RIETI Report September 2020

Detecting the impact of policy uncertainty on foreign direct investment

FDI is always a hot topic for governments and corporations attempting to improve their bottom line, so any insight into the inner workings of the decision-making process for investing parties are invaluable. In this VoxEU Column, Co-authors Mitsuo INADA and Naoto JINJI examine the effect of policy uncertainty on this decision-making process, providing empirical evidence from reservations in international investment agreements to provide valuable advice to policymakers.

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Detecting the impact of policy uncertainty on foreign direct investment

INADA MitsuoAssociate Professor, Faculty of Humanities, Miyazaki Municipal University

JINJI NaotoProfessor of Economics, Graduate School of Economics, Kyoto University

Policy uncertainty is believed to affect foreign direct investment significantly, but, empirical evidence on the impact is scarce. This column proposes a unique empirical strategy for identifying the impact of a change in policy uncertainty on FDI at the sector level by utilising information about reservations of certain obligations contained in international investment agreements. It provides evidence that policy uncertainty discourages FDI. Policy uncertainty will continue to rise in the post-COVID-19 era, and the results highlight the importance of aligning globalisation with the mitigation of public health threats by implementing policies to reduce uncertainty.

Policy uncertainty – the uncertainty regarding future policies implemented by governments – has suddenly become a major impediment to globalisation. It affects firms' decisions related to significant sunk costs. An example of such a decision is foreign direct investment (FDI). Firms operating their business in foreign countries face uncertainty if the implementation of laws and regulations in their host countries can be reversed or undone. Recently, the spread of COVID-19 has further increased the level of uncertainty. Many countries are taking restrictive policy measures – the duration of which cannot be predicted – to prevent the spread of the virus, including limiting international trade and FDI (Baldwin and Freeman 2020). Consequently, in the post-COVID-19 era, the crucial policy issue is how to reconcile globalisation with the elimination of public health threats, which have the potential to cause high policy uncertainty.

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