Foreign Direct Investment and Labor Market Flexibility in Host and Source Countries

Recent studies have identified the tendency of host countries with flexible labor markets or lax employment protection to attract more foreign direct investment (FDI). However, most such studies have examined the relationship between the strictness of labor regulations in individual countries and their aggregated inward FDI. This study investigates the extent to which FDI is attracted by labor market flexibility, with a focus on host countries’ institutional flexibility in employment adjustment and their relative flexibility compared to investor firms’ home countries, through an empirical analysis using a unique dataset constructed with bilateral data on FDI between a large number of both developed and developing countries and various indicators concerning labor market regulations in those countries. The result suggests the following: (i) what primarily matters is the (absolute) flexibility in the host country, that is, a country with a greater degree of flexibility in labor regulations or employment adjustment tends to draw larger FDI inflow; (ii) the impact of a host country’s relative flexibility compared to the FDI source country may be secondary, particularly in the case of the stock of FDI; and (iii) there is some evidence of the “anchorage effect†of a source country’s labor market regulations, which implies that inflexibility in employment adjustment or strict labor regulations could discourage outward FDI from the country.