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Government regulation, corruption, and FDI

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We analyze favors as utilization of informal modes of exchange within a formal economy, relating their negative aspects to corruption. This exercise enables us to integrate them into a model linking national institutional factors to the magnitude of cross-country FDI flows. In our empirical tests of FDI inflows in 55 countries across four distinct time periods, we find that the level of economic regulation is a major determinant of the extent of FDI inflows as well as the level of corruption, but corruption does not have an independent influence on levels of FDI inflows. Our results have important policy implications regarding the role of the state in influencing the location decisions of MNEs.
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Asia Pacific Journal of Management
ISSN 0217-4561
Volume 30
Number 2
Asia Pac J Manag (2013) 30:487-511
DOI 10.1007/s10490-012-9311-y
Government regulation, corruption, and
FDI
Ram Mudambi, Pietro Navarra &
Andrew Delios
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Government regulation, corruption, and FDI
Ram Mudambi &Pietro Navarra &Andrew Delios
Published online: 12 July 2012
#Springer Science+Business Media, LLC 2012
Abstract We analyze favors as utilization of informal modes of exchange within a
formal economy, relating their negative aspects to corruption. This exercise enables
us to integrate them into a model linking national institutional factors to the magni-
tude of cross-country FDI flows. In our empirical tests of FDI inflows in 55 countries
across four distinct time periods, we find that the level of economic regulation is a
major determinant of the extent of FDI inflows as well as the level of corruption, but
corruption does not have an independent influence on levels of FDI inflows. Our
results have important policy implications regarding the role of the state in influenc-
ing the location decisions of MNEs.
Keywords Favors .Corruption .Foreign direct investment
(FDI) .Endogenous .Systems approach
One way of conceiving favors is to think of them as the pervasive utilization of
informal modes of exchange within the formal sector (Lomnitz, 1988). These
exchanges vary according to the extent of reciprocity expected by the parties
Asia Pac J Manag (2013) 30:487511
DOI 10.1007/s10490-012-9311-y
R. Mudambi (*)
Department of Strategic Management, Fox School of Business, Temple University, Philadelphia,
PA 19122, USA
e-mail: ram.mudambi@temple.edu
P. Navarra
Dipartimento di Economia, Universitadegli Studi di Messina, Piazza Pugliatti 1, 98100 Messina, Italy
e-mail: navarrap@unime.it
P. Navarra
CPNSS, London School of Economics, London, UK
A. Delios
Department of Business Policy, National University of Singapore, 15 Law Link, Singapore, Singapore
e-mail: andrew@nus.edu.sg
Author's personal copy
involved. Favors are often seen as a necessary part of business activities, especially in
emerging market economies (Myrdal, 1970). Favors can be positive or negative
elements of the business environment. On the one hand, favors can facilitate extant
business transactions or trigger ones that would not otherwise occur. On the other
hand, they can lead to inefficient outcomes, since decisions may not be made based
on the underlying capabilities of market participants. This negative aspect is the
subject of this paper.
We concentrate our attention on those informal exchanges that involve public
decision makers. Therefore, the formal system is the public sector and the decision
makers are public bureaucrats. From a transaction costs perspective, firms might
implement informal exchanges as a means of circumventing the expensive regulatory
burden and/or pursuing governmental support (Husted, 1994). In this context, favors
may be defined more specifically as the occurrence of at least two transactions, with
the roles of service supplier and receiver being reversed in sequential transactions,
and with reciprocity that can be delayed and indirect (Verbeke & Greidanus, 2009;
Verbeke & Kano, 2013). In this sense, favors consist of various forms of trading
influence and bureaucratic favoritisms for equivalent services or cash. These situa-
tions arise whenever decisions are made by bureaucrats, who are not guided by
market-based metrics (Niskanen, 1968). To put it more generally, informal exchanges
take place to obtain preferential treatment from bureaucrats in response to the
inadequacies of the formal mechanisms of decision making.
Informal exchanges may take the form of either legal or illegal practices. In the
first case, we think of interpersonal connections embedded and exploited on business
activities that promote mutual benefit within the bounds of the law. These connec-
tions are reciprocal practices exploited by different individuals to secure bureaucratic
favoritism in obtaining certificates, transcripts of documents, permits, tax clearances,
and countless other items, including social introductions to people who can eventu-
ally procure these favors. In the second case, illegal informal exchanges involve the
misuse of public power for private benefit, through unauthorized payments of money
or other in-kind substitutes. Such material payments in return for favors performed by
public officials take the form of bribes and are generally not associated with personal
relationships.
It is important to note that the boundary between legal and illegal informal
exchanges is often a matter of social norms. Societal tolerance toward strong inter-
personal involvements is higher in relational cultures and this can lead to practices of
bureaucratic favoritism (Husted, 1999; Luo, 2002; Myrdal, 1970).
In this paper the type of favors we focus on are illegal informal exchanges that are
commonly known as corrupt practices. More specifically, we are interested in exam-
ining the effect of corruption on the location decision of foreign direct investment
(FDI) by multinational enterprises (MNEs). We argue that the more the economic
system is regulated and planned the greater the scope for informal modes of exchange
through illegal shortcuts. Corruption thrives on the inefficiencies of the regulatory
system and tends to perpetuate itself through the temptations for personal gain that are
presented to the relevant bureaucrats. We develop a systematic theory examining the
effect of regulation on corruption, that has important implication for cross-country
FDI flows.
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Research in international business devotes considerable conceptual and empirical
effort to identifying the determinants of cross-border FDI flows (Dunning, 1993). This
rather large literature has uncovered a number of host country institutional factors
(political, social, and economic) that are related to firm performance and FDI inflows
(Cuervo-Cazurra & Dau, 2009). This literature has largely documentedboth theo-
retically and empiricallythat the burden of regulation (Bengoa & Sanchez-Robles,
2003) and corruption (Cuervo-Cazurra, 2008; Habib & Zurawicki, 2002; Wei, 2000)
affect the location decisions of MNEs. The impact of these two institutional factors on
FDI has been analyzed in separate but parallel research paths, without any systematic
effort to conceptually link these factors. In this study, we develop a coherent theory
that describes the mechanisms by which economic regulation and corruption are
related to each other, and how these inter-relationships affect FDI inflows.
By adopting this integrated approach, we are able to demonstrate that much of the
existing literature suffers from the causal fallacy of joint effects. In the literature, FDI
is held to be independently determined by corruption (Habib & Zurawicki, 2002;
Voyer & Beamish, 2004), when in fact both FDI and corruption are each caused by the
burden of government regulation (Rose-Ackermam, 1999; Shleifer & Vishny, 1999).
Aside from this objective of conceptualizing and testing an integrated approach,
our motivation for this study extends from two conclusions being drawn from these
distinct streams of research. First, there is reasonable evidence to conclude that
corruption is related to a nations institutional features (Djankov, La Porta, Lopez-
de-Silanes, & Shleifer, 2002). As excessive regulation is a contributor to corruption,
deregulation and privatization can be effective measures to fight corruption, to
increase competition in an economy, and to lower the level of opportunistic behavior
of state officials (Bliss & Di Tella, 1997; Rose-Ackermam, 1988). Second, corruption
in an economy can be seen as a rational response to a given institutional environment.
Although research has begun to recognize the important institutional antecedents to
corruption activities, research on the relationship between FDI and corruption con-
tinues to treat corruption as an exogenous variable unaffected by other social,
political, and economic conditions in place in the economies under investigation
(Habib & Zurawicki, 2002; Hines, 1995; Smarzynska & Wei, 2002; Wei, 2000).
In this paper, we bridge these ideas, using the focal point of the FDI decision, to
examine how the restrictions placed on economic activities and corruption in emerging
economies influence the strategies of MNEs. Our approach is novel because we treat
corruption as an endogenous feature of a host country environment. Instead of asking the
question: What is the influence of corruption on firm strategy and performance?, we ask
the more essential question: What factors determine cross-national variances in levels of
corruption, and do these same factors influence FDI inflows?
