Policy Uncertainty, Irreversibility, and Cross-Border Flows of Capital

Abstract:     
Government policy uncertainty has a dampening effect on foreign direct investment (FDI) around the world. Using the timing of national elections as a measure of exogenous fluctuations in policy uncertainty, we find that FDI flows from US companies to foreign affiliates drop significantly during election periods. The patterns in FDI flows are more pronounced in countries with higher propensities for policy reversals and when election outcomes are more uncertain. Irreversibility is an important channel through which uncertainty affects investment decisions as the electoral cycles are present in relatively irreversible FDI flows but not in foreign portfolio investment flows. Finally, FDI flows are sensitive to policy uncertainty in both high- and low-income countries, implying that the effect of policy uncertainty is not only an emerging market phenomenon.

Number of Pages in PDF File: 47

JEL Classification: G31, G38

working papers series