The effect of institutional quality on economic integration and growth: the case study of the European Union Name:

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The effect of institutional quality on economic integration and growth: the case study of the European Union

Name: Gábor Csingi

Student number: S4064569

Major: International Business & Management MSc

Supervisor: Juliette de Wit, PhD candidate

Co-assessor: dr. R. de Vries

Wordcount: 14 285

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Abstract

In the past decade, intensive public debate has been going on with respect to the necessity of the European Union and the vision it represents. While it traces its origin back to the Cold War (European Steal and Coal Community) and was originally created as community between Western powers after WWII to promote economic development and cooperation, it outgrew that vision considerably since then. The present paper aims to analyze what perks the EU and the Eurozone offers its members, based on institutional economics and the integration theory. Membership of both organizations has been operationalized as dummies, trying to explain cross-border trade (import, export), investments (FDI-inflow, acquisition deals, joint venture deals) and changes in overall economic prosperity (GDP per capita) using an OLS regression model. While control variables indicating the macroeconomic fundamentals and institutional quality have also been employed. In line with previous studies, the study shows that introduction of the euro leads to a higher volume of trade flows and higher levels of wellbeing, yet a surprising result is also yielded by the model: a decrease of the acquisition deals is also found to be related to the common currency. On the other hand, the paper founds no confirmation of any significant effect of the EU-membership.

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There have been many studies focusing on the benefits of international trade openness and integration, yet, surprisingly, being a member of the European Union is still a contested idea due to a widespread skepticism (Guderjan and Wilding, 2020) in terms of its efficiency in promoting economic development, homogenizing member countries, and mitigating inequalities between them. The populists argue that such an economic and political integration would result in the impoverishment of the poorer countries who join the club (Bakare and Sherazi, 2019). Such and similar Eurosceptic, anti-integration or populistic arguments can be found in contemporary Polish and Hungarian political debates (Moskwa and Jefferson, 2019). Such debates have also set the tone previously in British politics before and after the Brexit referendum. As such economic and political integration efforts are very much present at other parts of the world as well (Amir, 2016; Ametoglo Guo and Wonyra, 2018; Márquez-Ramos, Florensa and Recalde, 2017; Selvarajan and Ab-Rahim, 2020), it would be beneficial to research the example of the European Union in order to give advice or guidance to those regions desiring to follow this path.

In order to better understand the impacts of being a member of the Union, a quantitative research is executed on a panel dataset of 35 European countries, including a linear regression model with various dependent variables measuring economic wellbeing and trade integration, while controlling for macroeconomic and economic freedom indicators. We postulate that according to the institutional theory and integration theory being a member of a trade block (Sun & Reed, 2010) or regional integration deepens trade relations and gives room to a more accelerated growth. Therefore, the first focal point of our present research is introduced as follows: whether the EU-membership yields additional trade flows/investments (import/export; inward-FDI), that is, more than simply the result of the calculation based on institutional quality determinants or macroeconomic fundamentals (Dua & Garg, 2015). To put it differently, the present paper explores the possibility that out of two countries with similar (economic, institutional etc.) characteristics, international investors, companies, and other partners will give preference to the one being a member of the Union.

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institutional environments of different countries or continents (Van Hoorn & Maseland, 2016). Particular attention has been made to analyze the integrative forces of regional integration efforts (Kojima & Bengtsson, 2015), such as the African Union or the EU itself (Okumu, 2009; Mathews, 2005). Yet, when analyzing the functioning of the EU most debate focuses on its aspects which are related to political science in nature. Another focus is usually put on sub-regions or specific case-studies of countries as such. These papers usually emphasize the importance of regional resources and value chains (Bilotta, 2018). In contrast, the present paper endeavors to break out from the geographical boundaries of previous studies and to look for more generalizable results, by using a panel dataset of 35 countries.

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The second stream of the present paper explores the option of additional rents in terms of general wellbeing, measured through the dependent variable GDP per capita (Hawkins, 2014). This stream is based on previous research establishing that institutional quality and economic openness do matter in economic development (Rodrik, 2000; Sachs et al., 1995). Yet, additional insight is offered in terms of using a qualitative method and pinpointing our investigation on a much more defined field of interest: EU/Eurozone-membership. While previous academic debate on this field infers increased growth opportunities from mainly the quality of the institutional environment, we explore whether the EU/Eurozone membership serves as a benchmark on its own, and hence surpasses the estimations derived from the macroeconomic or institutional indicators. Furthermore, we posit that the examination of the effects of the EU/Eurozone-membership on the trade relations and wellbeing has not just theoretical but practical implications as well. In today's uncertain world, where challenging science and conventional wisdom is becoming more and more ordinary, it is pivotal to offer answers to topical questions in areas of public interest, such as the European integration.

Our findings are in line with previous scholarship and show that while institutional factors such as economic freedom are important, significant, and positively correlated with deepening trade ties and economic blossom alike, the EU-membership itself is insignificant in terms of explaining the course of the dependent variables. Another finding of the paper is the fact that eurozone-membership seems to be significant in most of the models and preserves its significance in most cases while controlling for macroeconomic or institutional quality determinants. These results indeed support the idea that both institutional and financial/monetary integration matters and positively influences trade relations, investments, and wealth generation. Perhaps the most surprising finding of the paper is that eurozone-membership significantly reduces the number of cross-border acquisition deals in a country.

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With regards to the structure of the thesis, the study commences with a literature review of the previous academic scholarship on institutional theory and integration theory, with particular attention to the changes due to institutional quality. The hypotheses are subsequently developed based on this theoretical background. Then, the methodological foundations of the research are laid, and the panel dataset is also introduced. The results section presents the findings, followed by a robustness section containing three tests in order to substantiate the structural validity of the research. The discussion section further elaborates on the findings and their relationship with existing literature. Finally, the conclusion is presented in order to summarize the findings and place it in the existing literature.

2. Literature review and hypothesis development

In the present section, firstly the theoretical frameworks and concepts of the research are outlined. We take particular attention to recent development in institutionalist economics, integration theory and previous scholarship on the role of uncertainty avoidance in entry mode decisions. We also extend previous research and identify possible future research directions with regards to quasi-rents generated by belonging to a certain organization or group of countries, e.g. the European Union. Furthermore, the conceptual model of the paper and the hypotheses are also presented on the basis of the identified research gap at the end of the section.