From a managerial standpoint, our work suggests that managers would be well
advised to look beyond simple measures of corruption in making their location
decisions. In particular, when comparing two locations with relatively similar cor-
ruption levels (as often happens in FDI short-listing exercises) (Cantwell &
Mudambi, 2000; Mudambi, 1998), managers would be well advised to examine the
underlying burden of government regulation. While this is unlikely to be captured in
a single summary statistic like a corruption index, it is the basis for making better FDI
location decisions.
Government regulation, corruption, and FDI 489
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Our empirical work is based on a sample of 55 countries, with four panels of FDI
data drawn from the 19852000 time period (198586, 199091, 199596, and
19992000). We find that when modeled conventionally, a nations corruption levels
are inversely related to FDI flows. When we place corruption as an endogenous
feature of a host country environment, in a simultaneous equations model, we find
that the economic impact of corruption on FDI inflows declines quite substantially, as
compared to a treatment of corruption as an exogenous feature of an institutional
environment. Meanwhile, the level of economic regulation emerges as a substantive
predictor of corruption levels and FDI inflows.
This paper is structured as follows. Next, we review the two theories of govern-
ment regulation. Then, we develop our theoretical hypotheses. In the Methods,we
describe the data and our empirical strategy and carry out the estimation. Then, we
discuss our findings and, finally, we present some concluding remarks.
Background
One of the recent focal areas of transition in economic policies in many nations
worldwide has been towards a decreased burden of government regulation. A declin-
ing burden of regulation decentralizes economic decision making from government-
owned to privately-owned enterprises and from highly-regulated to deregulated
private enterprises. Accordingly, policies aimed at liberalization, deregulation, and
privatization are macro-level factors that can sharply reduce opportunities for cor-
ruption (Aguilera & Vadera, 2008; Djankov et al., 2002). In economies with exten-
sive state regulation, greater opportunities for venality exist. The supply of rents for
officials to allocate will be higher than in more liberal settings.
The burden of government regulation can also be connected to the extent of
corruption in an economy, via either the public interest view or public choice theory.
The first approach sees regulation as a remedy for market failures. In this perspective,
benevolent government intervention may alleviate the inefficiencies arising from
monopoly power and externalities. The second approach questions the very existence
of benevolent government. In this view, regulation is essentially a redistributive
process among self-interested individuals and/or groups that aim to obtain specific
benefits by the means of governmental intervention. The two approaches, therefore,
differ in terms of who gets the benefits of regulation.
The public interest view of public policy emphasizes the point that unregulated
markets exhibit frequent failures that can be corrected by government regulation
(Maidment & Eldridge, 1999; Pigou, 1947). The public interest view (Pigou, 1947)
identifies economic regulation as a response to market failures ranging from monop-
oly power to externalities. Economic regulation overcomes the inefficiencies of these
failures through benevolent governmental intervention. Scholars have criticized this
approach as unrealistic and have questioned the appropriateness of assuming a
government composed of selfless public servants (Stigler, 1971). Critics argue that
regulation is a redistributive process influenced by self-interested individuals who
attempt to gain specific benefits by the means of government intervention.
In line with this criticism, public choice theory considers governments to be less
than benign, and regulation as socially inefficient (Buchanan & Tullock, 1962). If
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there is less competition in an economy, firms can enjoy higher rents and bureaucrats
with high control rights over industries (such as tax inspectors or industry regulators)
have greater incentives to engage in malfeasant behavior (Bliss & Di Tella, 1997).
Consistent with this line of argument, Ades and Di Tella (1997,1999) found that
corruption is higher in countries where domestic firms are sheltered from foreign
competition by natural or policy-induced barriers to trade. Similarly, public sector
corruption tends to be more prevalent in economies dominated by small numbers of
firms with low levels of product market competition and where antitrust regulations
are not effective in preventing anticompetitive practices. The inverse of this is the
point that increased competition in an economy discourages corrupt activities and
promotes economic growth. Well-established market institutions, characterized by
clear and transparent rules, fully functioning checks and balances, and a robust
competitive environment reduce incentives for corruption.
In a study of the regulatory burden faced by entrepreneurs seeking to establish
start-up firms in 85 countries, Djankov et al. (2002: 26) reported that “…corruption
levels and the intensity of entry regulation are positively correlated.This suggests
that the principal beneficiaries of the regulatory burden imposed on start-up busi-
nesses are politicians and bureaucrats. Endemic corruption does not suggest a pres-
ence or absence of self-interested behavior, but rather a failure to tap self-interest for
productive purposes (Rose-Ackerman, 1999).
Corruption in an economy can also extend from another aspect of the regulatory
environment, namely where firms face legal obstacles to enter an industry or operate a
business. Politicians use their temporary monopoly rights to distort economic policy
to generate large rents for themselves (Bardhan, 1997). These activities are most
prominent when there is low electoral accountability (Coate & Morris, 1999).
Corruption, hence, extends from an underlying weakness of the state to control its
bureaucrats, to protect property and contract rights, and to provide institutions that
underpin an effective rule of law. Whether these same features of the political
environment influence the level of regulation, and thereby make corruption an
endogenous feature of a national institutional environment, with respect to its influ-
ence on FDI flows is the focus of our hypotheses.
Hypotheses development
Our study connects two distinct bodies of literature: (1) economic regulation and
corruption and (2) market liberalization (the burden of government regulation) and
FDI. We integrate ideas from these literatures to show how corruption has been
considered to be an exogenous influence on FDI, yet it is fundamentally an endog-
enous feature of a nations business environment. In Figure 1, we graphically depict
our contention that the regulatory burden of the state in an economy affects both
levels of corruption and of FDI.
Government regulation and corruption
Much of the existing literature points to the regulatory state as being a source of
corruption (Bardhan, 1997). The burden of regulation with its elaborate system of
Government regulation, corruption, and FDI 491
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permits and licenses spawns corruption (Rose-Ackermam, 1999) and, therefore,
different countries with different degrees to which the regulatory state is inserted into
the economy give rise to varying levels of corruption (Shleifer & Vishny, 1999).
Regulations and bureaucratic allocation of scarce public resources breed corruption,
and so the immediate task is to get rid of them. In some sense the simplest and the
most radical way of eliminating corruption is to legalize the activity that was formerly
prohibited or controlled (Bardhan, 1997). When Hong Kong legalized off-track
betting, police corruption fell significantly, and as Singapore allowed more imported
products duty free, corruption in customs went down (Klitgaard, 1988).
Tanzi (1998) identified that corrupt activities take place more often in environ-
ments where laws and procedures are opaque, which creates a situation in which
administrators enjoy substantial discretionary power. The more the rules (the greater
the burden of the regulation), the more confusing the system and the more opaque it
becomes. In this framework, the more the rules, the greater the chances that they
contrast with each other, the less likely they can be effectively enforced and the
greater the chances of corruption. As noted by Shleifer and Vishny (1993), regula-
tions provide opportunities for politicians and government officials to engage in
corrupt activities, for example, the extortion of payments from private businesses
and citizens in exchange for licenses. Where regulation is extensive, we expect that
the pervasiveness of corruption is greater.
This point is supported by the large literature on the tollbooth view of regulation,
in which a strong regulatory environment creates sufficient conditions for public
sector employees to extract benefits for the provision of services governed by
regulations (De Soto, 1990; Djankov et al., 2002). Even though the regulatory state
can create opportunities for corruption, the extent to which actors engage in corrup-
tion will depend to an extent on individual cost-benefit calculations. In a situation in
which a public sector official has a low income, corrupt practices will yield a high
benefit in relation to the level of risk (Aguilera & Vadera, 2008). As incomes rise,
however, the benefits derived from corrupt practices will be less attractive
relative to the risks. This form of calculation suggests that corruption should
be less prevalent richer societies, as found by Husted (1999). That said, given
appropriate consideration for the general administrative tendencies in a nation to the
pursuit of public interest, an increased burden of regulation in a nation should lead to
a greater level of corruption. All other things being equal, we hence expect to find a
higher level of corruption to be associated with a higher level of government
regulation.
