Policy Uncertainty and FDI Flows: The Role of Institutional Quality and Financial Development

While foreign direct investment is known to be the most stable type of capital flows, it may be particularly susceptible to heightened uncertainty due to its higher fixed costs than that of other types of capital flows. We investigate the effect of higher policy uncertainty on FDI inflows in 16 host countries using the OECD bilateral FDI panel dataset and the economic policy uncertainty index from 1985 to 2013. The bilateral structure of these data enables us to disentangle the host country factors affecting FDI inflows from the source country factors, thereby obtains a cleaner causal identification of the higher domestic policy uncertainty effect largely immune to endogeneity issues. To alleviate further endogeneity problems, we use the election timing data as an instrument. We find that domestic policy uncertainty in a host country robustly reduces the FDI inflows. As regards the channel through which policy uncertainty affects FDI inflows, the institutional quality and financial development of the host country are key to mitigating this adverse impact of policy uncertainty.