = ∑j ωj γj (1)

σ 2 = ∑ j ω j σ j2 (2)

where the weights (ω j) are proportional to the likelihoods:

ωj = Lj / ∑j Lj (3)

Once the mean and standard deviation of the distribution is calculated I com-
pute the F(0) using the standard normal distribution 14. Intuitively, the ratio-

12. See Leamer (1983).

13. Of course, finding a robust partial correlation (in either test described above) does not neces-
sarily imply that the variable of interest essentially causes FDI. The crucial, though nettlesome,
issue of empirically identifying causal channels has not yet been adequately addressed by the
literature on the determinants of FDI. See Chakrabarti (1998 b).
14. Even though each individual estimate follows a Student-t distribution, the estimates themselves
can be distributed differently. However, it turns out that the levels of significance found under
the assumption of non-normal distribution are virtually identical. See Chakrabarti (1998 a,
chapter 1). This may indicate that the estimates are distributed approximately normally or that,
for each variable of interest, there is only one model that takes all the weight.

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 AVIK CHAKRABARTI

nale 15 for using this weighting scheme is to assign more weight to the regres-
sions that are more likely to be the true model. To the extent that the fit of re-
gression j is an indication of its likelihood of being the true model, the weight-
ing scheme is reasonable.
There is a possibility of running into problems associated with multicolline-
arity in any EBA unless the Z-variables are carefully combined. Although mul-
ticollinearity, to be precise, reflects weak data rather than a procedural prob-
lem 16, the analysis presented in this paper does carefully restrict the choice of
Z-variables to avoid any serious multicollinearity problems. First, to the va-
riables always included in the regression (the X-variable and the I-variable),
only two Z-variables are added in any regression. This restricts the total
number of explanatory variables included in any regression to be 4 17. Second,
for every variable of interest, I, the pool of variables from which the Z-varia-
bles are chosen is restricted by excluding variables that may measure the same
phenomenon as the I-variable. For example, when the relationship between
FDI and trade balance is studied, external debt, tariff, real exchange rate and
openness are not included in the subset of Z-variables; the wage is not com-
bined with inflation; openness is not combined with tariff or trade balance; and
so on 18.

III. X, I AND Z VARIABLES

X-variable (Market Size): The X-variable (free variable) is chosen on the basis
of its general acceptance in past empirical studies and economic theory. This is
the host country’s per-capita Gross Domestic Product (GDP).
Market size has, by far, been the single most widely accepted as a significant
determinant of FDI flows. The market-size hypothesis upholds that a large mar-
ket is necessary for efficient utilization of resources and exploitation of econo-
mies of scale: as the market-size grows to some critical value, FDI will start to
increase thereafter with its further expansion (Scaperlanda and Mauer 1969).
This hypothesis has been rather popular and a variable representing the size
of the host country market has appeared as an explanatory variable in nearly all

15. Incidentally, the same rationale applies for using the same number (4) of explanatory variables
in all the regressions since regressions with more variables will generally have a better fit.
16. Note that existence of multicollinearity may mean that the data evidence is weak but it does not
invalidate the OLS estimate.
17. Although a limitation, this only makes it more difficult to implicate past findings as fragile.
18. See also Table 3 for correlations between explanatory variables.

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 THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT

empirical studies on the determinants of FDI. Bandera and White (1968), using
aggregate pooled data on US manufacturing FDI in 7 European economies over
the period 1958–1962, strongly supported the hypothesized dependency of the
level of FDI (but not the first order change in FDI) on the level of national in-
come in the host country. Schmitz and Bieri (1972) in their analyses of a single
equation model using aggregate data on US direct investment in the EEC over
the period 1952–1966 found market-size to be an important determinant of
FDI. Lunn (1980) found similar results even after controlling for changes in
growth rates.
Root and Ahmed (1979) in their econometric analysis of a single equation
model using aggregate data on 58 developing economies over the period 1966–
1970 demonstrated per capita GNP to be the most dominant variable in deter-
mining per-capita FDI. Kravis and Lipsey (1982) observed a significantly pos-
itive impact of the host country’s market size on the location decision of U. S.
multinationals in the 1960s. Nigh (1985), in an econometric analysis using
pooled aggregate data on US manufacturing investment in 24 countries over the
period 1954–1975, found per-capita GDP of the host country to be an impor-
tant factor determining FDI. Schneider and Frey (1985) analyzed a single equa-
tion politico-economic model using aggregate data on 54 less developed econ-
omies for 1976, 1979, and 1980, to conclude that real per capita GNP is the
most significant determinant of per-capita FDI.
Culem (1988), in his study of bilateral flows of direct investment among 6
industrialized countries over the period 1969–1982, found strong support for
the market-size hypothesis. Similar conclusions were drawn for the country
composition of UK manufacturing FDI by Papanastassiou and Pearce (1990),
for Swedish FDI by Swedenborg (1979), and for US FDI (both aggregate and
manufacturing) by Dunning (1980).
The results obtained by Wheeler and Mody (1992) in their econometric
analysis of a single equation model using aggregate sectoral data on US multi-
national investment in 42 countries over the period 1982–1988 demonstrate
that market-size is an important factor in determining multinational investor re-
sponse and that it plays an even more significant role in the developing econo-
mies than in the industrial economies. Sader (1993) in his cross-country regres-
sion, using data on 21 developing economies over the period 1988–1992,
observed a strong correlation between FDI and market-size. Tsai (1994) in an
econometric analysis of a non-linear simultaneous equations model using
pooled aggregate data for 62 countries over the period 1975–1978 and for 51
countries over the period 1983–1986 demonstrated that a larger market-size is
associated with a higher level of inward FDI. Shamsuddin (1994), Billington
(1999), and Pistoresi (2000) arrived at a similar conclusion.

