It has been argued that foreign direct investment (FDI) can exert upward or downward pressure on the domestic interest rate depending onforeign investors' relative weights on internal and external finance with respect to the domestic economy. It has also been argued that a country's level of institutional uncertainty influences firms' ability to obtain external finance. We empirically test the hypothesis that institutional uncertainty matters in the association between the domestic interest rate and FDI flows.

We fit a semi parametric model to an unbalanced panel data of 137 developed and developing countries spanning 1984 to 2010. Using corruption to measure institutional uncertainty, we find that across countries a 1 percent increase in FDI inflows (outflows) is more likely to reduce the domestic interest rate by as much as 0.7 (1) percent. Our evidence corroborates the view that corruption influences the ability of foreign firms to obtain external finance within the domestic economy.

Foreign investors do not always obtain added external finance within the domestic economy as a result of lower corruption.This peculiar result lends credence to the use of second-best, rather than first-best, policies to curb the influence of corruption on the nexus between FDI and domestic interest rate.