Do Institutions Matter for Foreign Direct Investment?

Abstract

In this paper the role of institutions in determining foreign direct investment (FDI) is investigated using a large panel of 107 countries during 1981 and 2005. We find that institutions are a robust predictor of FDI and that the most significant institutional aspects are linked to propriety rights, the rule of law and expropriation risk. Using a novel data set, we also study the impact of institutions on FDI at the sectoral level. We find that institutions do not have a significant impact on FDI in the primary sector but that institutional quality matters for FDI in manufacturing and particularly in services. We also provide policy implications for institutional reform.

Institutions, Foreign Direct Investment, and Domestic Investment: Crowding Out or Crowding In?

“…Several scholars find evidence of a positive relation between foreign direct investment (FDI) on the one hand and institutions on the other hand, e.g. legal protection, rule of law, investment treaties, and trade agreements, political stability, government efficiency, control of corruption, and financial supervision (see Buchanan et al (2012); Morrissey and Udomkerdmongkol (2012); Ali et al (2010); Javorcik and Wei (2009);Daude and Fratzscher (2008); Daude and Stein (2007); Busse and Hefeker (2007); Benassy-Quere et al (2007)). …”

Expropriation risk and FDI in developing countries: Does return of capital dominate return on capital?

“…target country's multiple legal and political institutions matter most to foreign investors. Some authors find that contract enforcement (or property rights relating to expropriation risk) is an important channel through which institutional quality influences foreign capital flows (e.g., Gastanaga et al, 1998;Ali et al, 2010;Asiedu et al, 2009;Asiedu and Lien, 2011;Daude and Stein, 2007;Harms and Ursprung, 2002;Li and Resnick, 2003).…”

“…National income normalization is adopted in much of the empirical FDI literature, where the dependent variable is either net or gross FDI expressed as a share of gross domestic product (GDP) or gross national income (GNI) (e.g., Ali et al, 2010;Addison and Heshmati, 2003;Asiedu, 2002Asiedu, , 2006Asiedu et al, 2009;Asiedu and Lien, 2011;Adam and Filippaios, 2007;Gastanaga et al, 1998;Méon and Sekkat, 2004;Naudé and Krugell, 2007;Noorbakhsh et al, 2001;Sánchez-Martin et al, 2014). Other empirical FDI studies, however, normalize by country-year-specific population and use FDI (net or gross) per capita as the dependent variable (e.g., Chakrabarti, 2001;Harms and Ursprung, 2002;Kinoshita and Campos, 2003;Schneider and Frey, 1985).…”

“…The challenge of jointly estimating the effects of conceptually overlapping indices of institutional quality is discussed in Gastanaga et al (1998) and Kolstad and Villanger (2008). Ali et al (2010) argue that highly disaggregated indices are more prone to measurement error, while Biswas (2002) and Busse and Hefeker (2007) emphasize multicollinearity (among the 12 ICRG indices) as the greater methodological challenge. Some authors deal with the issue of multicollinearity by focusing only on a selective set of institutional variables (e.g., Adam and Filippaios, 2007;Sánchez-Martin et al, 2014) or by presenting estimates from models that include only one political risk variable at a time (Busse and Hefeker, 2007;Bénassy-Quéré et al, 2007;Daude and Stein, 2007;Gastanaga et al, 1998).…”

“…Each taxonomy maps the information of all 12 indices into one of the five following composite risk categories: 20 This definition of expropriation risk is also used in Ali et al (2010). 21 Taxonomy 3 is intended to correspond to the classification scheme used in Kolstad and Villanger (2008).…”