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 AVIK CHAKRABARTI

It is evident, therefore, that the support for the market-size hypothesis is gen-
erally valid across a variety of countries, periods, and specification of variables.
While the market size variable may have statistical and conceptual prob-
lems, in keeping with this paper’s focus on assessing the statistical sensitivity
of past findings these problems are mentioned only briefly. First, while per-cap-
ita GDP has served as a proxy for market size in most empirical works on the
determinants of FDI and has, by far, been the most widely accepted as having
a significantly positive impact on FDI, some studies have used absolute GDP
as an alternative measure. It has been pointed out 19 that absolute GDP is a rel-
atively poor indicator of market potential for the products of foreign investors,
particularly in many developing economies, since it reflects size of the popula-
tion rather than income. On the one hand, for the purpose of the EBA, given
that the dataset includes countries of different size it seems appropriate to scale
the variables by population. On the other hand, the use of per-capita data may
introduce a bias in that it places the high-population countries in a less-attrac-
tive category. In line with these issues and the understanding that per-capita
GDP and absolute GDP mirror two very different aspects of market-size, in that
per-capita GDP reflects the income level while absolute GDP reflects the size
of the whole economy, for the EBA, per-capita GDP as well as absolute GDP
of the host country, in current U.S. dollars, are used as alternative proxies for
market size.
Second, some studies have used GNP or per-capita GNP as measures of mar-
ket size. However, GNP appears to be a less appropriate measure of the market
size of the multinationals’ products than GDP, for obvious reasons. On the one
hand, GNP captures earnings by nationals in foreign locations and, therefore,
over-estimates the market for the products of multinationals located in the
home country. On the other hand, GNP excludes the earnings of foreigners lo-
cated in the home country and, therefore, under-estimates the market for the
products of multinationals located in the home country.
I-variables: The I-variables (variables of interest) include the host country’s
wage (W), openness (OP), real exchange rate (REX), tariff (TAR), trade balance
(NX), growth rate of real GDP (GRGDP), and tax rate (TAX). W is the industrial
wage rate measured in U. S. dollars at current market prices. OP measures the
ratio of the sum of exports and imports to GDP. REX denotes the real exchange
rate 20. TAR is measured by average tariff on intermediate and final goods.
GRGDP is growth rate of GDP calculated on an annual percentage basis. NX

19. Root and Ahmed (1979).

20. The real exchange rate of a location is expressed as the amount of U.S. dollars exchanged for
a unit of the local currency, deflated by the respective price indices.

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 THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT

