DP13491 | Gravity, Counterparties, and Foreign Investment

Publication Date

01/26/2019

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Abstract

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.