2.1. Imitate or not? Are successful institutions sticky?

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factors as well. As the topic of membership in an international or regional organization (Bauhr and Nasiritousi, 2012; Seyoum, 2011) shapes perceptions of the world in the eyes of the individual actors, we argue that this theory offers a valuable perspective in theorizing and explaining possible shifts in the decision-making processes of actors.

Institutional economists distinguish between two kinds of institutions: the formal and the informal ones. Formal institutions include laws, regulations, and contracts (Scott and Meyer, 1994). These institutions are usually codified, specific and the violation of these regulations brings about explicit sanctions. Informal institutions however are not likely to be explicitly codified (Abramson and Inglehart 1986; North, 1990), and a breach of them is not sanctioned as gravely as of the formal ones. This category includes beliefs, practices, and traditions amongst others. Informal institutional settings are harder to measure or observe for an outsider (Crubbelate, 2007), as these rules are most known by the group members, who learn them and use them instinctively (Aliyev, 2017; Casson and Giusta and Kambhampati, 2010; Shand, 2015).

Despite both of them affecting/controlling human behavior, the effect of the latter ones are considered to be less overt by academic scholarship. This is particularly relevant to the present research, as the set of rules, regulations and laws codified in the Copenhagen and Maastricht Treaties can be regarded as a formal set of institutions, which facilitates its monitoring for outsiders.

A more recent stream of research is particularly relevant for our research, that is of institutional stickiness (Boettke, Coyne, & Leeson, 2008). This notion emphasized the fact that history, development, and previous outcomes of institutional environment matter, as their successes lend credit to the need of their existence, hence prolonging their life and making them sticky. It is pivotal to understand that institutional development is a gradual process, and while some institutions change or disappear, others tend to survive and proliferate. An essential question raised by contemporary scholarship is amongst others is how successful institutions can be implemented in less countries with inferior institutional arrangements. Could the accession criteria set out in Copenhagen create the urgency and need for institutional reforms in countries wishing to join? And if so, is mimicking or adopting a certain set of institutions will result in additional growth, reduced uncertainty, and deeper economic ties?

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itself in terms of economic development or foreign investments (Doytch and Eren, 2012). Or would the institutional mimicking in itself do the deal in terms of rapprochement? As more Balkan states wish to join the Union, populistic movements across Europe question the very need for such an integration. This expectation from the public also substantiates the practical need for more research in the field. Pressure from international investors and domestic actors alike increase the need for information of another stakeholder: central governments.

2.2 Integration – an unavoidable consequence or a mere preference?

Balassa argues in his book laying the foundation of integration economics that the free, cross-border flow of economic factors will contribute to the overall wellbeing of those belonging to the free-trade area (Balassa, 1967). The idea behind this increase in economic rents is the continuous reallocation of factors/resources (e.g. capital, labor force etc.), seeking better trade-offs between costs and profit (Arısoy, 2012; Chen, 2018). The more rentable a resource endowment is, the higher rents it might generate, hence the pooling of opportunities (support and demand of factors) can generate more efficient endowments (Borensztein et al., 1998). Previous studies have also confirmed that economic freedom and the abolishment of trade barriers contribute to the overall increase of wealth (Bastos and Cabral, 2007). This raises the question if the economic/financial results yielded by more economic freedom sets the course for the policymakers and leads to unavoidably deeper integration out of fear of staying out, or, is such an integration still a choice?

Motta and Norman (1996) elaborate on the idea of trading blocs and trade diversion as further detrimental effects of regional economic integration. Trading blocs are formed between countries who wish to integrate economically (Nguyen, 2019), and their integration and abolishment of inner customs and trade barriers can certainly pave the way to the build-up of new barriers of trade (Meyer, 2001) between the group and other countries. Trade diversion on the other hand is the restructuring of economic ties (Hamid and Aslam, 2017) while decoupling ties with non-members and reallocating them to the countries taking part in the integration. This can easily result in efficiency losses (Lipsey, 1957), as companies may prefer other enterprises present in member states, even though a third party out of the economic area may very well be more competitive.

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investment decisions. The membership in a reputable international organization like OECD or the EU itself can act as an additional provider of confidence and predictability. This confidence in the institutions and the diligence of members on upholding its shared rules, regulations and norms can also reduce uncertainty, that is, the variance of economic expectations. Previous scholarship also argues in favor of leveraging on the reputational capital offered by membership.

2.3 EU-membership conditionality – a set of exogenously introduced changes

The accession to the European Union has a set of rules and requirements which are to be fulfilled before a country may be granted accession. The Copenhagen Treaty outlines the expectations set by the community. These expectations include obligations to respect human rights and the rights of ethnic minorities (Grabbe, 2002), freedom of speech and establishing a functioning market economy competitive on the EU market. In the present research we disregard legislative and political requirements in order to focus on the economic aspect of institutional harmonization, which is instrumental according to development economists (Ribarova, 2005).

The adoption of such an all-encompassing set of rules requires discipline and absorption capacity from the member states. The EU Commission monitors the progress of the candidates to make sure the compliance with the Acquis Communautaire (Lightfoot, 2010). This monitoring/harmonization process is argued by some to be a pivotal period of time in terms of the institutional development of the future member states (Sasse, 2008; Yesilada, 2002). As local governments work towards fulfilling the membership criteria, their institutional environments are changed by legislative processes, mimicking those environments present in the EU already. This incremental improvement in institutions can bring about the reduction of the liability of foreignness (LOF) and uncertainty (Firat, 2014). This is the reason why the attribution of additional growth, wealth or investments is non-trivial. On the one hand a plausible explanation could be the fact that these additional incomes are the result of the gradual improvement in the institutional quality of the country in case, which was due to negotiations about their EU-accession. On the other hand, one might also argue that the institutional improvement itself could not have had such an impact in itself, and the trade diversion effect of being a group member could have contributed to the change, if any.

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does, one could infer that the exogenous pressure might fall, resulting in a deterioration of the institutional environment. As the EU has not yet excluded any members before, it remains to be seen how much power it has in terms of safeguarding the Acquis Communautaire not from outsiders, but from the member states themselves. Should the EU prove to be effective in safeguarding these institutional developments, the fact of belonging to the Union could have more pronounced advantages, as a shield against institutional deterioration.

