1 The determinants of Institutional FDI Fitness and its effect on emerging economies
A study on how the institutional characteristics influence the FDI attractiveness of emerging economies.
Name: Alexander N. Driesprong Student Number: s1951564
E-mail: alex_driesprong@yahoo.com University: Rijks Universiteit Groningen
major: Msc. International Economics & Business Supervisor: Dhr. D.H.M. Akkermans
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Abstract
Institutional FDI fitness refers to a country’s institutions and how their characteristics play a role in attracting Inward FDI. In this thesis we test the influence of institutions in emerging economies and see the relationship between institutional fitness for FDI and Inward FDI. Our results show that the governmental institution (using the variables control of corruption and rule of law) is the most influential institution and that improving rule of law and decreasing corruption will improve an economy’s attractiveness. We also find that within the market institution trade barriers also play an influential role when attracting inward FDI. Taxation showed a significance, but with a positive coefficient. We believe this result to have been influenced by the fact that most Inward FDI was natural resource oriented leaving resource seeking firms little choice but to pay higher taxes. A majority of inward FDI to emerging economies were mainly resource seeking, which can be seen by the significance of our natural resource rents variable. According to our model Inward FDI was not influenced by the financial crisis in between 2007-2009.
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Table of Contents
Abstract ... 2
1 Introduction ... 5
2 Literature Review ... 7
2.1 Institutional FDI Fitness ... 8
2.3 What is an institution? ... 10
2.4 Why do institutional characteristics matter? ... 10
2.5 Four institutions that can influence FDI inflow ... 11
3 Data and Methods ... 24
3.1 Dependent Variable and lag ... 27
3.2 Time Dummy Variable to control for Crisis period 2007-2009 ... 28
3.3 Dummy variable natural resources ... 28
4 Empirical Results ... 29
5 Conclusion ... 36
6 Recommendations & Future Expansions ... 41
6.1 Recommendations ... 41
6.2 Future Expansions ... 43
Bibliography ... 45
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Tables & Graphs
Table 1: Descriptives ... 30
Table2:multicollinearity ... 31
Table 3: White test for hetroskedasticity ... 31
Table 4: Jacque-Bera Test for Normal Distribution ... 32
Table 5: OLS regression results: Control of Corruption and Rule of law tested separately ... 35
Table 6: FE regression results: Control of Corruption and Rule of Law tested separately ... 36
Graph 1: Residuals Squared showing outliers ... 29
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1 Introduction
In order to help combat uncertainties that foreign firms might have, emerging economies can (to some extent) improve their country institutions in order to be more attractive for foreign investments. Vittorio & Ugo (2006) found that “good institutions” can encourage private investments, improve the overall efficiency of the economic system and significantly contribute to the economic growth in the long run1. The reason why it is so important for these emerging economies to be attractive is to increase foreign investments. Doing so leads to a creation of jobs, spillovers, and investments in infrastructure. An example of Foreign Direct Investment (hereafter FDI) inflow was the establishment of the SHELL refinery on the island of Curacao, a former island of the Netherlands Antilles in 1918. Due to its investments in infrastructure numerous neighborhoods were built which still stands today. It also brought spillovers in the form of numerous establishments opening up to fulfill the demand of the radical changes the refinery brought with it. On the island stores opened ranging from hardware sales to building material and even additional supermarkets. More importantly the SHELL provided employment for thousands of people. Over the years due to the automation of the refinery the amount of jobs offered declined, however in the Caribbean a new form of FDI inflow occurred. The off- shore financial business came into existence which benefitted many islands in the Caribbean such as the British Virgin Islands, the Cayman Islands, and once more the Netherlands Antilles.
This form of Foreign Direct Investment once again contributed positively to economies by creating a demand for high skilled labor and prompting many local universities to focus their attention to the development of their business faculties.
Foreign investors seek local markets and export platforms based on local resources such
as low cost labor or natural resources. Most investors pursue market-seeking objectives, however resource-seeking investors also account for many large projects. In first instance, many investors may be motivated by only one of the objectives, but most investors over time develop a range of activities and serve both domestic and export markets2. Regardless of the goals of the investor however, no FDI will take place if the uncertainties or push factors outweigh the
1 Vittorio & Ugo, 2006
2 Meyer, Estrin, Bhaumik, & Peng, 2009
6 potential gains. These circumstances can scare off potential investments in an economy.
The overall benefits of FDI for developing country economies are well documented. Studies show that FDI triggers technology spillovers, assists human capital formation, contributes to international trade integration, helps create a more competitive business environment and enhances enterprise development. All of these contribute to higher economic growth, which is the most potent tool for alleviating poverty in developing countries. Moreover, beyond the strictly economic benefits, FDI may help improve environmental and social conditions in the host country by, for example, transferring “cleaner” technologies and leading to more socially responsible corporate policies.3
This thesis will analyze the subject of institutional fitness for attracting FDI. In analyzing the relationship between FDI inflow and FDI fitness the objective of this thesis is to help policy makers from emerging countries understand what it is they could do to improve their attractiveness for foreign investors; this thesis should also provide scholars with data on the relationship between these two variables. An improved understanding on this subject can be the beginning steps towards an enhanced and improved communication and understanding between scholars and policy makers. Which in the future can lead to the (re)structuring of institutions in order to improve FDI viability.
The research question that will be answered is the following:
To what extent do institutional characteristics influence the FDI attractiveness of emerging economies?
Institutional FDI fitness theory implies that it is the country’s institutions that influence the Foreign Direct investment inflows, and not its generic conditions such as geographic location or natural resources. All else equal the institutional fitness theory would suggest that countries with a high institutional fitness will receive a higher inflow of Foreign Direct Investments, as opposed to countries with lower levels of institutional fitness.
3 OECD, 2002
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2 Literature Review
This study focuses on the influence that institutional characteristics have on FDI inflow in 41 emerging economies4. With this in mind the purpose of this study is to analyze how the different institutions play a role in attracting FDI.
Emerging economies are low-income countries. They fall into two groups: emerging countries in Asia, Latin America, Africa, and the Middle East and transition economies in the former Soviet Union and China5. Such countries constitute approximately 80% of the global population, and represent about 20% of the world's economies.
