Determinants of FDI: The role of institutions

Abstract: Extension of international markets in the form of foreign direct investment (FDI) is one of the most salient features of globalisation since the 1980s.  For both developing and developed economies, FDI is an important source of capital, technology and skills transfer.  FDI outflow on the other hand helps the source economy to enjoy market expansion, lower factor costs and facilitate “tariff-hopping”.  All these suggest that FDI could potentially lead, for both capital exporter and importer, to economic growth and economic development. However, the conundrum exists, unlike what neoclassical economics would have suggested, why capital does not flow from rich economies to poor, where production costs are low and marginal productivity of capital is high. In this paper we assess three potential macroeconomic determinants of FDI, namely, natural barrier, de jure “at-the border” external institutions and de facto “behind-the-border” domestic institution, which cannot always be placed neatly within the neoclassical paradigm.  In addition, regional integration and behind-the-border regulatory obstacles have lately drawn keen interests of policymakers with an aim to improve institutional frameworks, regulatory environment and government policies for attracting foreign investment.  We intend to evaluate their respective impacts under a unified econometric assessment framework. Our estimation is based on an augmented gravity model.  We utilise a large-scale bilateral panel data set from the 1980s onwards to empirically estimate a series of models (including fixed and random effects models, instrumental variables as well as two-stage least-squares generalizations of simple panel-data estimators) to derive a set of comparable and robust estimators and results. Essentially, we use a bilateral FDI stock dataset of 60 FDI destination economies sourcing from OECD economies during 1985 - 2006.  The augmented gravity framework fits our data quite well.  Our empirical results suggest that geographical and institutional factors generally explain bilateral FDI significantly, even after controlling for unobserved country-pair heterogeneity and time effects.

JEL classification: F13, F21, F23