Foreign Direct Investment and institutional quality: Empirical Evidence from Countries with different Income Levels

Abstract

Less developed countries admire attracting foreign direct investment because it is considered to play a vital role in achieving growth targets. Weak Quality of Institutional governance may obstacle to achieving the target. This paper examines, whether the quality of institutions has any impact on the inflow of foreign direct investment by using the data for 165 countries for the time period 1996-2014. The study uses the classification of the countries according to income levels published by the World Bank. Fixed and Random effect models are used to investigate, whether all institutions are equally important for countries with different income levels. The results exhibit that countries with different income levels have differing importance of institutions. Control of corruption has a positive and significant influence on the inflow of FDI, for the overall 165 countries and for high OECD countries. Quality of Institutional governance has no effect on the inflow of FDI in low-income countries but trade openness, GDP per capita growth, and population growth have a significantly positive influence. Trade openness has a positive impact on FDI inflows in countries with all income levels. The paper concludes that countries should focus on the improvement of institutional governance, especially the institutions which are important to attract FDI for them. Trade openness has a crucial role in attracting FDI, therefore, all countries might be open outward.

Full text

Foreign Direct Investment and institutional quality: Empirical Evidence from
Countries with different Income Levels
Fouzia Awan
University of Central Punjab, Lahore, Pakistan
fouziawan@yahoo.com
Abstract
Less developed countries admire to attract foreign direct investment because it is considered to
play a vital role in achieving the growth targets. Weak Quality of Institutional governance may
obstacle to achieve the target. This paper examines, whether the quality of institutions have any
impact on the inflow of foreign direct investment by using the data for 165 countries for the time
period 1996-2014. The study uses classification of the countries according to income levels
published by the World Bank. Fixed and Random effect models are used to investigate, whether
all institutions are equally important for countries with different income levels.
The results exhibits that countries with different income levels have differing importance of
institutions. Control of corruption has positive and significant influence on the inflow of FDI, for
the overall 165 countries and for high OECD countries. Quality of Institutional governance have
no effect on the inflow of FDI in low income countries but trade openness, GDP per capita growth
and population growth have significantly positive influence. Trade openness has a positive impact
on FDI inflows in the countries with all income levels. The paper concludes that countries should
focus on the improvement of institutional governance, especially the institutions which are
important to attract the FDI for them. Trade openness has a crucial role in attracting FDI,
therefore, all countries might be open outward.
Keywords: foreign direct investment, institutions, Trade, Income levels, GDP

1. Introduction
Profitable investment and capital accumulation plays vital role in the growth and development of
any country. In this era of globalization, countries can exploit the opportunity of having access to
foreign investment. But all type of investment may not be desirable for the economy, because as
political, economic and social conditions of any country change investors response in accordance.
Portfolio investments and short term credit shows quick reversal in case of any unfortunate
situation, which worsen the economic condition in the host country. Whereas, foreign direct
investments are more robust to such type of crises. Therefore, it is recommended that countries
would try to attract foreign direct investment and must be cautious in admitting other sources of
finance (Prasad et al., 2003). The question is that, what are the factors and what measures host
country can adopt to attract FDI.
Along with economic factors, the significance of socio-economic factors cannot be undermined.
This importance has been realized even in early literature as Basi (1963) examined the influence
of political instability on foreign investment. The recent studies, following the persuasive research
paper of North (1990), emphasis on the importance of institutions in attracting FDI and in
achieving growth targets. During 1990s as flows of FDI experienced a large growth, countries tried
to reform their institutions in order to attract more and more foreign investment. Furthermore,
foreign investors are more concerned with the quality of institutions while deciding in which
country to invest (Bevan et al 2004).
Sound institutions, as claimed by policy makers, are important to attract more and more FDI. But
no clear evidence have been found in favor of institutions in the literature. Lim (2001) asserts that
mixed results are reported by the empirical studies and he notices that all institutional indicators
are not equally important for FDI. Blonigen (2005) reports some evidence in favor of institutions
and others against them, deducing that more studies are required in order to have conclusive
results. These authors ascribe that conceptual, measurement and methodological problems might
be the reason for indecisive results.
More recently, several studies investigated the FDI and institutions link, (Globerman and Shapiro
(2002), Bènassy-Quèrè et al (2007), Busse and Hefeker (2007),), using different econometric
techniques, although no definite results yet been found. The main intention of this study is to asses
that either all institutional indicators are equally important for FDI inflows in the groups of the
countries with different income levels or some institutional aspects matter more in one group of
country than the other.
The paper is organized as: second section is literature review on FDI and institutions, third one
explains methodology and data description, fourth includes result analysis and fifth section provide
conclusion.