H3
H2
H1
Extent of
corruption
Burden of
government regulaton
Levels of FDI
Figure 1 Government regula-
tion, corruption, and FDI
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Hypothesis 1 The lower the level of government regulation, the lower the prevalence
of corruption in the economy.
Corruption and FDI
Corruption can be defined as the abuse of public power for private benefit (Tanzi,
1998), in which there is a transfer from private firms or individuals to government
officials or politicians, in exchange for preferential treatment in a regulated environ-
ment. The mainstream literature on the effects of corruption on FDI almost uniformly
argues that corruption negatively influences levels of FDI inflows (Habib &
Zurawicki, 2002; Wei, 2000). The argument begins with the point that MNEs often
encounter corruption in their FDI, particularly when they enter emerging market
economies (Cuervo-Cazurra, 2008; Smarzynska & Wei, 2000). Corruption deters
investment because it increases the direct costs and uncertainty of doing business.
Further, in most nations, corruption is illegal. The consequent requirement for secrecy
for business undertaken with corruption is risky since investors have limited protec-
tion from expropriation (Shleifer & Vishny, 1993).
The pervasiveness of corruption is a probabilistic measure and refers to the
likelihood that an entering firm will encounter corruption in its dealings with gov-
ernment officials or politicians in the host country (Rodriguez, Uhlenbruck, & Eden,
2005). A high level of pervasiveness indicates that firms are more likely to encounter
corruption when undertaking normal business activities.
As with other dimensions of the political environment (Henisz & Delios, 2004),
MNEs can cope with corruption by either avoiding locations where they encounter it,
as marked by the pervasiveness of corruption, or by adjusting their entry modes to
reduce their exposure (Doh, Rodriguez, Uhlenbruck, Collins, & Eden, 2003). If
corruption is pervasive, MNEs are more likely to choose no entry, or an arms-length
entry strategy, such as exporting or licensing. Hence, corruption can impose a cost on
MNEs that leads to a negative effect of corruption on FDI inflows (Habib &
Zurawicki, 2002; Wei, 2000). Accordingly, we expect that when modeled indepen-
dently of other features of the national institutional environment, the pervasiveness of
corruption should be negatively associated with levels of FDI inflows.
Hypothesis 2 The greater is the pervasiveness of corruption in the host country, the
lower the level of FDI inflows.
Government regulation, corruption, and FDI
We connect the ideas in our first two hypotheses with our view that corruption can be
considered as an endogenously determined feature of a nations business environ-
ment. Further, as we contend in H1, corruption levels can be connected to the burden
of government regulation.
Even with a general worldwide trend in the 1990s and 2000s towards lower levels
of government regulation, it is still present in all economies and yet pervasive in
others. Economic regulation is one of the policy decisions that matters the most for
the functioning of an economy. It concerns the extent of state intervention in the
market economy and the degree of discretionary power allocated implicitly or
Government regulation, corruption, and FDI 493
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explicitly to bureaucrats. A major impetus in the trend towards decreased levels of
government regulations has been its connection to economic outcomes, such as the
intensity of foreign participation in an economy.
A small but focused literature calls attention to the effect of the burden of
regulation on FDI (Bengoa & Sanchez-Robles, 2003). With respect to the FDI
decision, corporate tax rates, as one area of regulation, have been found to be an
important factor in explaining location decisions by MNEs (Wheeler & Mody, 1992).
Within a single country, tax incentives can influence the location choice of a firms
investment (Tung & Cho, 2001). Bengoa and Sanchez-Robles (2003) found econom-
ic freedom and economic growth to be positively correlated with FDI inflows into
Latin American countries. Latin American countries with high levels of political
stability, together with a deregulated environment, tend to attract high levels of
inward FDI.
This emerging literature points to the existence of a relationship between the
burden of government regulation and FDI, just as the literature has documented a
link between corruption and FDI. We posit that these relationships are two sides of
the same coin. Specifically, we suggest that the literature on corruption focuses
excessively on legal status. For example, Shleifer and Vishny (1993) argued that
corruption imposes a greater burden on the economy than taxation because of the
secrecy that is necessarily associated with an illegal activity. We do not dispute this
point. Taxes reduce welfare by distorting resource allocation, but they can also have
positive welfare effects, for example, in terms of the provision of public goods.
Corruption, on the other hand, imposes an asymmetric cost on an economy. It
provides a public sector official with a gain, but it does so by imposing a cost on a
firm, that can deter private sector activity, such as FDI.
These arguments suggest that the level of government regulation has both a direct
and indirect effect on FDI. The direct effect works through lowering the legal
expenses of complying with regulatory procedures and red tape. The indirect effect
works through the hypothesized (H1) negative relationship between the burden of
government regulation and corruption. As regulations are removed, the scope for
corrupt activities shrinks, reducing the costs of operating in the host country. Hence:
Hypothesis 3 The lower the burden of government regulation, the higher the level of
FDI inflows into the host economy.
Although we cannot form a hypothesis about a null effect, our previous arguments
also suggest that corruption should have a decreased, or at the extreme, no influence
on FDI levels, when it is considered to be an endogenous feature of the environment,
or a consequence of the level of government regulation in an economy (H1). An
argument for a null effect of corruption on FDI inflows is consistent with existing
empirical work, which does not find a link between the extent of corruption and the
level of FDI inflows (Hines, 1995; Wheeler & Mody, 1992). We have predicted in H3
that FDI levels respond directly to levels of government regulation. Continuing the
argument along these lines, we expect that FDI should not be related to levels of
corruption, once we account for the state of the regulatory environment. We examine
this alternative outcome to H2 (i.e., corruption is not related to FDI inflows) in the
models we construct to test our hypotheses.
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Regulation enforcement and corruption in developing countries
In Figure 1we describe a situation in which the more the economic system is
regulated and planned, the greater the scope for informal modes of exchange through
illegal shortcuts. A more careful examination of the figure, might lead a reader to ask
whether there is any role played by the enforcement of regulation in determining its
effects on corruption. Although to the best of our knowledge there are no data that
measure the effectiveness of the judiciary and regulators in the fight against corrup-
tion for the countries and the time span under investigation in this study, it is
interesting to comment on some findings obtained in the literature examining the
relationship between the extent of government regulation and the enforcement capa-
bilities of the judiciary in developing countries.
Starting with Becker (1968) and Stigler (1970), a line of research investigated the
optimal enforcement of laws (see Polinsky & Shavell 2000; Shavell 1993). One
important result in this literature is that stricter and more complex laws and regu-
lations require more incisive and costly enforcement machinery (Holmes & Cass,
1999). This result has important implications for less developed countries. Although
good laws and rules are rather simple to import from the developed to the developing
world, their enforcement is much more difficult because of the lack of financial and
technical resources and because of the weak bargaining position of regulators
(Ordover, Pittman, & Clyde, 1994). Therefore, less developed countries suffer from
significant weaknesses of enforcement capabilities (Laffont, 1996). This implies that
regulations in developing and emerging economies tend to be either loose and
effective or strict and ineffective. In both cases there is large scope for corruption.
Loose regulations are more likely to be overturned by illegal actions and behaviors.
On the other hand, strict regulations are associated to weak and often fruitless
enforcement and, as a consequence, are more likely to open the way for the enactment
of corrupt practices.
Methods
Sample
We develop our sample using country-level data drawn from several published and
electronic sources. We provide complete details on sampled countries, and a descrip-
tion of the data and the data sources in the Appendix. The sample we constructed for
the analysis is panel data that has cross-national variance across 55 countries. The
within-country variance comes from the four panels of data (198586, 199091,
199596, and 19992000) we have to cover the period from 1986 to 2000, which is a
comparatively long period for corruption-FDI related research. In line with the panel
nature of our data, our variables are time-varying, with the exception of the indicator
variables which will not change over time. By using time periods, rather than annual
observations in our sample, we provide opportunity for institutional variables to
change over time, even given the point that the rate of institutional change can be
slow. In these ways, our sample is primarily cross-sectional, but it does provide
multiple period snapshots of each of the 55 countries in our sample.
