Cross-sectional estimation of FDI spillovers when FDI is endogenous: OLS and IV estimates for Mexican manufacturing industries

Cross-sectional estimates of Foreign Direct Investment (FDI) spillovers are biased when the variable capturing the cross-industry variation of foreign participation is endogenous to the estimated regression model. In this article I introduce an original instrument for this problematic FDI variable, capturing the general FDI intensity of manufacturing industries. I use this instrument to estimate FDI externalities in a cross-section of Mexican manufacturing industries. The main findings show that, in contrast to the common criticism that Ordinary Least Squares (OLS) estimation produces an upward bias in the estimated FDI externality effect, for the sample of Mexican manufacturing industries OLS estimation causes a downward bias. Controlling for the tendency among foreign manufacturing firms to gravitate towards low productivity industries, the instrumental variable estimations provide robust evidence of significantly larger positive FDI spillover effects.