2. Previous empirical contributions
Morrissey and Udomkerdmongkol (2012) sued data from 1996-2009, for 46 developing countries
and discovered that countries experiencing good governance have higher level of total (domestic
and foreign) investment. Among the governance indicators, Political stability and corruption have
the greatest effect on investment.
Ali et al., (2010) investigated the role of institutions in determining FDI, while using large panel
data for 107 countries for the period 1981-2005. The study found a significant effect of institutional
governance on foreign investment and most influencing factors were rule of law, expropriation
risk and propriety rights. Institutions are not equally important for all sectors of the economy.
Primary sector is less dependent on the institutions as compare to manufacturing and service sector.
Javorcik and Wei (2009) examined the entry decision for the mode (joint venture verses wholly
owned subsidiary) as determined by the R&D intensity of industry and corruption in the host
country. High R&D increase the risk of leakage of technology, therefore wholly owned subsidiary
was favored. In more corrupt countries, stronger impact of R&D intensity favoring the wholly
owned mode was found. Entry decision halts in the presence of corruption in the host country but,
if enters, then joint venture would be opted.
Busse and Hefeker (2007) used data from 83 developing countries for the period 1984-2003 to
explore the factors that are most important for multinationals activities. The study verified that
government stability, law and order, internal and external conflict, quality of bureaucracy,
corruption and ethnic tensions and democratic accountability of government are highly significant
determining factors of FDI. However, the study empirically validated that only few institutional
indicators have statistically significant effect.
Witt and Lewin (2007) described unfavorable institutions were the reason for increased outward
FDI from industrialized countries. It was stated that firms escape the location due to restrictions in
the home countries. Bénassy-Quér, Coupet and Mayer (2007) used newly available data for 52
developing countries to explore the impact of institutional quality on FDI, then compare the results
with other more familiar data sets. The study revealed that quality of institutions was an important
determinant of FDI, therefore, improved quality of institutions may attract more foreign capital.
The results made known that in order to attract FDI, developing countries need to make efforts to
improve the institutional quality.
Bengoa et al., (2003) employed panel data analysis for Latin American countries for the period
1970-1999 and found positive relationship between economic growth and FDI. Furthermore,
economic stability, human capital and liberalized markets argued as helpful in attracting FDI in
the long-run. Harms and Ursprung (2002) found positive relationship among protection of
individual freedom, defense of citizens’ rights and FDI. Asiedu (2002) concluded trade openness,
rate of return, country risk and infrastructure as important factors effecting FDI inflows.

Globerman and Shapiro (2002) explored positive impact of improved institutions on both inflow
and outflow of FDI, especially strong for developing countries.
Chakrabarti (2001) inquired that major determinants of FDI were growth rate, exchange rate
stability, size of market, cost of inputs, trade openness, trade and non-trade barriers. Daude and
Stein (2001) mentioned that spurious results would appear if GDP per capita will not be included,
because GDP per capita and corruption are highly collinear. The study used six institutional
governance indicators provided by Kaufman et al. (1999) and exhibited that institutions
significantly affect the FDI. Only the voice and accountability was non-significant while all other
indicators as government effectiveness, rule of law, Political instability and violence have
significant impact on FDI.
Henisz (2000) investigated the relationship of institutional variables with two forms of FDI joint
ventures and majority owned subsidiaries. He discussed the difference between political and
contract enforcement hazards. Both interact in joint ventures: local partner firm can cheat the
foreign firm by using its political influence. The study found week support for this hypothesis
while used US manufacturing firms’ data on FDI. Lipsey’s (1999) findings were in line with
Chakrabarti (2001), when he used real GDP per capita, size of market, a distance variable, measure
of tax rates and growth to inspect the determinants of US affiliates in Asia.
Ayal and Georgios (1998) used OLS to analyze the impact of components of economic freedom
on output, investment and growth rate. Results demonstrated that economic growth was
accelerated by economic freedom through capital accumulation process. Furthermore, factor
productivity enhanced positively by these factors. Eaton and Tamura (1994) presented an
application of gravity model to foreign investment, to analyze that how much FDI depends on
GDP or population in the host country and on the earthly distance between both countries.
Wheeler and Mody (1992) was unable to explore any significant impact of host country risk factors
on the location of US foreign affiliates.
Factors that attract FDI may be different in the countries with different income levels. Low income
countries may have poor institutions, higher inflation and inferior development indicators as
compare to high income countries. Investment decisions of multinationals consider different
factors while investing in developed or under developed nations. In developed nations, educated
labor, macroeconomic stability has to be traded off with lower wages or profitable but shielded
market in lower income countries, Walsh and Jiangyan (2010).
As the literature reviewed shows distinctive impact of institutions on FDI when data taken from
different sources and for different groups of countries. Furthermore, it is necessary to check
whether the differences in incomes of the countries can produce different results, when relationship
of FDI and institutional factors will be judged.

