P35∼47

Quality of Institutions and FDI Inflow: Evidence from Asian Economies ∗

Aye Mengistu Alemu*

Abstract This paper examines the separate effects of the host countries’ quality of institutions as captured by the six elements of ‘good governance’ on FDI inflow through their effect on investment decisions and by raising productivity prospects. The results reveal that government effectiveness, political stability and absence of violence, rule of law, and the absence of corruption are robust determinants for FDI inflow, taking into account other factors such as human capital, infrastructure and openness. Nevertheless, no evidence has been found for voice and accountability and regulatory quality to significantly affect FDI inflow. This implies a government that may enhance political stability, rule of law and low level of corruption is likely to attract more FDI despite offsetting deficiencies in voice and accountability that captures the extent to which citizens of a country are able to participate in the selection of governments. Keywords: Quality of Institutions, FDI Inflow, Good Governance, Asian Economies

I. Introduction FDI is one of the main avenues for the movement of finance, technology and modern business methods across national borders. According to Dunning (2005), among the possible welfare gains in developing host countries as a result of FDI inflow, at least the following four factors are important: the resource transfer effect (FDI can make a positive contribution to a host economy by supplying capital, technology, and management resources that would otherwise not be available), the employment effect (FDI can bring jobs to a host country that would otherwise not be created there), the balance of payments effect (FDI can help a country achieve a current account surplus) and the effects on competition and economic growth (FDI, mainly in the form of green-field investment, increases the level of competition in a market, driving down prices and improving the welfare of consumers. Similarly, increased competition can lead to increased productivity * Assistant Professor of Economics, SolBridge International School of Business, 151-13 Samsung 1-dong, Dong-gu, Daejeon 300-814, Korea; E-mail: [email protected]; Tel: +82-10-9818-2327.

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growth, product and process innovation, and greater economic growth). However, there are also two main different views about the impact of FDI on host countries’ economies (Somorajah, 2004). On one hand, modernization theory, which is based on the neoclassical and endogenous growth theories, suggests FDI could promote economic growth in developing countries. The modernization perspective is based on a fundamental principle in economics that economic growth requires capital investment. From the perspective of the new growth theories, the transfer of technology through FDI in developing countries is especially important because most developing countries lack the necessary infrastructure in terms of an educated population, liberalized markets, economic and social stability that are needed for innovation to promote growth (Sanchez-Robles and Bengoa-Calvo, 2003). Furthermore, according to Kumar (2002), apart from technology and capital, FDI usually flows as a bundle of resources, including organizational and managerial skills, marketing know-how, and market access through the marketing networks of multinational enterprises (MNEs). As a result, FDI plays a twofold function by contributing to capital accumulation and by increasing total factor productivity (Nath, 2005). Similarly, Acemoglu and Zilibotti (1997) explain that opening international capital markets generates flows from capital-abundant towards capital-scarce countries, thereby accelerating convergence (hence short-term growth) in the poor countries. In a more sophisticated context, productivity may also increase since capital inflows may relieve the economy from credit constraints and thus allow agents to undertake more productive investments. Thus, FDI can increase competition in the host economy, making domestic companies more efficient and stimulates sectoral and product diversification. On the other hand, in contrast to the modernization perspective, dependency theorists argue that dependence on foreign investment is expected to have a negative effect on growth and the distribution of income. According to the dependency theorists, FDI could be a threat to young, growing companies/firms with limited capital outlays as compared to the multi-national corporations (MNCs), since the young domestic firms will be unable to compete with the MNCs with huge capital outlays. As a result, this could possibly lead to the extinction of such small local firms. Moreover, critics further argue that FDI can have adverse effects on employment, income distribution, and national sovereignty and autonomy. FDI can also have adverse balance-of-payments if inputs need to be imported. Foreign reserves can also diminish when profits are repatriated. Thus, FDI is seen not to aid but to undermine the very process of development (Razin et al., 1999). Moreover, there is a growing proposition that foreign investment should be carefully regulated by host country governments so as to effectively be used for the objectives of economic development. Towards this effect, government policies can mitigate some of the potentially negative effects of FDI. For instance, an appropriate regulatory framework is crucial for guiding successful private participation in infrastructure, and environmental policy is also equally desirable, particularly in countries with fragile ecosystems or sizable resource extraction activities. On balance, therefore, there is a common consensus that the benefits of FDI outweigh its costs. It should be noted that the higher productivity of FDI holds only when the host country has enhanced ‘good governance’ infrastructure, effective institutions, a minimum