Prior to the financial crisis FDI rose to over 2.3 trillion dollars in 2007, this is a considerable increase from 340 billion dollars in 1995. Data from 2005 shows that Global FDI inflows were 29% higher than in 2004 - a total of $916 billion. Flows to developing countries in 2005 rose by 22% to reach a record high of $334 billion. Developed countries also saw increased flows. They saw a rise of 37% to $542 billion6.
Among developing regions, the highest growth rate in inward FDI was seen in West Asia (85%) which received record inflows of $34 billion. The second highest growth was in Africa which saw a 78% increase to $31 billion. FDI inflows in the 50 least developed countries also recorded a historic high of US$10 billion (see footnote 3).
4 The countries were chosen based on the IMF’s list of developing and emerging economies.
5 Hoskisson R. E., Eden, Lau, & M, 2000
6 UNCTAD, 2010
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2.1 Institutional FDI Fitness
FDI Fitness refers to a country’s ability to attract, absorb, and retain FDI. FDI Fitness theory uses this concept with the thought that smaller economies can compete based on adapting and fitting their economy for the global investment market and thus possibly improving its attractiveness for inward FDI .
Since the 90s Foreign Direct Investment in emerging economies has been increasing.
The reasons for firms to invest in another country can range from cheap labor to large markets this of course depends on whether firms that are considering Foreign Direct Investment do it for Vertical FDI or Horizontal FDI reasons7. This thesis will focus on the pull factors that play a role in attracting FDI; Factors that to some extent can be influenced by an economy’s policy, such as Governmental, Social, Absorptive Capacity, and Market factors. A similar study has been done by Wilhelms et. al (1998) in testing for FDI Fitness for emerging countries8. The former study uses data from 1978 up to 1995 and seeing the current advances in globalization, I wish to do a similar test, using the same general independent variables. The years I will use will be 1992 till 2009. A major change over the past decades has been that governments have become more open towards FDI, and have liberalized their FDI regime accordingly. This has been done at different speeds and different depths over different regions. Over the past fifteen years, countries have regarded FDI inflow as contributing to their economic development because of its technology and capital that it provides. They have even started to compete for FDI inflow by improving Investment policies.9 Another radical change is the development of technology and the globalization trend over the years. (high-speed )internet allowing for the ability to communicate at low cost due to the inventions such as the e-mail and Skype; and the increasing trend of doing business across borders, gives reason to a more recent study on topic.
7 Navaretti & Venables, 2006
8 Wilhelms et al, 1998
9 Willem, 2006
9 Besides creating an atmosphere of stability for foreign investors, economies should also be able to react towards global trends in order to keep up its competitiveness when competing for inward FDI. India can be taken as an example, having flourished in its IT knowledge and building up a reputation as “the country to go to” for numerous IT related needs.
Some countries rich in natural resources and adequate for FDI do not always receive as much FDI as could be expected. An example can be taken from the continent of Africa. The OECD stated in a 2002 report10 that even though gross returns on investment can be very high in Africa there is still a lack of investment in the continent. According to the report the lack of FDI inflow in African countries is attributed to high taxes and a significant risk of capital losses. As for the risk factors, analysts agreed that macroeconomic instability, loss of assets due to nonenforceability of contracts, and physical destruction caused by armed conflicts play an important role in deterring investors. Moreover they concluded that the loss of assets due to nonenforcebility of contracts may be particularly discouraging to investors domiciled abroad, since they are generally excluded from the informal networks of agreements and enforcement that develop in the absence of a transparent judicial system. In short even though a particular country is rich in resources, weak institutions may exert a counterinfluence that has a larger influence on investors than the host economy’s natural resources do. The Institutional FDI fitness theory suggests that disadvantaged countries are able to attract substantial FDI by providing an attractive environment by means of improving its institutions and thus becoming attractive, even if an economy is at a disadvantaged position11
10 UNCTAD, 2010
11 See footnote 10
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2.3 What is an institution?
Before continuing let us take a look at what an institution is and how it came into existence.
Ever since this planet has been populated by humans, they have made arrangements for governing their lives. These arrangements are often referred to as ‘institutions’. They may be formal arrangements, such as legal systems and property rights, or informal arrangements, like moral standards. In some cases, they take the form of implicit world views or mental maps, i.e.
cognitive frameworks for looking at the world around you. These arrangements or institutions operate at different levels, ranging from an international level (such as trade arrangements) to community and individual levels (for instance, the values that determine the way in which people interact with each other). 12
According to North’s famous definition, institutions are ‘humanly devised constraints that shape human interaction13. They are the ‘rules of the game’ in a society, the rules that facilitate human interaction and societal life.
2.4 Why do institutional characteristics matter?
Institutions in an economy are now widely considered to be central to sustainable development and poverty reduction. However, during the 1990s institutional arrangements were generally believed to constrain the impact, effectiveness and efficiency of development aid. It is now believed that good governance, political dialogue, fair trade and ownership all depend on the presence of adequate local institutional frameworks, both formal and informal (see footnote 9).
As a result the Institutional fitness of an economy has been prominently on the agenda of many economies and considerable resources have been invested to improving the institutions that characterize an economy.
12 ECDPM), European Centre for Development Policy Management; Netherlands Ministry of Foreign Affairs, Poverty Policy and Institutional Development Division (DSI/AI) n.d.)
13 North, 1990
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2.5 Four institutions that can influence FDI inflow
There are four institutions that according to the theory of Wilhems et al.(1998) every country has14. The four institutions in a country are Sociocultural, Absorptive Capacity, Market, and Governmental institutions. They are the pillars which shape a country’s characteristics.
The following pages give an overview of the different institutions and the variables used to test them.
The sociocultural institution:
the sociocultural institution is considered to be the base of all the other institutions. The reason for this is because socioculture is the oldest of the 4 institutions that will be discussed. Having been in existence before all other institutions were formed, socioculture refers to the culture in a specific country, its norms and values. It is also the most complex and most time consuming institution to change, because it is a combination of past and current events that have spanned generations to make Socioculture is influenced by education, history, exposure with other cultures. Accounting for and understanding sociocultural factors in business planning can help investment decisions and also help the outcome of business operations. An example of this can be understanding the Spanish Siesta work ethic for foreign investors or McDonalds understanding the religious importance of the Cow for Hindus and taking this into consideration when opening a restaurant in this region.