3. Data Description and Methodology
In this section description of variables, sources of data and methodology is described.
3.1 Description of variables and Data sources
The analysis is based on 165 countries, for the period 1996-2014. Along with this comprehensive
evaluation of all the countries, the study examine them in categories according to their income
levels, i.e. High non OECD, High OECD, Low, Lower Middle, Upper Middle. Foreign direct
investment, net inflows (% of GDP) is used as dependent variable to observe the impact of
institutional governance and other control variables.
This study uses estimates of six governance indicators: Control of Corruption, Government
Effectiveness, Political Stability and Absence of Violence/Terrorism, Regulatory Quality, Rule of
Law, Voice and Accountability provided by Kaufman et al. (1999), taken from World Governance
Indicators (WGI), World Bank data site. These indicators are created from 31 different data sources
and are based on several hundred variables. Whereas reports of survey respondents, commercial
business information providers, nongovernmental organizations and public sector organizations
used to capture governance perceptions for these variables. Estimates of governance indicators
provide the score of a country on the aggregate indicator, in units of a standard normal distribution,
i.e. ranging from approximately -2.5 to 2.5.
The paper also uses five control variables in the regressions: Gross Domestic Product (GDP) used
for size of market, GDP per capita growth (GROWTH) for market growth and potential,
population growth (PG) (as proxy of labor force growth) for human capital, TRADE to control for
openness and Inflation, GDP deflator (INF) as a proxy for policy distortions. Data Source is World
Development Indicators (WDI), from World Bank data site.

Table 1. Description of variables
Variable
Name
Definition
FDI
Foreign direct investment is the net inflows of investment (% of GDP)
CC
Control of Corruption encapsulates perceptions of the extent to which public
power is exercised for private gain, including both trivial and large forms of
corruption, furthermore, "capture" of the state by elites and self-contained
interests.
GE
Government Effectiveness describes insights of the quality of public services,
the civil service and the extent of its independence from political pressures, the
quality of policy design and execution, and the reliability of the government's
commitment to such policies.
PS
Political Stability and Absence of Violence/Terrorism gauges perceptions of the
possibility of political instability and/or politically-motivated violence,
including terrorism.
RQ
Regulatory Quality depicts perceptions of the ability of the government to
formulate and implement rigorous policies and rules that permit and promote
private sector development.
RL
Rule of Law summarizes observations of the extent to which agents have
confidence in and accept the rules of society, and in actual the quality of contract
enforcement, property rights, the police, and the courts, as well as the likelihood
of crime and violence.
VA
Voice and Accountability portrays pictures of the degree to which a country's
citizens are able to participate in selecting their government, as well as freedom
of expression, freedom of association, and a free media.
INF
Inflation is measured by the annual growth rate of the GDP deflator (annual %),
which shows the rate of price change in the economy as a whole.
TRADE
Trade (% of GDP) is the sum of imports and exports of goods and services,
which is measured as a share of GDP.
GDP
Gross Domestic Product (constant 2005 US$)
GROWTH
Annual percentage growth rate of GDP per capita, Aggregates are based on
constant 2005 U.S. dollars. GDP per capita is GDP divided by midyear
population.
PG
Annual population growth rate