measures the value of exports less imports in U.S. dollars at current market
prices. TAX captures taxes on income, profits and capital gains as a percentage
of current revenue.
Wage: Wage has been the most controversial of all the potential determi-
nants of FDI. Theoretically, the importance of cheap labor in attracting multi-
nationals is agreed upon by the proponents of the dependency hypothesis as
well as those of the modernization hypothesis, though with very different
implications 21. There is, however, no unanimity even among the comparatively
small number of studies that have explored the role of wage in affecting FDI:
results range from higher host country wages discouraging inbound FDI to hav-
ing no significant effect or even a positive association.
Goldsbrough (1979), Saunders (1982), Flamm (1984), Schneider and Frey
(1985), Culem (1988), Shamsuddin (1994), and Pistoresi (2000) demonstrated
that higher wage discouraged FDI. Sader (1993) observed a significantly nega-
tive impact of wages on FDI in a share equation but only a weak inverse link in a
per-capita regression. Tsai (1994) obtained a strong support for the cheap-labor
hypothesis over the period 1983–1986 but only weak support over 1975–1978.
Owen (1982), while analyzing the inter-industry determinants of FDI in Ca-
nadian manufacturing industries, found wage differentials between Canada and
the US to be statistically insignificant. Gupta (1983) found that the wage of pro-
duction workers in Canada relative to their counterparts in the US was not a sig-
nificant determinant in a comprehensive model. Edwards (1990) observed an
insignificant effect of wage on FDI for a cross-section of 58 developing coun-
tries during the period 1971–1981. Caves (1974), Swedenborg (1979), and
Nankani (1979) obtained a positive association between inbound FDI and the
real wage. Wheeler and Mody (1992) obtained a significantly positive impact
of the wage on FDI in the electronics industry but only a weak positive link in
the manufacturing sector.
Openness: There is mixed evidence regarding the significance of openness
(measured mostly by the ratio of exports plus imports to GDP) in determining
FDI, as well. The maintained hypothesis is: given that most investment projects
are directed towards the tradable sector, a country’s degree of openness to in-
ternational trade should be a relevant factor in the decision. Kravis and Lipsey
(1982), Culem (1988), Edwards (1990), and Pistoresi (2000) reported a strong

21. The dependency theorists argue that MNCs create an ‘international division of labor’ in a way
that ‘high-paying white collar jobs’ are located in the source country whereas ‘low-paying blue
collar’ jobs are located in the host country. The modernization theorists do not refute the pos-
sibility of such an international division of labor – they argue that all international economic
activity create a division of labor and it is indeed from the resulting specialization that mutual
gains from trade are generated.

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positive effect of openness on FDI. Wheeler and Mody (1992) observed strong
support for the hypothesis in the manufacturing sector but a weak negative link
in the electronics sector. Schmitz and Bieri (1972) obtained a weak positive
link between openness and FDI.
Exchange Rate: The exchange rate is often cited as a critical determinant of
FDI. The currency area hypothesis runs as follows: the weaker the currency of
a country the less likely it is that foreign firms will invest in that location. The
crucial assumption of this theory is the existence of a bias in the capital market:
the bias is assumed to arise because an income stream from a country with a
weak currency is associated with an exchange rate risk and, therefore, an in-
come stream is capitalized at a higher rate by the market when it is owned by a
weak currency firm (Aliber 1970). A more elaborate theory based on capital
market imperfections with similar implications was developed by Froot and
Stein (1989). Caves (1988), Froot and Stein (1991), Blonigen (1995) and Blo-
nigen and Feenstra (1996) observed strong negative correlations between a
country’s exchange rate (foreign currency per domestic currency) and FDI. Ed-
wards (1990) reported a significantly positive effect of the exchange rate on
FDI. Sader (1991) and Tuman and Emmert (1999) observed that the exchange
rate has an insignificant effect on FDI in a share regression but a significantly
negative effect in a per-capita regression.
Trade Barriers: The effect of trade barriers on FDI has also been widely de-
bated. The tariff discrimination hypothesis holds that to avoid obstacles in
trade, resulting from the imposition of a tariff, foreign investment is undertaken
in the country to which it is difficult to export because of the tariff obstacle;
trade liberalization allows goods to move freely and, hence, is expected to re-
duce the amount of international investment (Mundell 1957). Schmitz and
Bieri (1972) and Lunn (1980) observed a significantly positive effect of trade
barriers on FDI. Culem (1988) reported a significantly negative correlation be-
tween trade barriers and FDI. Beaurdeau (1986) and Blonigen and Feenstra
(1996) found that trade barriers play an insignificant role in attracting FDI.
Trade Deficit: The trade deficit has often been referred to as being an im-
portant determinant of FDI. The hypothesis, based on Torissi (1985), is that a
trade surplus is indicative of a dynamic and healthy economy with export po-
tential and is therefore likely to encourage FDI. Torissi (1985), Schneider and
Frey (1985), Hein (1992), Dollar (1992) and Lucas (1993) reported a strong
positive correlation between trade surpluses and FDI. Culem (1988), Tsai
(1994), and Shamsuddin (1994), on the other hand, observed a significantly
positive effect of trade deficit on FDI.
Growth: The role of growth in attracting FDI has also been the subject of
controversy. The growth hypothesis maintains that a rapidly growing economy

