The Role of National Competitiveness in Attracting FDI Inflows

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Thesis

The Role of National Competitiveness

in Attracting FDI Inflows

Supervisor: Dr. D. Dikova

Nguyen Thi Hong Thinh (1668331)

MSc. of International Economics and Business

Faculty of Economics

University of Groningen

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Acknowledgement

First of all, I would like to extend my sincere thanks to my supervisor, Dr. D.Dikova who grants me useful suggestions on my thesis topic and gives me invaluable comments and tremendous assistance in all of the stages of my thesis.

I am also greatly indebted to the Groningen University and the Huygens Scholarship Program for their financial support that gives me an opportunity to study in The Netherlands.

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Abstract

This paper provides a perspective toward understanding the influence of national competitiveness that represents the country’s attractiveness on FDI inflows. Having used fixed effect vector decomposition, the results on a sample of 65 nations, after controlling for openness of trade and market size, show that advanced factors of production particularly, quality of human capital and financial market development and technological development positively influence on FDI inflows, however, the role of infrastructure is found to have no significant impact on FDI inflows. We have also confirmed that the institutions do matter in FDI inflows. A country with low level of corruption attracts more FDI inflows than that with high level of corruption. We argue that host country cultural variables consisting of individualism, uncertainty avoidance and power distance play a role on formulating country’s attractiveness. Furthermore, we have found clear evidence on the impact of regional integration which enhances country’s competitiveness, strongly affects FDI inflows.

Keywords: Foreign Direct Investment (FDI), competitiveness, attractiveness, factors of production, institutions, and government policies

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List of Tables and Figures

Pages

Table 1: Detail description of variables and their sources ………..25

Table 2: Descriptive statistics………..28

Table 3: Correlation matrix of the variables………37

Table 4: The results of the three- step procedure……… 39

Table 5: The outcomes of the first step with corrected procedure of White cross section...54

Table 6: The outcomes of the second step with corrected procedure of White cross section….54 Table 7: The outcomes of the third step with corrected procedure of White cross section…….55

Figure 1: Histogram and normality test of the residuals -The first step- Fixed effects model… 56 Figure 2: Histogram and normality test of the residuals - The second step- OLS model………56

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1. Problem Statement

Foreign direct investment (FDI) plays a key role as an engine of economic growth and development for both home and host country’s economy. FDI inflows have been recognized to generate employment, raise productivity, transfer skills and technology, enhance exports and especially contribute to the long-term economic development of the world’s developing countries1. More than ever, every country has attempted to attract FDI inflows for their economic development. The reason is that national competitiveness has become a central preoccupation of both advanced and developing countries in an increasingly open and integrated world economy (Lopez-Claros et al., 2004), economists have recently emphasized national competitiveness as a crucial determinant of countries’ capability to compete for FDI inflows (Lall and Urata, 2003; Dunning and Zang, 2007). This is because the national competitiveness determines and enhances the national attractiveness to foreign investors. At national level, the country’s attractiveness is known to come from the highly supportive environment which includes factor endowments, low cost of production, level of qualifications, political and economic stability, and sound regulatory framework and economic policies. A country’s environment, as reflected in the attractiveness of the market to foreign investors, is a fundamental factor that determines the amount of foreign direct investment (FDI) in that country.

The international business literature has recognized the importance of country-specific attractiveness as the determinants of FDI inflows. According to the resource based view economists, the competitiveness of the location varies and is greatly influenced by the availability and quality of production factors (Porter, 1990; Hickman, 1992; Kasper and Streit, 1998; Lall and Urata, 2003). Porter (1990) specifies the competitiveness of the nation rooted in the resources that countries can offer to perform specific value activities. Until the 1950, most explanation of the international location of economic activity was based on the distribution of natural resources especially labour and land. However, since the rapid liberalization of trade and investment has caused an unprecedented intensity of global competition exposed to all countries, a focus on technology and innovation is a successful strategy for boosting competitiveness in an increasingly complex global economy (Hickman, 1992; Lopez-Claros et al., 2005). Several traditional parameters of competitive production are loosing their roles in attracting FDI (Lall, 2001). The endowed factors still account for a part of determinants of worldwide FDI inflows, but only in underdeveloped and developing countries whose economies are much based on natural resources. There has been a shift in FDI activities toward more capital, knowledge and skill-intensive

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industries (Pfeffermann and Madarassy, 1992; Dunning, 1998). The quality of advanced factors has been now becoming the prominent determinant of a country’s attractiveness on appealing FDI inflows.

Institutional economists consider the quality of a country’s institutions as a country’s valuable productive assets or competitive advantages. Hanalainen (2003) conceives institutional environment as a vital factor shaping the country’s competitiveness, because institutional environment influences the economy’s business activities in terms of national resource base, technological capabilities, organizational arrangements and product market characteristics etc. The impact of institutions on FDI inflows is also recently emerged as a hot debate in research arena by academic authors. Trends in foreign investment flows show that institutions in host country become prerequisite for attracting FDI inflows (Sethi et al., 2003) and the interaction between host country’s institution and organizational strategies has been seriously under researched (Bevan and Estrin, 2000; Li and Resnick, 2003).

The role of national competitiveness presenting the country’s attractiveness has been elaborated in several literatures. In their recent study, Dunning and Zang (2007) make an attempt to investigate the competitiveness of countries and FDI inflows, particularly, examine how extent, content and quality of which are associated with inward FDI. In this study, the main elements of competitiveness of national economies are based on country’s resources, capabilities and market and institutions. Their empirical results show the more competitive advantages of a country the more inward FDI it receives.

Recently, several economists have argued that the national competitiveness is most strongly influenced by government policies (Porter, 1990; Lall, 2001; Eduardo et al., 2002). Government policies are designed to improve country’s competitiveness in terms of altering factors and institutions towards more advantages. Furthermore, the government policies have changed significantly over the past decade to adapt to changes on the international rules of games and their enforcement (Lall, 2001: 25). Among the government policies that affect the national competitiveness, regional integration policies captured by regional integration organizations like EU, APEC, NAFTA, ASEAN etc which are expected to stimulate regional trade and investment, are among the most important ones. Hence, it turns our attention to exploring how such arrangements may influence on FDI inflows in the process of regional integration.

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to some extent, the conclusion on the determinants of FDI is mixed due to differences in methodologies, sample selection and analytical tool (Chakrabarti, 2001). Therefore, not surprisingly, understanding the determinants of FDI inflows or the capability of the nation in the relation to FDI inflows is becoming a controversial issue.