Quality of Institutions and FDI Inflow • 37

threshold stock of human capital and adequate physical infrastructure. Apart from these, macroeconomic stability, market size, and degree of openness are some of the key factors which can increase incoming FDI. For instance, the recent experience of East Asian nations suggests that the combination of a highly skilled labor force, improved physical infrastructure and appropriate policies have significantly contributed to high inward FDI and increased international trade, which allowed these countries to break away from low-skills patterns of specialization in international markets.

II. Quality of Institutions and FDI Inflow: Theory and Concepts The theory hypothesized that countries with ‘good quality institutions’ tend to attract more FDI. Good quality institutions that guarantee economic freedom plausibly have the capacity to provide the growth-enhancing kind of incentives, for several reasons: they promote a high return on productive efforts through low taxation, an independent legal system, and the protection of private property; they enable talent to be allocated to where it generates the highest value (Murphy, Schleifer, and Vishny, 1991), they foster a dynamic, experimentally organized economy in which a large amount of business trial and error can take place (Johansson, 2001) and in which competition between different actors occurs because regulations and government enterprises are few; they facilitate predictable and rational decision making through a low and stable inflation rate; and they promote the flow of trade and capital investment to where preference satisfaction and returns are the highest. By the same token, Globerman and Shapiro (2002) argue that the governance infrastructure of a country would help to define its investment environment, and thus creates favorable conditions for economic growth. Recent empirical evidence tends to confirm the hypothesis that cross-country differences in growth and productivity are related to differences in quality of institutions (Kaufmann and ZoidoLobaton, 1999). In sum, there is an emerging consensus among economists, political scientists and international business scholars that FDI inflows to developing nations are conditioned by the host country’s governing institutions, and that countries possessing strong institutions (i.e. competent regulatory agencies, efficient legislatures, transparent judiciaries etc.), tend to receive an FDI dividend over those with weak institutions, all else being equal. In this study, therefore, the “quality of institutions” has been captured by the six good governance indicators that are devised by Kaufmann et al. (1999) as follows: • Voice and Accountability Voice and accountability captures the extent to which citizens of a country are able to participate in the selection of governments. • Political Stability and Absence of Violence Political stability and absence of violence index measures perception of the likelihood that the government in power will be destabilized or overthrown by possibly unconstitutional and/or violent means. Political stability is essential if markets are to

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work effectively in guiding resource allocation and fostering confidence of economic agents in the economy especially to attract multinationals in investing their capital in the host country. In other words, foreign firms are reluctant to invest their capital in areas of high uncertainty. • Government Effectiveness Government effectiveness captures the capacity of the state to implement sound policies. This refers to the quality of public service provision, the quality of bureaucracy, the independence of the civil service from political pressures, and the credibility of the government’s commitment to policies. Hence, the quality of government effectiveness of a host economy is expected to have a crucial contribution for foreign firms to be attracted to invest their capital in that economy. • Rule of Law Rule of law captures the respect of citizens and the state for the institutions which govern their interactions. Rule of law in broad terms would include: an effective, impartial and transparent legal system that protects property and individual rights; public institutions that are stable, credible and honest; and government policies that favor free and open markets. It is rational to argue that inventions and innovations can be promoted only when they are well protected through protection of intellectual properties. In a more recent study, Javorcik (2004) examined the effect of IPR on the composition of FDI for a group of transition economies in Eastern Europe and the former Soviet Union. The study concludes that weak IPR protection has a negative effect on FDI in technology-intensive sectors. Similarly, Nunnenkamp and Spatz (2004) investigated the IPR-FDI linkage using sectorally disaggregated FDI data for a large sample of host countries and found that stronger IPR protection played a positive role in attracting FDI.