2.4 Dealing with uncertainty – entry mode choices in an ever-changing world

After having laid the theoretical foundation of the present paper and before outlining the research gap and the hypotheses, we have one more idea to tackle: the role of increased complexity in managerial cognition (Kashefi, 2015; Kim, 2017). As MNEs and decision-makers have to deal with a complex business environment, they inevitably try to reduce its complexity by creating routines, processes and focusing on the most relevant information at hand. Management science is the field dealing with possible options to reduce this complexity and provide the decision-maker with absorbable information.

One of the complexities included in international business scholarship is penetrating foreign markets and the entry mode decisions. Academics cite various exogenous and endogenous factors weighing in when making an entry mode decision (Brouthers, 2013; Chang and Rosenzweig, 2001), including the previous experience of the MNE in an international environment or in the respective region, but also about exogenous factors like the protection of intellectual property in the target country. As the paper is focusing on the role of institutional environments, we focus on the exogenous factors represented by EU/Eurozone-membership.

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Based on the above, we arrive to our conclusion and begin to theorize the hypotheses.

2.5 Three hypotheses

As outlined in the previous subsections, understanding the effects of institutional/integration factors on the generation of wealth, economic development and managerial cognition is essential (Brown, 2006; Djankov and Murrell, 2002; Linz, 2015). Yet, our understanding of this is still limited. Despite considerable research is being conducted on the effect of institutional quality on the before-mentioned phenomena (Kostevc et al., 2011), the research regarding the European integration is closer to political science in nature. This is why we argue that there is a gap in business/economics science in terms of researching what consequences do the EU/Eurozone-membership have.

Firstly, we hypothesize based on the above presented theorem, that the institutional and political convergence embodied by the European Union may bring about deeper economic ties and higher trade volumes. In order to test this proposition, we divide this into two hypotheses. Hypothesis 1a argues that an increase in import/export volume is seen post-accession. This stems from the notion that more open economies will be easier to trade with (Harrison, 1996; Johnson, 1965), hence existing import/export relations can expand further, and new companies can also enter the market, bringing about more intensive multilateral trade relations. Our first hypothesis hence explores the possibility that an increase in import/export flows can be seen while controlling for macroeconomic and economic openness factors.

Hypothesis 1a: Based on the institutionalist theory, the abolishment of trade barriers/tariffs etc. will enhance the economic integration of countries, resulting in higher volumes of multilateral trade flows (export and import volume).

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Peres et al., 2018), but we argue that not enough particular attention has been turned towards the effects of the EU-membership in terms of qualitative research (Rios-Morales et al., 2016; Arana, 2017).

Hypothesis 1b: Based on the institutionalist theory, the abolishment of trade barriers/tariffs etc. will result in a more integrated, transparent economy (inward FDI).

We continue by identifying a possible extension of previous research on the causal relationship between institutional quality improvement and wealth generation. While previous research focused on particular countries and provided the academic community with valuable insights through country-specific or sub-region-specific case studies (Kisswani et al., 2015; Godby & Anderson, 2016), we argue that it would be useful to expand the horizon of this research and employ a more generalized model.

As GDP per capita is one of the most wide-spread measures of general wellbeing and quality of life in a country, we will operationalize this as a dependent variable. Our second proposition examines the opportunity that EU/Eurozone-membership translates into an increase in wellbeing, while controlling for macroeconomic factors and economic openness indicators.

Hypothesis 2: Based on the institutionalist theory, the abolishment of trade barriers/tariffs etc. will result in better performing national economies (higher GDP per capita).

Our last proposition considers the possibility of an increased number of joint ventures and acquisition entries in EU/Eurozone member states. We employ the number of joint ventures and number of acquisition deals as dependent variables instead of the overall volume of them. The reason behind this operationalization of the variables is the fact that we explore whether the change in the environment opens up this way of integration to a wider spectrum of companies. A change in the deal numbers will not be interfered by high-value deals made by capital-rich MNEs but will rather examine the possibility whether the EU-accession brings cross-border expansion more achievable by smaller companies as well.

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that we do not just operationalize membership status but extend the scope of research from sub-regions or a particular industry sectors to 35 European countries. We do this in hope of finding more generalizable results than previous scholarship.

Hypothesis 3: Based on the institutionalist theory, the abolishment of trade barriers/tariffs etc. will result in an increase in equity entry modes, such as JVs and acquisitions.

3.Methodology

In this section we present the methodology used in order to explore the possible impacts of the EU-and eurozone-accession. First, we briefly summarize the three hypotheses EU-and then describe the variables used. Lastly, we introduce the estimation model and provide an overview on the operationalization of the variables.

We will use a multivariate linear regression model in order to better understand the potential consequences of being a member of the EU or the eurozone. The first hypothesis dealt with a potential change in trade flows, namely import and export. Based on the institutionalist theory, we hypothesized that the reduction of uncertainty, the suppression of trade barriers and an increase in institutional quality can result in deepening trade ties between countries. We also included the inward-FDI flows, as measure of a deeper form of economic integration. We also note that we will calculate with the log-transformed values of the import/export, and also of the inward-FDI as both of these values vary a lot on the relative scale (Gelman & Hill, 2007).

Our second hypothesis explores the possibility of an increase in welfare and economic growth, potentially attributable to membership. For this purpose, we use the log-transformed values of GDP per capita to reduce the scale of the variables as presented previously. And lastly, our third hypothesis argued that an increased openness could boost the number of acquisition and joint venture deals, causing a surge in cross-border investments.

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time events, but the institutional environments are being changed gradually, as accepting the norms and regulations required in order to satisfy the membership criteria. It is therefore essential to control for these gradual changes to see whether the accession serves truly as a benchmark.

Our first two control variables will namely be Economic Freedom of the World Index and FDI Regulatory Restrictiveness Index. Both of these indexes are well-known by international business researchers and are widely used when controlling for gradual changes in economic openness and foreign trade. Two more control variables are also introduced: inflation rate and unemployment rate. Inflation rate will help us to eliminate the effects of changes in the prices of products and services, hence inflating the values. Unemployment rates will be used in order to capture economic downturns and the overall state of the national economy in a respective country.

We contend that should the membership serve as a true benchmark, or watershed moment in trade flows, economic prosperity, or foreign investments, then this effect would be best found by an OLS regression model. The model is designed to control for incremental changes measured by the previously introduced control variables and confirm if there is a significant change attributable to the dummy variables. We will run five regression models separately, by using the following dependent variables: (1) log-transformed Import/export (created by adding import and export together); (2) log-transformed FDI-inflow; (3) log-transformed GDP per capita; (4) Number of acquisition deals (5) Number of joint venture deals.