Government regulation, corruption, and FDI 495
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Measures
Endogenous variables Our two endogenous variables (Figure 1) are (1) the extent of
corruption and (2) the level of FDI inflows.
We measure the level of corruption with the widely-used survey-based measure
created by Transparency International (Husted, 1999; Rodriguez et al., 2005; Wei,
2000). The formal Transparency International Corruption Perceptions Index (CPI)
began to be reported in 1995, which are the data we used for the 1995 and 2000
panels. The Transparency International CPI evolved out of a precursor index developed
at the Internet Center for Corruption Research, University of Passau, Germany
(Lambsdorff, 1999), which was constructed using the same methodology as the
CPI. The precursor index is available for the 198085 and 198892 periods, in two
snapshots anchored in the years 1985 and 1990. The range of country coverage for
the precursor index is less than the CPI, hence resulting in our sample being limited to
55 countries. For the Transparency International measure, high values mark low
levels of corruption.
It is important to note that several other corruption measures are available in the
literature. Among them, one of the most used indicators of corruption is the one
offered by International Country Risk Guide (ICRG) compiled by the political Risk
Service Group. However, our choice of the CPI for measuring corruption is deter-
mined by the fact that it is the only one that covers all the countries considered in the
empirical analysis for the time span under investigation in our study.
We measure the level of inward FDI inflows by the average annual value in US
dollars of FDI into a given country for each panel. We used the log form of this
variable after testing for normality using the standard Jarque-Bera test. The value of
the test statistic [chi-square(2)] was marginally significant, suggesting that the use of
the log form is not essential, but a useful precaution. We note here that both the
logged and (mean-centered) unlogged FDI flow measures yield very similar results in
our models, indicating that normality is not a significant concern. We implement
models using the logged form because it reduces leverage issues associated with
outliers, yielding superior estimates to those from the unlogged form.
Exogenous variables The three variables used to test our hypotheses are the two
endogenous variables, plus a measure of the extent of government regulation. To
operationalize the burden of government regulation we use the economic freedom
index generated by the Fraser Institute (Doucouliagos & Ulubasoglu, 2006; Dreher &
Rupprecht, 2007). There are a number of measures of economic freedom, but the
Fraser Institute data is our preferred measure for a number of reasons. It is the only
economic freedom measure that covers our intended wide time span. The Heritage
Foundation index is not available before 1995, while the economic freedom indices
generated by the World Bank are only available from 2000 onwards. Further, in a
recent survey, De Haan, Lundstrom, and Sturm (2006) compared several indices of
economic freedom including the Fraser Institute and the Heritage Foundation indices.
Their survey concludes that the Fraser Institute index is the best at capturing the
essence of market-oriented economic institutions. Finally, we note that the correlation
between the Fraser Institute and the Heritage Foundation indices is reasonable at a
level .85 (Cumings, 1984).
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To complete our specification of exogenous variables in our models, we turned to
the literature to identify variables that determine each of the two endogenous varia-
bles. Both corruption and FDI are likely to be sensitive to a number of other
environmental influences. Hence we control for socio-economic (Cheng & Kwan,
2000; Smarzynska & Wei, 2002;Wei,2000) and institutional factors (Adam &
Filippaios, 2007; Bengoa & Sanchez-Robles, 2003; La Porta, Lopez-de-Silanes, &
Shleifer, 2008, Lopez-de-Silanes, & Shleifer, 2008). We control for the level of GDP
(income and the extent of the market) and the growth rate of GDP (income and
market growth), country risk and inflation (macroeconomic stability), trade exposure
and export diversity (open economy measures), literacy rate (human capital and
demand sophistication) and the level of civil liberties and the legal heritage of the
country (civic and legal institutions).
The model
In Table 1, we present summary statistics and a correlation matrix for all variables
used in this study. As can be seen in the table, inter-item correlations are modest to
low, but still at a level where we needed to institute checks to see if estimated
coefficients were affected by collinearity concerns. Aside from our examination of
the correlation matrix, we tried various specifications that included or excluded
variables that were moderately correlated with one another. When doing this, we
checked for the stability of coefficient estimates across specifications and we looked
Table 1 Summary statistics. Variable Mean SD N
Endogenous variables
Corruption 3.4667 1.4112 218
Ln(FDI inflows) 4.7813 2.4202 220
Exogenous variables
Secure property rights 4.6341 1.3036 218
Freedom to trade 5.8160 1.3602 215
Sound money 6.0068 2.4635 220
Government size 5.9548 1.4751 220
Business regulation 5.3289 .9565 217
Ln(GDP) 7.6423 .8293 220
GDP growth 3.2037 2.5231 218
Country risk 41.2776 16.4640 214
Inflation 14.3965 97.7202 216
Trade exposure 8.3620 16.8246 220
Export diversity .3818 .4869 220
Africa .2727 .4464 220
Literacy 28.4529 2.4946 212
Civil liberties 4.0454 1.4580 220
LegalUK .2909 .4552 220
LegalFrance .6545 .4766 220
Government regulation, corruption, and FDI 497
Author's personal copy
for large changes in standard errors, both of which are symptomatic of collinearity.
We did not observe any instability in estimates, enhancing the confidence with which
we could interpret the estimated coefficients as not being the product of collinearity.
Finally, for all specifications and variables, we estimated VIFs, with all VIFS well
below the threshold value of 10.
Our hypotheses predict a series of relationships in stages, for which a common
method to use is structural equation modeling (SEM). SEM is particularly useful for
modeling exogenous and endogenous variables, but it has its greatest utility when
constructs have multiple items. All variables in our analysis are single-item measures,
so we use a simultaneous equations approach (two-stage least squares, or 2SLS)
instead of SEM.
The simultaneous equation system we use consists of two equations:
Corruption ¼f1Government Regulation;C1
½ð1Þ
FDI ¼f2Government Regulation;Corruption;C2
½ð2Þ
where C
1
and C
2
are the vectors of control variables, as identified in the preceding
section. This model builds from the idea that estimating the effects of economic
institutions on FDI requires a simultaneous equations approach in which levels of
corruption (Eq. 1) are predicted by burden of government regulation. Equation 2
predicts FDI levels from government regulation, corruption, and the control variables.
As one of the main points of investigation in our study is to identify whether
corruption, and its influence on FDI inflows, is endogenously determined, we first
establish an empirical benchmark by estimating a set of single equations of the
variables on FDI inflows, following Habib and Zurawicki (2002) and Harms and
Ursprung (2002). This benchmark establishes the point that our results for the effects
of corruption on FDI in the 2SLS estimation are not a consequence of poor variable
definitions nor of sample selection bias. Instead, the effect of corruption on FDI
emerges as a consequence of how we have modelled corruption as an endogenous
variable in the 2SLS estimation.
The estimation
We estimate FDI inflows two ways. First, we generate estimates akin to those that
appear in the corruption-FDI literature. These involve using ordinary least squares
(OLS) to estimate Eq. 2, treating corruption as an exogenous variable. We wish to
demonstrate that we are able to reproduce the effects of corruption on FDI in our
sample.
Second, we estimate Eq. 2using 2SLS, treating corruption as an endogenous
determinant of FDI. 2SLS is a robust and consistent estimation methodology,
although it is not unbiased (Greene, 1997). However, it is well-known that the quality
of 2SLS results is crucially dependent on the validity and quality of instruments used.
A strong instrument is correlated with the endogenous regressor for reasons the
researcher can verify and explain, but uncorrelated with the outcome variable beyond
its effect on the endogenous regressor (Bowden & Turkington, 1984). Further, with
one endogenous regressor, it is necessary to have at least three over-identifying
498 R. Mudambi et al.
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restrictions to extract a consistent estimate along with its standard error (Kinal, 1980).
We ensure that this requirement is met.
We use inflation, the level of civil liberties, export diversity, and legal heritage as
our main instruments. These variables were identified on the basis of the prior
literature as being correlated with corruption but not with FDI, indicating their
suitability as potential instruments. Corruption has been associated with inflation
rates (Paldam, 2002), the level of civil liberties (Lambsdorff, 2003), the extent of
trade openness (Knack & Azfar, 2003), and legal institutions and heritage (Fisman &
Gatti, 2006).
