Institutional Similarity and Foreign Direct Investment

Gravity models of foreign direct investment have been theoretically justified by supervision costs. Those costs fall when investors understand how the destination's institutions work, which is easier the more they resemble their own. We construct a measure of institutional similarity from Wikipedia's hyperlink network connecting countries. Like investment, our measure is directional. Unlike preexisting indices, it decomposes under one rule into institutional layers. Every layer predicts the probability of positive investment and the size of the position, and jointly they explain more than gravity controls and established institutional indices. We find that similarity pays most when investors have a channel to act on it. Where domestic institutions are weak, that channel may be absent. Between non‐OECD countries without a trade agreement, formal similarity is worth a third of what it is elsewhere, and an agreement closes most of the gap. Such agreements can therefore unlock investment that domestic institutions cannot yet support.