Drawing on from the arguments, this research aims to specifically address the effects of national competitiveness on the attraction of FDI inflows or in other words, the effect of a host country’s competitiveness on shaping the country’s attractiveness to foreign investors. Using the construct of national competitiveness developed by Porter (1990), the national competitiveness consists of not only the factors of productions but also institutions, government policies. The thesis aims to examine the relationship between national competitiveness and FDI inflows. To achieve the research objective, the three following sub-questions are investigated:

- How do advanced factors of production affect FDI inflows? - How do institutions affect FDI inflows?

- How do government policies affect FDI inflows?

This study makes some contributions to the current literature. First, this thesis investigates the effects of the country’s competitiveness, conceived as comprising the factors of production, institutions and government policies, which have been never jointly taken into account by previous studies, on FDI inflows. Second, scholars have argued the quality of formal institutions as host country’s attractiveness to FDI inflows but the informal institutions in the light of cultural factors on FDI activities have not properly given consideration. Hence, this thesis also contributes to the current literature by attempting to explore the influence of a host country’s cultural characteristics on the total sum of FDI, a country receives. Third, the thesis employs a panel data of three-step estimation procedure on the research of FDI inflows that rarely used before as most of research on FDI is applied either random effects or fixed effects model. The three-step estimation procedure which efficiently estimates the impact of time-invariant variables is useful for removing the biases caused by unobserved heterogeneity across countries while also controlling for fixed effects and overcoming problems faced by random effects model.

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2. Theoretical background and hypothesis

2.1 Theoretical background

In the current globalized world, the national competitiveness has become milestone for every country to attract FDI inflows. The Porter’s theory of national competitive advantages, based on the analysis of national environment which influences firm’s ability to compete, identifies a set of variables including factors of productions, demand conditions, related and supporting industries and firm strategies, structure and rivalry. Such factors play a major role in shaping national competitive advantages which allow firms to gain and sustain their competitiveness. According to Porter (1990), each of such determinants is affected by the others, turning the system into a dynamic one in which all the elements interact and reinforce with each other. Competitive advantage based on only one or two determinants is possible in the natural resource dependent environment but this competitive advantage will be rapidly lost out under the severe global competition.

In the diamond framework, Porter (1990) emphasizes the importance of productive resources, institutional frameworks and government policies as a country’s competitive advantages on the following main points. First, factors of production, specially advanced factors of production are necessary for a country to attain the most significant and sustainable competitive advantages whereby a country is enable to compete with others in attracting FDI flows. He wrote “nation succeeds in industries where they are particularly good at creating and most importantly, upgrading needed factors of production” (Porter, 1990: 80). In addition, the availability and quality of advanced factors of production determine the sophistication of competitive advantages that can potentially be achieved and upgraded. Second, nations will be more competitive when they possess high quality of institutions because the effective institutional mechanism is required to create and upgrade advanced factors. Furthermore, institutional factors namely cultural factors are essential on the establishment of national competitive advantages as they shape the environment in which firms operate, and closely work through such other determinants rather than isolate from them. Social norms and values create differences among nations and play a role in national competitive advantages in many industries (Porter, 1990:129). Third, national competitive advantages can be partly dependent on whether government policies influence each of four determinants either in positive or negatively way (Porter, 1990: 128). For example, government policies may positively influence factors of production by favourably paving the way for creating and upgrading factors like skilled human resources, scientific knowledge or advanced infrastructure.

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the level productivity of a country and therefore, provide the level of propensity that can be attained by a country (Lopez-Claros et al., 2005).

An adaptation of Porter's diamond framework and the other lines of reasoning, a host country’s competitiveness presenting its attractiveness in terms of factors of production, institutions and government policies are offered to explain the determinants of FDI inflows in this thesis. The assumption underling is that the host country’s competitiveness shapes the nation’s ability to attract foreign investors, encouraging FDI inflows. Furthermore, countries offering the best operating environment may receive high FDI inflow as foreign firms’ strategies and capabilities are matched with country’s competitive advantages (Hanalainen, 2003). To the extent that countries differ in their competitive advantages (Porter, 1990), their abilities to attract FDI inflows also vary from country to country.

The distinction among those factors has relevant implications. Firstly, a host country’s factors of production provide a physical environment in which foreign investors may exploit resources to sustain and foster their competitive advantages and business growth. Secondly, institutions provide favourable conditions by setting up the rules of the games which govern the actions of players. Moreover, informal institutions are the norms, conventions and ways of doing things that can also affect foreign investors in term of the costs of undertaking economic, political and social interaction like costs of searching for reliable partners, writing business agreements, and enforcing mutually beneficial (OECD, 2006). Thirdly, government policies play an inevitable role on the country’s attractiveness to FDI since government policies affects many aspects of the business environment, for instance, providing framework and incentives for foreign firms to operate in.

2.1.1. Advanced factors of production and FDI inflows

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environment (natural resource), advanced factors referring to capital resource, physical infrastructure and human factors like labour quality.

Basic factors like natural resources have been declined its role in national competitiveness because the advanced resources have substituted for natural resources (Porter, 1990; Lall and Urata, 2003; Lopez-Claros et, al. 2004). Moreover, abundant natural resources also carry risk as the forces set in motion that limit the development of policies, skill and attitudes to enhance national competitiveness (Lopez-Claros et, al. 2004: 23).

The importance of the advanced factors on the country’s competitiveness has been embodied on numerous studies. Porter (1990) stresses on the importance of the advanced factors as now among the most significant ones for the national competitive advantages because they are necessary for a country to achieve high order of competitive advantages such as in technology of production. For instance, in Japan, the role of advanced factors has now become more decisive in shaping the national competitiveness and has compensated for the deficiencies in natural resources. Also, empirical evidence indicates that during the 1980s, FDI inflows have begun to shift toward services and technology intensive manufacturing (UNCTAD, 1993; Dunning, 1998). Globalization and the telecommunication revolution have led to a shift in the competitive advantages of economies toward increasing importance of knowledge-based innovative activities (Audretsch, 1998). Foreign firms’ investment strategies also have shown that the advanced factors are now seriously taken into account when the firms choose to locate their activities abroad.

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country-specific effects and not use a longitudinal data to reflect the changing pattern of FDI inflows.

Dunning and Zang (2007) use a dataset from 117 countries classified into 3 main groups of countries based on their GDP per capita to investigate the competitiveness of national economies in terms of resources, capabilities and market and institutions. In their study, the nation’s resource and capability are measured by indicators consisting of infrastructure and supported services and technology capability. Their findings show that infrastructure and supported services are positively correlated with FDI inflows but technology capability is negatively correlated with FDI inflows. Given the limitation of using cross-section method in this study, the results do not allow reflecting fully the causal relationship between FDI inflows and a host country’s competitiveness. Hence, results may be biased. Moreover, the challenge how to control for country-specific effects in the assessment of a country’s attractiveness on FDI inflows is not treated appropriately.