The first two test will test for Hypothesis 1, the third test for Hypothesis 2, while the last two models will yield results for Hypothesis 3. By using a linear regression, we will be able to find out if the independent variables presented above are significant or not, and the coefficients will reveal the direction and size of their effects. We also establish that we will use the p-value of 0.05, which is commonly used in academic scholarship (Gerring, 2011).

4. Data

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various, open-access sources, such as the International Monetary Fund and the World Bank Database amongst others. The datastores will be further explained in the following sections.

After having collected the needed datasets, they have been coded by firstly assigning them the three-letter country codes as defined in ISO 3166-1 published by the International Organization for Standardization (ISO). Then, this country code has been connected to the year-code, resulting in a separate country-year code pair for each country and year. (e.g. For the year 1980 for Albania the code is ALB1980.) The coding facilitates the allocation of the variable values, resulting in one panel data set. The datasets were also cleared from redundancies (e.g. occasional monthly/quarterly values) and then merged together through Microsoft Excel and Stata.

Below, the dependent, independent and control variables are introduced in three subsections. Descriptive statistics of the variables used in the paper can be found in the below table (Table 1).

Variable Obs Mean Std. Dev. Min Max

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Table 1 – The descriptive statistics of the variables

4.1 Dependent variables

The dependent variables were selected in order to examine the three hypotheses presented before: (1) GDP per capita (current USD); (2) FDI-inflows and Import/Export; (3) Acquisitions/JV entries. We shortly discuss each below.

The GDP per capita values (current USD) are obtained from the World Bank database. The FDI inflows (Foreign direct investment, net inflows (BoP, current USD)) were accessed from the website of the International Monetary Fund. The import (Imports of goods and services (current USD)) and exports (Exports of goods and services (current USD)) are based on data from the World Bank database. Lastly, we accessed the data regarding acquisitions and joint venture entries through the Zephyr database from Bureau van Dijk.

We establish that firms strive to reduce uncertainty and the liability of foreignness (LOF) amongst others by differentiating the levels of control in a new subsidiary. For this reason, we follow the distinction made by Zephyr between acquisitions, which are usually referring to a majority stake, and joint ventures, which are usually run in cooperation with other major players, leveraging on their knowledge of local markets, assets, and processes. We note that as the LOF diminishes, enterprises may opt for higher levels of investments (more acquisitions than joint ventures) hence opting for higher control and returns.

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For an overview of the data sources of the dependent variables, please consult the below table.

Dependent variables

Name Source

GDP per capita (current USD)* World Bank Foreign direct investment, net inflows (BoP,

current USD)*

International Monetary Found

Imports of goods and services (current USD)* World Bank Exports of goods and services (current USD)* World Bank

Value of acquisitions (EUR) ZEPHYR Bureau van Dijk Value of joint ventures (EUR) ZEPHYR Bureau van Dijk

*Used as log-transformed values.

Table 2 - The data sources of the dependent variables

Lastly, we posit that, we will use the log-transformed version of the GDP per capita, FDI-inflows and the export/import variables in order to reduce the differences in terms of their sizes. For instance, poorer countries such as Macedonia would have outstandingly low GDP per capita compared to richer countries like Luxembourg. Log-transformation is in line with scholarship aiming to reduce the scale of differences enabling observations in terms of general underlying patterns (Feng et al., 2014).

4.2. Independent variables

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Please regard the below chart about the sources of the data. (For an overview of the EU-, and eurozone accession dates of the countries, please refer to Appendix B in the Appendices. The table also contains the countries that are not EU and/or Euro Area members but are used in the present analysis.)

Independent variables

Name Source

EU-membership European Parliament

Eurozone-membership European Commission

Table 3 - The data sources of the independent variables

4.3. Control variables

We collected various control variables in order to control for various institutional and macroeconomic effects on both the dependent and the independent variables. Please find these variables in the below table with their respective sources. We will shortly discuss each variable hereafter.

Control variables

Name Source

FDI Regulatory Restrictiveness Index OECD

Economic Freedom of the World Index Fraser Institute

Unemployment rates International Monetary Found

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4.3.1. FDI Regulatory Restrictiveness Index

This index is widely used in international business scholarship (Malkin, 2020; Miller et al., 2017) when analyzing the dominant policies of countries targeted for international joint ventures or acquisitions for instance. It is vital that countries trying to lure foreign investments establish favorable conditions for such investments. The index is a composite one, that is calculated on a yearly basis, based on various indicators, ranging from the legal environment, stability of government and the ease of bureaucratic processes in countries. The measuring also englobes screening mechanisms, foreign equity limitations and restrictions on capital repatriation.

The data is the simple average of values generated from 22 business sectors in 69 countries across the globe. This way, peculiarities are not handled, such as different restrictions in one industry or another. As the value changes over time, we will be able to see a more nuanced process of opening up and easing restrictions on foreign entries. Also, it reflects the very nature of a gradual change in law-making, bureaucratic processes and the attitude to foreign investments compared to the radical changes represented by the independent variables. FDI Regulatory Restrictiveness Index can range between 0 and 1. The closer the national value is to 0, the more open the country is. While 1 on the other hand would signal a totally closed economy.

4.3.2. Economic Freedom of the World Index (EFW)

The Economic Freedom of the World Index is another widely used composite indicator (Faria & Montesinos, 2009; Nowrasteh, Forrester & Blondin, 2018) published by the Canadian think tank Fraser Institute. The values range between zero and ten, and the higher a country scores, the freer its economy is. The EFW Index consists of the following variables: size of government, legal structure and security of property rights, access to sound money, freedom to trade internationally, and regulation of credit, labor, and business. All of these areas are affected by the Copenhagen and/or Maastricht criteria defining whether a country can be accepted to the EU or the Eurozone, respectively. We contend that by controlling for the changes in terms of these fields of the institutional environment through the operationalization of the EFW Index, we will be able to establish whether there is a membership-effect or not.

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of these factors can translate into both more inward-FDI, acquisitions and joint ventures and higher trade volumes. As easier access to business partners and markets would result in more opportunities.

