Interest Rates and FDI Inflows: Comparative Evidence from Western Balkan versus Central and Eastern EU Countries

Abstract

This paper investigates the relationship between interest rates and foreign direct investment (FDI) across two groups of countries, the Western Balkans (WB-6) and the Central and Eastern European Union (CE-EU-11), using annual panel data for the period 2000–2023. The analysis employs a fixed-effects model with Driscoll–Kraay standard errors to address cross-sectional dependence, heteroscedasticity, and serial correlation. The findings reveal that the effect of interest rates on FDI differs markedly between the two regions. Higher interest rates are associated with greater FDI inflows in the WB-6 economies but lower inflows in the CE-EU-11 countries. The results underscore the importance of macroeconomic and institutional conditions in attracting foreign investment, with economic growth, inflation, political risk, and government effectiveness identified as key determinants of FDI. Additionally, interest rates exhibit a stronger positive association with FDI during periods of external economic shocks, particularly during the COVID-19 pandemic. Moreover, the negative and statistically significant coefficient of the squared interest-rate term confirms a nonlinear, inverted U-shaped relationship, indicating that moderate increases in interest rates may initially encourage FDI, while further increases beyond a threshold reduce the host economy's attractiveness to foreign investors.