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With regard to financial development and FDI inflows, Alfaro et al. (2004) examine whether countries with well developed financial systems can draw FDI more efficiently. Their findings assert the level of development of local financial institutions is a crucial factor that determines the decision of foreign investors to invest in a particular country and countries with well-developed financial markets gain significantly from FDI inflows. Conversely, Bevan et al. (2004) use a dataset of FDI inflows from individual market economies to transition ones to examine the relationship between institutional development and FDI inflows. In this study, financial market development has been investigated in terms of banks and securities markets. Their findings show that banking sector reform has been significantly associated with greater FDI inflows. This implies that foreign investors are concerned with the effectiveness of the banking sector to serve as a payment system and a source of non-equity finance, and are worried about the possibility of banking crises meanwhile non-bank reform is of little importance for foreign investors into transition economies, suggesting that foreign investors operating in transition countries make little use of local capital market institutions.

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In respect to the relationship between technological development and FDI inflows, Akhter and Lusch (1991) attempt to explain empirically the influences of the developed and developing country’s environment on foreign investment from the United States (US) through interaction of 3 variables including technological development, quality of life and political instability. The sample for this study consisting of 54 developed and developing countries is used to analyse. The findings indicate that technological development in host country is significant to FDI inflow. In particular, the authors confirm that countries with higher level of technological development tend to attract more FDI from the US than countries with lower level of technological development.

In short, empirical studies have tried to identify the effects of the country’s advanced factors of production on the inflows of FDI into countries. However, the results are quite mixed mostly due to the difference in the methodologies and samples. Given the mixed results on the relationship between the country’s advanced factors of production which formulate the country’s attractiveness and FDI inflows, more research is necessary to illuminate the role of the country’s advanced factors on drawing FDI inflows. This thesis advances current studies on the effects of the country’s attractiveness on FDI inflows by using a large sample of countries with regard to quality of human capital, financial market development, quality of infrastructure, and technological development that would make our study more comprehensive than other studies. Moreover, the existing empirical literature on determinants of FDI has devoted somewhat limited attention to the technological development measure, presumably difficulty in quantifying the degree of national technological development. This thesis aims to contribute to current studies on FDI by using the measure of country’s technological development taken from Global Competitiveness Report. Furthermore, in order to reflect the effect of advanced factors on variation in FDI inflows, this study unites four advanced factors into one specification model by using three-step model which is able to control for agglomeration effects (and any other observed or unobserved cross-sectional variation).

2.1.2 Institutions and FDI inflows

First a detail distinction of institutions has been made after that, the role of institutions as source of national competitiveness is put forward and finally the role of institutions on FDI inflows has been extensively reviewed.

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institutions of a host country matter its attractiveness to foreign investors. According to Hennart and Larimo (1998), a country’s institutions add to the context that shape "national character" and influence investment decisions. The function of institutions is to reduce transaction costs i.e., the cost of information, measurement and enforcement of property right and contracts etc., (Hoskisson et al., 2000). The results are successfully achieved through putting constraints on the behaviours of economic agents to avoid opportunistic behaviours. Given the institutions differ across nations, quality of institutional environment will attract more FDI by luring foreign investors to enter because foreign investors would shift their activities to nations in which they could secure advantages of institutional framework offered by host country to pursue those activities (Hall and Soskice, 2001).

The role of institutions as the country’s competitive advantages on attracting FDI inflows is largely discussed on the existing studies. Globerman and Shapiro (2002) estimate the role of institutions on both FDI inflows and outflows for a broad sample of developed and developing countries over a time period from 1995 to 1997 by using governance infrastructure constructed by Kaufman et al. (1999). This index is based on the measures of voice and accountability, political stability, government regulatory quality, rule of laws, control of corruption. Authors find good institutions have positive effects on FDI inflows. Furthermore, Globerman et al., (2004) also prove that strong legal institutions will increase FDI flows in high-tech industries as high tech industries bear greater problems in enforcing opportunistic behaviours and protection of intangible assets than other sectors. The limitation of this study is to apply cross-section methodology because panel data was not sufficiently available.

Kostevc et al, (2007) analyze the relation between foreign direct investment and the quality of the institutional environment in transition economies. Their analysis confirms a significant impact of various institutional aspects on the inflow of foreign investment. To isolate the importance of the institutional environment from the impact of other factors, a panel data analysis is performed by using the data taken from the Heritage Foundation Organisation, which comprises 24 transition economies in the period 1995–2002. The results show that in the observed period, the quality of the institutional environment significantly influences the level of foreign direct investment into transition economies in particular; regulation, property rights protection, and black market have the strongest impact on FDI inflows.

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literature by using a new database derived from French Ministry of Finance network in 52 developing countries. Employing the two-stage estimation procedure to control for mullticollearity and heterogeneity bias, their findings highlight the impact of institutional environment of the host country on bilateral FDI. However, there are two drawbacks on their dataset. First, given the availability of the data and their coverage of using 72 institution variables, only cross-section methodology is employed. Second, only developing countries are included in the sample which reduces the scope of studying on the impact of the host country’s institutions on bilateral FDI flows.

The capability of a country to control for corruption reflects how efficiently the legal system and rule of law are exercised. Furthermore, quality of a country’s formal institutions which reflects the quality of institutions or the rules of the game in a country is defined in terms of the degree of property rights protection, the extent control of corruption, the degree to which laws and regulations are fairly applied. Several papers have also used corruption to measure inefficient institutions in a country (Gastanaga et al., 1998; and Wei, 2000; Habib and Zurawicki, 2002; Kostevc et al, 2007)

Habib and Zurawicki (2002) make an effort to study a large number of 89 host countries comprising developed, developing, and transition economies, which offer a broad perspective on FDI and corruption in three years from 1996 to 1998. The statistics on aggregate bilateral FDI flows derived from the International Monetary Fund and corruption index coming from Transparency International Organization are analyzed in conjunction with key observational variables consisting of GDP growth, GDP per capita, openness of trade, availability of labour, political stability, and cultural distance. These findings suggest that corruption is a serious obstacle for foreign investment. Furthermore, the study also finds a negative effect of difference in corruption levels between the home and host countries on FDI inflows. Likewise, Kwok and Radesse (2006), based on the data on foreign direct investment and corruption for a large sample of countries over the last 30 years, explore the relationship between corruption and FDI inflows while controlling for potential-country factors like political and legal environment. Their findings also figure out that the current corruption level is significantly lower in countries with high FDI inflows in the past.