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provides relatively better opportunities for making profits than the ones grow-
ing slowly or not growing at all (Lim 1983). Bandera and White (1968), Lunn
(1980), Schneider and Frey (1985), Culem (1988), and Billington (1999) ob-
served a significantly positive effect of growth on FDI. Tsai (1994) obtained
strong support for the hypothesis over the period 1983–1986 but only a weak
link over 1975–1978. Nigh (1988), on the other hand, reported a differential
impact of growth on FDI: a weak positive correlation for the less developed
economies and a weak negative correlation for the developed countries.
Tax: The literature remains fairly inconclusive as to whether FDI may be
sensitive to tax incentives. Hartman (1984), Grubert and Mutti (1991), Hines
and Rice (1994), Loree and Guisinger (1995), Guisinger (1995), Cassou
(1997), Kemsley (1998), and Billington (1999) observed that host country cor-
porate taxes (corporate and income) have a significant negative effect on FDI
flows. Root and Ahmed (1978), Lim (1983), Wheeler and Mody (1992), Jack-
son and Markowski (1995), Yulin and Reed (1995), and Porcano and Price
(1996) have concluded that taxes do not have a significant effect on FDI. Swen-
son (1994) reported a positive correlation between taxes and FDI.
Z-variables: The pool of variables, from which the Z-variables (doubtful
variables) are chosen, include all the I-variables and inflation (INF), budget
deficit (DEF), domestic investment (DI), external debt (ED), government con-
sumption (GC), and political stability (PS). Lower case letters represent the
per-capita measurement of the corresponding variable. DEF measures the
budget deficit in U.S. dollars at current market prices. INF is based on con-
sumer price indices (CPI). DI measures domestic investment in U.S. dollars at
current market prices. ED is measured by public and publicly guaranteed exter-
nal debt in U.S. dollars at current market prices. GC represents government
consumption in U.S. dollars at current market prices. PS is measured by the
Business Environment Risk Intelligence (BERI) political stability index.
The list of Z-variables can be extended to include variables like human cap-
ital, natural resources, infrastructure etc. 22, but even the set considered in this
paper yields substantial amount of fragility in the coefficients of the variables
of interest.

22. See Chakrabarti (1998 a, chapter 3)

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 AVIK CHAKRABARTI

IV. DATA AND ESTIMATION

Table 2 below lists all variables used in the EBA. Note that some of the explan-
atory variables are in per-capita terms (i.e., scaled by population) since the
sample includes countries of vastly different size.

Table 2
List of Variables

Variable Name Description

fdi Per-capita net FDI in U.S. dollars at current market prices
gdp Per-capita gross domestic product in U.S. dollars at current market prices
GDP Gross domestic product in U.S. dollars at current market prices
TAX Taxes on income, profits and capital gains (% of current revenue)
W Industrial wage rate measured in U.S. dollars at current market prices
OP Ratio of exports and imports to GDP
REX Real exchanges rate in terms of U.S. dollars
def Per-capita budget deficit in U.S. dollars at current market prices
INF Annual percentage change in consumer price index (CPI)
TAR Average tariff on imports
GRGDP Annual percentage change in GDP
nx Per-capita value of exports less imports in U.S. dollars at current market
prices
di Per-capita domestic investment in U.S. dollars at current market prices
gc Per-capita government consumption in U.S. dollars at current market prices
ed Per-capita external debt in U.S. dollars at current market prices
PS BERI political stability index

In the case of PS, problems may arise due to the fact that the concept embodies
a variety of concerns, ranging from production disruptions (riots, strikes etc.),
coups, civil wars, institutionally sanctioned dissolution of legislature, to a
change in macroeconomic management or the regulatory environment. This
makes the measurement of political uncertainty inherently difficult. The exist-
ing literature has so far used a variety of indices, none of which can be regarded
as being meaningfully comprehensive. The BERI political stability index used
here for the EBA ranges from 0 (prohibitive political risk) to 100 (complete sta-
bility) and takes into account internal causes of political risk (e.g., linguistic,

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 THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT

ethnic and religious fractionalization, fractionalization of the political spec-

trum etc.), external causes of political risk (e.g., dependence on and/or impor-
tance to a hostile power) as well as symptoms of political risk (e.g., societal
conflict involving demonstrations and street violence).
The data used for the EBA involves 135 countries 23 for the year 1994 24. The
sample size varies across the regressions run for the EBA depending on the
availability of data on the specific variables included in a particular regression.
The data used in this paper are extracted from the World Bank National Ac-
counts Database, the IMF Balance of Payments Database, the IMF Interna-
tional Financial Statistics, the ILO Year Book of Labor Statistics, and the UN
Statistical Yearbook. The series on Political Stability was obtained from the
Business Environment Risk Intelligence (BERI) 25. Ordinary Least Squares
(OLS) method is used to estimate the parameters of the linear regressions for
the EBA.