We now examine the relationship between each one of these potential instruments
and FDI. FDI is based on foreign inputs and/or markets, so that it may remain
relatively insulated from domestic inflation, a position that has found empirical
support (Trevino, Daniels, Arbelaez, & Upadhyaya, 2002). Further, foreign firms
are essentially profit maximizing entities and it is unclear why the state of domestic
civil liberties should have a systematic effect on FDI. The empirical evidence with
regard to this relationship is mixed (e.g., Jakobsen & de Soysa, 2006; Li & Resnick,
2003). Direct measures of trade openness like the level of exports have a clear
theoretical relationship with FDI and are unsuitable as instruments. However, the
diversity of exports relates to openness, but has no systematic link to the level of FDI,
that is, a country may have a high level of FDI either from a single dominant sector or
from general openness leading to inflows into a wide range of sectors. Thus, greater
export diversity relates to trade openness, but need be correlated with FDI.
Our above discussion is borne out by the data. With the exception of legal heritage,
all instruments are highly correlated with the level of corruption, but not with the
level of FDI inflows. Finally, previous research has identified Africa as a region with
a significantly different corruption profile compared to other geographical regions
(Heineman & Heimann, 2006). Therefore, in our estimation of corruption we include
an instrument to control for this effect.
Results
As mentioned above, prior studies of FDI flows have focused on estimating a single
equation (like Eq. 2). We first estimate Eq. 2alone to ensure that we can reproduce
the results reported in the corruption-FDI literature using our data. We use a panel
data approach and present the estimates in Table 2. These estimates demonstrate that
we are able to reproduce the negative effect of corruption on FDI that is reported in
much of recent literature. In other words, a higher level of corruption (a lower value
of the corruption index) is associated with lower levels of FDI inflows.
Having reproduced the findings of the literature in this area, we proceed to
examine the effect of treating corruption as an endogenous variable. The panel
estimates of Eq. 2are presented in Table 3. We estimate Eq. 2using an instrumental
variables (IV) methodology, with corruption as an endogenous regressor. The results
of this estimation are presented in Table 4. We also reproduce the estimates of Eq. 2
alone in the second column of Table 4for purposes of comparison.
Two aspects of the regulatory burden appear to be associated with corruption
(Table 3): the legal structure of private property rights protection and the freedom to
Government regulation, corruption, and FDI 499
Author's personal copy
trade internationally. The lower the security afforded to private property through the
legal system, the greater the incentive to obtain protection through alternative means.
These are likely to involve corrupt practices. For instance, it has been documented
that the greater the extent of tariffs and other restrictions on the availability of
desirable foreign products, the greater the extent of practices like smuggling that
often involve corruption (Gillespie & McBride, 1996). This applies with even more
force in the international context, where the illegality of drugs has created extra-legal
corporations that fund corruption on an international scale (Mudambi & Paul, 2003).
Further, in many African countries, police forces often extract protection payments or
bribes and provide security for life and property only to those who pay, rather than to
the public at large (Rose-Ackermam, 1999).
Several of the control variables are significant in the direction expected in esti-
mating the extent of corruption. Higher incomes, more trade-exposed economies with
greater export diversity, higher literacy, and higher levels of civil liberties are all
associated with lower levels of corruption. As noted by Shleifer and Vishny (1993),
the illegality of corruption means that it requires secrecy. This means that open
Table 2 Estimating Eq. 1FDI
inflows (Exogenous corruption).
Regressand: Ln(FDI inflows).
t-statistics are
presented in parentheses. The IV
t-statistics are computed
using IV standard errors. In the
case of the OLS estimates,
Whites heteroskedasticity-
consistent variance-covariance
matrix is used.
* Estimates significant at the 10 %
level;
** Estimates significant at the 5 %
level;
*** Estimates significant at the 1 %
level.
Regressor Panel estimates (Fixed effects)
Coefficient (t-statistic)
Constant 5.200 (4.52)***
Secure property rights .429× 10
3
(.36)
Freedom to trade .443× 10
3
(.59)
Sound money .046 (.97)
Government size .152 (1.90)*
Business regulation .500 × 10
3
(.54)
Corruption .748× 10
3
(2.55)**
Ln(GDP) 1.294 (8.91)***
GDP growth .502×10
3
(.45)
Country risk .554× 10
4
(.08)
Trade exposure .058 (9.03)***
Literacy .111×10
2
(1.93)*
Fixed effects
Panel 1 1.621 (4.88)***
Panel 2 1.330 (4.32)***
Panel 3 .378 (1.27)
Diagnostics
Adj. R
2
.6059
F(df); p25.05 (14, 197); .000
A kaike I.C. 3.740
LR Test χ
2
(3): Panel vs. OLS; p32.037; .000
Log-L. 396.4185
Rest. Log-L. 506.1161
500 R. Mudambi et al.
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societies with high levels of civil liberties are less likely to be conducive to such
behaviors.
The geographic dummy identifying African countries appears to be associated
with lower levels of corruption. Although this result may appear surprising, the
positive effect of the Africa dummy on corruption may be interpreted as follows.
The African economies in our sample have among the lowest incomes and highest
regulatory burdens. The expected levels of corruption are therefore extremely high
higher in fact than the index is able to capture since it is bounded below by zero.
Further, the multiple-survey-based nature of the Transparency International CPI
means that even very low reported scores tend to be positive. Since the expected
values of the index for many African economies are negative, while the actual values
are all positive, the coefficient of the dummy takes a significant positive value.
We now proceed to examine the estimates of FDI flows presented in Table 4. The
two main explanatory variables are the extent of the regulatory burden and the
endogenous level of corruption. The aspect of the regulatory burden that is a
significant determinant of FDI flows is the size of the government as measured by
extent of public expenditure, public enterprises, and taxes. This is consistent with
Table 3 Estimating Eq. 2The
level of corruption. Regressand:
Corruption.
t-statistics are presented in
parentheses. Whites
heteroskedasticity-consistent
variance-covariance matrix is
used to generate them.
a
The
Hausman test suggests the use of
the fixed effects
model.
* Estimates significant at the 10 %
level;
** Estimates significant at the 5 %
level;
*** Estimates significant at the 1 %
level.
Regressor Panel estimates (fixed effects)
a
Coefficient (t-statistic)
Constant 1.557 (3.63)***
Secure property rights .520 (1.99)**
Freedom to trade .276 (1.65)*
Sound money 1.244 (1.08)
Government size 1.816 (.92)
Business regulation .222 (.95)
Ln(GDP) 1.726 (4.11)***
Inflation .047 (1.63)
Trade exposure .542 (2.91)***
Export diversity .112 (2.10)**
Africa .306 (3.80)***
Literacy .818 (6.32)***
Civil liberties .860 (4.18)***
LegalUK .146 (.10)
LegalFrance .858 (.61)
Diagnostics
Adj. R
2
.3606
F(df); p8.27 (17, 194); .000
Akaike I.C. 14.568
LR Test χ
2
(3): Panel vs. OLS; p4.556; .2073
Log-L. 1584.5228
Rest. Log-L. 1642.6072
Government regulation, corruption, and FDI 501
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several studies that point to taxes as the most important factor influencing MNE
location decisions (Mutti & Grubert, 2004; Wheeler & Mody, 1992).
Most importantly, we emphasize that whether we treat the level of corruption as
exogenous or endogenous changes its estimated effect on FDI. As noted above, when
the level of corruption is treated as exogenous, it appears to exert a significant
negative influence on FDI (see column 2 in Table 4). However, when it is treated
as endogenous, its relationship with FDI is no longer statistically significant (see
column 3 in Table 4). Further, the significance of the effect of the regulatory burden
on FDI flows is increased when the endogeneity of corruption levels is taken into
account.
Why is the regulatory burden associated with tariffs and trade not significant in
determining FDI? This is because the measure examines the costs of undertaking
exportimport activity. Assuming that most FDI into developing countries is market-
Table 4 FDI inflows (Comparing exogenous and endogenous treatment of corruption). Regressand: Ln
(FDI inflows).
