International Evidence on the link between Foreign Direct Investment and Institutional Quality

Multinational corporations (MNCs) are known for their huge investments in research and development activity. They are also known for superior patents, trade secrets, brand names, management techniques and marketing strategies. The provision of incentives (i.e., tax incentives and/or subsidies) and the adoption of FDI-stimulating policies stem from the expectations that FDI brings enormous benefits such as the transfer of new technology. Numerous empirical studies have demonstrated FDI has a positive impact on economic growth of the host countries. However, it should be noted that the distribution of FDI across countries is not uniform with some countries receive more FDI than the others. This observation raises the question of whether it is possible to identify a set of policies that might enhance the attractiveness of host countries as destinations for MNCs. In the investigation of factors that influence FDI flows, existing studies have mainly focussed on the traditional factors such as market size, trade openness, infrastructure and human capital. The role of other factors such as the quality of institution in the host country was largely ignored. Institution can be defined as the humanly devised constraints or rules of the game that structure political, economic, and social interaction. Institutions provide the incentive structure of an economy. Specifically, it affects security of property rights, prevalence of corruption, distorted or extractive policies, and thereby affects the incentive to invest in human and physical capital, and hence economic growth. The role of institutional quality in the development process has been extensively examined and economists have reached a consensus on the importance of good domestic institutions in explaining cross-country differences in both growth rates and income per capita. Following recent literature that emphasize on the importance of institution, this paper examines whether domestic institutional quality has any important role in attracting FDI. Instead of investigating the direct effect of institution on growth, this paper focuses on the indirect effect that institution may bring via FDI inflows. Arguably, countries with better institutional quality should be able to attract more investment because it improves productivity prospect, reduces the cost of doing business and uncertainty. In order to test the hypothesis, data from 77 countries over the period of 1981-2005 is utilised. Methodologically, this paper