The FDI Regulatory Restrictiveness Index and the Economic Freedom of the World Index are slightly different. This is why we include both of them in the current research. The difference stems from the fact that while the first of them focuses clearly on inward FDI-flows, the EFW Index could give a broader view about how open a national economy is. We argue that the restrictions concerning FDI investments can serve as a deterrent in the eyes of a foreign investor, who may as a result opt for either establishing a licensing, exporting or other partnership. This substantiates that the FDI Regulatory Restrictiveness Index can be used even when testing for the import/export flows, despite its more focused nature at first sight.

4.3.3. Unemployment rates

Unemployment rates are used as indicators controlling for business cycles, economic upturns, and downturns for instance. This is useful as some of our dependent variables are also related to economic growth (e.g. GDP per capita). Higher unemployment rates are believed to be the results of inefficient labor markets. May it be the result of a geographically uneven distribution of work force or the lack of necessary training, unemployed masses can be attractive to foreign investors who may wish to leverage on cheap work force. High unemployment in a country may also result in less purchasing power, hence lowering the demand for the imports of goods or services.

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The dataset has been obtained for the period of 1980-2019 from the International Monetary Fund Database and represents the annual percentage of those unemployed compared to the total labor force in the respective country.

4.3.4. Inflation rates

Inflation is one of the most widespread indicators used in economics scholarship (Lucas & Rapping, 1969; Smith, 2005). We use it to control for the general hikes in prices, as an increase in product or service prices for instance could bring about an increase in the exports. Therefore, we downloaded the inflation rates as measured by consumer prices index (annual %) from the database of the International Monetary Fund for the period of 1980 and 2019. We wish to eliminate the effects of such changes in prices by using this variable, which will prove useful not only with regards to trade flows, but in terms of GDP growth as well.

Furthermore, inflation rates are also regarded as a way of conveying information about the macroeconomic state of a national economy in a similar way as unemployment rates do. This stems from the fact that inflation is a proxy of aggregating demand and supply on the market, hence acting as a coordinator in terms of enhancing the reallocation of resources hence establishing more efficient endowments. The signal is also particularly important not just merely because of the changes in volumes pointed out before, but because of being one of the primordial indicators of macroeconomic stability in a country, which is of great importance when a corporate decision is being made about the launch of an M&A investment. Hence inflation rates can not just affect GDP per capita or the trade flow indicators, but also prove to be an instrumental factor with respect to the number of acquisition and joint venture deals measured by the third hypothesis of the paper.

5. Results

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5.1. Data screening

According to Green (1991) a rule-of-thumb is suggested for determining how many control variables to choose, depending on the number of the observations as follows: the minimum size of a multiple regressions model is 𝑁 ≥50+8∗ 𝑚; whereas N refers to the number of observations and m refers to the number of predictors used during the calculation. Following upon our estimation models (described the methodology section) we will use one independent variable and four control variables. Given that we have 197 number of observations, we find that the number of observations can be deemed sufficient.

We check for multicollinearity by using the variance inflation factor (VIF) which is a wide-spread method to control whether there is correlation between the predictors (Hair et al., 2010). If there is to be a strong correlation, it can harm the reliability of the model. This would mean that it would be hard to find the cause of a certain effect as we could not attribute it to a certain variable. This would also mean that the variance of the coefficients would increase, leading to less precise predictive power. We adopt the commonly used 2.5 value of tolerance for VIF (Field, 2009). In the present research, we accept our findings as the VIF-values were always below this level. (VIF-values are given in Table 5.) The individual VIF-(VIF-values remained under pre-determined 2.5 value in each test. This means that we can trust that the independent and control variables can be safely used together in the present analysis, without the risk misinterpreting their effects.

Variable VIF 1/VIF

Economic Freedom of the World Index 1.64 0.61 Inflation rate 1.41 0.70 FDI Regulatory Restrictiveness Index 1.25 0.79 Unemployment rate 1.11 0.90 Mean VIF 1.35

Table 5 - The VIF-values of the control variables

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independent, dependent and control variables, and the second option to run it only when there is sufficient data for the respective year. We decide to choose the second option, which will naturally reduce the number of observations, but yield more precise results. (Please regard Appendix C with regards to the data availability per country, per year.)

5.2 Main results

We run a linear regression model in all three subsections, with OLS standard errors. The chosen level of significance is 0.05. For the sake of creating a more detailed overview of the results, we also added a footnote explaining the level of significance of the respective variable, hence distinguishing between p-values of 0.05, 0.02 and 0.01.

To interpret the models, we note the fact, that when explaining the effects of the variables we will consider the estimated beta coefficients. For instance, the dummy variable of being an EU-member can take either the value of 0 or 1, with a 1 indicating EU-membership. Hence should we find a positive and significant coefficient for that variable, we assume that being a member state has a positive effect. On the other hand, for instance FDI Regulatory Restrictiveness is an index based on how hard it is to penetrate a market and the higher the value, the stricter the rules/requirements are. It can be expected that, should the coefficient be negative and significant, then stricter investment barriers will result in less (log-transformed) FDI-inflow, less (log-transformed) GDP per capita etc.

We will also elaborate on the possible comparison between significance levels and the sizes of the coefficients when presenting the results below. The higher the coefficient is, the more pronounced its effect is on the dependent variable, hence we can distinguish between multiple significant variables.

5.3. Import, export and FDI

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further investments or not. We examine the two variables separately, as inward-FDI is usually regarded as a deeper and riskier form of trade integration, due to the increased commitment.

Table 6 summarizes the linear regression results of the EU-membership dummy used as independent variable. The log-transformed import/export variable and also the log-transformed FDI-inflow variable were used as dependent variables. We also control for the inflation and unemployment rates; the Economic Freedom of the World Index and the FDI Regulatory Restrictiveness Index. Dependent variables Import/Export - EU Import/Export - Eurozone FDI-inflow - EU FDI-inflow - Eurozone Independent variables EU-membership 2.45*** (.42) - 1.16 (.62) - Eurozone membership - .86*** (.19) - .77*** (.28) Control variables Economic Freedom of the World Index .08 (.27) .58* (.25) 1.14*** (.40) 1.34*** (.36) FDI Regulatory Restrictiveness Index 16.03*** (3.10) 11.80*** (3.08) 10.85* (4.79) 9.68* (4.55) Inflation rate -.01 (.02) -.02 (.02) .01 (.03) .01 (.03) Unemployment rate -.01 (.01) -.03 (.01) -.03 (.02) -.04 (.02) Observations 197 197 183 183 R2 0.25 0.20 0.15 0.17

Significance levels indicated by * 0.05, ** 0.02, *** 0.01 Both the imports/exports and the FDI-inflow are log-transformed.