Regressor Exogenous corruption Endogenous corruption
Panel estimates (Fixed effects) IV
Coefficient (t-statistic) Coefficient (t-statistic)
Constant 5.200 (4.52)*** 5.630 (4.51)***
Corruption
a
.748× 10
3
(2.55)** .545× 10
3
(1.05)
Secure property rights .429× 10
3
(.36) .380× 10
3
(.32)
Freedom to trade .443 × 10
3
(.59) .355× 10
3
(.44)
Sound money .046 (.97) .047 (.98)
Government size .152 (1.90)* .163 (2.01)**
Business regulation .500 ×10
3
(.54) .206× 10
3
(.20)
Ln(GDP) 1.294 (8.91)*** 1.335 (8.72)***
GDP growth .502×10
3
(.45) .381× 10
3
(.34)
Country risk .554× 10
4
(.08) .351× 10
3
(.51)
Trade exposure .058 (9.03)*** .059 (9.07)***
Literacy .111×10
2
(1.93)* .121× 10
2
(1.83)*
Diagnostics
Adj. R
2
.6059 .5956
F(df); p25.05 (14, 197); .000 24.04 (14, 197); .000
Akaike I.C. 3.740
LR Test χ
2
(3): Panel vs. OLS; p32.037; .000
Log-L. 396.4185 399.2580
Rest. Log-L. 506.1161 506.1161
t-statistics are presented in parentheses. The IV t-statistics are computed using IV standard errors. In the
case of the OLS estimates, Whites heteroskedasticity-consistent variance-covariance matrix is used.
a
Endogenous regressor.
*Estimates significant at the 10 % level; ** Estimates significant at the 5 % level; *** Estimates significant
at the 1 % level.
502 R. Mudambi et al.
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seeking and based largely on domestic tangibles and imported intangibles, tariffs
would not have strong effects on FDI flows. In fact, as tariffs and other restrictions on
trade rise, ceteris paribus, the incentive to undertake tariff-jumping FDI increases
(Dehejia & Weichenrieder, 2001). Thus, the negative effects of trade regulation on
FDI flows may be counter-balanced by tariff-jumping, so that the overall impact is
insignificant.
Finally, we control for standard location attractiveness factors like the size of the
market (GDP), the growth rate of the market (the growth rate of GDP), macroeco-
nomic stability (the level of country risk and the inflation rate), openness of the
economy (trade percentage) as well as human capital and demand sophistication
(adult literacy). Market size and the openness of the economy appear to be the
strongest control variables associated with FDI flows.
Discussion
We examine the influence of corruption on FDI levels, by developing arguments
about, and constructing an empirical model for, corruption as both a cause and an
effect. The starting point for our analysis is our consideration that corruption will vary
systematically across countries, according to the nature of a countrys institutional
environment. The same features of a national institutional environment that influence
levels of corruption can also operate as influences on FDI inflows as they affect
managerial behavior (Zhou & Peng, 2013). As such, we constructed a systems model
in which we considered FDI and corruption as endogenous variables that are related
to other features of national institutional environments, when we tested the determi-
nants of cross-national FDI inflows across 4 panels of data for 55 emerging
economies.
In our analysis, we contend that the level of corruption is determined by the burden
of government regulation in the economy (Djankov et al., 2002). Hence, the level of
corruption is also endogenous. Relatedly, we find FDI inflows to be positively
influenced by economic freedom. Our theoretical integration thus indicates that
models that treat the level of corruption as an exogenous determinant of FDI inflows
are mis-specified, so that their results are questionable (e.g., Habib & Zurawicki,
2002).
These points emerge in our empirical results. When we model corruption in a
standard fashion (Table 2), as an exogenous feature of an institutional environment,
we find that consistent with much of the extant empirical literature it is negatively
related to the extent of FDI inflows. When we consider corruption as an endogenous
feature of an institutional environment (Tables 3and 4), we find that corruption has
no relationship to FDI inflows. Instead, the burden of government regulation is the
principal determinant of the level of FDI inflows, as well as a determinant of the level
of corruption. Hence, once we conceptualize and empirically test the endogeneity of
corruption, we find that its net effect over and above that of the regulatory burden
(economic freedom) is negligible.
This latter point is evident when we plot the predicted influences of economic
freedom and corruption on FDI inflows: As can be seen in Figure 2, moving from a
mean level of economic freedom to the highest level of economic freedom increases
Government regulation, corruption, and FDI 503
Author's personal copy
the predicted level of FDI inflows by a factor of eight. A similar shift in corruption,
from its mean level to its lowest level, results in no substantive change in the level of
expected FDI inflows. Clearly, the regulatory burden of the state has a much stronger
negative impact on FDI inflows than corruption. Corruption appears to be an outcome
of the institutional features of a nation, with the consequence that its marginal impact
on FDI inflows is negligible.
These findings are important theoretically for three main reasons. First, we con-
tribute to the international business and economics literatures on the determinants of
FDI by offering a systematic theory to evaluate the impact of economic institutional
factors on FDI. Second, our findings help us to understand the causal links that define
the investment climate that influences the magnitude and direction of cross-country
FDI flows. Third, our results have important policy implications regarding the role of
the state in influencing the location decisions of MNEs.
Related to this third point, our arguments and findings point to the idea that
reducing the burden of government regulation can be a powerful stimulus for inward
FDI flows. The effect of lower regulation is both direct and indirect. The direct effect
spurs FDI through the removal of barriers to entry and exit. The indirect effect works
through the positive consequences of the reduced regulatory burden: more transpar-
ency, higher levels of competition, and lower returns to public sector corruption. We
provide evidence that the direct effect dominates the indirect effect, although the
indirect effect can be important.
In a related fashion, our results have important government policy implications.
Since corruption affects the investment location decisions of foreign firms, govern-
ments might be tempted to implement policy actions to fight corruption to attract FDI.
However, this policy choice will likely be limited in its effectiveness if it is not
accompanied by a reform in markets and political institutions. This is because
corruption and FDI are jointly determined by the extent of regulatory burden. Put
another way, corruption is an effect and not a cause.
The perspective we adopt in this study also has value for practitioners. Managers
contemplating an investment in potential host country sites will clearly be concerned
with the level of corruption in the countries under consideration. Their concern is not
0
200
400
600
800
1000
1200
1400
1600
1800
1234567891011
Economic Freedom, Corruption
a Computed at variable means, usin
g
coefficient estimates from equation 2 in table 3.
FDI ($million)
Economic Freedom
Corruption
Figure 2 Economic freedom, corruption, and FDI flows
a
504 R. Mudambi et al.
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just with the present environment, but also with the future environment. By directing
attention to the influence of economic regulation on corruption, we can suggest that
managers try to identify how government regulation reforms are progressing when
forming predictions about future levels of corruption in a nation. Rather than viewing
corruption as a static element in a nation, corruption levels can change, particularly in
emerging economies where economic institutions are undergoing a relatively rapid
evolution.
Recent data supports this contention, especially for Asian countries. Results from
the Business Environment and Enterprise Performance Surveys that cover over
11,000 firms (World Bank, 2011) indicate that the overall trend in emerging market
economies is towards a lower burden of administrative regulation as well as a decline
in the level of corruption over the period 20052010. This is a broad-based trend
wherein we witness a reduction in the three major burdens associated with state
intervention: taxes, customs, and legal requirements. The data indicate that this trend
is particularly pronounced in the East Asia and Pacific groups of countries, which
have also witnessed the fastest economic growth in recent years. In fact, the share of
the largest Asian economies in global outward FDI flows increased from about 10 %
to over 20 % during the same 5-year period. The importance of this relationship is
underscored by the fact that FDI constitutes a large and increasing percentage of
overall gross fixed capital formation in Asian countries. For example, the figures for
Singapore, Cambodia, and Vietnam are 60 %, 52 %, and 25 %, respectively.
