Developing countries are facing new competitive challenges to attract sufficient external financing to sustain their growth. This paper attempts to answer the question: How can a country attract more long-term, stable foreign investment? Our study shows the increasing role of a political risk factor as a driver of foreign direct investment (FDI) inflows, and suggests that reduced financial risk after the East Asian crisis might have led to a substitution of FDI with capital market flows. Our study also shows the importance of fostering sound regulatory systems and good institutions for attracting FDI, for example, establishing a stable government that implements economic policy effectively and reduces uncertainty associated with internal disorder and a lack of democratic regime. The simulation exercise suggests that an improved investment climate would increase FDI by 7 percent and would benefit China most.

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