Why and how FDI stocks are a biased measure of MNE affiliate activity

Many international business (IB) studies have used foreign direct investment (FDI) stocks to measure the aggregate value adding activity of multinational enterprises (MNE) affiliates in host countries We argue that FDI stocks are a biased measure of that activity, because the degree to which they overestimate or underestimate affiliate activity varies systematically with host-country characteristics First, most FDI into countries that serve as tax havens generate no actual productive activity, thus FDI stocks in such countries overestimate affiliate activity Second, FDI stocks do not include locally raised external funds, funds widely used in countries with well developed financial markets or volatile exchange rates resulting in an underestimation of affiliate activity in such countries Finally, the extent to which FDI translates into affiliate activity increases with affiliate labor productivity, so in countries where labor is more productive, FDI stocks also result in an underestimation of affiliate activity We test these hypotheses by first regressing affiliate value-added and affiliate sales on FDI stocks to calculate a country specific mismatch, and then by regressing this mismatch on a host country's tax haven status, level of financial market development, exchange rate volatility, and affiliate labor productivity All hypotheses are supported, implying that FDI stocks are a biased measure of MNE affiliate activity, and hence that the results of FDI data-based studies of such activity need to be reconsidered Journal of International Business Studies (2010) 41,1444-1459 doi 10 1057/jibs 2010 29