Country Risk and FDI Inflow in Mauritius: An asymmetric impact

Technical Summary: Country Risk and FDI Inflow in Mauritius: An Asymmetric Impact

Problem Statement
While Foreign Direct Investment (FDI) is widely recognized as a critical driver for economic development, particularly in developing nations like Mauritius, the determinants of FDI inflows remain a subject of empirical debate. A significant portion of existing literature focuses on country risk—comprising political, economic, and financial dimensions—as a deterrent to investment. However, empirical findings regarding the country risk-FDI nexus are mixed and often inconclusive. Some studies suggest risk significantly deters FDI, while others find no impact or varying results depending on the specific risk component analyzed. Furthermore, traditional linear models often fail to capture the dynamic and non-linear nature of investor behavior, specifically the potential asymmetry where positive and negative shocks to country risk may not have equal or opposite effects on investment flows. This study addresses the gap in the literature by investigating the asymmetric impact of country risk on FDI inflows in Mauritius, a context where such non-linear analysis has been previously overlooked.

Methodology
The study employs a dynamic time-series approach using annual data spanning from 1980 to 2019.

• Data Construction: A composite Country Risk Index (CRISK) for Mauritius was constructed using Principal Component Analysis (PCA). This index aggregates sub-components of political, financial, and economic risks derived from the International Country Risk Guide (ICRG) dataset.
• Control Variables: The model controls for Gross Enrolment Ratio (human capital), Rate of Interest, Trade Openness, and Gross Domestic Product (GDP).
• Econometric Approach: The core methodology utilizes the Non-linear Autoregressive Distributed Lag (NARDL) model proposed by Shin et al. (2014). This technique allows for the decomposition of the country risk variable into positive ($CRISK^+$) and negative ($CRISK^-$) partial sums to test for asymmetric effects in both the short run and long run.
• Diagnostic Testing: The study validates the model through unit root tests (ADF), bounds testing for cointegration, Wald tests for asymmetry, and diagnostic checks for normality, serial correlation, heteroskedasticity, and parameter stability (CUSUM and CUSUMSQ).

Key Results
The empirical analysis yields the following findings:

1. Cointegration and Asymmetry: The bounds test confirms the existence of a long-run cointegrating relationship between country risk and FDI inflows. The Wald test rejects the null hypothesis of symmetry, confirming the presence of significant asymmetric effects.
2. Asymmetric Impact:
   • Negative Shocks (Risk Reduction): A decrease in country risk (a negative shock to the risk index) has a statistically significant and substantial positive impact on FDI inflows. In the long run, a one-unit reduction in country risk leads to an approximate 39.9% increase in FDI inflows.
   • Positive Shocks (Risk Increase): Conversely, an increase in country risk (a positive shock) is found to be statistically insignificant in both the short and long run. This suggests that rising uncertainty does not proportionally deter FDI in the same magnitude that risk reduction attracts it.
3. Other Determinants: Trade openness is identified as a significant positive determinant of FDI in the long run. Other control variables, including interest rates, GDP, and human capital (enrolment ratio), were found to be insignificant in explaining FDI variations within this specific model.
4. Model Stability: Diagnostic tests and cumulative sum (CUSUM) plots confirm that the estimated coefficients are stable over the sample period, validating the robustness of the NARDL specification.

Key Contributions
The paper makes three primary contributions to the existing literature:

1. Resolution of Mixed Evidence: By applying a non-linear framework, the study offers new insights into the conflicting results found in previous linear studies regarding the country risk-FDI nexus, demonstrating that the relationship is not uniform.
2. Contextual Specificity: Unlike previous studies that relied on panel data, this research provides a focused time-series analysis specific to the Mauritian context, offering granular insights into how a small island developing state (SIDS) responds to risk fluctuations.
3. Methodological Robustness: The application of the NARDL model addresses endogeneity biases and captures the dynamic adjustment processes of FDI, providing a more realistic representation of investor behavior under uncertainty compared to conventional linear models.

Significance and Claims
The authors claim that the findings highlight a distinct behavioral pattern among foreign investors in Mauritius: a high sensitivity to risk reduction (gaining confidence) versus a muted reaction to risk increases. This asymmetry suggests that investors are more responsive to improvements in the predictability and security of the investment climate than to deteriorations, a phenomenon linked to the "sunk cost" nature of FDI and investor caution.

The study concludes that while rising country risk may not immediately trigger a proportional withdrawal of capital, a reduction in risk acts as a powerful catalyst for investment inflows. Consequently, the paper posits that policy efforts aimed at minimizing country risk—through enhanced governance, financial stability, and regulatory effectiveness—will yield disproportionately high returns in attracting FDI. The results challenge the linear assumption that risk and investment are inversely proportional in a symmetric manner, suggesting instead that the "downside" of risk is less damaging than the "upside" of stability is beneficial.