Reserves as Insurance: International Buffers and Inward FDI in Emerging Markets

Abstract

Emerging markets have accumulated large reserve buffers, but whether these buffers causally affect inward foreign direct investment (FDI) remains an open question. Using an unbalanced panel of emerging market economies over 2001–2020, we estimate twoway fixed-effects models of net inward FDI inflows with a rich set of lagged controls. We address the endogeneity of reserve accumulation by instrumenting lagged reserves with the two-year-lagged log of each country’s commodity import price index—a source of balance-of-payments pressure orthogonal to export-driven profitability shocks, conditional on a country-specific commodity export price index. The IV estimates imply that a 10% increase in reserves raises FDI inflows by about 18.5% (an elasticity of 1.85), more than four times the fixed-effects OLS estimate of 0.4. The effect is amplified during global stress episodes: the IV elasticity is 1.85 in the full sample but falls to 1.34 when crisis years (2008–2009, 2020) are excluded, consistent with reserves functioning as insurance that matters most when downside risks are salient.