Threshold effects in the capital account liberalization and foreign direct investment relationship

Abstract

This paper examines the effects of capital account liberalization (CAL) on foreign direct investment (FDI). We use the System Generalized-Method-of-Moments (GMM) estimator developed for the dynamic panel model for a sample of 14 Middle East countries from 1985 to 2009. We find new evidence that countries that are able to reap the benefits of the capital openness policy satisfy certain threshold conditions regarding the level of financial development and institutional quality. Our results are relevant for Middle East countries since many of them have engaged in a process of liberalization, have weak institutions and an inappropriate financial framework.

Keywords:

• capital account liberalization
• foreign direct investment
• institutional quality
• system-GMM estimator

JEL classification:

• C23.F21

Notes

1 Cyprus, Egypt Arab Republic, Iran Islamic Republic, Iraq, Jordan, Kuwait, Lebanon, Oman, Qatar, Saudi Arabia, Syrian Arab Republic, Turkey, United Arab Emirates and Yemen.

2 The system-GMM estimation allows us to control for the potential endogeneity not only of FDI, but also of all other explanatory variables.

3 We use the KAOPEN index updated to 2011 which covers 181 countries from 1970 through 2011.

4 Two-step robust (in xtabond2 command) requests the finite-sample correction for the two-step covariance matrix developed by Windmeijer (2005), which dramatically improved accuracy in his Monte Carlo simulations.

5 By construction, the differenced error term is probably first order serially correlated even if the original error term is not.