Financial system heterogeneity and FDI flows: evidence from OECD economies

Foreign direct investment (FDI) has grown dramatically as a major form of international capital transfer over the past decades. The unprecedented growth of cross-country FDI flows has been attributed to a rich set of economic, geographical and institutional factors. In this paper we examine the role of financial system heterogeneity as a potential detrimental factor to FDI flows across OECD economies. To do so, we use a panel dataset of the most recently updated bilateral FDI data at the country level according to OECD BMD4 definition and construct measures of financial distance using a broad set of financial indicators. The econometric approach consists of a gravity-style model, estimated according to the latest advancements in econometric techniques in order to avoid omitted variable bias. The results indicate that financial system similarityis associated with increased bilateral FDI flows, a conclusion that is robust across different estimation strategies and financial distance measures. This insightful policy implication for advanced economies is that the restructuring of the financial system and harmonization to best practices can contribute to economic recovery through the FDI channel as well. Finally, the results highlight the importance for the full implementation of the Banking Union and the Capital Markets Union in the EU.