Bilateral Foreign Direct Investment Flows: The Role of Institutional and Financial Distance

Abstract

This thesis empirically examines the impact of financial and institutional distance on bilateral foreign direct investment (FDI) flows between countries between 2000 and 2020. To this end, 15 upper-middle-income countries, 12 lower-middle-income countries, and 37 OECD countries are analyzed within a gravity model framework using OLS, Fixed Effects (FE), and Poisson Pseudo Maximum Likelihood (PPML) methods. This thesis comprehensively explores the effect of financial and institutional similarities on FDI by employing multidimensional financial distance indicators such as banking system depth, stock market capitalization, financial development, financial institutions, financial markets, and financial inclusion for countries at different stages of development. Empirical findings suggest that the impact of financial distance on FDI is both multidimensional and heterogeneous across country groups. For the full sample of middle-income countries, the results indicate that not all dimensions of financial distance similarly affect FDI. While banking-sector distance does not significantly affect FDI, stock market capitalization distance has a weak positive effect on FDI. However, overall financial development, financial institutions, and financial market distances consistently harm FDI. The upper-middle-income country results largely mirror the full sample. Contrarily, lower-middle-income countries have a different pattern, where financial distance often acts as an investment opportunity rather than a barrier. In these countries, banking-sector gaps play a more significant role. For OECD countries, there is strong evidence supporting the similarity hypothesis. In the OECD, almost all financial distance indicators are negatively related to FDI. In the context of institutional distance, the results present an imprecise pattern across country groups.