DP13491 Gravity, Counterparties, and Foreign Investment

Author(s):	Cristian Badarinza, Tarun Ramadorai, Chihiro Shimizu
Publication Date:	January 2019
Keyword(s):	Commercial real estate, Cross-border flows, Foreign investment, Gravity, Matching, Trust
JEL(s):	D83, F14, F30, G11
Programme Areas:	Financial Economics, International Trade and Regional Economics, International Macroeconomics and Finance
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=13491

Gravity models excel at explaining international trade and investment flows; their success poses a continuing puzzle. In a comprehensive dataset of global commercial real-estate investments, we find that the role of distance in the gravity model is well-explained by preferential matching between counterparties of the same nationality. This tendency for same-country matching is widespread, robust, and increases in poorly-governed locations. We structurally estimate an equilibrium matching model with a friction affecting different-nationality transactions. The model explains the persistent success of gravity using a combination of this friction and the spatial distribution of same-nationality counterparties, which is well-predicted by current and historical linguistic, cultural, and trade links between countries.