Uncertainty avoidance and trust are 2 sociocultural variables that influence the location choices of foreign firms such that foreign firms. Company owners prefer to invest in nations with (1) low levels of uncertainty avoidance and (2) high levels of trust15.For this thesis only the uncertainty avoidance variable will be used as an indicator for the Sociocultural Fitness institution. The reason for this is that Bhardwaj, Dietz, & Beamish, 2007 have shown that the higher the uncertainty avoidance the less influential the level of trust variable becomes. The variable uncertainty avoidance is expected to have a negative influence on Foreign Direct Investment (FDI) inflow.
14 The theory has been taken from Wilhems et al.(1998)
15 Bhardwaj, Dietz, & Beamish, 2007
12 How uncertainty avoidance influences FDI inflow:
“Several processes (such as: attitudes toward the unknown, attitudes toward competition, preference for formalized contracts and structures, and the nature of rules and regulations) sustain the potential effects of uncertainty avoidance on the investments by foreign firms in a country”.16 In Economies with high uncertainty avoidance, feelings of "what is different is dangerous" (feelings that may be associated with ethnocentrism)17 may create barriers that potential foreign investors have to overcome. These additional barriers may result because of
"discrimination by government, by consumers, and by suppliers"18. These barriers may put foreign investors at a disadvantage in comparison to local investors, potentially making them reluctant to invest19). Moreover, in high uncertainty avoidance countries, general attitudes toward competition are more negative than they are in low uncertainty avoidance countries20 Thus, any new competition that foreign investors bring may not be welcome in high uncertainty avoidance nations.
In combination with negative attitudes toward the unknown, these negative attitudes toward competition may enhance the "liability of foreignness” 21. To be more precise, the theory of multinational enterprises22 emphasizes the additional costs investors’ face when doing business in foreign nations. This is often referred to as a liability of foreignness23 . Zaheer (1995), defines liability of foreignness as "the costs of doing business abroad that result in a competitive disadvantage for an MNE subunit ... broadly defined as all additional costs a firm operating in a market overseas incurs that a local firm would not incur." Hymer, (1976) suggests that the liability arises from "... the fact that in given countries, foreigners and nationals may receive very different treatment." 24The higher liability of foreignness in high uncertainty avoidance nations may put foreign firms at a greater disadvantage (relative to local firms) and deters FDI. By
16 Bhardwaj, Dietz, & Beamish, 2007
17 Hofstede 1999
18 Hymer 1976 (in Bhardwaj, Dietz, & Beamish, 2007)
19 Doney et al. 1998 (in Bhardwaj, Dietz, & Beamish, 2007)
20 Jones/Teegen 2001(in Bhardwaj, Dietz, & Beamish, 2007)
21 Hymer 1976 (in Bhardwaj, Dietz, & Beamish, 2007)
22 Dunning 1993, Caves 1996 (in Bhardwaj, Dietz, & Beamish, 2007)
23 Hymer 1976, Miller/Parkhe 2002, Zaheer 1995(in Bhardwaj, Dietz, & Beamish, 2007)
13 contrast, lower liability of foreignness in low uncertainty avoidance nations, may reduce the relative disadvantage of foreign firms, and facilitates FDI. Foreign corporations may have trouble functioning properly, because of the simple fact that they are foreign and thus would receive another type of treatment as opposed to local firms. Simple things such as being forced to wait longer for paper work to be or sales might be hindered because consumers would prefer local products as opposed to foreign products. An example of the latter is the closing of Mc Donald’s in Bolivia in 2002. Mc Donald’s closed due to a low profit margin which was contributed to among other things the radical difference between fast-food and traditional Bolivian Cuisine. It took too long for Bolivians to get accustomed to this foreign product and many preferred their traditional local cuisines and restaurants.
Furthermore, in high uncertainty avoidance nations, relative to low uncertainty avoidance nations, the emphasis on rigid structures and the preference for extensive written rules25 discourages foreign investors. Specifically, foreign firms may have to incur considerable costs to acquire such information 26 while local investors, because of the advantage of greater localized and tacit knowledge in managing the bureaucratic complexities, may have to incur relatively lower costs. Further, researchers (e.g., Porter et al. 2000), suggested that Japan's lower attraction for FDI, at least partially, results from formal rules that may often deter foreign competition.
Hofstede’s Uncertainty Avoidance Index (UAI) deals with a society's tolerance for uncertainty and ambiguity; In other words to what extent are members of a society anxious about the unknown, and as a consequence attempt to cope with anxiety by minimizing uncertainty. In cultures with strong uncertainty avoidance, people prefer explicit rules (e.g. about religion and food) and formally structured activities. In cultures with weak uncertainty avoidance, people prefer implicit or flexible rules or guidelines and informal activities. Uncertainty avoiding cultures try to minimize the possibility of such situations by strict laws and rules, safety and security measures, and on the philosophical and religious level by a belief in absolute Truth;
'there can only be one Truth and we have it'. People in uncertainty avoiding countries are also more emotional, and motivated by inner nervous energy. The opposite type, uncertainty accepting cultures, are more tolerant of opinions different from what they are used to; they try
25 Hofstede 2001
26 Hymer 1976
14 to have as few rules as possible, and on the philosophical and religious level they are relativist and allow many currents to flow side by side. People within these cultures are more phlegmatic and contemplative, and not expected by their environment to express emotions.27
One can argue that High Uncertainty Avoidance (lots of rules and regulations) is a good thing, as it provides a sense of security for foreign firms investing. Knowing that everything is regulated to prevent unwanted surprises would most likely be seen as the main argument for foreign investors to be pro-high uncertainty avoidance cultures. However, due to the lack of trust in foreign firms and its products or services can turn out to be bad for business.
Froese, Park, & Lee(2010) argue that risk perceptions from a business point of view makes Inward FDI difficult due to Uncertainty Avoidance. Risk perception determines risk preference and new business ventures always ensure a certain amount of risk. Such risks might be far larger when ventured with a foreign business partner or potential investors from foreign countries.
