FDI distance elasticity varies by sector, aggregate models mislead
A new European Central Bank working paper reveals that aggregate models of foreign direct investment (FDI) mask significant sector-specific heterogeneities in the distance elasticity. Researchers found that while distance is negatively correlated with FDI at an aggregate level, this relationship varies considerably across sectors.
Aggregate models hide FDI nuances
This paper re-examines foreign direct investment (FDI) motives, particularly the role of distance, using the novel MREID dataset.
This dataset provides granular FDI data at the 2-digit NAICS level for 184 countries from 2010 to 2020.
The study reveals that aggregate and pooled gravity models for FDI obscure significant sector heterogeneities.
These differences manifest in two key aspects: the varying importance of horizontal versus vertical FDI motives, and the distinct distance elasticity across sectors.
While distance generally shows a negative correlation with FDI at an aggregate level, this relationship is not uniform, exhibiting substantial sector-specific variations that standard economic rationales struggle to explain.
This implies that previous aggregate analyses may have misrepresented the true drivers of global investment flows, necessitating more refined, sector-level studies for accurate interpretation.
Market vs. efficiency: FDI motives
The study delves into the traditional distinction between market-seeking (horizontal) and efficiency-seeking (vertical) FDI motives.
Market-seeking FDI suggests a positive correlation with distance, as firms establish local subsidiaries to serve distant customers, avoiding export costs.
Conversely, efficiency-seeking FDI implies a negative correlation, as firms offshore production to lower-wage countries, but face increased intra-firm trade costs with greater distance.
The paper highlights that the relative importance of these motives, and the economic concepts captured by geographic distance (e.g., trade costs, information frictions, coordination needs), differ significantly across sectors.
For instance, manufacturing offers more potential for value chain fragmentation than personal services, influencing how distance affects investment decisions.
Beyond the aggregate illusion
This paper decisively shows aggregate FDI models obscure critical sector-specific investment drivers.
Policymakers must therefore craft tailored strategies to attract foreign direct investment, recognizing that a universal approach is fundamentally flawed.
The unexplained sector heterogeneity in distance elasticity also highlights significant gaps in current international investment theory.