• Regulatory Quality Regulatory quality measures the market-friendly policies such as lifting price controls or inadequate bank supervision as well as other efforts to lessen excessive regulations in areas of foreign trade and business development. According to political economy theory, governments are the controllers, regulators, and adjudicators of business sectors. Accordingly, governments are instrumental in creating legislation to regulate the economy, frame the competitive environment and factor endowment, and establish a regulatory environment in which business is conducted (Henisz, 2000; and Rugman and Verbeke, 1998).

• Absence of Corruption Absence of corruption mostly measures the extent of corruption which is a manifestation of a lack of respect of both the corruptor and the corrupted for the rules which govern their interactions. For instance, as Vittal (2001) notes, if China manages to reduce red tape and corruption and enhance better rule of law and property protection, it could even double its FDI. Similarly, if corruption levels in India come down to those

Quality of Institutions and FDI Inflow • 39

of Scandinavian countries, the GDP growth would increase by 1.5% and FDI by 12%. In line with this, a high level of corruption is likely to exacerbate the information asymmetry problem. Corruption also increases the cost of doing business in other ways (Fisman and Wei, 2004). Based on the above indicators, the average index for “voice and accountability” of (about) 15 Asian economies has been shown in Figure 1. Figure 1: Average ‘Voice and Accountability’ Index in Asian Economies (1996-2012) 1 0.5

Ch on ina g K o In ng do So ne ut sia h K o Si rea ng ap M ore al ay Th sia ai l Ph and ili pp in V es ie tn Ca am m bo di a Br un ei In di Pa a ki Ba sta ng n la d Sr esh iL an ka

0

H

-0.5 -1

-1.5 -2

As shown from Figure 1, it was evident that China followed by Vietnam and Pakistan experienced the lowest level of voice and accountability indexes. On the other hand, South Korea, India, Hong Kong, Thailand and Singapore have experienced a much better index of voice and accountability compared to other countries in the sample. Figure 2: Average ‘Political Stability’ Index in Asian Economies (1996-2012)

1.5 1 0.5

M o re a la y T h si a ai P h la n d il i pp i V i ne s etn Ca am m bo di a Br un ei In d P a ia ki B a st a ng n la d Sr e sh iL an ka

a

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-1

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-0.5

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-1.5 -2 Similarly, Figure 2 demonstrates that Pakistan, Sri Lanka, India, Bangladesh and Philippines have experienced high level of political instability while Singapore, Brunei,

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Hong Kong and South Korea are enjoying high level of political stability in the study period. The average “government effectiveness” index for those Asian economies has been shown in Figure 3. It was evident that Singapore, Hong Kong, South Korea, Malaysia, Brunei and Thailand are in better positions to implement policies effectively. On the contrary, Vietnam, Cambodia, India, Pakistan, Bangladesh and Sri Lanka are the worst performers in terms of government effectiveness in implementing policies and programs. Figure 3: Average ‘Government Effectiveness’ Index in Asian Economies (1996-2012)

3 2 1

H o C h in ng a K In d o n g So one u th s ia K S in o re ga a M p o re a la T h y sia a P h ila n ilip d p V i in e s et C a nam mb o B r d ia un ei In d P a ia B a k is ta ng n l Sr ades iL h an ka

0 -1 -2

Figure 4: Average ‘Regulatory Quality’ Index in Asian Economies (1996-2013) 2 1.5 1 0.5

or ala e ys i Th a ai P h lan d ili pp in Vi es etn Ca am m bo di a Br un ei In di a Pa ki B a sta ng n la d Sr e sh iL an ka

a re

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ap

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ng

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The fourth index refers to “regulatory quality” and includes the incidence of market-unfriendly policies, and perception of the burdens imposed by excessive regulation. The average index of “regulatory quality” for those economies has been displayed in Figure 4. Again, Singapore, Hong Kong, Brunei, South Korea, Malaysia,

