International evidence on the link between foreign direct investment and institutional quality

Tun, yin-li and Azman-saini, w.n.w. and Law, siong-hook (2012): International evidence on the link between foreign direct investment and institutional quality. Published in: Inzinerine Ekonomik - Engineering Economics , Vol. 23, No. 4 (2012): pp. 379-386.

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 expectationsthat FDI bringsenormous 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 uniformwith 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 1981-2005 period 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 emerge from this analysis. First, institution appears to be important determinant of FDI inflows. This finding is 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 infrastructurequality. 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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Foreign direct investment; Institutions; Generalised method-of-moment; Panel data; FDI determinants.
• Subjects: F - International Economics > F2 - International Factor Movements and International Business > F21 - International Investment ; Long-Term Capital Movements; F - International Economics > F2 - International Factor Movements and International Business > F23 - Multinational Firms ; International Business; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance

References

Acemoglu, D., & Robinson, J. A. (2008).Persistence of power, elites, and institutions.American Economic Review, 98(1), 267-293.

Acemoglu, D., Johnson, S., & Robinson, J. (2005). ‘Institutions as the Fundamental Cause of Long-run Growth’, in P. Aghion and S. Durlauf (eds.), Handbook of Economic Growth(Amsterdam: North-Holland).

Ali, F., Fiess, N., & Macdonald, R. (2010).Do Institutions Matter for Foreign Direct Investment? Open Economic Review, 21(2), 201-219.

Alfaro, L., Chanda, A., Kalemli-Ozcan, S., &Sayek, S.(2004). FDI and economic growth: the role of local financial markets. Journal of International Economics,64(1), 89–112.

Alonso-Borrego, C., & Arellano, M. (1999).Symmetrically normalized instrument-variable estimation using panel data.Journal of Business and Economic Statistic, 17(1), 36-49.

Ang, J. B. (2008). Determinants of foreign direct investment in Malaysia.Journal of Policy Modelling, 30(1), 185-189.

Arellano, M., & Bond, S. (1991). Some tests of specification for panel data: Monte Carlo evidence with an application for employment equation. Review of Economic Studies, 58(2), 277-297.

Arellano, M., &Bover, O. (1995).Another look at the instrumental-variable estimation of error-components models.Journal of Econometrics, 68(1), 29-52.

Asiedu, E. (2002). On the determinants of foreign direct investment to developing countries: Is Africa different? World Development, 30(1), 107-119.

Azman-Saini, W. N. W., Baharumshah, A. Z., & Law, S. H. (2010a). Foreign direct investment, economic freedom and economic growth: International evidence. Economic Modelling, 27(5), 1079-1089.

Azman-Saini, W. N. W., Law, S. H., & Ahmad, A.H. (2010b) FDI and Economic Growth: New Evidence on the Role of Financial Market. Economics Letters, 107(2), 211–213

Belsley, D. Kuh, E., & Welsh, R. (1980).Regression diagnostics: Identifying influential data and sources of collinearity. New York: Wiley.

Blonigen, B. A. (2005). A Review of the Empirical Literature on FDI Determinants, Atlantic Economic Journal, 33(4), 383-403.

Blundell, R., & Bond, S. (1998). Initial conditions and moment restrictions in dynamic panel data models.Journal of Econometrics, 87(1), 115-143.

Borensztein, E., Gregorio, J., & Lee, J. (1998). How Does Foreign Direct Investment Affect Economic Growth? Journal of International Economics, 45(1), 115-135.

Bowsher, C. (2002). On testing overidentifying restrictions in dynamic panel data models. Economics Letters 77(2), 211–220.

Busse, M., &Hefeker, C. (2007).Political risk, institutions and foreign direct investment.European Journal of Political Economy, 23(2), 397-415.

Chakrabarti, A. (2001). The determinants of foreign direct investment: Sensitivity analyses of cross-country regressions. Kyklos, 54(1), 89-114.

Dunning, J. (1993). Multinational enterprises and the global economy. Wokingham: Addison-Wesley Publishing Company.

Durham, J. (2004). Absorptive capacity and the effects of foreign direct investment and equity foreign portfolio investment on economic growth.European Economic Review, 48(2), 285–306.

Fedderke, J. W., &Romm, A. T. (2006).Growth impact and determinants of foreign direct investment into South Africa, 1956-2003.Economic Modelling, 23(5), 738-760.

Fosfuri, A., Motta, M., & Ronde, T. (2001).Foreign Direct Investment and Spillovers through Workers’ Mobility.Journal of International Economics, 53(1), 205-222.

Glass, A., &Saggi, K. (2002). Multinational firms and technology transfer. Scandinavian Journal of Economics, 104(4), 495–513.

Holtz-Eakin, D., Newey, W., & Rosen, H. S. (1988).Estimating vector autoregressions with panel data.Econometrica, 56(6), 1371-1395.

Markusen, J. (1995). The boundaries of multinational enterprises and the theory international trade.Journal of Economic Perpectives, 9(2), 169-189.

Noorbakhsh, F., Paloni, A., & Youssef, A. (2001). Human capital and FDI inflows to developing countries: New empirical evidence. World Development, 29(9), 1593-1610.

North, D.C. (1990). Institutions, Institutional Change, and Economic Performance. Cambridge University Press, Cambridge.

Quazi, R. (2007). Economic freedom and foreign direct investment in East-Asia.Journal of the Asia Pacific Economy, 12(3), 329-344.

Ramirez, M. D. (2006). Economic and institutional determinants of foreign direct investment in Chile: A time series analysis 1960-2001. Contemporary Economic Policy, 24(3), 459-471.

Roodman, D. (2009a). How to do xtabond2: an introduction to difference and system GMM in Stata. Stata Journal 9, 86–136.

Roodman, D. (2009b). A note on the theme of too many instruments. Oxford Bulletin of Economics and Statistics 71, 135–158.

Root, F. R., & Ahmed, A. A. (1979). Empirical determinants of manufacturing direct foreign investment in developing countries. Economic Development and Cultural Change, 27(4), 751-767.

UNCTAD, 2001. World Investment Report: Promoting Linkages. United Nations.

UNCTAD, 2009. World Investment Report: Transnational Corporations, Agricultural Production and Development. United Nations.

Wei, S. J. (2000). How taxing is corruption on internal investors? Review of Economics and Statistic, 82(1), 1-11.

Windmeijer, F. (2005).A finite sample correction for the variance of linear efficient twostep GMM estimators.Journal of Econometrics,126(1), 25–51.

Zilinske, A. (2010) Incoming Foreign Investment: holly water or menu of potential troubles? InzinerineEkonomika-Engineering Economics, 21(5), 518-524.