This having been said, businessmen from countries with hig uncertainty avoidance may want to avoid doing business with foreigners, whilst people coming from a country with low uncertainty avoidance will be more open towards risk taking and foreign uncertainty. 28
Hypothesis: 1
Because of the presence of barriers associated with High Uncertainty Avoidance Inward Foreign Direct Investment is more likely to take place in countries where the level of uncertainty avoidance is lower.
27 Hofstede, 2009
28Froese, Park, & Lee, 2010
15 The Absorptive Capacity Institution:
Education influences thinking and acting and it can help prepare for successful handling in a rapidly changing global economy. Education is also an indicator of human capital, meaning that the human capital in a given economy is able to process information, enhance creativity and thus provide an attractive environment for FDI. The importance of the level of education varies depending on the type of work foreign firms require from the local work force. However research has found that Education has an influence on Inward FDI. The education of the labor force in the host country, as researched by Carstensen & Toubal (2004) has a strong positive impact on FDI inflows. Skilled labor force is crucial to the implementation of innovative production technologies and to the adaptation to a Western business culture. At the same time, education may influence the size and composition of demand. Hence, MNEs are not only motivated by relatively cheap labor but also discriminate between more or less skilled labor.29 Depending on the type of FDI a well educated labor force can be very attractive for foreign investments. Kinoshita & Campos, 2002 found that for Commonwealth of Independent States (CIS), the availability of skilled labor was one of the main factors influencing FDI flows.30 .
During this research the variable that will be used for testing this institution are 1) high school graduation and 2) labor force. Fallon, (2001) found that the location of FDI is especially sensitive to among other things resource-based influences such as labor availability and educational attainment levels31. This finding leads us to believe that investors make a distinction between both education and labor force. First off high school education was chosen because an economy with a population that has at least a basic education is most attractive for foreign investors.
Even if FDI inflow exists out of low skilled jobs, a basic education makes it easier for the employee to understand and grasp tasks faster. Also obtaining the basic numerical and literacy levels of a high school graduate makes communication easier. We can also assume that if someone has graduated from high school he/she possesses a decent literacy and numeracy level.
29 Carstensen & Toubal, 2004
30 Kinoshita & Campos, 2002
31 Fallon, 2001 (Little, 1978; Glickman and Woodward, 1988; Mandell and Killian, 1974; and Arpan and Ricks, 1995 were mentioned by Fallon for having found similar results)
16 Besides high school graduation we will also make use of the total labor population as a percentage of the total population. Firms seeking FDI not only need a local population with a certain level of education in order to work for their firms, but also need enough labor force to sustain the production/service need of a foreign firm. A lack of labor will force foreign firms to having to import labor, meaning dealing with immigration laws and just plainly making the process of running a business less smoothly. A panel model of the location determinants of FDI in Hungary found that counties with higher labor availability attract more FDI32. Multinationals engaged in business process outsourcing (which entails taking over the entire back office business processes of corporations such the accounting department) require not only skilled but also a high amount of labor force in order to put up with the demand of their services labor force is most likely to have a positive influence on our regression model.
Hypothesis 2:
The higher the literacy and numeracy rate the more likely are Economies to receive foreign direct investment compared to countries with a lower literacy and numeracy rate.
Hypothesis3:
Economies with a higher amount of labor force will attract more FDI than an economy with a lower level.
32 Boudier-Bensebaa, Fabienne, 2005
17 The Market Institution:
The Market institution refers to the economic and financial indicators of an Economy. The health of the market institution to some extent reflects governmental policies that shape the institution. The more attractive the market institution of an economy the more these economies are able to attract foreign investment.
In order to test the influence of Market institutions this research will make use of the variables 1. Gross Domestic Product per Capita, 2. Trade-GDP ratio, 3. Tax Revenue as percentage of GDP, and 4. Credit provided by financial institutions. These variables represent the market environment at the time the data was collected from the given economies that will be tested.
They are a reflection of the “rules” and strategies that exist in an economy’s market. These variables were also used in the paper from Wilhelms et al (1998) to describe the Market Institution.
GDP per capita is an indicator of economic development, it measures the total output of goods and services in an economy. A high GDP per capita reflects both high purchasing power of consumers and high real wages, meaning that the local population has the ability to spend. It can also be argued; however that low GDP can also act as an attraction factor, because low GDP can be connected with low labor costs and thus lower production costs in general. Natural resources are usually labor intensive and thus low labor adds to the attractiveness of a country when choosing between countries with similar natural resources. The contradicting theories on how GDP, impacts inward FDI we can consider it theoretically ambiguous, however an empirical study done by Benassy-Quere, Coupet, & Mayer(2005) showed that GDP per capita generally has a positive impact on inward FDI.33 It may be argued that GDPpc is generally low in emerging economies, thus the main reason investors go there is mainly for the low wages. However we believe that over the years Inward FDI based on increasing wealth in emerging economies has been taking off. Countries in former Eastern Europe or Latin America, have a large low-income group, but they also have a growing number of high income individuals. For this thesis we
33 Benassy-Quere, Coupet, & Mayer, 2005
34 Zhang (2006)
18 expect a Low GDP per capita to have a positive effect in our economic model. Besides GDP per Capita we will also be using the GDP growth ratio. The GDP growth ratio is an indicator of economic health. If an economy is growing compared to the previous year GDP growth ratio will be positive. There is evidence to say that GDP growth and Inward FDI are linked together. On the one hand Inward FDI is a cause for GDP growth, while on the other GDP growth is a pull factor for Foreign Investment36GDP growth just like GDP per capita is a measurement used to measure economic advances. GDP growth emphasizes the growth of the host country through economic growth which may create large domestic markets and businesses. Swain and Wang (1995), Liu et al (1997), Zhang (2000), Wei and Liu (2001), Zhang (2002) have used GDP growth in past studies. 37 The GDP growth ratio is expected to have a positive influence in our model.