V. RESULTS

First an EBA is performed on the base equation which regresses the level of
per-capita FDI exclusively on per-capita GDP (gdp) and absolute GDP (GDP).
The t-statistics are provided in parentheses below the estimated parameters.

fdi = 72 313*** + 0.010 787 gdp*** (4a)

(4.746) (3.153)

(n = 135; Adj. R2 = 0.05589; F = 9.94)

fdi = 0.149*** + 0.143 GDP*** (4b)

(3.322) (4.330)

(n = 135; Adj. R2 = 0.112; F = 12.55)

23. For a list of countries included in the sample see the Appendix (Data).
24. Results from the same EBA were reported in Chakrabarti (1998 a, chapter 1) for earlier years
(1970, 1975, 1980, 1985, 1990). The conclusions were strikingly similar in that market size
(GDP) was found to be the only robust predictor of FDI.
25. The BERI multi-component system of country risk assessment was developed in the mid 1960s
and was opened to general subscription in 1971. The political stability index was constructed
by a group of more than 60 political scientists from over the world and is used by hundreds of
major corporations, banks and government agencies to assess risk in conducting international
business. See Chakrabarti (1998 a, chapter 3).

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 AVIK CHAKRABARTI

Variation in per-capita GDP explains, on an average, only about 6% while var-

iation in absolute GDP explains about 11% of the cross-section variation in fdi.
Both coefficients have the positive sign predicted by a wide class of models and
the coefficient is significant at 1% level.

Table 3
Sensitivity Results for the X-Variables (Dependent Variable: fdi)

X-Var β SE t # of countries R-sq* Z-VARIA- Robust (?)

BLES
MAX 0.02210 0.007 3.27 135 0.18134 di, gc
gdp BASE 0.01078 0.003 3.15 135 0.05589 YES
MIN 0.00115 0.0004 3.06 135 0.06546 INF, GRGDP
MAX 0.14451 0.036 4.01 135 0.46718 GRGDP, ed, gc
GDP BASE 0.14300 0.033 4.33 135 0.11258 YES
MIN 0.11490 0.083 1.38 135 0.34265 GRGDP, nx
Notes: * Refers to adjusted R-squared. The base β is the coefficient estimated from the regression
of fdi exclusively on the free variable (X-variable). The MAX refers to the estimated β from the re-
gression yielding the EUB and the MIN refers to the estimated β from the regression yielding the
ELB, identified from the set of regressions run by permuting the subset of Z-variables.

Table 3 presents the EBA test for per-capita GDP and absolute GDP using fdi
as the dependent variable. The coefficient of per-capita GDP is positive and ro-
bust. At the lower bound the coefficient of per-capita GDP is 0.00115 with a t-
statistic of 3.06; at the upper bound it is 0.0221 with a t-statistic of 3.27. The
robust positive relationship between fdi and gdp confirms that there is enough
independent variation in gdp that can significantly explain some of the cross-
country differences in fdi. However, the positive coefficient of absolute GDP is
not robust: at the lower bound the coefficient of absolute GDP is 0.1149 with a
t-statistic of 1.38.
Given the robustness of the base regression (4a), the main aim of the rest of
the paper is to evaluate the degree of confidence one should have in the partial
correlations between fdi and other potential candidates, some of which are
more controversial than the others, that have found their place in the empirical
literature on the determinants of FDI. Before reporting the results from the for-
mal EBA it is, perhaps, useful to note that Table 4, in a crude sense, anticipates
some of the paper’s findings in this direction. Most (6 out of 7) of the I-variables
(tax, wage, openness, exchange rate, tariff, and growth rate) show a low and in-

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significant correlation with the residuals calculated from the base regressions
of fdi on the X-variable. Therefore, while many of these variables may be found
to be significantly related to FDI in cross-country regressions, it is not unlikely
that at least some of these relationships depend critically on which factors are
being held constant.

