Bilateral Lucas Paradox

Using the bilateral international investment data across countries for 2009-2018, we find that the returns on international investments are lower for rich countries than for poor countries, seemingly consistent with the Lucas Paradox. However, when we look at the excess returns on international investments relative to domestic investments, rich countries are investing more wisely than poor countries. A puzzle arises: Why do poor countries invest mostly in rich countries where relative returns are negative? We investigate the effects of institutional qualities of investor countries, in addition to recipient countries’ characteristics, which the literature has been focusing on. We find that investor countries’ institutional qualities do matter for participating in a wider set of investment destinations, but that they do not affect return sensitivity in allocating funds across participating markets.