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In short, empirical studies have tried to identify the effects of formal institutions on the inflows of FDI into countries. However, the results are quite controversial mostly due to the difficulty of measuring qualitative variables like institutions and due to the difference in the methodologies and samples. According to Transparency International Organisation2, China, Brazil, Thailand and Mexico attract a large amount of FDI despite their perceived high corruption. Within the industrialized world, while Italy is perceived relatively corrupt and receives modest FDI inflows FDI, Belgium, which is similarly rated on corruption, attracts substantial FDI. Drawing on from arguments, on the scope of this thesis, the level of corruption is chosen to stand for formal institutions. The capability of a country to control for corruption has been found to be important for the country’s attractiveness

Contrary to formal institutions, informal institutions are characterized by the unwritten rules of society or code of conduct and behaviour, traditions and cultural conventions (North, 1990). They refer to the ways in which actors pursue their goal (Scott, 1995) and the belief and value system of a society (Dimaggio and Powell, 1983), for example, cultural mores, trust, norms etc. Yeager (1999) stresses on informal rules are probably much more important than formal rules because culture is so pervasive in which culture is embedded on informal rules and greatly influences formal institutions. Following the arguments, in this thesis, the informal institutions are conceived on the view of cultural factors. Hofstede (2001) categorizes national culture in terms of five dimensions: individualism, power distance, uncertainty avoidance, masculinity, and long-term orientation. Hofstede (2001) finds that the national cultures vary significantly along these indices, however, in this scope of studying, three cultural dimensions are taken on consideration which are supposed have strong effects on FDI inflows namely individualism (IDV), uncertainty avoidance (UAI), and power distance (PDI). The two remaining cultural dimensions, particularly long term orientation (LTO) and masculinity (MAS) are not taken into account for the following points. First, the LTO data is only available for only 27 countries (Hofstede, 2001) so it limits scope of our study in a large sample of countries. Second, the effect of MAS on FDI inflows seems to be unclear. The reason is that MAS refers to the distribution of roles between the genders which overemphasizes conventional gender role (House et al., 2004:346) and is unlikely to have unclear impacts on FDI inflows. This is because masculine societies offer foreign investors both advantages and disadvantages. In particular, since masculine culture stresses equity, competition among colleagues, performance, and resulting material success and progress, people from a masculine culture live to work and tend to pursue success (Paul et al., 2006). Such characteristics may encourage foreign investors to enter because they bring more advantages to organisations. In contrast, masculine

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cultures have higher levels of corruption (Getz and Volkema 2001) and are more likely to overlook business practices (Paul et al., 2006) which may put foreign investors in a disadvantage position.

The impact of informal institutions on inward FDI has been more analyzed within the framework of gravity model by using the culture distance between the host and the home country on bilateral FDI data. The result of cultural distance in the relation to FDI inflows is still controversial one. On the one hand, Terpstra and Yu (1988) find that cultural distance doesn’t matter the overseas expansion of U.S. advertising firms. Likewise, by testing the sample of outward Norwegian firms, Benito and Gripsrud (1992) find no evidence that cultural distance deters investment. On the other hand, Grosse and Trevino (1996) show that cultural distance relates inversely to FDI inflows into the U.S in a time period 1980-1991. The larger national cultural differences increase the amount of uncertainty, hindering them to expansion overseas activities. In the same line, Siegel et al. (2007), investigating cultural distance on egalitarianism, find it economically significant obstacle to FDI flows. However, Shenkar (2001) concludes that FDI research involving cultural distance suffers from both conceptual and methodological shortcomings and may lead to inconsistent findings.

To my knowledge, Bhardwaj et al., (2007) are the first to examine the influence of national culture on the total sum of FDI a country receive. The authors investigate national culture in terms of uncertainty avoidance and trust on FDI inflows by using a sample of 43 nations. Their findings assert the influence of uncertainty avoidance and trust on the location choices of foreign investors in which a country with low level of uncertainty avoidance and high level of trust will attract more FDI inflows. The first limitation in this study is using 3 year data inward FDI index which is a ratio of a country’s share in worldwide inward FDI relative to its share in GDP, employment and exports, averaged over a period of three years may not be long enough to reflect pattern of FDI inflows. Another limitation lies on the cross-section method which does not allow reflecting fully the causal relationship between FDI inflows and cultural variables and may cause results biased. Third, authors only look into the effect of uncertainty avoidance and trust but ignore the effect of other culture variables on FDI inflows.

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attractiveness of the countries’ institutional environment on the FDI inflows by using FDI inflow data a country receives, not using bilateral FDI data. Moreover, given the characteristics of institutional data which includes time- invariant cultural variables, the problem is pinpointed in the econometric method as most previous studies employ cross- section method, which is not able to control for country-specific effects and time-invariant variables. A three-step procedure has been exploited in an attempt to overcome this problem, making the results of this thesis be more reliable and unbiased compared to those similar studies using cross-section data.

2.1.3 Government policies and FDI inflows

Government policies play a role in shaping and upgrading national advantages (Porter, 1990: 29). According to Porter, government policies can improve national advantages by influencing each of the determinants or otherwise they are likely to undermine national advantages. Along with the globalization process and the rising economic integration that have occurred among countries on a regional basis, trade and investment liberalization in the form of EU, NAFTA, AFTA and other regional agreements have led to increasing market integrations, triggering countries’ attractiveness.

The emergence of an extensive network of regional agreements which are supposed to improve the countries’ attractiveness (Brenton et al., 1999; Eduardo et al., 2002) reflects the host government’s goodwill to promote FDI coming from the partner countries and outsider countries. These regional integration policies aim at gradually decreasing or eliminating the measures and restrictions on the entry and operations of foreign firms and application of equal standards of treatment. The role of regional integration in attracting FDI inflow may be illustrated by a rapid increase of intra regional FDI inflows among regional blocks like EU, NAFTA, East Asia since the half of 1980 (Cable and Henderson, 1994). On this ground, it can be argued that FDI activities may be attracted by not only the economic factors of the host economy but also the government policies, particularly the regional integration policies.

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Blomstrom and Kokko (1997) separate the effects of regional trade agreements (RTA) along two dimensions, the first one is the indirect effects on FDI through trade liberalization and the second one is the direct effects from changes in investment rules connected with the regional trade agreements. According to the authors, lowering interregional tariffs can expand markets and increase FDI but lowering external tariffs can reduce FDI to the region if the FDI motivation is a tariff jumping.

