Foreign Aid as a Signal to Investors: Predicting FDI in Post-Conflict Countries

Abstract

Does development aid attract FDI in post-conflict countries? This paper contributes to the growing literature on effects of aid and on determinants of FDI by explaining how development aid in low-information environments is a signal that can attract investment. Before investing abroad, firms seek data on potential host countries. In post-conflict countries, reliable information is poor, in part because governments face unusual incentives to misrepresent information. In these conditions, firms look to signals. One is development aid, because donors tend to give more to countries they trust to properly handle the funds. Our results show that aid seems to draw FDI – however, this is conditional on whether the aid can be considered geostrategically motivated. We also show that this effect decreases as time elapses after the conflict. This suggests that aid’s signaling effect is specific to low-information environments, and helps rule out alternative causal mechanisms linking aid and FDI.

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