These data emphasize the importance of our results. We do not claim that policy-
makers reduced the burden of regulation with the express purpose of fighting
corruption. As our paper demonstrates, supported by the above empirical evidence,
liberalization policies, especially in Asia, had two salutary outcomes: one intended
and one unintended. The intended consequence was that reductions in the extent of
state intervention typically attracted FDI. The unintended consequence was that the
extent of corruption declined.
Limitations
In the design of our study, we contend that government regulation is tightly related to
levels of corruption. A limitation of our study is that we only consider the existence of
regulation as an indicator of the opportunities for corrupt practices. The quality of the
rules and regulations is likewise important. The Fraser Institute variable that we use to
measure the burden of government regulation is a composite measure that includes
both quantitative (number of rules) and qualitative (impact of rules) dimensions. In
this way, our measure does capture elements of the existence and quality of rules.
However, a finer distinction could be drawn, such as recent work decomposing
corruption along the two dimensions of pervasiveness and arbitrariness (Rodriguez
et al., 2005): the first dimension relates to how widespread corruption is and the
second refers to the uncertainty associated with having to make corruption payments.
An important aspect that might affect the relationship between regulation, corrup-
tion, and FDI is the impact of national culture. There is an established strand of
research that examines whether and to what extent cultural distance determines the
location decision of multinationals, their entry mode and the successes and/or failures
of their business operations (Shenkar, 2001). We have not explicitly taken into
Government regulation, corruption, and FDI 505
Author's personal copy
consideration national cultures in our empirical analysis. Nonetheless, the effect of
culture is indirectly picked up in our estimations by the country dummies. Although
this can be viewed as a limitation of our research, it opens the scope for future
research in which to address how culture might relate to corruption by comparing
developing and developed countries.
Finally, we recognize that our data relate to less developed and emerging market
economies. We chose such a restricted sample in order to ensure an apples to apples
comparison. Further, such economies tend to have rapidly changing institutional
environments (Kumaraswamy, Mudambi, Saranga, & Tripathy, 2012). This creates
many opportunities for the exercise of corrupt practices since such countries exhibit
more institutional flexibility than more developed countries where property rights are
well established and defended(Mudambi, Navarra, & Paul, 2002: 185). Therefore,
we would be cautious about extending our results to the case of advanced market
economies. However, very poor countries are likely to exhibit similar institutional
characteristics with regard to the defense of property rights as the countries in our
sample, so we would expect our results to hold there.
Conclusion
There is a substantial empirical literature documenting the negative effect of corrup-
tion on FDI (Habib & Zurawicki, 2002; Hines, 1995; Smarzynska & Wei, 2002; Wei,
2000). There is also a literature documenting the linkage between corruption and the
extent of the regulatory burden (Ades & Di Tella, 1999,1997; Djankov et al., 2002;
Shleifer & Vishny, 1999). Integrating these findings leads to the implication that an
increased burden of regulation leads to both higher levels of corruption and lower
levels of FDI.
In this paper, we develop a theoretical model in which the volume of FDI and the
level of corruption are jointly determined by the extent of the government regulatory
burden. The model integrates the two strands of literature discussed above. In doing
so, we are able to develop a choice-theoretic framework explaining the determination
of the extent of the regulatory burden. The level of corruption emerges as endogenous
outcome of the interaction between MNC firms and the government. Intuitively,
governments that have very short time horizons are more likely to choose heavier
regulatory burdens since they place less value on future inflows of FDI. In contrast,
governments that have longer time horizons choose lighter regulatory systems. Such
policies have two self-reinforcing effects. First, they stimulate the development of a
larger FDI stock that is a lucrative source of future corruption payments. Second, they
enhance the likelihood of government survival through more rapid economic growth
and high skill employment through technology transfer and spillovers (Cantwell,
1995).
Estimating FDI using corruption and other standard control variables, we are
able to reproduce the results reported in the FDI-corruption literature: higher levels
of corruption are associated with lower levels of FDI. Estimating corruption using
the regulatory burden and other controls, we obtain results that are consistent with
the findings reported in the literature on regulatory burden (i.e., higher levels of
regulation are associated with higher levels of corruption). Finally, when we
506 R. Mudambi et al.
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combine these results and treat corruption as endogenously determined by the
extent of regulation, we find that it is the regulatory burden that has the significant
effect on the level of FDI inflows. Once corruption is treated as an effect of the
regulatory burden, rather than an exogenous factor, its direct effect on FDI is
statistically insignificant.
This finding has important policy implications. Both governments and interna-
tional agencies spend substantial resources on policies aimed at combating corrup-
tion. The expenses associated with these policies include both the costs of
enforcement, as well as the costs of designing and maintaining detailed location-
specific codes of conduct and action plans (e.g., Asian Development Bank, 2006;
United Nations, 2001). The effects of these policies have shown up in the delaying or
denial of development aid to countries with poor corruption records (Institute for
Global Ethics, 2006). These policies are touted as means of improving economic
performance and attracting foreign investors. However, it has been recognized that
the success of such policies may be doubtful when officials expend resources to
avoid detection and punishment(Manion, 1996).
Our analysis suggests that such monitoringpolicies fail to address the root cause
of the problem. More importantly, they may not have a discernable impact since they
are likely to be overwhelmed by the powerful incentives for public officials created
by the regulatory burden. Thus, in addition to their direct effect on market efficiency,
deregulation and liberalization can have strong indirect benefits through reducing the
opportunities for corrupt practices.
Appendix
Variables, definitions, and sources
Variable Definition Source
Endogenous variables
FDI inflows FDI inflows in constant 1986 US$ (millions) UNCTAD
a
Corruption Corruption Index (Higher values 0less corrupt) Transparency
International
b
Exogenous variables
Burden of regulation Economic freedom indices
(Higher values 0less regulation)
The Fraser
Institute
c
Secure property rights Economic freedom indexdimension 1
Freedom to trade Economic freedom indexdimension 2
Sound money Economic freedom indexdimension 3
Government size Economic freedom indexdimension 4
Business regulation Economic freedom indexdimension 5
GDP Constant 1986 US$ (millions) The World Bank
d
GDP growth Average annual growth rate of GDP, 19852000 The World Bank
Country risk Country financial risk rating (Scale 1 to 100,
higher values 0lower risk)
The World Bank
Government regulation, corruption, and FDI 507
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Emerging and developing economies in the dataset:
Argentina, Bolivia, Botswana, Brazil, Cameroon, Chile, P.R. China, Colombia, Congo Dem.
R., Costa Rica, Dominican Rep., Ecuador, Egypt, El Salvador, Gabon, Ghana, Guatemala,
Haiti, Honduras, India, Indonesia, Iran, Jamaica, Jordan, Madagascar, Malawi, Malaysia, Mali,
Mauritius, Mexico, Morocco, Nigeria, Pakistan, Panama, Papua New Guinea, Paraguay, Peru,
Philippines, Poland, Rwanda, Senegal, Sierra Leone, South Korea, Sri Lanka, Syria, Thailand,
Togo, Trinidad and Tobago, Tunisia, Turkey, Uganda, Uruguay, Venezuela, Zambia,
Zimbabwe.
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(continued)
Variable Definition Source
Inflation Annual inflation rate (%) The IMF
Trade exposure Trade as a percentage of GDP UNCTAD
Export diversity Country where no single category (manufactures,
non fuel primary, fuels, services) accounts for
more than 50 % of total exports
UNCTAD
Africa African country (dummy)
Literacy Adult literacy rate (%) UNESCO
e
Civil liberties Index of civil liberties (Scale 1 to 7; higher
values 0more civil liberties)
The Freedom House
f
LegalUK Legal institutionsUK (dummy) National sources
LegalFrance Legal institutionsFrance (dummy) National sources
a
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b
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Corruption Research at the University of Passau, Germany).
c
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of government: Expenditures, taxes, and enterprises; and (5) Regulation of credit, labor, and business.
d
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e
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f
The Freedom House (20002002).
(continued)
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Ram Mudambi (PhD, Cornell University) is a professor and Perelman Senior Research Fellow at the Fox
School of Business, Temple University. He is a visiting professor of international business at the University
of Reading and an honorary professor at the Centre for International Business, University of Leeds. He has
published more than 60 refereed articles in refereed journals including the Journal of Political Economy,
Journal of Economic Geography,Strategic Management Journal, and Journal of International Business
Studies. His research focuses on the geography of innovation, especially in the context of multinational
firms.