Banga (2003) employs a panel data of fifteen developing countries of South, East and South East Asia for the period 1980-81 to 1999-2000 to investigate the role of the selective government policies and investment agreements in attracting FDI flows into developing countries. The results based on panel data and fixed-effects model show that bilateral investment treaties which emphasize on non-discriminatory treatment of FDI are found to have a significant impact on aggregate FDI. But bilateral investment treaties with developed countries rather than developing countries that are found to have a significant impact on FDI inflows to developing countries

Jaumotte (2004) investigates whether a regional trade agreement (RTA) is a determinant of foreign direct investment (FDI) received by countries participating the RTA. The author tests on a sample of 71 developing countries during the period 1980–99. His findings reveal RTA has a positive impact on the FDI received by the member countries, especially after 1990s, the FDI inflows have even increased when such agreements are revived and become more widespread. Likewise, MacDermott (2007) examines the relationship between regional trade agreements and FDI, especially the impact of the North American Free Trade Agreement on FDI inflows. By using a fixed-effects gravity model for a panel data of OECD countries over the time period 1982–1997, the author indicates regional trade agreements encourage FDI inflows among those participating countries.

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Eastern Europe Countries) as countries’s attractiveness to foreign investors. In order to examine the possible link between FDI and regional integration, a dummy for host country membership in the 15 European countries is also included. Unlike expected, the result shows that host country membership in the EU does not significantly influence the stock of inward FDI. The explanation could be that the sample size for each home country is between 35 and 50 countries so that the roughly 15 EU countries can account for close to half of the sample. Since few other countries of similar per capita income are located in geographical proximity to the group, the EU dummy is likely to be correlated with the other explanatory variables.

Given the mixed results of the impact of regional integration on FDI inflows and growing importance of these regional integration agreements, there is also a need to empirically re-examine their impact on FDI inflows. This study marks an attempt to contribute on the existing literature on FDI by looking further the effects of regional integration policies on FDI inflows. Moreover, the scope of previous studies is limited in only small sample of countries. The thesis tries to investigate the linkage between FDI inflows and regional integration policies on larger sample size of countries. Furthermore, this study aims to keep track of the changes in FDI pattern before and after the country’s participation into regional integration organizations. The reason to restrict our attention on government policies by looking into regional integration policies is that countries have been increasing their regional economic links through regional integration agreements and the policies of regional integration have become among the most important ones and play a crucial role in attracting FDI inflows whereby, even a small country may now take advantage of regional integration to compete for FDI.

2.2. Hypotheses

2.2.1. Advanced factors of production and FDI inflows

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Quality of human capital

The quality of human capital in a host country is vital when foreign investors want to add value to their core competitive advantages or knowledge-intensive activities. In other words, the quality of the human capital is important in the production of most sophisticated modern services and manufacturing (Lall, 2001). In addition, the quality of human capital is regarded as created and specialized resources needed for firms to work in uncertain environments (Sabel, 1990) as skilled labour is likely to adapt to the fast changing environments, contributing more to firm’s growth. On this background, it can be argued that the local skilled labour is one of the essential sources for foreign firms to gain competitiveness. There are numerous studies on the role of human capital of host countries in attracting FDI inflows. Pfeffermanm and Madarassy (1992) argue that countries which have availability of a well-educated pool of labour become increasingly attractive to foreign firms than those which have cheap labour costs. Likewise, a country which has a relatively high level of human capital may be able to attract large amounts of investment from foreign investors, especially in the technology intensive sectors (Blomström and Kokko, 2003).

The human capital sources vary across countries depending on their history, education system, origins. Tendency also shows that the quality of labour now overweighs its price. Countries with abundant skilled labour and talented researchers would have more competitive advantages compared to those countries that lack of these sources (Calliano and Carpano, 2000). Furthermore, according to Navaretti and Venables (2004), firms are unlikely to engage in FDI in countries with very scare supplier of skilled labour. It can be argued that quality of human capital resource is associated with the level of FDI inflows. Thus, we come to hypothesis:

Hypothesis 1a: Host country’s quality level of human capital is positively related to its FDI inflows.

Financial market development

A well-developed financial market helps firms lower transaction costs associated with local financial services such as sourcing credit and settlement of payments. In addition, it ensures capital to be allocated to the projects that yield the highest returns, and therefore, enhances growth rates (Alfaro et al., 2004). A well-developed stock market improves the means to finance for entrepreneurs and play an important role in creating a bridge between domestic and foreign investors (Alfaro et al., 2004).

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development of domestic financial institutions and markets as technology diffusion might occur with the presence of not only domestic financial markets but also the foreign financial markets (Alfaro et al., 2004). Second, the lack of well developed financial institutions and markets may also constrain potential foreign entrepreneurs to entry. Because foreign investors can access financial markets in their host countries to utilize the tax deductibility of interest expenses and hedge against fluctuations in future local currency earnings. Local market-oriented FDI may be discouraged in the absence of such hedging opportunities which are provided by domestic financial markets (Feldstein, 1994). Third, financial market development will be good signals for foreign investors to enter as it confirms a transparency and trustworthy environment for firms to work in.

The empirical studies in the international finance literature have demonstrated the importance of local financial markets for foreign investors. For example, Lehmann et al., (2004) using a dataset to examine the determinants of the financing choices of multinational subsidiaries in 53 countries over the period 1983 to 2001, point out that foreign direct investors take use of local financial markets with the purpose of reducing their exposure to host country currency or other risks. Moreover, Lehmann et al., (2004) also stress on the role of financial market in a host country as a source of supplying funds to foreign investors. Drawing on from arguments above, it is expected that host countries with a better financial market development are supposed to be more attractive to FDI than the others.

Hypothesis 1b: Host country’s level of financial market development is positively related to FDI inflow

Quality of infrastructure

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The favourable role of good physical infrastructure in influencing the patterns of FDI inflows has been embodied on recent studies. Wheeler and Mody (1992) conduct a study on foreign investment determinants of FDI inflows and find that agglomeration measured by infrastructure quality namely quality of transport, communications, and energy infrastructure is an important determinant for U.S. investors. Reynolds et al., (2004) also provide some empirical support for this position by employing a two-step method to examine the relationship between telecommunication data and FDI inflows. The empirical result shows a strong relationship between the number of the telecommunications and the amount of FDI a country receives. Hence, the infrastructure development should become an integral part of the strategy to attract FDI inflows (Kumar, 2001). Following the above literatures, a hypothesis is proposed:

Hypothesis 1c: Host country’s quality level of infrastructure is positively associated with FDI inflows

Technological development

Technological development has become an increasingly central element in today’s knowledge based global economy. Especially, technological development is a critical determinant of developing countries’ ability to compete in integrated global markets. From host country’s perspective, countries that are technologically developed not only indicate the greater proficiency in the development and the usage of resources but also provide greater investment opportunities for exploitation of resources by foreign investors. Technological development leads to rapid a pace of innovation and an increase of productivity that make the country become more attractive in the international trade and investment arena (Lall, 2001; Lall and Urata, 2003). The reason is that new technologies benefit all activities in the form of creating and innovating new products, equipment, and knowledge, thus technological development becomes crucial for firms and an essential part of doing business.

