Outward FDI and HOST country financial transparency

OUTWARD FDI AND HOST COUNTRY FINANCIAL TRANSPARENCY

J.K. Mullen and Martin Williams

ABSTRACT

The broad determinants underlying outward FDI have attracted much attention in the empirical literature.  One strand of this research has focused on the role of host country corruption as either an attractant or deterrent to foreign investment.  A number of studies provide evidence that outward FDI, especially from advanced economies, tends to be discouraged by corruption and poor institutions.  These findings generally support the view that corruption acts more like a “grabbing hand” than as a “helping hand”.  However, it is plausible that a significant component of foreign investment may be attracted to locales offering money laundering opportunities because of their opaque financial environments.  Foreign portfolio investment, in view of its more extensive reporting requirements, offers fewer avenues to launder money generated by criminal activities.  Alternatively, FDI may be an easier conduit for money laundering, especially in jurisdictions with lax financial standards.  Business acquisitions by foreign investors may represent the most direct path for money laundering.   The size of the money laundering clientele bolsters the contention that some direct investment is motivated by other than traditional considerations.   The proceeds available for money laundering from U.S. cocaine trafficking in 2009 have been estimated at $2.87 billion.  Given that cocaine trafficking is typically less than 30% of total criminal proceeds for the U.S., the funds available for laundering are likely a factor motivating offshore investment.    

This study augments our empirical understanding of the link between FDI flows and host country institutional quality, especially as it pertains to financial transparency.  We hypothesize that weak institutions may foster conditions which facilitate money laundering, thus attracting funds generated by illegal activities.  Relying primarily on OECD data (International Direct Investment Statistics Yearbook), we conduct an analysis of the determinants of outward FDI flows from advanced economies.  Besides the traditional variables (e.g., GDP, exchange rates, distance, etc.), the regression model also includes different measures of money laundering opportunities.  One such measure is the Basel AML index which provides a country risk ranking based on its adherence to money laundering standards.  Another measure is based on the Financial Action’s Task Force’s “blacklist” of non-cooperating countries. 

The empirical model explaining outward FDI flows is estimated separately for the U.S. and for a group of 24 OECD economies.  These analyses consider FDI flows into both advanced and emerging economies, the latter which are more likely to be attractive money laundering locales.  Our empirical inquiry utilizes two distinct data panels, for two purposes.  First, the dramatic drop-off in cross-border investment that accompanied the global financial crisis suggests that traditional determinants of FDI flows may be less important in the post- 2007 period.  Second, stratifying the analysis across two separate panels allows us to conform to the different time horizons covered by the money laundering variables.  Our empirical findings help in identifying the role of financial transparency in attracting “rogue” foreign capital, and may indicate its changing importance in the wake of the global financial crisis.