FDI potential and shortfalls in South Mediterranean countries: the role of institutions as determinants and diversion forces

We examine FDI flows (1994-2003) from the EU to two neighbouring regions: Central and Eastern Europe (CEE) and the South Mediterranean area (MED). A GLS random effect gravity regression of the determinants of bilateral FDI flows to a large sample of 84 developed and developing partners shows that MED countries are not different from the rest of the sample, and from the CEE region in particular, once institutional and policy variables are included in the analysis, i.e. the actual capital inflows to MED economies are not much different from the flows predicted on the basis of a gravity equation enlarged to include policy and institutional factors. This suggests that the low inflows of FDI to the MED region might correspond to equilibrium conditions given institutional and policy distortions which economic agents have to face. The analysis also provides circumstantial evidence that the intensification of FDI in CEE, following integration with the EU, has had no discernible dampening effect on FDI flows directed to MED countries. The lack of displacement effects is confirmed by the common trends followed by coefficients obtained interacting yearly with regional dummies representing the two neighbouring areas considered