Pietro Navarra (PhD, University of Buckingham) is a professor of public sector economics at the
University of Messina (Italy). He is a visiting professor at the University of Pennsylvania (USA) and
research associate in the Centre for Philosophy of Natural and Social Sciences at the London School of
Economics (UK). He has published more than 50 articles in refereed journals such as the Journal of
International Business Studies,Journal of Product Innovation Management,Oxford Bulletin of Economics
and Statistics,European Journal of Political Economy, and Public Choice. His research interests embrace
the measurement of freedom, the relationship between political institutions and economic reforms, and the
interplay between individual empowerment, entrepreneurship, and economic growth.
Andrew Delios (PhD, Richard Ivey School of Business, University of Western Ontario) is a professor in the
Strategy & Policy Department, National University of Singapore. He is a General Editor of the UK-based
Journal of Management Studies. He has published extensively in strategy and international business
journals on topics such as foreign direct investment and international strategy. He is the author of several
books including China 88: The Real China and How to Deal with It (Pearson).
Government regulation, corruption, and FDI 511
Author's personal copy
... There is evidence that low government performance hinders FDI inflow and vice versa. For instance, corruption has been found to reduce capital accumulation in general (Méon and Sekkat 2005), and negatively affect FDI in particular (Mudambi et al. 2013). It is recommended that countries that are small or lack of natural resources can attract FDI by improving their institutions and policy atmosphere (Asiedu 2006). ...
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Thesis
In this dissertation, both globalization forces and internal sociopolitical aspects are analyzed to examine how these factors affect growth and environmental quality in various countries, with a closer focus on developing economies and then Vietnamese small and medium-sized enterprises (SMEs). So far, there are few works attempting to address sustainability in a holistic approach of both outside and inside contexts. The research aims to provide a comprehensive discussion on how a country should match its integration level and its governance quality to achieve sustainable development. The three empirical studies are presented in three main chapters of this dissertation, from Chapter 2 to Chapter 4. Chapter 2 - An empirical investigation of the Environmental Kuznets Curve (EKC) from an international economics perspective: trade, FDI and the origin factor of FDI. This study tests the EKC hypothesis and studying the environmental impacts of FDI (from developed and developing partners) and trade, the two important physical aspects of globalization. Furthermore, the country-of-origin factor of FDI, which is largely ignored in the literature, is proved to be important to understand the impact of international investment on the environment. Chapter 3 - Interaction between FDI and domestic factors in terms of their environmental impacts in developing countries. Utilizing the Environmental Kuznets Curve (EKC) model, this chapter examines the environmental impacts of institutional variables in their relationships with foreign direct investment (FDI) in 23 developing countries. All six elements of government indicators are tested while controlling their interaction terms with the two types of FDI, which originate from developed and developing regions. There are two important findings. First, FDI is proven to be an important channel to deliver the environmental effects of institutional qualities. Second, the FDI origin factor is critical to the nature of this interactive connection. Chapter 4 - Export propensity, informal payment, politician ties and the Environment Standard Certificates (ESCs) of Vietnamese SMEs: Using firm-level data from a survey of more than 2600 Vietnamese SMEs, the last study finds empirical evidence of how export and corruption affect firms’ attitude toward environmental protection. The study emphasizes the need for better corruption control to make pollution control certification reflect the real environmental protection attitude of firms. All in all, in the globalization era, when market forces greatly connect economies and drive firms behaviours, the role of environmental leadership at both national and international levels has become an essential element of the sustainable development. From that, a discussion on how governments and businesses should embrace globalization through a sustainable path is elaborated.
... According to its results, the role of poor governance in increasing FDI is not only in transition countries but also in Latin America. Mudambi, Navarra & Delios (2013), applied empirical testing of FDI inflows in 55 countries in four different time periods. According to these test results, the level of economic regulation is an important determinant of the level of corruption as well as the extent of FDI inflows. ...
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Foreign Direct Investment (FDI) has been always associated with a high level of trade openness and freedom environment, and with a lower incidence of institutional corruption. Because it is assumed that a high level of international capital mobility makes foreign investors more cautious when there is a fluctuation in political stability and institutional transparency. Most American countries (except Canada and the USA) have been always related to a lack of transparency in their institutional and bureaucratic procedures, which conduct to important levels of corruption and in consequence, to other serious issues such as prominent level of violence, or even the inequality phenomena. Considering the above, this study investigates whether the variables of corruption indices, trade openness and inflation rates have positive or negative effects on FDI between Turkey and American countries. For analyzing this econometric model, it was gathered information from OECD, COMTRADE, TUIK, Heritage Foundation, OEC, UNCTAD, and the World Bank Database. The observed data correspond to a decade (2005-2014) and were only taken a sample of 14 American countries. The empirical results of the present study revealed that there is a positive correlation between the trade openness index and FDI; despite that, and against academic literature, it was found a positive correlation between corruption index, inflation, and FDI.
... According to its results, the role of poor governance in increasing FDI is not only in transition countries but also in Latin America. Mudambi, Navarra & Delios (2013), applied empirical testing of FDI inflows in 55 countries in four different time periods. According to these test results, the level of economic regulation is an important determinant of the level of corruption as well as the extent of FDI inflows. ...
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Foreign Direct Investment (FDI) has been always associated with a high level of trade openness and freedom environment, and with a lower incidence of institutional corruption. Because it is assumed that a high level of international capital mobility makes foreign investors more cautious when there is a fluctuation in political stability and institutional transparency. Most American countries (except Canada and the USA) have been always related to a lack of transparency in their institutional and bureaucratic procedures, which conduct to important levels of corruption and in consequence, to other serious issues such as prominent level of violence, or even the inequality phenomena. Considering the above, this study investigates whether the variables of corruption indices, trade openness and inflation rates have positive or negative effects on FDI between Turkey and American countries. For analyzing this econometric model, it was gathered information from OECD, COMTRADE, TUIK, Heritage Foundation, OEC, UNCTAD, and the World Bank Database. The observed data correspond to a decade (2005-2014) and were only taken a sample of 14 American countries. The empirical results of the present study revealed that there is a positive correlation between the trade openness index and FDI; despite that, and against academic literature, it was found a positive correlation between corruption index, inflation, and FDI.
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This paper empirically evaluates the impact of environment stringency policy, business regulations, policy and economic uncertainty, and real GDP per capita on foreign direct investment (FDI) inflows by employing the autoregressive distributed lag approach and using data from 2000 to 2015. Specifically, we focus on two groups of countries with different economic development, the Group of Seven (G7) and the BRICS countries, and the composite indices of business and environmental regulations and policy-induced uncertainty, along with real gross domestic capital (GDP) per capita, were selected to reflect the multidimensionality of the settings in the selected countries. Our results indicate that only the effect of real GDP per capita turned out to be homogenous and statistically significant across different income groups and time horizons. Findings also show that more friendly business regulations significantly encourage FDI inflows in the long run, but there is a bottom line. When regulations are already at a low level, as is the case with G7 countries, further liberalization would adversely affect FDI inflows. Furthermore, more stringent environmental regulations have a marginally adverse effect on FDI inflows only in the long run. At the same time, they weakly support the pollution haven hypothesis. The impact of policy-induced uncertainty on investment is adverse but largely nonsignificant in the short run. It appears that cross-border investments follow a pattern of the safe-haven effect to avoid uncertainty in the long run.
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Book
Recent advances in establishing the nature and scope of estimators in econometrics have shed more light on the importance of instrumental variables. In this book, the authors argue that such methods may be regarded as a strong organizing principle for a wide variety of estimation and hypothesis testing problems in econometrics and statistics. In support of this claim they present and develop the methodology of instrumental variables in its most general and explanatory form. They show, for instance, that techniques commonly used to handle simultaneity and related problems can be reduced to one of two generic variables of instrumental variables estimators, allowing them to explore further the conditions under which different proposed estimators are efficient.