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Evidences also show that high tech firms have been found to locate in countries which have higher technology capability like Silicon Valley, United State or Cambridge, United Kingdom whereby they can interact and enhance their R&D activity (Navaretti and Venables, 2004). According to OECD (2002), research and development (R&D) are considered among the most important sources of new knowledge, technological progress of a country which, in turn are significant elements on attracting FDI inflows. Therefore, it can be argued that knowledge-spillovers become increasingly important for firm’s competitiveness and induce foreign firms to locate in countries possessing high level of technological development. Because the level of technological development differs among countries due to the variations in local depth and rooting of high-technology activities thus countries with higher level of technological development position are expected to draw more foreign investors. Hypothesis 1d: Host country’s level of technological development is positively associated with its FDI inflows

2.2.2. Institutions and FDI inflows Formal institution

Level of corruption

Corruption is traditionally defined as “the abuse of public office for private gain”. In broad sense, corruption is viewed as an illegal action when the private agents act not ethics (Lopez-Caros et.al, 2005). Corruption is an obstacle to foreign investors and undermines country’s competitiveness for the following reasons. First, corruption may lead to higher transaction cost of doing business because investors need to bribe officials and to deal with extortion caused by corrupt bureaucrats and delays in their business activities in order to obtain licenses and permits. Second, corruption increases uncertainty faced by foreign investors, which may deter their investment as well. Moreover, foreign investors are more likely to have repeated interactions with local officials for permits, licenses and so on. As a result, local corruption would be more detrimental to foreign investors.

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where corruption is high. The reason is that corruption varies widely across countries, a country which has a low level of corruption, is a pulling destination for FDI. Thus, it is argued that the host country with low level of corruption the more FDI inflow than that with high level of corruption. Hypothesis 2a: Host country’s low level of corruption is positively associated with its FDI inflows

Informal institutions Individualism

Individualism (IDV) describes the degree to which people in a society value an individual’s opinion and put their individual interests and the interests of their immediate family above those of others (Hofstede, 2001). On the individualist side, countries with high values on individualism are those in which people act independently and pursue independent initiatives. In addition, people in individualist societies tend to be largely unconnected with others. In contrast to individualist societies, the collectivist societies emphasize on the inter-dependent relationship, personal goal therefore tend to correlate with each other (Hofstede, 2001).

In the individualist societies, task concerns prevail over relationship concerns in contrast to collectivist societies in which relationships among group members prevail over tasks when making group decisions (Hofstede, 2001). As a result, in the individualist societies, individual’s self interest and independent decision would contribute toward more efficient allocation of resources than those in the collectivist ones (Tsang, 2002). Moreover, individualist societies value uniqueness and encourage people to be independent from the groups. Consequently, these societies encourage individuals to maintain their points of view, develop their innovative ideas and make their own choices. Such characteristics have been found to encourage innovation, facilitate creativity to arrive at task solutions, thus improve firm performance (Goncalo and Staw, 2005); whereas collectivist societies typically try to coordinate their actions with others to minimize social friction, and have an abiding fear of being separated or disconnected from the group, consequently restricting their innovative ideas (Ho et al., 1989). Therefore, it might be suggested the high individualist countries may be more attractive to the foreign investors

Hypothesis 2b: Host country’s individualism level is positively related to its FDI inflows

Uncertainty Avoidance

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“not only familiar but also unfamiliar risks are accepted, so low uncertainty avoidance implies “willingness to enter into unknown ventures” (Hofstede, 2001: 164), thus induce potential foreign investors to enter. In contrast, in high uncertainty avoidance nations, feelings of “what is different is dangerous” may create additional barriers that potential foreign investors have to overcome (Hofstede, 1980: 41). These barriers may put foreign investors in a disadvantage position, potentially deterring them to invest.

Literature has found that uncertainty about foreign market would influence the entrance choices of investors to access overseas markets. For example, in high uncertainty avoidance countries, general attitudes toward competition are more negative than they are those in low uncertainty avoidance countries (Jones and Teegen, 2001). These negative attitudes toward competition may be enhanced by the liability of foreignness which is the additional costs incurred by foreign investors (Hymer, 1976). It can be argued that the higher liability of foreignness in high uncertainty avoidance nations may push foreign firms on a greater disadvantage and consequently hindering FDI inflows. Thus, we suggest the following hypothesis:

Hypothesis 2c: Host country’s uncertainty avoidance level is negatively related to its FDI inflows

Power Distance

Power distance (PDI) indicates the degree to which the less powerful segment of a society expects and accepts that power is distributed unequally. In countries that have a score high on this dimension, individuals consent to a less equal society and organizations are likely to have centralized, top-down control. Hofstede (2001) finds that power distant societies exhibit low interpersonal trust and a great need to control on the behaviour of individuals.

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are less likely. In the relation to corruption, Husted (1999) and Kimbro (2002) conclude that power distance has significant impact on the nation’s corruption. Drawing on from the lines of above reasoning, it is expected that countries with high power distance tend to attract less FDI inflows than those with low power distance.

Hypothesis 2d: Host country power distance level is negatively related to its FDI inflows.

2.2.3. Government policies and FDI inflows Regional integration policies

The impacts of regional integration policies have led to changes in entry barriers to foreign investors. Under the regional integration, FDI could be facilitated by the elimination of trade-related-investment measure or in other words the tariff jumping. There is empirical support that countries participating a regional integration organisation are more likely to attract more intra regional FDI inflows as the reduction of entry barriers could stimulate overall FDI flows among the organisation’s members by enabling foreign firms to operate more efficiently across the international borders (Blomstrom and Kokko, 1997). Second, the regional integration enhances the nation’s attractiveness to FDI by creating a larger common market. These growth-enhancing and market-augmenting effects of regional integration give the rise to FDI- via FDI firms seek advantages in growing demand and new markets. Third, regional integration also provides a favourable environment with harmonization of policies affecting trade and investment and procedure and a sound coordination of investment needed for FDI activities. For example, members of a regional block may require all participating countries to curb corruption, implement sound and stable macroeconomic policies, and adopt an ‘investor-friendly’ regulatory framework (Asiedu, 2006). Fourth, regional integration helps to reduce trade costs among their membership which consequently induces vertical FDI (MacDermott, 2007). Studies show that regionalization of trade and investment in East Asia facilitates FDI inflows into theirs member states (Sohn, 2002). Buckley et al. (1998) examine the impact of regional integration in North America on the foreign investment strategies of Canadian, European, and Japanese firms. Their empirical results provide supports for the theory that regional integration should exert a positive impact on FDI inflows. Given the advantages of regional integration, it is expected an increase in FDI inflows when countries take part in regional integration.

