Financial market development in host and source countries and its effects on bilateral FDI

We estimate gravity-type models to assess the effects of financial market development in the host and source countries on bilateral FDI stocks. We address potential reverse causality, inter alia by performing instrumental variable estimations and restricting the sample to observations where reverse causality, if existent, should be less relevant. Our major and robust finding is that bilateral FDI increases with better developed financial markets in both the host and the source country. Furthermore, for developing host countries, we find evidence that financial market development in source and host countries function as substitutes for each other.