Table 4
Magnitude of Cross-Country Correlations

VARIA- fdi gdp TAX W OP REX TAR GRGDP Nx RESID

BLES
fdi 1.0000
gdp 0.9671 1.0000
TAX 0.2761 0.3223 1.0000
W – 0.3815 – 0.3250 0.0529 1.0000
OP – 0.2758 – 0.3153 0.0642 0.2383 1.0000
REX – 0.0642 – 0.0682 0.0189 0.0045 – 0.1260 1.0000
TAR – 0.2890 – 0.2276 – 0.1474 0.3946 0.0706 0.3529 1.0000
GRGDP 0.0446 0.0054 0.0687 – 0.1726 0.5412 0.2480 – 0.1052 1.0000
nx – 0.9033 – 0.9410 – 0.3121 0.2049 0.2274 0.0127 0.1056 – 0.0508 1.0000
RESID 0.8816 0.7324 0.1409 – 0.4177 – 0.1530 – 0.0452 – 0.3511 0.1092 – 0.6714 1.0000
Notes: 1. The variable RESID refers to the OLS residual from regression (1).
2. A bold-faced entry indicates that the correlation is significant at 5 % level.

Table 5 summarizes the results from the EBA. The number of observations
fluctuates across I-variables due to missing data problems. For each I-variable
I have used the same sample across all regressions to ensure that fragility in any
coefficient is due exclusively to the configuration of Z-variables and not a
change in the sample size and composition 26. The results signify that, for each
of the I-variables, one can find a significant coefficient of the theoretically pre-
dicted sign only by selectively adding and combining explanatory variables as
there is not enough independent variation in any of these variables to explain
cross-country differences in FDI.

26. Allowing the sample to vary across regressions for any given I-variable would enlarge the sam-
ple but undermine the power of the conclusions since a change in the size and composition of
the sample can highlight underlying heterogeneity. For instance, when the sample comprises
lots of countries without natural resources, wage can have a significant effect on FDI but not
so when these countries are absent. Moreover, homogenizing the sample only makes it more
difficult to implicate past findings as fragile.

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 AVIK CHAKRABARTI

Table 5
Sensitivity Results for the I-Variables (Dependent Variable: fdi; X-Variable: gdp)

I-Var γ t # of R-sq1 F Z-VARIA- Robust (?)

countries BLES
TAX BASE + 0.20774 1.233 93 0.40427 28.48 NO
MAX + 0.26614 0.419 0.26638 3.72 TAX, PS
W BASE − 0.47789 ** − 2.014 66 0.17557 8.67 NO
MIN − 0.29323 − 0.452 0.20681 2.63 PS, TAR
OP BASE + 0.38512 0.264 135 0.04010 4.18 NO
REX BASE − 0.60821 − 0.439 74 0.01316 1.43 NO
TAR BASE – 0.35862 −1.619 79 0.49065 34.23 NO
MAX + 0.13062 1.442 0.41081 4.53 W, PS
GRGDP BASE + 0.36125* 1.807 61 0.07102 6.47 NO
MIN + 0.59431 0.081 0.23364 5.57 REX, nx
MAX + 0.15559*** 3.475 0.32221 9.32 W, def
nx BASE – 0.59842*** – 3.039 83 0.10543 9.54 NO
MIN – 0.23316*** – 5.716 0.57457 21.93 TAR, di
Notes: 1 Refers to adjusted R-squared. The base (is the coefficient estimated from the regression of
fdi exclusively on the free variables (I-variables). The MAX refers to the estimated γ from the re-
gression yielding the EUB and the MIN refers to the estimated γ from the regression yielding the
ELB, identified from the set of regressions run by permuting the subset of Z-variables. Also, the co-
efficients corresponding to the extreme bounds are not reported in the cases where γ is insignificant
in the base regression, since it is redundant.

For instance, most of the studies reporting a negative significant coefficient of

W, combined it with growth rate, inflation, trade deficit etc., among the other
explanatory variables. On the other hand, most of the studies reporting a posi-
tive significant coefficient of W, combined it with taxes, openness etc., among
the other explanatory variables. Most of the studies reporting a positive signif-
icant coefficient of GRGDP, combined it with inflation, trade deficit, wage etc.,
among the other explanatory variables. Most of the studies reporting a positive
significant coefficient of TAR, combined it with growth rate, openness etc.,
among the other explanatory variables. On the other hand, most of the studies
reporting a negative significant coefficient of TAR, combined it with wage,
growth rate etc., among the other explanatory variables. Most of the studies re-
porting a positive significant coefficient of REX, combined it with openness,
domestic investment, government consumption etc., among the other explana-

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 THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT

tory variables. On the other hand, most of the studies reporting a negative sig-
nificant coefficient on REX, combined it with openness, government consump-
tion etc., among the other explanatory variables.
Next I look at the entire distribution of the estimated coefficients. Table 6
ranks the explanatory variables in terms of their relative likelihood of being
correlated with FDI. Column (i) reports the weighted mean (using (1)) of the
estimated coefficients for each explanatory variable. Column (ii) reports the
weighted standard error (using (2)). Column (iii) reports the level of signifi-
cance under the assumption of normality.