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3. Research method

3.1 Data sources and definition

This part describes the sample used in the empirical analysis. A comprehensive study on the effect of country’s attractiveness on FDI inflows is conducted on a large sample size of 65 countries including advanced, middle-income and developing countries. To construct our sample, a complete data is available for 5 years covering a time period from 2001 to 2005, given the limitation of the availability of institutional data3. The number of observations in the panel therefore, is 325 (=65x5).

The data used in this study is derived from several data sources. First, this study uses data FDI inflows, control variables from WDI 2006 (World Bank’s World Development Indicators). WDI 2006 compiles a comprehensive database on economic development data, covering more than 600 indicators, 208 economies, and 18 regional and income groups.

Second, human capital data is collected from Human Development Report (HDR) initiated by UNDP (United Nations Development Program). The Human Development Report has included data about gender equity, education, democracy, human rights, globalization, cultural liberty and water scarcity. In this database, the quality of human capital is calculated by the education index constructed from a variety of education sources like United Nations Educational, Scientific and Cultural Organization (UNESCO).

Third, financial market development indicator comes from World Bank Financial Structure Database. This dataset combines a wide range of indicators that measure the size, activity, and development of financial intermediaries and markets. The data compilation permits the construction of financial structure indicators to measure financial market development.

Fourth, the quality of technological development and quality of infrastructure data are taken from the Global Competitiveness Report which annually issues the countries’ competitiveness report. The Global Competitiveness Report now assesses 125 countries in collaboration with leading academics and a global network of 122 partner institutes. The report is unique in that the methodology combines the publicly available data with survey data that captures the perceptions and observations of business leaders in a given country.

3_{Institutional data comprises of institutional indices which measure the institutional variables like Corruption}

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Fifth, the level of corruption data is obtained from Transparency International Organization which ranks more than 150 countries by their perceived levels of corruption, as drawn on corruption indices of nine independent institutions, such as the World Bank (World Business Environment Survey), the European Intelligence Unit (EIU).

Sixth, in terms of culture data, we rely on the studies of cultural dimensions by Hofstede (2001) and his colleagues on national cultures. The database compiles paper and pencil survey results collected within subsidiaries of one large multinational business organization (IBM) in 72 countries and covering many questions about cultural values. A large body of research has indicated the usefulness of Hofstede’s cultural dimensions in explaining cultural differences among countries (Kogut and Singh, 1988; Shane, 1993; Nakata and Sivakumar, 1996)

Finally, the information about the host country’s participation in regional integration organisations is taken from the World Bank and UNCTAD website. In particular, those websites provide the information about the status of a country participating regional integration organisation, which is used to estimate the change in FDI inflows between before and after the participation of a country and the difference in FDI inflows between countries which join regional integration and those which do not.

Table 1: Detailed description of variables and their sources

Variables Data source

1. Dependent variables: FDI inflows WDI, 2005, World Bank development indicators 2. Independent variables

a. Production factors:

- Technological development The Global Competitiveness Reports - Infrastructure quality The Global Competitiveness Reports - Human capital quality Human Development Report

- Financial market development World Bank New Database on Financial Development and Structure Database b. Institution:

+ Formal institutions:

- Level of corruption World Bank: Worldwide Governance Indicators (1996-2005)

+ Informal institutions:

- Individualism (IDV) Hofstede’s Individualism index. - Power Distance(PDI) Hofstede’s Power Distance index.

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c. Government policies

-Regional integration organization World Bank, UNCTAD 3. Control variables:

- Openness of trade WDI, 2005 World bank development indicators - GDP per capita WDI, 2005 World bank development indicators

Dependent variable

The dependent variable is measured by FDI inflows. It is the sum of equity capital, reinvestment earnings, other long-term capital, and short-term capital as shown in the balance of payments statistics4. FDI inflow is a measure of the change in foreign capital into a country. A country in a positive FDI inflow position is attracting new foreign direct investment, while a country in a negative position is experiencing an outflow of foreign capital. Logarithm of FDI inflow has been used in the model.

Explanatory variables

Quality of Human Capital (henceforth, HUMAN CAPITAL) is measured by education index which is based on the aggregation calculation of adult literacy rate and the combined gross enrolment ratio for primary, secondary and tertiary schools.

Financial Market Development (henceforth, FINANCIAL MARKET) captures the level of development of local financial institutions. In this study, the financial market development is measured by the ratio of the value of the total shares traded on the stock market exchange to GDP

Quality of Infrastructure (henceforth, INFRASTRUCTURE) refers to the quality of the transportation, communication, energy availability, commercial services. Quality of infrastructure in country is ranked from 1 equally to poorly developed and inefficient to 7 correspondingly among the best in the world.

Technological Development (henceforth, TECHNOLOGY) refers to factors which facilitate and enable the technological capacity of a country. This includes the general availability of technologies and the penetration rate of information and communication technologies (Lopez-Claros, 2005). Country's position in technology is ranked from 1 generally lags behind countries to 7 equivalent to among the world's leaders.

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Level of Corruption (henceforth, CPI) is measured by Corruption Perception Index (CPI). The extent of corruption conventionally is defined as the exercise of public power for private gain based on scores of variables from polls of experts and surveys ranging from 0 to 10. A high CPI score of a country indicates that the corruption in this country is low and a country with a low score of CPI is highly corrupt.

Individualism (henceforth, INDIVIDUALISM) refers to degree to which the society reinforces individual or collective achievement and interpersonal relationships (Hofstede, 2001). A high individualism ranking indicates that individuality and individual rights are paramount within the society. A low individualism ranking represents societies of a more collectivist nature with close ties between individuals. The values range from Ecuador (8) to Unites State (91).

Uncertainty avoidance (henceforth, UNCERTAINTY_AVOIDANCE) refers to the extent to which members in society feel either uncomfortable or comfortable in unexpected situations which are novel, unknown, surprising, and different from usual (Hofstede, 2001). A high uncertainty avoidance index indicates the country has low tolerance for uncertainty and ambiguity. A low uncertainty avoidance index indicates the country has less concerned about ambiguity and uncertainty and has been more tolerance for a variety of opinions. The values range between 23 (Denmark) and 104 (Portugal).