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Through these tests we find that EU-membership is significant in terms of trade volume, but not in incoming FDI-investments. Eurozone membership was found to be significant with regards to both trade flows and inward-FDI. Hence the regression model confirms the significance of EU-membership with a coefficient of 2.45 when it comes to imports/exports on the p-value of 0.01.

The coefficient of the eurozone-membership dummy is positive (.86), meaning that if the dummy takes the value of 1 (as coded for the years in which the respective country is a member of the eurozone), on average, member countries can expect higher trade volume compared to those who are not members of the eurozone.

We also find that both in terms of import/export flows and inward-FDI, the Economic Freedom of the World index is significant and positive, with a coefficient of .58 for the trade flows, and 1.14 and 1.34 for the inward-FDI flows. In most cases the coefficients are highly significant with a p-value of 0.05 and 0.01. It means that economic openness will eventually create more trade flows and attract cross-border investments.

Our findings also point out, that higher values in FDI Regulatory Restrictiveness Index contribute very significantly to higher levels of non-equity investments, namely exports and imports (with coefficients of 16.03 and 11.80, both on the p-value of 0.01). While higher economic freedom (measured through the Economic Freedom of the World Index) implies higher equity-investment inflows (FDI-inflow). We also note here that overall macroeconomic fundamentals can also play a role in attracting foreign direct investments (Strat, Davidescu & Paul, 2015), yet, the present analysis does not confirm the role of unemployment or inflation in that matter.

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Dependent variables Export volume Import

volume Independent variables EU-membership 1.97*** (.44) 1.91*** (.45) Eurozone membership .68*** (.20) .47** (.20) Control variables Economic Freedom of the World Index .08 (.27) .04 (.26) FDI Regulatory Restrictiveness Index 14.74*** (3.12) 16.30*** (3.13) Inflation rate -.00 (.02) -.01 (.02) Unemployment rate -.02 (.01) -.00 (.01) Observations 197 186 R2 0.28 0.25

Significance levels indicated by * 0.05, ** 0.02, *** 0.01

Both exports and imports are log-transformed.

Table 7 - Separate tests for export and import with regards to membership status

Our findings show that only FDI Regulatory Restrictiveness Index could retain its significance amongst the control variables, while both the EU-, and eurozone-dummy remained significant. We deduct from these findings, that both membership is indeed a valuable status. Also, when comparing the two coefficient-pairs we see, that being an EU-member can bring about higher returns, as its coefficient is significantly higher in all trade flow tests, namely 1.97 and 1.91 compared to that of the eurozone-variable, .68 and .47.

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Regulatory Restrictiveness seems to play a significantly positive role with a coefficient of 14.74 at the p-value of 0.01. This might be explained by a diversion of trade towards non-equity investments, due to formal restrictions.

5.4. GDP growth

Hypothesis 2 explores the possibility whether the (EU/eurozone) membership gives room to further growth opportunities or not. For testing this we use the log-transformed values of GDP per capita (current US$) as a dependent variable. As this variable is commonly used when measuring the overall well-being of a society (Korotayev, Bilyuga & Shishkina, 2018; Carrion-i-Silvestre, Del Barrio-Castro & López-Bazo, 2005), we will be able to see whether the accession proves to be significant to the standard of living.

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Significance levels indicated by * 0.05, ** 0.02, *** 0.01

GDP per capita is log-transformed.

Table 8 - GDP per capita and membership status

The linear regression model confirms the significance of the EU-membership variable (.97). While on the other hand, being a eurozone member is also found the be significant on the same p-value of 0.01.

The coefficient for the eurozone-membership dummy is .83 in the linear model, which implies that when comparing the two dummies, that of the EU-membership comes into play with a relatively stronger effect. These coefficients are higher than that of any control variable in the model. This lets us to conclude that the EU/eurozone-membership indeed have a positive and significant effect on the standards of life in a respective country. This means, that while keeping other factors constant, higher values of GDP per capita can expected in the case when the target country belongs to the EU or the eurozone-area.

Also, the Economic Freedom of the World Index and unemployment rates were also found to be significant. The former alluding to the fact that greater economic freedom will bring greater growth, and the latter hinting that higher unemployment rates hinder prosperity. These findings are in line with our expectations pointed out in previous chapters. Academic scholarship agrees upon the fact that open economies outperform closed ones, as more openness leads to reduced costs, a greater variety of choices for both consumers and enterprises. It also entails more competitivity in order to compete on a global market, hence enhancing efficiency further.

5.5. Market entries

The third hypothesis considers the possibility of a relationship between (EU/Eurozone) membership status and the foreign direct investments in the forms of acquisition and joint venture. Both of these investment forms can signal a long-term interest in the target country and from this regression test we may learn more about whether the member states are more attractive for such forms of investments or not.

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31 Dependent variables Acquisitions, EU-dummy Acquisitions, Eurozone-dummy JVs, EU-dummy JVs, Eurozone-dummy Independent variables EU-membership -76.82 (58.40) - -3.58 (2.91) - Eurozone membership - -44.99* (23.14) - -.42 (1.13) Control variables Economic Freedom of the World Index 143.25*** (34.29) 130.69*** (29.45) 6.57*** (1.72) 5.57*** (1.50) FDI Regulatory Restrictiveness Index 600.96 (363.66) 714.00* (342.09) 7.43 (16.79) 12.81 (16.27) Inflation rate 2.44 (3.03) 2.45 (3.00) .16 (.28) .22 (.28) Unemployment rate -3.32 (2.30) -2.92 (2.27) -.06 (.11) -.06 (.11) Observations 176 176 141 141 R2 0.14 0.15 0.12 0.11

Significance levels indicated by * 0.05, ** 0.02, *** 0.01

Table 9 - Number of Acquisition and JV deals

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other hand were found to be significant. Economic Freedom of the World Index has a coefficient of 130.69 in the model relating to the acquisitions, while in the model about joint ventures, the value of the coefficient is 5.57. The result is significant in both cases with a p-value of 0.01. This suggests that economic openness attracts both kinds of investment.