Table 6
The Distribution of Estimated Coefficients of the I-Variables
(Dependent Variable: FDI; X-Variable: gdp)

Independent (i) (ii) (iii)

Variable γ σ F (0)
OP 0.873 751 0.626 171 0.9177
W – 0.36 293 0.343 309 0.8554
nx – 0.43 782 0.424 702 0.8485
GRGDP 0.623 103 0.682 694 0.8186
TAX 0.144 857 0.187 036 0.7794
TAR – 0.28 422 0.500 279 0.7157
REX – 0.3536 1.926 938 0.5714

The Table departs from the labeling of variables as ‘robust’ or ‘fragile’ and as-
signs some level of confidence to each of the variables. OP has the highest like-
lihood of being correlated with FDI among all the explanatory variables clas-
sified as ‘fragile’ by the EBA. It is followed by W, nx, GRGDP, TAX, TAR, and
REX, in descending order of their likelihood of being correlated with FDI. The
results also indicate that, on an average, the variables OP, GRGDP, TAX are
more likely to be positively correlated with FDI and the variables W, nx, TAR,
and REX are more likely to be negatively correlated with FDI. In some sense,
the distribution results validate the studies of Kravis and Lipsey (1982), Culem
(1988), and Edwards (1990). The evidence encourages policy makers, intent on
increasing FDI, to increase participation in international trade.

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 AVIK CHAKRABARTI

VI. CONCLUSION

This paper is a natural follow-up on the exploratory cross-country empirical in-

vestigations of the determinants of FDI. It systematically evaluates the robust-
ness of the partial correlation between the level of FDI and a wide assortment
of economic indicators. It marks the first attempt to assess the claims of major
cross-country regressions of FDI on its potential determinants. Although I do
not claim that the exercise leads to a ‘proof’ that past empirical literature on
determinants of FDI is not dependable, some important results follow from the
analyses. First, the EBA shows strong support for the explanatory power of
market size of a host country, as measured by per-capita GDP, in its FDI. Sec-
ond, the EBA reveals that the relations between FDI and many of the controver-
sial variables that have been reported in the empirical literature (namely, tax,
wage, openness, exchange rate, tariff, growth rate of GDP, trade balance) are
highly sensitive to small alterations in the conditioning information set. Finally,
a close look at the entire distribution of the estimated coefficients of the con-
troversial explanatory variables indicates that a country’s openness to trade is
more ‘likely’ to be correlated with its FDI than any other potential explanatory
variables studied in this paper, followed by its wage, net exports, growth rate,
tax, tariffs, and exchange rate (in order of likelihood). The evidence encourages
policy makers, intent on increasing FDI, to increase participation in interna-
tional trade. All said and done, it is important to interpret the findings of this
study with caution since some studies have imposed exclusion restrictions on
certain variables for sound theoretical reasons and therefore continue to offer
important lessons though the empirical results have not been found to be robust
in this exercise.

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 THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT

APPENDIX

Data

Country List, 135-Country Sample (Year = 1994)

Algeria Costa Rica Iceland Moldova Singapore

Angola Cote d’Ivoire India Mongolia Slovak Republic
Argentina Croatia Indonesia Morocco Slovenia
Armenia Cyprus Ireland Mozambique Solomon Islands
Aruba Czech Republic Israel Nepal South Africa
Australia Denmark Italy Netherlands Spain
Austria Dominican Republic Jamaica Netherlands Antilles Sri Lanka
Bahamas, The Ecuador Japan New Zealand Swaziland
Bangladesh Egypt, Arab Rep. Jordan Nicaragua Sweden
Barbados Equatorial Guinea Kazakhstan Niger Switzerland
Belarus Estonia Kenya Nigeria Syrian Arab Republic
Belgium Ethiopia Korea, Rep. Norway Tajikistan
Bolivia Fiji Lao PDR Oman Tanzania
Botswana Finland Latvia Pakistan Thailand
Brazil France Lebanon Panama Tonga
Bulgaria Gabon Lesotho Papua New Guinea Trinidad and Tobago
Cambodia Gambia Lithuania Paraguay Tunisia
Cameroon Georgia Macedonia, FYR Peru Turkey
Canada Germany Madagascar Philippines Ukraine
Cape Verde Ghana Malawi Poland United Kingdom
Central African Greece Malaysia Portugal United States
Republic
Chile Grenada Maldives Romania Uruguay
China Guatemala Mali Russian Federation Venezuela
Colombia Guinea Malta Rwanda Vietnam
Comoros Guyana Mauritania Samoa Yemen, Rep.
Congo, Dem. Rep. Honduras Mauritius Senegal Zambia
Congo, Rep. Hungary Mexico Sierra Leone Zimbabwe

