A dynamic gravity model for global bilateral investment holdings

Purpose - This paper seeks to explain the serial persistence as well as the substantial number of zeros characterizing global bilateral investment holdings. We explore the different sources of serial persistence in the data (unobserved country pair effects, genuine state dependence, and transitory shocks) and examine the crucial factors affecting the decision to invest in a host country. Methodology - Based on a gravity setup, we consider investment behavior at the extensive (participation) margin and employ dynamic first-order Markov probit models, controlling for unobserved cross-sectional heterogeneity and serial correlation in the transitory error component, in order to explore the sources of persistence. Within this modeling framework we explore the importance of institutional quality of the host country in attracting foreign investment. Findings - The data support that the strong persistence is driven by true state dependence, implying that past investment experiences strongly impact on the trajectory of future investment holdings. Institutional quality appears to play a significant role to attract foreign investment. Research implications - The empirical findings suggest that due to the existence of genuine state dependence, inward-investment stimulating policy measures could have a more pronounced effect since they are likely to induce a permanent change to the future trajectory of inward investment. Originality - Both the substantial number of zeros and the salient persistence characterizing bilateral investment holdings decision have been previously overlooked in the literature. A study modeling jointly the levels and the selection mechanism could prove a fruitful direction for future research.