Power distance (henceforth, POWER_DISTANCE) refers to the extent to which the less powerful members in societies accept and expect that power is distributed unequally (Hofstede, 2001). High power distance index indicates that inequalities of power and wealth have been allowed to grow within the society. A low power distance index indicates in these societies the equality and opportunity for everyone is emphasized. The values range from Austria, Australia (11) to Slovakia and Malaysia (104)

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Control variables

The choice of control variables is based on the existing theoretical and empirical literature on studying determinants of FDI. Dunning (1993) suggests that there are several factors such as openness of trade, GDP growth, market size, macroeconomics variables that one should consider when analyzing FDI inflows. Chakrabarti (2001) makes an attempt to establish a significant relationship between FDI inflows and set of explanatory variables, of which, openness of trade, market size are among the most determinant factors. To control for potential endogeneity, this study uses market size and openness of trade as control variables.

Market size

Market size (henceforth, MARTKET_SIZE), is proxied by the real gross domestic product, GDP. Market size has been widely regarded as the most significant determinant of FDI inflows and has been appeared as a control variable in almost empirical studies on the determinants of FDI inflows. Market size captures potential economies of large scale production and distribution for products sold in the host market. The larger the host markets the more a country is able to attract foreign investors due to a greater demand. Empirical work has generally supported the hypotheses that a host country’s market size has significantly positive effects on FDI inflows (Chakrabarti, 2001; Globerman et al., 2004). Like FDI inflows, market size is measured in the natural logarithm term of GDP. We expect a positive relationship between the market size and FDI inflows.

Openness of Trade

The trade openness of a host country (henceforth, TRADE_OPENNESS) is measured by the sum of export and export relative to GDP of the country. Trade openness reflects the liberalization of the trade regime in the host country. It is widely argued that trade openness of the economy and FDI inflows are positively related (Singh and Jun, 1995; Caves, 1996). Based on the research of Chakrabarti (2001), the author concludes that openness of trade has the highest likelihood of being positively correlated with FDI among all explanatory variables. Thus, we expect that the more countries open to trade, the more they receive foreign direct investment. The natural logarithm term of this variable is also used in this model.

3.2 Analytical framework

3.2.1 Fixed-effects vs. Random-effects models

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brought forward. Finally, the choice of using fixed effect vector decomposer over those two techniques is reasoned.

To begin with, using panel data has certain advantages on three prominent points. Firstly, panel data allows controlling for country heterogeneity in contrast to cross-section estimates which are likely to suffer from omitted variables bias caused by disregarding country specific heterogeneity effects (Baltagi, 2005). Heterogeneity may lead to biased results and cause serious misspecifications. Secondly, panel data is able to control for time-invariant variables like cultural variables whereas the time series and cross section studies cannot (Hsiao, 2003). Thirdly, panel data helps to increase the degrees of freedom and reduce the multicollinearity among explanatory variables, hence improve the efficiency of econometric estimates (Baltagi, 2005). Fourth, panel data enables us to study more complicated behavioural models, for example, effect of regional integration on FDI inflows when economies had undertaken and completed regional trade integration, during the time period covered in our data. Cross-sectional data would not allow us to assess changes in FDI inflows before and after a country takes part in regional integration organisation

Normally, the choice of the fixed-effects and the random-effects models should be made when analyzing the FDI inflows, depending on the data characteristics. According to Blonigen (2005), the presence of unobserved country heterogeneity and differences in the data set may lead to controversial results on FDI inflows and most determinants of cross-country FDI are fairly fragile statistically (Chakrabarti, 2001).

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component and explanatory variables are correlated, then estimators of random-effects model are inconsistent and biased.

In contrast, the effects model is able to control for unit effects (Hsiao, 2003). The fixed-effects model is suitable if a specific set of number of countries is investigated, our inference is restricted to the behaviour of these sets of countries (Baltagi, 2005). The fixed-effects model can be used if we want to assess differences between those specific countries (Hsiao, 2003). The fixed-effects allow controlling for the potential large number of unmeasured explanatory variables or unobserved heterogeneity. Moreover, the fixed-effect approach allows us to investigate more systematically the effects of changes like technological changes, changes in government regulatory and tax policies on FDI inflows over time as well as across countries (Gastanaga et al., 1998). The fixed-effects method has been widely used on the FDI studies and it is proved to be useful since the variance in the data comes from different levels across countries. Given the data collected from 65 countries including advanced, middle-income and developing countries, these countries differ in terms of FDI inflows, factors of production, institutions, market size etc. Therefore, the fixed-effects model which is able to control for the country heterogeneity is preferred to the random-effects model in this study.

However, there are some drawbacks of using the fixed-effects model. This technique cannot estimate the time-invariant variables in the model along with the unobserved effects thus it does not allow the estimation of time-invariant variables (Wooldridge, 2002; Hsiao, 2003; Baltagi, 2005). These time-invariant variables are wiped out in this model (Baltagi, 2005:13). As a result, when using the fixed-effects model to control for unobserved variation across the countries, the coefficient for these time-invariant variables cannot be estimated (Baltagi, 2005). Since this study estimates the effects of culture dimensions on FDI inflows, which are extremely stable overtime (Hofstede, 2001: 34) and thus perceived to be time-invariant, the fixed-effects model can not be employed in this study.

3.2.2 Fixed effect vector decomposition

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results that are more robust than the OLS (Ordinary Least Squares) one. Second, as mentioned, the random-effects model performs well in estimating the effect of time-invariant variables, nevertheless, this random-effects model fails to adequately account for the correlation between country specific effects and both time-invariant and time-variant variables. Hence, the estimators for all variables in the random-effects model correlated with the country specific effect are biased.

The fixed effect vector decomposition technique can overcome the potential severe problems of correlation between country specific effect and both time-invariant and time-variant variables. Since these cultural variables do not vary over time, vector decomposition is useful in estimating the impact of time-invariant variables, removing the biases caused by unobserved heterogeneities across countries. To sum up, we can combine advantages of both fixed-effects and random-effects models into one model called “fixed effect vector decomposition” which can overcome disadvantages aroused from those two models, thus improve the reliable estimates of coefficients.

Three step procedure

This part describes the estimation procedure of three-step model developed by Plumer and Troeger (2007) together with assumptions applied for each step which should be seriously taken into account.

The basic regression model is described as following:

it i mi M m m kit K k k it x z u e y = +

∑

+

∑

+ + = =1 1 γ β α , (1) t=1, 2,3,4,5 where: y: FDI inflows

x- individual-time-variant variables: quality of human capital, financial market development, quality of infrastructure, technological development; level of corruption, regional integration, market size, openness of trade

z- time-invariant variables: individualism, uncertainty avoidance, power distance i

u : country specific effects it

e : The error term β andγ : the coefficients

The Role of National Competitiveness in Attracting FDI Inflows

Thesis