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 AVIK CHAKRABARTI

Descriptive Statistics

Variable n Mean s. d.
FDI 135 1415128231 4880873637
GDP 135 1.48664E+11 6.60644E+11
PS 69 50.75510204 13.54703321
TAX 93 23.67691496 13.21298478
W 83 22.94274007 11.39983
OP 135 82.77454365 48.04049161
REX 74 99.56710405 21.10948405
DEF 92 – 3.061887665 4.560416836
INF 135 352.0706829 2271.095486
TAR 79 10.53848111 11.2782549
DI 135 35368409919 1.53027E+11
GC 135 25195971567 1.04234E+11
GRGDP 135 2.128340173 7.417818667
ED 135 12989058696 26813020839
NX 134 – 400302268.2 15335212296

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SUMMARY

A vast empirical literature has used ad hoc linear cross-country regressions to search for the deter-
minants of FDI. The literature is extensive and controversial. Can policy-makers use this body of re-
search to learn anything that can help them stimulate FDI? The author uses Extreme Bound Analysis
(EBA) to examine if any of the conclusions from the existing studies is robust to small changes in
the conditioning information set. The EBA upholds the robustness of the correlation between FDI
and market-size, as measured by per-capita GDP, but indicates that the relation between FDI and
many of the controversial variables (namely, tax, wage, openness, exchange rate, tariff, growth, and
trade balance) are highly sensitive to small alterations in the conditioning information set. The author
also studies the distribution of the estimated coefficients of the controversial explanatory variables
to rank them in order of their likelihood of their being correlated with FDI.

ZUSAMMENFASSUNG

Eine umfangreiche empirische Literatur hat mit Hilfe von ad-hoc-Querschnittsregressionen nach den
Determinanten der direkten Auslandsinvestition (DA) gesucht. Die Publikationen sind ebenso um-
fangreich wie widersprüchlich. Können politische Entscheidungsträger aus diesen gesammelten Re-
cherchen Lehren ziehen über die Förderung der DA? In dieser Arbeit wird mittels der Extreme Bound
Analyse (EBA) untersucht, ob Schlussfolgerungen aus den vorliegenden Studien geringen Verände-
rungen des bestimmenden Informationssatzes standhalten. Die EBA bestätigt die Robustheit der
Korrelation zwischen DA und Marktgrösse, gemessen als Bruttosozialprodukt pro Kopf, zeigt aber
auf, dass das Verhältnis zwischen DA und zahlreichen kontroversen Variablen (wie z.B. Steuern, Ein-
kommen, Öffnung, Wechselkurs, Zölle, Wachstum und Handelsbilanz) auch auf geringe Schwankun-
gen im bestimmenden Informationssatz reagiert. Darüber hinaus untersuchen wir auch die Verteilung
der geschätzten Koeffizienten der kontroversen Erklärungsvariablen, um sie nach der Wahrschein-
lichkeit ihrer Korrelation zur DA zu ordnen.

RÉSUMÉ

De nombreuses documentations ont utilisé et adapté les principes de régression linéaire à travers le
pays pour expliquer les facteurs de l’investissement direct à l’étranger (IDE). Cette documentation
est considérable et controversée. Les responsables politiques peuvent-ils utiliser ce corps de recher-
che afin de trouver quelque élément qui puisse aider à stimuler l’IDE? Dans cet article, j’utilise
l’Analyse Appliquée Extrême (AAE) pour déterminer si certaines des conclusions des études déjà
existantes résistent à de légers changements effectués sur le groupe d’informations déterminantes.
L’AAE confirme la solidité de la corrélation entre l’IDE et la taille du marché, calculée en PIB par
personne, mais indique que la relation entre l’IDE et grand nombre des variables controversées
(c’est-à-dire les taxes, les salaires, la franchise, les taux d’échanges, les tarifs douaniers, la crois-
sance et l’équilibre commercial) est extrêmement sensible aux faibles altérations dans le groupe d’in-
formations déterminantes. J’étudie également la distribution des coefficients estimés des variables
explicatives controversées afin de les classer en fonction de leur possibilité d’être en corrélation avec
l’IDE.

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