IMF Working Papers

This paper develops a simple real options model that demonstrates the role of country-specific risk and sunk costs in determining a multinational’s choice between exports and foreign investment. The hypotheses from the model are tested for the distribution of capital expenditures by U.S.-owned foreign affiliates in 29 developing countries during 1984–95. Political and economic risk ratings are identified as deterrents to foreign capital formation; scale economies, unit wage differentials, trade openness, and agglomeration effects are found to be stimulating. These findings provide an additional rationale for a multilateral investment agreement that could function as an agency of restraint.