International Evidence on the link between Foreign Direct Investment and Institutional Quality

Abstract

Multinational corporations (MNCs) are known for their huge investments in research and development activity. They are also known for superior patents, trade secrets, brand names, management techniques and marketing strategies. The provision of incentives (i.e., tax incentives and/or subsidies) and the adoption of FDI-stimulating policies stem from the expectations that FDI brings enormous benefits such as the transfer of new technology. Numerous empirical studies have demonstrated FDI has a positive impact on economic growth of the host countries. However, it should be noted that the distribution of FDI across countries is not uniform with some countries receive more FDI than the others. This observation raises the question of whether it is possible to identify a set of policies that might enhance the attractiveness of host countries as destinations for MNCs.

In the investigation of factors that influence FDI flows, existing studies have mainly focussed on the traditional factors such as market size, trade openness, infrastructure and human capital. The role of other factors such as the quality of institution in the host country was largely ignored. Institution can be defined as the humanly devised constraints or rules of the game that structure political, economic, and social interaction. Institutions provide the incentive structure of an economy. Specifically, it affects security of property rights, prevalence of corruption, distorted or extractive policies, and thereby affects the incentive to invest in human and physical capital, and hence economic growth. The role of institutional quality in the development process has been extensively examined and economists have reached a consensus on the importance of good domestic institutions in explaining cross-country differences in both growth rates and income per capita.

Following recent literature that emphasize on the importance of institution, this paper examines whether domestic institutional quality has any important role in attracting FDI. Instead of investigating the direct effect of institution on growth, this paper focuses on the indirect effect that institution may bring via FDI inflows. Arguably, countries with better institutional quality should be able to attract more investment because it improves productivity prospect, reduces the cost of doing business and uncertainty. In order to test the hypothesis, data from 77 countries over the period of 1981-2005 is utilised. Methodologically, this paper uses a system generalised method-of-moment panel estimator to address some of the weaknesses encountered in the previous literature on FDI-institution link. Specifically, this estimator is able to formally address biases induced by the inclusion of lagged dependent variable, country-specific effects and endogeneity problem.

There are several important conclusions emerging from this analysis. First, institution appears to be important determinant of FDI inflows. This finding is a line with the view that improvements in the quality of domestic institution will reduce the cost of doing business, reduce uncertainty, and improve productivity prospect. This will eventually lead to more investments. Second, FDI is also seeking human capital and trade openness. The availability of quality workforce in the host countries is an important pre-condition for the successful operations of MNCs as they need people who are able to understand and work with new technology. Trade openness is important because most FDI is export oriented in nature such that MNC will invest in countries that pursue trade-promotion policies. In addition, MNCs investment decision also depends on the amount of existing FDI invested in the countries. This is consistent with the view that the success of MNCs in the host countries is an important signal for further investments by MNCs. Finally, FDI is not influenced by market size and infrastructure quality. This is not surprising and in fact consistent with recent literature.

Importantly, the finding on the important role played by domestic institution in attracting FDI is robust and is not driven by outlier observations, or problems caused by weak instruments and simultaneity bias.

DOI: http://dx.doi.org/10.5755/j01.ee.23.4.2569