However, FDI Regulatory Restrictiveness was only confirmed to be significant in the case of acquisitions. The coefficient has the value of 714.00 with a p-value of 0.03. This suggests a positive and significant causality. As FDI Regulatory Restrictiveness takes a value between 0 and 1, 0 meaning a totally open and 1 meaning a totally closed economy, the model suggests that more acquisitions are to be expected in closed economies than open ones. As acquisitions refer to stronger corporate control over the company than the joint ventures do, we suggest the following explanations. As more closed, more restrictive countries tend to be less developed, an MNEs goal of gaining a larger stake of control in the subsidiary might sings its intention to keep its intellectual property safeguarded. As less developed institutional environments are less effective at IPP protection, keeping a stronger grip on the company might balance this lack of regulation.

Another cause of more acquisitions in restrictive economies could be that local assets are less-tradable on international markets, hence the option-value of joint ventures (that is, exiting the investment for reallocating to better opportunities) is less valuable. It is also of importance, that the future growth potential of a local subsidiary can be leveraged on easier, should the additional investment be effectuated easily. The value of this growth potential is also decreased by red tape, investment barriers and discriminatory laws on foreign equity.

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6. Robustness tests

In this section, three robustness tests are run in order to assess whether the results obtained in the previous section remain structurally stable when changing the estimation model. First, we run a stepwise forward regression model with the p-value of 0.05 while using the same control variables as previously. Then, we run two additional robustness tests while changing the set of control variables for other measurement indexes developed to give further insight into the institutional environments. Namely, one of the new models will test further for the effects of corrupt institutional environments hindering economic activity and trust, while the third robustness check will assess a wider variety of institutional determinants ranging from government efficiency to the rule of law.

6.1 Stepwise regression results

We commence with changing the multiple regression model to a stepwise forward regression model. From this test, we will be able to see if there is a change in the effect exerted by the independent or control variables on the dependent variables. The computer will begin with an empty model and will test the variables one by one and keep adding them until it finds a variable which is not significant at the p-value of 0.05.

We run this regression with the same four control variables and the two independent variables. As the model does not keep the insignificant variables, we only present the ones found to be significant. Table 10 depicts the findings. The stepwise regression yielded the very same results as the main linear model presented in the previous chapter. This gives further support to our results.

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34 Eurozone membership .58*** (.19) .76*** (.28) .77*** (.07) -47.45* (23.10) - Control variables Economic Freedom of the World Index - 1.42*** (.31) .65*** (.09) 130.02*** (25.23) 4.76*** (1.20) FDI Regulatory Restrictiveness Index 16.29*** (2.91) 11.33** (4.45) - 849.90** (332.76) - Inflation rate - - - - - Unemployment rate - - -.02*** (.00) - - Observations 197 183 197 176 141 R2 0.28 0.15 0.68 0.13 0.10

Table 10 - Robustness check 1. - Stepwise regression

6.2. Controlling for corruption

We conduct a second robustness test to further support the validity of the main results. For this test, we will use the same linear regression as in the previous chapter, but we add an additional control variable: the Corruption Perception Index (CPI).

We wish to better understand the effect of perceived corruption in economic development. Hence we run the tests separately for the five dependent variable by using two independent variables (EU-membership; Eurozone-membership) and the five control variables (Corruption Perceptions Index; Economic Freedom of the World Index; FDI Regulatory Restrictiveness Index; inflation rate and unemployment rate).

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greater trade volume it may expect. (As the CPI takes smaller values for corrupt, and higher values for non-corrupt countries.)

As it is depicted on Table 11., the both the EU/Eurozone-membership stays significant with a coefficient of .50 and .43 respectively with regards to GDP per capita on a p-value of 0.01, which implies that even when controlling for corruption, being a member of the integration positively and significantly contributes to the well-being of the country. On the other hand, the adverse effect of the eurozone-membership dummy is underlined once again, with a coefficient of -107.11 at a p-value of 0.01 concerning the number of acquisition deals.

The results yielded by the model suggest that high levels of corruption hinder economic activity in terms of all the dependent variables. The fact that eurozone-membership did not keep its significance in terms of trade flows when controlling for corruption implies that the inefficient market conditions created by corrupt government officials (Harrison, 2007) can hinder the export of goods and services, as the corrupt, misshaped market conditions do not persist outside the national borders. This could render export uncompetitive compared to the products/services of rivals. Another explanation could be that import may be diverted by the corrupt central government, close to certain business circles to give local products/companies a competitive edge, at the expense of efficiency.

In order to better understand the moderating effect of CPI on trade flows, further research is sought analyzing export and import separately, divided by sectors.

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36 Control variables Corruption Perception Index .04*** (.00) .08*** (.01) .02*** (.00) 5.32*** (1.04) .11* (.05) Economic Freedom of the World Index -.80*** (.29) -.38 (.42) .07 (.09) 33.46 (38.79) 4.04 (2.09) FDI Regulatory Restrictiveness Index 16.84*** (2.84) 13.47*** (4.23) .90 (.89) 697.98* (338.21) 10.06 (16.68) Inflation rate -.01 (.02) .00 (.03) -.01 (.00) 1.06 (2.83) .17 (.28) Unemployment rate .02 (.01) .02 (.02) .00 (.00) .92 (2.28) .05 (.12) Observations 197 183 197 176 141 R2 0.38 0.35 0.81 0.26 0.15

Table 11 - Robustness check 2. - Corruption Perception Index

6.3 Alternative operationalization of institutional quality

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We run a linear regression model once more, but now we include the six control variables of the WGI (Voice & Accountability, Political Stability and Lack of Violence, Government Effectiveness, Regulatory Quality, Rule of Law, and Control of Corruption). We keep the inflation rate and the unemployment rate, but we drop the Economic Freedom of the World Index and the FDI Regulatory Restrictiveness Index.

From this test, we learn that the eurozone-dummy is still significant when controlling for various institutional quality measures. Hence these results give further support for the argument that he eurozone-membership is indeed worth it. With a coefficient of .41 and with a p-value of 0.01, the eurozone membership contributes to the increase of FDI-inflow, while GDP per capita is also expected to see a rise with a coefficient of .29 at the p-value of 0.01. On the other hand, eurozone-membership was not found to be significant in terms of trade flows, which is a deviation from the original linear regression results. The significance of EU-membership persists, while it also gains significance with a coefficient of .73 on the p-value of 0.01.

Our previous findings about the decrease in the number of acquisition deals persists with a coefficient of -40.01 with a p-value of 0.01, as seen in Table 12.