Trade to GDP ratio indicates trade volume. A high ratio of trade suggests relatively low trade barriers and is expected to have a positive influence in our model. Multinationals often conduct intra-firm trading with its other sister firms around the globe. This input or output which is related to FDI operations can be very costly if trade often occurs in markets with high trade barriers. We believe thus that foreign firms look for host economies with low trade barriers, and as indicator we use the trade-GDP ratio. The trade-to-GDP ratio is often called the "trade openness ratio". It has been debated that using this variable for openness may be somewhat misleading as a low ratio for a country does not necessarily imply high tariff or non-tariff obstacles to foreign trade, but may be due to a range of other factors such as the resource endowments, country size, tastes, technology and other determinants of comparative advantage and the other set is the levels of trade restrictions. The former are non-policy variables whereas the latter are policy variables. A country may have a high trade ratio because it is small or has resources which are valuable to other countries or perhaps because its residents have a preference for foreign goods rather than because it has low restrictions on trade with other countries. Nevertheless studies have shown that countries with high trade ratios tend to grow more than countries that trade less. Considering that our sample group is based on emerging economies we can agree that these countries have not yet reached their full potential and in the short-run an improvement in trade can positively influence their attractiveness for inward FDI.
19 High taxation means a burden on companies operating in the private sector. Furthermore due to a lack of administrative funds and capacity, emerging economies tend to rely more heavily on trade taxes as opposed to tax income generated from income or value added taxes on local production. The reason for this is because trade taxes can be easily collected at the port of entry or exit. It has been found in Mexico that multinationals are indeed sensitive to tax regimes and thus restructuring policies regarding taxes can increase FDI.34
This having been said, tax revenues in emerging economies are generally gained through trade taxes which affects in particular foreign investors, who are dependent on imports and exports.
High tax revenue as a percentage of GDP in this case refers to a high trade taxes. Even where FDI-related imports are duty free, high taxation translates into more administrative and financial strains on FDI operations.35 Further studies examining cross-border flows have indicated that on average, Inward FDI decreases by 3.7% following a 1 percentage point increase in the tax rate on FDI. However, the range of FDI decrease varies between 0% to 5%. This variation can be contributed to the difference between industries and countries being examined, or the time periods concerned.36 The variable on tax revenue is expected to have a negative influence on FDI inflow.
Before economic reforms, China failed to catch up with the west because it adopted a close- door, self-reliance and import-substitution policy. India did not perform well before 1990 because it stuck to its close-door and self-reliance policy as did China before 1978. Market liberalization and policy reforms were key elements for the economic success of China since 1978 and India since 1991.37 Chang (2003) argued that developed countries became developed by implementing policies that protected their domestic industry and only opened its trade once they were strong enough.38 While this may be true and it is arguable that developing countries should protect infant industries and that there is possibly no “best practice” solution that can be implemented in all economies; it should also be remembered that due to globalization economies are more intertwined with one another as opposed to the era where developed countries were still in a developing stage. Countries are more dependent on one another and
37 Taken from (Ali & Guo, 2005)
35 Wilhelms et all, 1998
36 OECD, 2008
37 Yao & Wei,2007
38 Chang, 2003
20 business is now crossing borders on a regular basis as was not the case a some decades ago. On short term developing countries not willing to implement more favorable trade policies might lose inward investments to other countries with similar economies who have opted for tax reform. Developing domestic industries are important for economic development, however on short term inward FDI can increase employment possibilities and in turn cause a snow ball effect, because members of the population that did not have an income suddenly have an income which they can spend in the local economy as well as have the government generate taxes through taxes derived from salaries and possibly value added taxes. In between the stages where developing economies become developed and their industries become self-sustainable, there must also worked on the creation of jobs and improvement of institutions on short term.
Credit as percentage of GDP refers to the amount of money available on the financial market.
Credit provided domestically by financial institutions such as banks as a percentage of GDP is an indicator of credit availability and financial intermediation.39 An analysis of the different types of financial institutions has show that stock markets and banks provide different services, but both stock market liquidity and banking development positively predict growth, capital accumulation, and productivity improvements.40 The more credit available the easier it is for firms to acquire funds domestically to start up. This variable is expected to have a positive coefficient in the statistical model. Credit is one of the most important functions of a financial institution. A financial institution that supplies credit is expected to positively influence FDI inflow, because available capital motivates business activity. This variable is expected to have a positive influence on FDI inflow.
Hypothesis 4:
A Low GDP per capita indicating low labor costs is expected to increase the total amount of inward foreign direct investment in a country.
39 Wilhelms et al, 1998
40 Levine and Zervos, 1998
21 Hypothesis5:
An increase in GDP growth indicating Economic growth is expected to increase the total amount of inward foreign direct investment in a country.
Hypothesis6:
High trade output, suggesting low trade barriers will increase foreign direct investment
Hypothesis 7:
A high taxation, indicating high trade taxations on companies will deter foreign direct investment.
Hypothesis 8:
Available domestic credit facilitating funds that can be used for foreign investors will increase foreign direct investment.
The governmental Institution:
Government institution can be considered the most influential of all institutions, because its policies and regulations influence to some extent all other country institutions. We can consider this institution to be a leading force in an economy, because policies implemented by the government to quite some extent play a role in how the local economy is regulated. It influences different areas of an economy, such as education and market circumstances. Investors often look at governments’ policies and regulations when making an investment decision. It is this institution that regulates government policies on taxes and investments and also has influence on the educational system and enforcing education on its population. The government institution is thus important for FDI inflow.
During this research there will be 2 variables that will be used for testing this institution:
22 1. The control of corruption41 and 2.The rule of law.
It has been found that the variables that have the most influence on FDI are corruption and rule of law42. The most common definition of corruption is the abuse of public office for private gain43. It covers a range of actions including bribery, extortion, asset-stripping, and illicit influence. This definition suggests that gains may accrue to individuals or to groups.
Corruption is related to bureaucratic quality and is generally felt more immediately by a foreign investor when entering a new market as opposed to rule of law. For example obtaining permits and the immigration process are felt more immediately and can make market entry more difficult if there is a strong corruption. It has been documented that corruption increases the cost of doing business and, thus, would also diminish Inward FDI activity44 An example can be situations in for example Romania where foreign investors have had tough times starting up, because officials were reluctant to help unless they received a personal incentive.
