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THE QUALITY OF INSTITUTIONS AND FOREIGN DIRECT INVESTMENT CHRISTIAN DAUDE Ã AND ERNESTO STEIN Using bilateral foreign direct investment (FDI) stocks around the world, we explore the importance of a wide range of institutional variables as determinants of the location of FDI. While we find that better institu- tions have overall a positive and economically significant effect on FDI, some institutional aspects matter more than others do. Especially, the un
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  THE QUALITY OF INSTITUTIONS ANDFOREIGN DIRECT INVESTMENT C HRISTIAN  D AUDE  AND  E RNESTO  S TEIN Using bilateral foreign direct investment (FDI) stocks around the world,we explore the importance of a wide range of institutional variables asdeterminants of the location of FDI. While we find that better institu-tions have overall a positive and economically significant effect on FDI,some institutional aspects matter more than others do. Especially, theunpredictability of laws, regulations and policies, excessive regulatoryburden, government instability and lack of commitment play a majorrole in deterring FDI. For example, the effect of a one standard devia-tion improvement in the regulatory quality of the host country increasesFDI by a factor of around 2. These results are robust to different spe-cifications, estimation methods, and institutional variables. We alsopresent evidence on the significance of institutions as a determinant of FDI over time. 1. INTRODUCTION O NE OF  the most notorious features of the trend toward globalization inrecent times has been the increased importance of foreign direct investment(FDI) around the world. Over the last couple of decades, worldwide FDIflows have grown by a factor of almost 10. To put this evolution in per-spective, trade flows around the world, by comparison, only doubled duringa similar period. In this context, a deeper understanding of the determinantsof the location of multinational enterprises is becoming more and morerelevant for the design of successful policies to attract investors.While the existing literature has focused mainly on the effects of corrup-tion or political risk on FDI, we contribute to the literature by testing abroader set of institutional variables that may affect the decision of foreigninvestors to undertake investment projects in a particular country. 1 This alsoallows us to assess what dimensions of the quality of governance institutionsaffect foreign investors’ location decisions more. In addition, while mostpapers in the literature analyze the effects of host country institutions on  Corresponding author: Christian Daude, Inter-American Development Bank, Stop E1009,1300 New York Avenue, NW, Washington, DC 20577, USA. E-mail: christiand@iadb.org 1 Among the papers that focus on the impact of political risk on U.S. investment abroad areFatehi-Sedeh and Safizadeh (1989, 1994), Loree and Guisinger (1995), and Schneider and Frey(1985), among others. For a more recent study, see Sethi et al. (2003). Schollhammer and Nigh(1987) focus on the impact of international conflicts German FDI. In general, the main messagefrom this literature is that the evidence for political instability as a significant determinant isweak. r 2007 The Authors. Journal compilation r 2007 Blackwell Publishing Ltd.,9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA02148, USA.  317 ECONOMICS & POLITICS DOI: 10.1111/j.1468-0343.2007.00318.xVolume 19 November 2007 No. 3  investment from a particular source, we use a large sample of bilateral in-vestment data. The use of bilateral data allows us also to estimate the impactof institutional variables embedded in an empirical model backed by FDItheory rather than ad hoc formulations as most studies in the literature.The impact of institutions on investment, either domestic or foreign, canbe related to two different channels. First, ‘‘bad’’ institutions might act as atax by increasing the cost of doing business. Second, imperfect enforcementof contracts might also increase uncertainty regarding future returns andthus have a negative impact on the level of investment. 2 Thus, for example,corruption may deter investment by increasing the cost of doing business, asinvestors need to bribe officials in order to obtain licenses and permits. Inaddition, corruption may increase uncertainty, which may deter investmentas well. According to Shleifer and Vishny (1993), the  secrecy  of corruption iswhat makes it much more distortionary than taxes.In the empirical literature of FDI location decisions, an often-cited paperrelated to ours is Wheeler and Mody (1992). They find that a compositemeasure of risk factors, which includes institutional variables such as theextent of bureaucratic red tape, political instability, corruption, and thequality of the legal system, does not affect the location of U.S. foreign af-filiates. However, their index aggregates these variables together with otherssuch as attitudes toward the private sector, living environment, inequality,risk of terrorism, etc., making it impossible to assess the role of individualvariables. In particular, the question of whether any of the institutionalaspects have a significant impact on FDI is left unanswered. Mauro (1995)represents the first systematic empirical study on a related topic. He showsthat corruption has a negative impact on the ratio of total and private in-vestment to gross domestic product (GDP) and therefore causes harm toeconomic growth. 3 Wei (2000), using data on bilateral FDI stocks fromOrganisation for Economic Co-operation and Development (OECD)countries, finds that corruption has an economically significant and negativeimpact on FDI. His results imply that an increase in the level of corruptionfrom Singapore to that of Mexico is equivalent to increasing the tax rate onmultinationals by more than 20 percentage points. In addition, Wei (1997)finds that uncertainty regarding corruption also has important negativeeffects on FDI location. 4 2 Althoughthis seemsto be anatural argument, Dixitand Pindyck(1993)showthat importantrestrictive assumptions are required to create a negative effect of uncertainty on the level of investment. See Stasavage (2002) for an empirical application that analyzes the effects ondomestic investment of checks and balances, as a mechanism to reduce time inconsistencyin capital taxation. 3 See also Henisz (2000) for an analysis of the impact of formal political institutions on eco-nomic growth, rather than outcome variables like those used by Mauro (1995). 