3.2 Methodology and Econometric Model
For FDI model specification there is no straightforward guidance in the theory. Researchers mostly
report more tempting results, which are in accordance with their specific research aims (Moosa
and Cardak 2006). But some researcher made careful efforts to conclude determinants of FDI.
Chakrabarti (2001) applied Extreme bound analysis and establish the market size as most robust
explanatory variable for FDI. Trade openness, prospect of growth, human capital and policy
measure are other important factors used by the researchers.
In line with other studies this paper used FDI, as the dependent variable whereas GDP, GDP per
capita growth, trade, population growth, inflation and institutions as explanatory variables.
FDIit = ß0 + ß1 GDPit + ß2 GROWTHit + ß3 TRADEit + ß4 INFit + ß5 PGit + ß6 INSTit + eit (1)
Where FDI is foreign direct investment (for country i and period t), net inflows (% of GDP); GDP
is Gross Domestic Product (constant 2005 US$); GROWTH is GDP per capita growth (annual %);
TRADE is sum of imports and exports of goods and services measured as a share of GDP;
INFLATION is annual growth rate of the GDP deflator (annual %); PG is Population growth
(annual %) and INST represent vector of six institutional governance variables which includes:
Control of Corruption, Government Effectiveness, Political Stability and Absence of
Violence/Terrorism, Regulatory Quality, Rule of Law, Voice and Accountability.
4. Empirical Results
The characteristics of the data used in the study allowed for conducting two types of econometrics
analysis. As the research includes panel data, the Fixed and Random Effect models are used for
the analysis. Firstly, Ordinary Least Square (OLS) Model, Fixed Effect Model and Random Effect
Model were calculated. Then F-Test was applied to make choice between OLS and Fixed effect
model, whereas, Lagrange multiplier (LM) test (Breusch and Pagan, 1980) to make decision for
OLS or Random Effect Model. The study found both Fixed and Random Effect models statistically
significant, therefore, Hausman test was conducted to choose between Random and Fixed Effect
Models. Between regression was used for the estimation of the results for Overall 165 Countries,
Low income countries and High OECD. Whereas, Random Effect GLS regression employed for
lower middle-income, Upper Middle-Income and High OECD countries.
Controlling for other variables, trade openness has a positive impact on the foreign investment
inflows in the countries with all income levels. Which expresses that free interaction with rest of
the world encourage multinationals to reach the countries, regardless the income level that country
has. GDP per capita growth have significantly positive impact on FDI inflows in low, lower
middle, upper middle, and overall countries. It reveals that growth prospect is an important factor
in determining FDI inflows in these countries. None of the institutional governance variables are
significant in case of low income countries, but GDP per capita growth, trade openness and

population growth have significantly positive influence. These results reveals that growth prospect,
free interaction with rest of the world and availability of low cost labor or human capital in low
income countries attract FDI.
The results exposes that institutions have varying effect on foreign investment in the countries
with different income levels. Analysis of overall 165 countries is presented in Table 2, column 1.
The study finds differing effects of control of corruption for different groups of countries.
Controlling for other determinants, a positive and significant influence of control of corruption has
shown on the inflow of FDI, for the overall 165 countries and for high OECD countries. Whereas,
a negative relation has gauged for lower middle income and high non OECD countries. This may
be due to the part of the fact that lower middle income countries have higher level of corruption
but they have low cost labor and resource of production. High non OECD countries are mostly
natural resource-rich countries, foreign companies’ investment in these countries in resource
industries. Amighini, Rabellotti and Sanfilippo (2011) also stated negative relation of control of
corruption and FDI in resource rich countries. Asiedu (2005) examined data from 1984-2000 for
22 African countries and revealed that lower level of corruption, reliable legal system and political
stability can attract foreign capital.
Political stability affirms continuity of the policies because as governments change priorities of
the ruling class will also change. Therefore political instability discourages multinationals to inter
in such a country. The study finds strong positive impact of political stability on FDI inflows in
the lower middle income countries. Drabek &Payne (1999) considered 49 countries’ data for the
period 1991-95, used ICRG Political Risk Index and unearthed that increased degree of
transparency in the institutions and policies could expect significant increase in FDI inflows.
Political stability is not significant for any of the other group of countries. Similarly, law and order
situation in the host countries does not affect the decisions of foreign investors in any group of
countries. Kolstad & Tondel (2002) employed data for 61 developing countries for 1989-2000
and exposed that foreign investors care less about law and order, external conflict and military in
politics. Bureaucratic quality and government stability is not significant for FDI. Noorbakhsh et al
(2001) while studding data from 1980-94 for 36 developing countries realized that political risk
has no effect on foreign investment.
The study explores positive relation between regulatory quality and FDI inflows in lower and
upper middle income countries. The results exhibits that formulation and implementation of sound
policies by the government, which promote private sector development, can attract foreign
investors in these countries. Busse and Hefeker (2007) verified that quality of bureaucracy and
democratic accountability of government are very important factors of FDI. However, the study
empirically validated that only few institutional indicators have statistically significant effect.
Voice and accountability significantly positive for FDI inflows in high non OECD and overall 165
countries but have negative relation with FDI in lower middle income countries. Rent seeking
behavior of ruling class in lower income countries provide benefits to foreign investors for their
own self-interest and free media or freedom of expression can hurdle this activity.