Harrison, (n.d.) found that generally the least corrupt countries were able to attract more Inward FDI than countries that were more corrupt.45 However it must be said that the study also concluded that the same paper found evidence that supports the argument that corrupt countries can attract FDI inflow as well. This can be attributed to the fact that even though there is corruption, some economy factors are just “too good to pass” such as the large Eastern European consumer market or the vast amount of natural resources suddenly made available for Western MNCs after the collapse of communism. However it should also be mentioned that foreign firms often times themselves are involved in questionable acts. Some studies indicate that foreign firms are not any less likely than local firms to bribe public officials and provide by
41 Originally the variable we were going to use was the corruption index from transparency international, however we chose “control of corruption” because the same measurement methods were used for both control of corruption and rule of law. Control of corruption refers to the level that corruption is under control. The measurement rating is from -3.5 to 3.5; the higher the rating the higher the control of corruption (the lesser the corruption) while rule of law refers to the extent that laws are enforced and respected.
42 Wilhelms et al, 1998
43 This simpler version is increasingly used in place of Joseph Nye’s 1967 definition of corruption as
“behaviour which deviates from the formal duties of a public role because of private regarding (personal, close family, private clique) pecuniary or status gains; or violates rules against the exercise of certain types of private-regarding influence.” See Joseph Nye, "Corruption and Political Development: A Cost-Benefit Analysis," American Political Science Review 61 (June 1967).
44 Blonigen, 2005
45Harrison, n.d.
23 far the largest payments46. One could argue then that there are foreign firms that actually do not mind bribing their way towards a profitable business. A famous example which happened during the 70s in the Netherlands is that of Lockheed an aviation company which paid Prince Bernhard a sum of $1.1 million in bribes to ensure winning a bid from its competitor.
“Corruption is not just a long-term “drag” or “tax” on development, but has real and immediate political salience often poorly understood by outsiders not experience corruption themselves.
For this reason, it has quickly become a first-order priority in some countries. Former World Bank President James Wolfensohn has repeatedly called corruption “the single greatest obstacle” to long-term development.”47
Corruption covers a range of behaviors, including “petty” or “administrative” corruption such as bribery or asset-stripping as well as “grand” corruption such as exacting influence over legislation or policy. When it becomes part of everyday life, corruption can derail political and economic transitions, undermine state capacity and legitimacy, and exacerbate poverty. Such was witnessed in the later years of the Marcus Regime in the Philippines between 1965 and 1986. Corruption is often times contributed to the fact that individuals in high positions abuse their power, and because often times they manage to get away with it. This is where rule of law comes to play. A weak rule of law (lack of power) makes it easier for corruption to prevail.
Strengthening the rule of law, by increasing the liability of those involved in corruption, is critical to controlling corruption. From an economic point of view, states that can govern well are the key to long-term development. It is estimated that funds lost due to corruption costs governments worldwide approximately $1 trillion per year48.
Rule of law is also a very important factor that foreign investors look into prior to investing in an economy. Contract repudiation, investor legal rights and asset protection all fall under Rule of law and are of importance to businesses. This is why Rule of Law is felt strongly by investors once the actual business comes to life. Contract repudiation or expropriation as well as investor
46 Joel Hellman, Geraint Jones, and Daniel Kaufmann, “Far From Home: Do Foreign Investors Import Higher Standards of Governance in Transition Economies?” Draft, August 2002.
47 Madalene, 2006
48 World Bank, Press Release, High-Level Political Signing Conference for the United Nations Convention Against Corruption, Merida, Mexico, 2003.
24 legal rights may not be well protected or respected in a poor, not well enforced legal system.
Blonigen (2005) found that poor legal protection of assets (a poor rule of law) increases the chance of expropriation of a firm’s assets making investment less likely49.
For this thesis we will use the variable Control of Corruption. This variable shows the level that countries have their corruption under control and is expected to have a positive influence on Inward FDI; while rule of law is expected to have a positive influence. Both of these variables are expected to have a higher influence in our model compared to all other variables tested, because these governmental institutions are what business owners are directly faced with on a day to day business when trying to operate in a foreign country.
Hypothesis 9:
A strong control of corruption indicating a low level of corruption is expected to increase foreign direct investment.
Hypothesis 10:
A high level of rule of law indicating a respected and enforced ruling system will increase foreign direct investment.
49 Blonigen, 2005
25
3 Data and Methods
The sample set of countries that were selected for this dataset were the ones that qualified as an emerging economy between the years 1992 until 2009 as indicated by the IMF. Due to a lack of administrative means, not every emerging economy has data readily available for testing. The Worldbank and other free resources provide data for a large number of emerging economies;
however they are not always as complete as is the case with developed countries. After randomly selecting emerging economies, we had to be sure that the data necessary was readily at hand. Due to a lack of funds it was unable to purchase data from private organizations, which could have possibly had a more detailed dataset.
In analyzing the relationship between FDI inflow and FDI fitness the object of this thesis is to illustrate to policy makers from emerging countries how institutions effects FDI inflow. And possibly provide a general direction as to what it is they could do to improve their attractiveness for foreign investors; this thesis should also provide scholars with data on the relationship between these two variables. An improved understanding can enhance and improve communication and understanding when it comes to structuring institutions related to FDI.
Our econometric analysis is based on data collected for the years 1992 to 2009.
The 18 years are divided into three time periods to measure the correlation between FDI, averaged over three years, and the explanatory variables, averaged over the preceding five years.50 Both Wilhelms et al (1998) and Stryker & Pandolfi (1997) used the averaging over several years to: 1) avoid random variability that may occur from year to year and 2) taking averages also bridges missing observations for the explanatory variables. Given that each of the 41 countries yields three cross-sections, the entire sample contains 123 observations.
50The same technique was used by J. Dirck Stryker and Selina Pandolfi, Impact of Outward-
Looking, Market-Oriented Policy Reform on Economic Growth and Poverty (Cambridge, MA: Associates forInternational Resources and Development, April 1997), 13.
And also by Saskia K.S. Wilhelms Morgan Stanley Dean Witter (1998), ‘Foreign Direct investment and its determinants in emerging economies’ African Economic Policy Paper Discussion Paper Number 9 July 1998. Funded by United States Agency for International Development Bureau for Africa Office of Sustainable Development Washington, D.C. 20523-4600.