4 See Smarzynska and Wei (2000) for a firm-level study in transition economies of the impactof corruption on FDI. 318  DAUDE AND STEIN r 2007 The AuthorsJournal compilation r 2007 Blackwell Publishing Ltd.  However, investment decisions may depend on different dimensions of public institutions in addition to corruption, like the regulatory framework,the predictability of economic policy, the protection of property right or theefficiency of law enforcement. In this paper, we provide evidence on theimpact of these different dimensions of governance institutions on the loca-tion of FDI. In addition, we use different types of institutional variablesbased on experts’ reports, surveys, and a combination of both in order toensure the robustness of our results.A different literature that is related to the present paper includes Aizmannand Spiegel (2002), Albuquerque (2003), Hausmann and Ferna ´ndez-Arias(2000), as well as Mody et al. (2003). This literature focuses on the effectsof institutions on the composition of capital flows. Albuquerque’s paperdevelops an imperfect enforcement model, where FDI has a risk-sharingadvantage over other capital flows, because it contains more intangibleassets that are inalienable and therefore make FDI less attractive toexpropriation. The optimal contract implies that the share of FDI in totalcapital flows is higher for financially constrained countries. In a set of cross-country regressions with the average FDI shares in gross private capitalflows as a dependent variable and controlling by GDP per capita and tradeopenness, he finds that the International Country Risk Guide (ICRG)variable of   Law and Order  has a negative but not significant effect. However,once credit ratings are included in the regression, the institutional quality hasa positive and significant effect on the FDI share. Mody et al. present amodel where multinational firms have an advantage over domestic firms inthe screening process of projects with a noisy signal concerning their reallevel of profitability. In this context, the value of this advantage is decreasingin the host country’s degree of corporate transparency. Thus, their modelpredicts that the proportion of FDI in comparison with portfolio investmentis lower in countries where institutions are more transparent. They presentempirical evidence in favor of this prediction, using an index of creditors’rights from La Porta et al. (2000) in a gravity model to explain the ratio of FDI flows to trade. Aizmann and Spiegel present an efficiency wage modelwhere ex-post monitoring costs and enforcement of labor contracts arelower for domestic firms than for multinationals, but the latter are moreproductive. In this situation, multinationals will be more sensitive tochanges in the enforcement cost (quality of institutions) and pay higherwages than domestic firms do. They find that the share of FDI to grossfixed investment, as well as the ratio of FDI to private domestic investment,is negatively and significantly correlated with the level of corruption, suchthat FDI seems to be more sensitive than domestic investment to theinstitutional quality. Finally, Hausmann and Ferna ´ndez-Arias study theeffects of institutional variables on the composition of capital inflows, usingsix different institutional variables compiled by Kaufmann et al. (1999a), aswell as indices of creditor and shareholder rights from La Porta et al.319 INSTITUTIONS AND FDI r 2007 The AuthorsJournal compilation r 2007 Blackwell Publishing Ltd.  (1998). 5 The authors find that better institutions lead to a reduction of theshare of inflows represented by FDI. They conclude that, in comparison withFDI, other forms of capital are more sensitive to the quality of institutions.When they look at the effects of their institutional variables on FDI as ashare of GDP, only a small subset of the institutional variables –   RegulatoryQuality ,  Government Effectiveness , and shareholder rights – remain sig-nificant after including some controls. Their summary index of institutions,the first principal component of the six institutional variables of Kaufmannet al., does not have significant effects on the ratio of FDI to GDP.Unlike these studies, our focus is on FDI per se, rather than on thecomposition of capital inflows. As in Wei (1997, 2000), we use bilateral dataon FDI stocks, but we use a wider range of institutional indicators. The useof bilateral data allows us to use a much richer set of control variables.Another contribution of our paper is that we avoid the shortcoming of theexisting empirical literature, especially the studies that analyze the effects of some institutional dimensions on FDI as Hausmann and Ferna ´ndez-Arias(2000), Mody et al. (2003), Wei (1997, 2000), and Wheeler and Mody (1992),in which they rely on ad hoc empirical specifications. In this sense, we testthe significance of the quality of institutions on FDI in an empirical modelthat follows recent developments in the theory of multinational enterpriselocation (see Markusen, 1997, 2001) more closely. Blonigen et al. (2002) andCarr et al. (2001) have used very similar econometrics specifications recently.The rest of the paper is organized as follows: in section 2, we present thedata, and discuss our empirical strategy. Section 3 presents our main resultson the institutional quality as a determinant of the location of FDI, while insection 4 we perform some sensitivity analysis and robustness checks. Insection 5, we extend to the effects of institutions over time using a panel dataanalysis. Finally, in section 6 we present our main conclusions. 2. DATA AND EMPIRICAL STRATEGY 2.1 FDI Data We use bilateral outward FDI stocks from the UNCTAD FDI database.The dataset covers FDI from 34 source countries, most of them developed,to 152 host countries. 6 By using  outward   stocks, we ensure that differencesacross countries in the definition and measurement of FDI do not alter therelative allocation of FDI for each of the source countries. The data are 5 The institutional variables from Kaufmann et al. (1999a) are  Regulatory Quality ,  Voice and Accountability ,  Government Effectiveness ,  Political Stability and Lack of Violence , and  Control of Corruption and Rule of Law .Wewill describethesein moredetailbelow,aswewill usethemhereas well. 6 Thus the number of annual observations is 34    (152  1) ¼ 5,134. However, data avail-ability in our regressions reduces significantly the effective number of observations. In addition,most of the observations present no investment at all (around 75% are 0). An important part of our robustness checks deals with this issue. 320  DAUDE AND STEIN r 2007 The AuthorsJournal compilation r 2007 Blackwell Publishing Ltd.
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