Quality of Institutions and FDI Inflow • 41

and Thailand are in better positions to implement policies effectively. Vietnam, Cambodia, India, Pakistan, Bangladesh and Sri Lanka are the worst performers in terms of government effectiveness in implementing policies and programs. The fifth indicator is “rule of law.” This indicator is one of the best and most often mentioned components of good governance and measures the extent to which agents have confidence in, and abide by, the rules of the society, including the effectiveness and predictability of the judiciary and the enforceability of contracts. As shown in Figure 5, Singapore, Hong Kong, South Korea, Thailand and Malaysia were economies that enhanced the rule of law in those years, while China, Philippines, Vietnam, Cambodia, Pakistan, Bangladesh and Sri Lanka showed the lowest performance in enhancing the rule of law in their respective countries. Figure 5: Average ‘Rule of Law’ Index in Asian Economies (1996-2013)

2 1.5 1 0.5 0 ng esi So a u th Ko S in re a g ap o M a re la y s ia Th ai P h la n d ilip p in es Vi e tn C a am mb od ia Br un ei In d ia Pa k is ta n Ba ng la d e S ri sh La nk a on

Ko

Ho

-1.5

In d

ng

Ch

-1

in a

-0.5

In n g d So one u t sia h Ko S i re a ng ap M o re a la y T h si a a il P h a nd i li pp in Vi es e tn Ca am m bo di Br a un ei In d Pa ia ki B a sta ng n lad Sr e sh iL an ka

Ko

in Ho

ng

Ch

2.5 2 1.5 1 0.5 0 -0.5 -1 -1.5

a

Figure 6: Average ‘Absence of Corruption’ Index in Asian Economies (1996-2012)

The sixth indicator refers to “control of corruption” and, as can be noted from Figure 6, Singapore and Hong Kong are the two countries that significantly managed to

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minimize corruption in Asia. The worst performing countries, in which corruption is rampant, include China, Philippines, Vietnam, Cambodia, India, Pakistan, Bangladesh and Sri Lanka.

III. Objective of the Study The overall objective of this study is to thoroughly examine the impact of “quality of institutions” on FDI inflow in Asian economies based on a panel data of 15 economies from 1996 to 2012. Research Questions • What exactly are the explicit effects of ‘good governance institutions’ on FDI inflow? • Other than institutional elements, what other factors cause the differences in FDI inflow to a host economy? Figure7: Theoretical Model for the Effects of “Quality of Institutions” on FDI Inflow Voice and Accountability (+)

FDI Inflow

Political Stability (+)

Other Control Variables

Government Effectiveness Rule of Law (+) Regulatory Quality (+) Control of Corruption (+)

Human Capital (+)

Physical Infrastructure (+)

Level of Development (+)

IV. The Data and Stylized Facts This study has made an intensive empirical analysis for a panel of 15 countries from Asian economies for the years 1996-2012. Only countries for which complete data was available were included in this study. Table 1 and Table 2 show the list of countries and the independent variables used in the regression analysis, respectively. Table 1: Countries Included in the Study China, Hong Kong, Indonesia, South Korea, Singapore, Malaysia, Thailand, Philippines, Vietnam, Cambodia, Brunei, India, Pakistan, Bangladesh, Sri Lanka

Quality of Institutions and FDI Inflow • 43

Table 2: Independent Variables, Their Expected Signs and Data Sources Variable

Indicator

+/-

Voice and Accountability

Index

+

Political Stability and Absence of Violence

Index

+

Government Effectiveness Index

+

Regulatory Quality

Index

+

Rule of Law

Index

+

Absence of Corruption

Index

+

Human Capital

Secondary School Enrollment Ratio

+

Data Sources Daniel Kauffman Good Governance data base Daniel Kauffman Good Governance data base Daniel Kauffman Good Governance data base Daniel Kauffman Good Governance data base Daniel Kauffman Good Governance data base Daniel Kauffman Good Governance data base WDI database