26 The regression between the dependent FDI model and the variables of the four institutions:
Government, Markets and Absorptive Capacity and Socioculture, will be measured in three different time periods using a panel analysis. This way we can observe how institutions influence inward FDI. A panel data model is a study consisting out of units (in this case the units are countries) observed over a period of time. When doing a panel analysis, we have the option of choosing different estimator models. We can make use of the OLS model, Random effects estimator model or the fixed effects estimator. In our case we can only make use of the OLS model and the fixed effects model. Considering the nature of our sample which is emerging economies, we can say that that our sample does not fall under the Random Effects category.
Next to the OLS method which was used by Wilhelms et. al. we will also test our data using the fixed effects method. The reasoning for using the fixed effects method is that first our dataset has not been randomly chosen. The countries chosen were based on the criteria that at the time this data was collected they were emerging economies. The fixed effects model differs from the OLS model because it captures not only the variables tested, but also country differences by creating a dummy variable for each country tested. The fixed effect estimator tests what is called the “within-person“ change; meaning that if X changes how much does it change within that one person. In our case our “person” is a country which we will use the fixed effects estimator on. It also takes into account unobserved specific effects that would affect FDI decision such as host country’s climate, culture and the level of infrastructure (Wei & Zhu, 2007). Since all these effects are taken up in the fixed effects dummy variable, we cannot interpret what influences the dummy variable. Testing both models will allow us to be able to compare economies based on their institution characteristics, and also allows us to track how changes within an economy influenced inward FDI.
In order to test these variables we will make use of the following regression model:
InwardFDI = G=Government
M= Markets
A=Absorptive Capacity S=Socioculture
27 All variables will be collected from the World Development Indicators51, with the exception of the variables High School Education52 and Uncertainty Avoidance Index53. For this research a dataset has been collected containing information of 41 countries that are currently considered emerging economies.
3.1 Dependent Variable and lag
The dependent variable InwardFDI is measured by the net inflows of foreign direct investment as a percentage of Gross Domestic Product (GDP). Most of the data will be taken from the World development indicators 2007 unless indicated otherwise. Wilhelms et al., (1998) assume that FDI projects have an incubation period between 1-3 years from planning to registration to actual operation. This means that before any FDI will be noticeable within an economy 1 to 3 years would have passed; this is due to the fact that some Inward FDI take more time to materialize than others. They further assume that Firms ponder their investment, by looking at data from the previous 5 years prior to starting the beginning phases of an FDI project. Thus for this research we establish that the lag between the collected data and the initial FDI will be 1 year. So let us say for example that a firm in 2007 would like to invest in a country X. It would first look at the available data from the previous 5 years, meaning 2002 till 2006. If the firm owners like what it sees it will start all necessary preparations for starting up and by the time of opening its establishment in country X; we assume that 1 to 3 years would have passed.
This having been said the regression analysis will consist of the explanatory variables being: The data from the 5 years prior to the decision to conduct inward FDI. The dependent variable will be : inward FDI lagged by 1 year. As mentioned earlier, the years used for testing will be 1992 up to 2009.
Years used for Explanatory Variables Year of FDI Projects (dependent variable)
1992-1996 1997-1999
1997-2001 2002-2004
2002-2006 2007-2009
51 Worldbank database,2010
52 Barro-Lee Dataset, 2010
53 Hofstede’s cultural variables
28 Besides the use of the independent variables the author of this research will also make use of time dummy variables to control for external factors affecting FDI inflows in the years between 2007 and 2009. The reason for this is because of the global financial crisis which caused a chain reaction for local economies globally. Due to the crisis we expect Inward FDI to have declined in this period. All data will be tested in STATA, placing all the data and testing it as one regression analysis with the time dummy variables indicating the influence of the periods.
3.2 Time Dummy Variable to control for Crisis period 2007-2009
A dummy variable is a numerical variable implemented in a regression analysis to represent subgroups of the sample in your study. In research design, a dummy variable is often used to distinguish different treatment groups. It is a variable one that takes the values 0 or 1 to indicate the absence or presence of some categorical effect that may be expected to shift the outcome.
A time dummy variable will be used in this regression analysis to account for period specific effects. During 2007 and 2009 the world economy experienced a financial crisis, this can cause for abnormal figures during this period. In order to account for this period we will use time dummy variables to help control for this specific period.
3.3 Control variable natural resources
For obvious reasons an oil company or diamond company will not invest an emerging economy if the natural resources the company bases its business on is nonexistent in the economy.
To account for the effects that natural resources can have on our model, we will use a control variable that will take into account the effect of natural resources on Inward FDI. The variable that we will use is the Natural Resources as a Percentage of GDP54. Using this control variable we will be able to see to what extent natural resources played a role in inward FDI, thus taking into account the resource seeking inward FDI. Considering the fact that countries do not choose to have natural resources or not, this control variable will help us distinguish between the types of FDI.
54 Taken from the World Development Indicator database
29
4 Empirical Results
Before running our regressions we ran additional tests to assure ourselves that our results will be as valid as possible. First we tested our data for outliers. When a sample size is small, outliers have a larger influence on the results. To prevent outliers from influencing our results, we removed them. After plotting the residuals squared we found Bulgaria and Hungary to be outliers.
Graph 1: Residuals Squared showing outliers
Description of the sample data
The following table illustrates a brief description on our sample data, the independent and dependent variables.
