Regulation, institutions, and FDI: An empirical analysis on panel data

Although the evidence is far from conclusive, FDI is considered to be a ’good’ to the host country and a ‘source’ of long-term capital especially for developing countries, which face liquidity constraints. Taking into account the economic importance of FDI, a large body of the literature has focused on its main determinants: market related factors, production cost differentials, transportation infrastructure and government policies. In a separate line of research, there has always been a clear interest in explaining economic development. Within this field, researchers have recently shown a growing interest regarding the role that institutions play for economic development. Good institutions are supposed to cause productivity growth thereby to attract foreign investors. Also, good institutions may lower the costs of FDI and reduce the uncertainty due to poor governance.

While there is large agreement on the key role of the institutional quality in attracting FDI, the institutional determinants of the FDI literature have not analysed in great detail the extent of regulation. The focus has been on the protection of property rights, the development of financial markets or corruption (Busse and Hefeker, 2007). However, the evidence presented in Botero and al. (2004) and Djankov et al. (2002) clearly suggests that the type and burden of regulation has an impact on economic outcomes such as unemployment or investment. To our best knowledge, the only works done on the impact of the regulatory environment on FDI are those of Bénassy-Quéré and al. (2007) and Busse and Groizard (2008). In these two papers evidence suggests that labour market regulations and the easiness to enter a market have explanatory power for inflows FDI.

The aim of this paper is to empirically investigate the impact of the regulatory environment as a determinant, independent of institutions, playing a key role to attract FDI. To gain a better understanding on this purpose, we explore two hypotheses. The first one states that only restrictive regulations may obstruct countries from taking advantage of higher FDI inflows. The second hypothesis is that countries with well-designed institutions and adequate regulations can attract more FDI inflows. To test theses assumptions, we use two panel models: a fixed effects model and a dynamic panel model for a set of 80 developing countries covering the period 2004-2010. More precisely, we exploit a FDI regression model in which FDI inflows are explained by set of explanatory variables including regulations, institutions and other traditional determinants of FDI. These methodological insights show that several regulation variables (dealing with construction permits, the difficulty of hiring index, the difficulty of redundancy index, the registering property, the extent of director liability index, the documents to import or export and procedures to enforce contracts) play an important role to attract FDI. Among considered regulation variables, the variable “starting a business” doesn’t appear as an important determinant of FDI. To put our results into perspective, the scale of FDI will depend on the progress made in delivering sound economic policies, good governance and wise regulatory environment.