Author(s): Najib Khan
This paper is an empirical assessment of the impact of inflation-targeting adoption –as a monetary policy framework by central banks– on foreign direct investment (FDI) inflows.
Literature on international trade acknowledges the paramount role that FDI plays in fostering economic development and growth via integrating economies around the globe. Studies, such as OECD in 2014; UNCTAD in 2019, have shown that FDI acts as a catalyst for technological change, competition and expansion. These studies have also suggested that FDI is attracted to countries that exhibit good governance, low uncertainty and macroeconomic stability.
The literature on monetary policy on the other hand argues that inflation targeting (IT) – a monetary policy framework– mitigates uncertainty, enhances governance and brings macroeconomic stability to the adopting countries. Hence, it would seem that the IT-adoption should enable the adopting countries attract the largest FDI inflows. To verify this conjecture, this study performs a comparative analysis between the IT-adopting countries and the non-adopters in attracting FDI.
Using a panel of OECD and middle-income countries (MICs), the study employs the matching-estimation methodology, often used in assessing a treatment effect by comparing the before-and-after effects, such as a medical treatment at the micro-level, or a policy implementation at the macro-level. This comparison is two-staged: at first, the author estimates the FDI flows into OECD countries and MICs before and after the adoption of IT. At the second stage, the author then compares the difference between the FDI inflows among the IT-adopting countries and those who did not adopt IT. The empirical findings exhibit an interesting but contradicting pattern: when it comes to the OECD countries, the results show that the IT-adopters do better than the non-adopters in attracting the FDI inflows. According to these findings, the IT-adopting OECD countries have enjoyed a significant increase in the FDI inflows by about 3 ½ to 4 ½ percentage points compared to the non-IT OECD countries.
For the middle-income countries, however, the IT-adoption appears to have an adverse effect on FDI inflows: a significant reduction in the FDI inflows is witnessed among the IT-adopters compared to their counterparts: The MICs that adopted inflation targeting have suffered a significant reduction in the FDI inflows by about 2 to 3 percentage points as compared to the non-IT adopting MICs.
The author also performed numerous robustness checks to verify the empirical findings. The study’s results seem to be robust to the post-estimation sensitivity tests recommended for such empirical analysis, including the Rosenbaum sensitivity test.