Bulgaria Trinidad and Tobago
Hungary Bulgaria
Jordan
Zambia Dominican Republic
Zambia Jordan
Indonesia China
Romania
Croatia
Czech Republic
Venezuela, RB
Indonesia Hungary
Trinidad and Tobago
Lithuania India
Hungary Colombia
Venezuela, RB Pakistan India Chile
Guatemala Ukraine
Brazil Thailand
Zambia Bulgaria
Turkey
Venezuela, RB Bolivia
Indonesia South Africa
Latvia
Philippines Lithuania
Ukraine Czech Republic Guatemala Czech Republic Paraguay Brazil
PakistanPhilippines Kenya
Poland Pakistan
Latvia Argentina Kenya Kenya
Guatemala South Africa
Paraguay
Croatia
Philippines Russian Federation India
Mexico Latvia Poland China
Croatia Chile
Trinidad and Tobago
Jordan
Mexico
0.1.2.3.4Leverage
0 .1 .2 .3 .4
Normalized residual squared
30 Table 1: Descriptives
Variable Obs Mean Std. Dev. Min Max
InwardFDI 116 3.464481 3.148332 -8.940547 13.97651
Hofstede 117 62.28205 22.74629 12 86
Labor 117 62.04632 8.256464 44.2 81.98
Highschool~c 108 17.65815 12.49752 0.54 62.26
GDPpc 117 2929.594 2428.813 234.7199 11231.29
Domcred 117 53.60143 37.24471 13.19145 202.1219
Taxrev 71 15.42144 4.561846 3.251806 25.7546
trade 116 72.58641 30.2335 17.69839 135.8818
Control of Corruption 117 -0.2932486 0.6769226 -1.609205 1.429538
Rule of law 117 -.2280624 .6844457 -1.730713 1.309801
GDP Growth Ratio 117 3.56547 3.756408 -13.81 12.44
Natural Resource Rent 117 6.54252 9.502598 0.003 47.79
Multicollinearity
We calculated the Variance Inflation Factor (VIF) using STATA and found that Corruption and Rule of law had a VIF of 5.3 and 5.2 respectively and a tolerance of about .18. Since there is no official cut-off point many scholars have different opinions on the VIF cut off point. Research into the topic of VIF cut off points lead us to a cutoff point of VIF ≥555. Thus we will run two separate regressions testing Rule of Law and Corruption Separately. Wilhelms et. al. (1998) also tested corruption and rule of law separately when running their tests.
55 Craney,Trevor & Surles, 2002
31 Our other independent variables have a VIF level of 2.3 or lower with tolerance of .4 and up.
Variable VIF 1/VIF
corruption 5.37 0.186223
ruleoflaw 5.29 0.189095
trade 2.27 0.440146
Highschool Education 2.14 0.468068
taxrevenues 2.13 0.469759
gdppc 2.04 0.490116
Gdp growth ratio 1.40 0.712917
Labor 1.66 0.601482
Natural Resource Rent 1.52 0.663548
domcred 1.46 0.683215
hofstede UAI 1.36 0.734548
Table2: test for multicollinearity using the Variance Inflation Factor (VIF) test The White test for Heteroskedasticity
We then tested for heteroskedasticity using the White test. The result shows a p-value of .4442 meaning that we reject the null-hypothesis that our results are not heteroskedastic.
Heteroscedasticity does not cause the OLS coefficients to be biased, however it may cause the OLS estimates of the standard errors of the coefficients to be biased. A regression analysis using heteroscedastic data will still provide an unbiased estimate for the relationship between the independent variable and the outcome, but standard errors and therefore inferences obtained from data analysis may be less reliable. Biased standard errors lead to biased inference, so results of hypothesis tests are possibly wrong. As a result the consequence of a biased standard error may lead to wrong assumptions when rejecting the null hypothesis (type II error).Having found that our variables suffer from heteroskedasticity we will use the robust variables to run our regressions in order to take into account heteroskedasticiy and limit our margin for error.
32
Source Chi2 P
Heteroskedasticity 71 .4442
Skewness 11.87 .3737
Kurtosis 1.36 .2430
Total 84.23 .4112
Table 3: White test for hetroskedasticity for our dataset
Jarque-Bera Test
To see if our sample is normally distributed we ran the Jarque Bera test on InwardFDI. The Jarque-Bera test is a Goodness of fit test used to test if the skewness and kurtosis of our sample data matches normal distribution. A normal distribution means that our sample data has a continuous probability distribution that would resemble a bell shaped curve.
The result shows a chi-square probability of 0.07 so we can accept the null hypothesis that residuals are normally distributed 5% confidence. Not having a normally distributed results may risk our results of not having valid t-statistics
Residuals
Percentiles Smallest
1% -3.43 -3.43
5% -2.89 -3.39
10% -2.13 -2.95
25% -1.41 -2.88
50% -0.33
Largest
75% 1.19 4.00
90% 2.7 4.50
95% 4.00 4.90
99% 5.36 5.36
Mean 2.07-E09 Variance 4.110
Std. Dev. 2.029 Skewness 0.713
Chi-Sq 0.070 Kurtosis 3.080
Table4: Results Jacque-Bera Test for our dataset
33 Results
When comparing our two models we find the following differences:
Firstly in our OLS mode model we find the trade to GDP ratio, control of corruption, rule of law and our natural resource variable to have significant influence on inward FDI. However in our fixed effects model we find trade to GDP ratio to fall away as well as the control of corruption variable. In the fixed effects model Domestic credit and tax revenues become significant/ Our time variable used to control for the 2007-2009 crisis also showed significance. When comparing the coefficients of the 2 models we find the fixed effects estimator to have larger coefficients for the variables tested. The significance of both models is high, and the R-square levels are higher in the OLS regressions.
In our OLS model we found that our variable natural resources rents made an impact on explaining where Inward Foreign Direct Investment takes place; leading us to believe that a great deal of foreign direct investment was based on resource seeking FDI. It must be added as well that generally speaking Resource based FDI has a higher investment than services related FDI. Think for example on oil corporations who must invest substantially in machinery, whilst service orientated FDI has a lower initial investment. Our expectations that we had about our time dummy variable, controlling for the financial crisis period of 2007-2009 has shown to be insignificant in our OLS results, but our fixed effects results show a positive significance. It was believed that our time dummy variable would have a negative effect on inward FDI, but our fixed effects results show that in the time period 2007-2009 there has been more Inward FDI within an economy then in the other periods. Leading us to believe that regardless of the global crisis, investments generally increased in emerging economies from 1992 to 2009.
Our first institution that we tested was the Sociocultural institution in which we tested how Uncertainty Avoidance influences investor decisions. We hypothesized that higher uncertainty avoidance in a culture would deter investors. Our results show that Uncertainty Avoidance to have no significant influence on Inward FDI.