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38 (.01) (.01) (.00) (1.35) (.09) Control of Corruption .00 (.01) .03*** (.01) .01*** (.00) 2.06 (1.27) .17* (.08) Inflation rate -.00 (.00) -.01 (.00) -.01*** (.00) -1.20 (1.12) -.06 (.09) Unemployment rate -.03*** (.00) -.06*** (.01) -.00 (.00) -4.49*** (.94) -.27*** (.07) Observations 637 596 617 493 360 R2 0.62 0.48 0.87 0.36 0.27

Import/export, FDI-inflow and GDP per capita are log-transformed values. Table 12 - Robustness check 3. - Worldwide Governance Indicators

6.4. Summary of the main results

A brief summary of the three hypotheses and the decisions with regards to the hypotheses (most of them confirmed by the robustness tests) on the 0.05 confidence level is presented below, in Table 13. De pe nde nt v aria bles MULTIPLE REGRESSION

TESTS Independent variables

0.05 CONFIDENCE LEVEL

EU-membership

Eurozone-membership

Import/export significant significant

FDI-inflow not significant significant

GDP per capita significant significant

Acquisition, number of deals not significant significant Joint-ventures, number of deals not significant not significant

Table 13 - Summary of the main results

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This leads us to the conclusion that trade relations and embeddedness in international value chains can be very much enhanced by joining the EU. Adversely, this beneficial effect of the EU-membership was not confirmed when we examined the capability to attract FDI. The models showed that the accession to the EU is not to be considered necessarily a watershed moment. As we found FDI Regulatory Restrictiveness and Economic Freedom of the World consecutively significant in various tests, we may infer that the liability of foreignness can be diminished through lifting trade barriers, legal harmonization, and the creation of reliable institutional environments. This supports the theorem presented in the literature review: institutions do matter.

Secondly, the effects of the eurozone-dummy variable were observed in various cases, lending credit to Hypothesis 1 (with certain limitations, as some of the robustness tests pointed out); Hypothesis 2 and Hypothesis 3.a. This is in line with our previous expectations based on economic openness and transaction costs theory. Academic scholarship argues that institutional boundaries increase the complexity of the environment demanding more cognitive capability to grasp the differences, analyze the situation and make a decision. The less complex, the more predictable the environment becomes. This may result in reducing uncertainty and transaction costs (especially exchange rates) and yield more business confidence. The fact that our findings support mostly the hypotheses in the case of the eurozone-membership dummy, we establish that there are fundamental differences between the two memberships (that of the EU and the eurozone) and those differences are likely in terms related to economic performance. This could be attributed to the fact that joining the EU requires mostly legal, institutional, and administrative reforms engraved in the Copenhagen criteria. On the other hand, joining the eurozone requires fulfilling the so-called Maastricht criteria, which deals with macroeconomic stability, convergence of interest rates and disciplined budgetary policies from the central government. Hence this latter set of criteria may prove to be a much more significant change than the previous one.

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watershed moment, as the opening up of the markets (for acquisitions amongst others) began sooner. The negative effect of the eurozone-membership might be explained by this same depletion, as the strengthening of the macro environment takes place before the accession, it might also give a boost for acquiring attractive local assets and companies before the eurozone-accession takes place. Hence eurozone-membership might not be a deterrent against acquisition, but only a state in which developed/efficient markets are to be found.

7. Discussion

In this section we continue by discussing the results yielded by the regression models. Firstly, we go through each three hypothesis one-by-one looking into possible explanations and consequences. Secondly, we summarize what can be deducted when looking at all the three hypotheses. Lastly, we offer outlook with regards to possible extension of the present research.

7.1. Hypothesis 1 – Trade flows

We commence with Hypothesis 1, which explored the possibility of an increasingly intensive trade relation between EU-members compared to non-members. Trade diversion in international trade created by multilateral treaties and free-trade agreements is grounded in economic scholarship, yet this paper finds only limited evidence of it with regards to the EU-membership. As we operationalized the sum of import and export flows, and FDI-inflows, the fact if a country belonged to the European Union or not remained insignificant for the FDI-inflows and counted only in relation with the trade flows. Still, this was not the case with respect to the Eurozone-membership. This variable was found to be significantly positive on import/export volume and FDI-inflows, mostly confirmed by the robustness tests as well. We deduce from this that the equity entry modes like FDI might not be significantly influenced by the institutional changes that the EU membership entails. We also deduce with regards to the Hypothesis 1, that a monetary union and a single currency such as the euro is found to be a significantly positive factor, enhancing deepened economic ties.

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to be insignificant. Yet, when thirdly controlled for the World Governance Indicators (WGI), the eurozone was found to be significant just for the inward-FDI flows. Hence the three robustness tests seem to not always confirm the importance of the eurozone-membership and find evidence of the significance of the EU-membership only when it comes to export/import.

With regards to other variables in the model, the FDI Regulatory Restrictiveness Index was found to be significant mostly with respect to the import/export variable. In contrast, the Economic Freedom of the World Index was found to be significant (and positive) rather when it came to FDI-inflows. These findings might imply that tougher restrictions contribute to less integrate trade endowments, such and exporting and importing, while greater economic freedom lures incoming cross-border equity-investments.

7.2. Hypothesis 2 – Wealth generation

The second proposition dealt with the prospect of a raise in income, wellbeing, or wealth possibly in relation with the European integration. The results of the regression model confirmed this positive relationship with respect to the EU-membership, and the eurozone alike. From this, we infer that joining the EU or the introduction of the euro can be a desirable asset in terms of raising living standards in a country. These findings are in line with previous research on the topics of integration theory (Balassa, 1967) pointed out in previous sections. We also establish, that all three robustness tests further confirm the positive and significant effects of the EU/euro on GDP per capita, lending further credit to the correctness of the analysis.

The fact that belonging to the EU or the Euro Area quantifiably supports an increase in GDP per capita suggests that that the common currency acts as a successful mediator in terms of reallocating resources to more effective endowments, resulting in an increase in quality of life. As it was pointed out in Chapter 2, Balassa (1967) and integration theorists argue, that the economies of scale and the increased market volumes created through the establishment of trading blocs, multilateral agreements or in this case the free trade between EU countries may result in such growth, stemming from the increased efficiency achieved on the factor markets.

The effect of institutional quality on economic integration and growth: the case study of the European Union Name:

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