Table 2: Estimation results for FDI inflows
Explanatory Variables
Overall
Countries
(1)
Low-
Income
countries
(2)
Lower
Middle-
Income
countries
(3)
Upper
Middle-
Income
countries
(4)
High Non
OECD
countries
(5)
High
OECD
countries
(6)
Control of Corruption
2.4894*
(1.2564)
0.5833
(2.8816)
-1.7025**
(0.8621)
-0.3002
(0.8658)
-9.1583*
(5.1382)
4.2978*
(2.2952)
Government
Effectiveness
-3.7836*
(1.4999)
0.0472
(2.9768)
-0.7220
(0.9998)
-2.0398**
(0.9837)
-7.2837
(6.4292)
-3.3836
(2.6241)
Political Stability and
Absence of
Violence/Terrorism
-0.5331
(0.5917)
-1.1677
(1.3512)
1.1394***
(0.4074)
0.0295
(0.4685)
2.5024
(3.4208)
-1.8412
(1.3711)
Regulatory Quality
0.8449
(1.1114)
-3.3205
(2.3915)
1.5488**
(0.7141)
1.8572**
(0.7626)
-2.5617
(4.9552)
1.7913
(2.4970)
Rule of Law
-0.4469
(1.6156)
0.0834
(3.5743)
1.3923
(0.8985)
-0.6171
(1.0968)
10.9249
(6.8772
-2.6285
(3.4900)
Voice and
Accountability
2.0987**
(0.6723)
2.4528
(1.5757)
-1.4107**
(0.5876)
0.4487
(0.5888)
6.8713**
(2.8704)
3.2237
(3.7740)
Inflation
-0.0061
(0.0157)
-0.0143
(0.0174)
0.0004
(0.0079)
-0.0052*
(0.0027)
0.0556
(0.3374)
0.2175
(0.1449)
Trade
0.0737**
(0.0069
0.1073***
(0.0279)
0.0393***
(0.0072)
0.0483***
(0.0078)
0.1146***
(0.0229)
0.1069***
(0.0115)
GDP
1.94e-13
(2.81e-13)
-3.65e-11
(1.90e-10)
8.57e-13
(1.79e-12)
1.15e-15
(5.88e-13)
7.08e-12
(8.71e-12)
3.51e-13
(2.71e-13)
GDP per capita Growth
0.5720**
(0.1321)
0.7342*
(0.3606)
0.1162***
(0.0389)
0.0604***
(0.0198)
-0.2359
(0.5006)
0.0192
(0.1401)
Population Growth
0.4302
(0.2745)
2.4289**
(0.9947)
0.4230
(0.3026)
0.1205
(0.0198)
0.7972
(0.8441)
0.9408
(0.8355)
Constant
-3.6648***
-11.1435**
-0.5748
-0.3689
-0.3970
-8.2512
R2
0.5849
0.8812
0.8197
rho
0.2457
0.3996
0.0673
Effect Test
4.53***
3.94***
302.38***
864.96***
3.36***
7.16***
Number of Groups
165
26
39
43
25
32
Number of Observations
3135
494
741
817
475
608
Standard Errors in parentheses; *** significant at 1% level; ** significant at 5% level; * significant at 10% level.
Government effectiveness has significant and negative effect on upper middle and overall 165
countries. Negative impact of the Government effectiveness may be due to the reason that if
political pressures can influence the policy implementation then politicians make commitments
with foreign companies to give them undue favors in return of rent seeking.
The study infers that countries should focus on the improvement of the institutional governance
indicators, which are important to attract the FDI for them. Trade openness has a vital role in
attracting FDI, therefore, all countries might be open outward.

5. Summary and conclusions
The study examines the relationship of FDI inflows with institutional governance indicators and
other economic variables while using panel data for 165 countries for the period 1996-2014.
Furthermore, the study analyzed the groups of countries with different income levels separately.
Fixed and Random effect models are used to investigate, whether all institutions are equally
important for countries with different income levels. The study reveals that institutional
governance variables have differing impact on these groups of countries. Trade openness is an
important determinant for the FDI inflows for all groups of countries because it exhibits a positive
impact on FDI in the countries with all income levels.
Control of corruption has significant and positive effect on the inflow of FDI, for the overall 165
countries and for high OECD countries but negative impact on lower middle income and high non
OECD countries. No Institutional governance indicator have any effect on the inflow of FDI in
low income countries, whereas, trade openness, GDP per capita growth and population growth
have significantly positive influence. It exposes that free interaction with rest of the world, growth
prospect and human capital/cost of labor are important determinants of FDI inflows for low income
countries.
The study deduces that countries should focus on the improvement of specific institutional
governance indicators which are important to attract the FDI inflows for them. Trade openness has
a crucial role in attracting FDI, therefore, all countries might adopt free interaction with rest of the
world in order to achieve foreign investment targets.

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