officials. The investor needs to have detailed knowledge of the consumer, the labor and input markets and the legal and regulatory regimes in the host country. Contractual and informational problems can be quite severe and that is why variables related to governance and legal regimes are found to be among the most important determinants of FDI flows into a country.<sup>2</sup> Thus, it is natural to expect a positive relationship between migration and FDI, yet surprisingly this is a relatively unexplored area.<sup>3</sup> The only studies examining this question are unpublished papers by Bhattacharya and Groznik (2003) and Buch et al. (2003), which find a positive relationship between migration and FDI flows, and a forthcoming study by Kugler and Rapoport (2006), whose results suggest that migration and FDI inflows are negatively correlated contemporaneously but that skilled migration is associated with an increase in future FDI.<sup>4</sup> This paper contributes to the literature by explicitly taking into account the endogeneity problem that has been ignored in the existing studies.<sup>5</sup> Endogeneity arises since migration and FDI flows may influence each other. On the one hand, as FDI inflows bring capital, new technologies and know-how to host countries, they may lead to faster economic growth (provided some conditions are fulfilled, see Alfaro et al. 2004). Entry of multinationals also tends to produce better employment opportunities and higher paying jobs (Lipsey and Sjoholm 2004). Therefore, FDI inflows may lower the incentives to migrate. On the other hand, the presence of FDI may have a positive effect on migration as local employees may be transferred by their 2 See for instance, Wei (2000) and Smarzynska and Wei (2000).

3 The importance of migrant networks for FDI flows is reflected in anecdotal evidence. For instance, Singh (2003) reports: “Many times top management of Indian origin in the U.S. was asked to start up the offices in India, usually in emerging industrialized cities such as Bangalore and Hyderabad. For example, a return migrant who had worked for Yahoo office in the U.S. for five years set up Yahoo’s development center in Bangalore. This returnee had made the personal decision of moving back to India with his family but ideally wanted to do the same work in India he was currently doing with Yahoo in the San Francisco Bay Area. His managers at Yahoo created a proposal for a new development center in Bangalore to be run by this returnee. After some negotiations the proposal was accepted by the executives of Yahoo and he soon was in charge of opening up a Yahoo development in India. This happened because Yahoo management in the U.S. valued his work and recognized his potential in creating a development center in India." The results of a recent survey of Indian software industry show that 14% of firms received investment from Indians domiciled in a developed country and in a quarter of those cases, such investment accounted for over half of new investment (Commander et al. 2004).

4 Kugler and Rapoport regress the growth in capital financed with US FDI in country k in the 1990s on the stock of migrants from country k present in the US in year 1990 and the change in this stock taking place between 1990 and 2000. They use three dependent variables: total FDI, FDI in manufacturing and FDI in services. They also distinguish between migrants with primary, secondary and tertiary education. They use information on 55 countries and find a positive relationship between total US FDI and the 1990 stock of migrants with primary and tertiary education and no significant relationship for the change in migrant stocks. When FDI in manufacturing is considered, the 1990 stock of migrants with tertiary education appears to have a positive effect, while the change in the stock of migrants with secondary education is associated with lower FDI. In the case of services, the stock of migrants with tertiary education appears to have a positive effect on FDI, and the change in this stock negatively affects FDI.

5 To assess causality Buch et al. (2003) use the Arellano-Bond approach, however, the tests of overidentifying restrictions reject the validity of this approach.

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