Domestic Capital

Ratio of FCF to GDP

+

WDI database

Infrastructure

Telephone/1000 People

+

WDI database

Lending Interest Rate

Interest Rate

-

WDI database

Openness

Degree of Openness

+

Penn World Table Version 6.2

Log (GDP)

Real GDP

+

WDI database

Labor Force

Population Size

+

WDI database

Growth in GDP

Growth in GDP

+

WDI database

Arable Land Ratio

Ratio of Arable Land to Total Land

+

WDI database

V. Model Specification and Estimation Methods Based on the previous studies and theoretical explanations discussed earlier, factors influencing FDI inflow in a given country can be specified as follows: FDI Inflow = f (voice, politic, effective, regulatory, rule of law, corrupt, Zit) (1) • Where; voice, politic, effective, regulatory, rule, corrupt represent voice and accountability, political stability, government effectiveness, regulatory quality, rule of law, and absence of corruption, respectively. Zit represents the set of control variables including human capital, infrastructure, etc., as mentioned in Table 2. Thus, our model becomes as follows: FDIit = β0+β1Voiceit+β2Politicit+β3Effectvit+β4Regulit+β5Ruleit +β6Corrupit+Zit+εit

(2)

• Where i indexes the countries under study, t denotes the year, and εit is the idiosyncratic errors. Thus, the model takes both the cross-section dimension and the time-series dimensions into consideration.

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In doing so, test for heteroscedasticity was conducted using Breusch-Pagan test and White test, and hence the null-hypothesis of homoscedasticity was rejected at 1% and 10% significance levels, respectively. This implies that there is evidence of heteroskedasticity in which the error variance is not constant. Likewise, test for serial correlation for the error terms was conducted using Wooldridge test for autocorrelation in panel data and the result yields a p-value of 0.5761, that implies there is no evidence of serial correlation (first order autocorrelation) and hence the error terms are not correlated. Apparently, a specification test has been conducted to determine which estimation methods would be more appropriate for this particular study. According to Gujarati (2003), there is a formal test that will help us to choose between fixed effect model (FEM) and Random effect Model (REM). Accordingly, Hausman (1978) test has been conducted and the test statistic has an asymptotic Chi-square value of 87.03 and the null hypothesis was rejected at 1 % significance level. Hence FEM is much more appropriate for this study. In addition to FEM, this study also used feasible general least Square (FGLS) and Prais-Winstein panel-estimation methods with corrected heteroscedasticity standard errors so as to check the consistency of the results. In fact, heteroscedastic models are usually fitted with FGLS and Prais-Winstein regression since the estimates assume that the disturbances are heteroscedastic.

VI. Empirical Results and Main Findings The empirical results using FEM, FGLS and Prais-Winstein panel estimation methods with heteroscedasticity-corrected standard errors are presented in Table 3. Accordingly, the empirical results revealed that political stability and absence of violence, government effectiveness, rule of law, and absence of corruption are found to be the key elements of governance institutions that are crucially important for stimulating FDI inflow in the host country. However, this study has found no evidence for voice and accountability and regulatory quality to significantly affect FDI inflow. This may imply that a government that has enhanced political stability, rule of law, and a low level of corruption is likely to attract foreign investors despite offsetting deficiencies in other dimensions such as voice and accountability and regulatory quality. The result mainly reflects the reality on the ground that many of the East Asian economies, including quasi-democratic ones, have achieved enormous FDI inflow for the last three to four decades. Other important control variables that have been found to be positive and significant factors for FDI inflow include: human capital, infrastructure, economic growth track record, interest rate, domestic capital, and availability of cheap labor. Indeed, the result is in line with previous arguments that the key for success in East Asia’s development was the ability of those countries to invest in education and physical infrastructure despite their poor natural resource endowment. The fact that a good economic growth track record matters for FDI inflow implies that a government that has generated impressive economic growth in income per capita in the past is likely to attract foreign investors because in countries with stable

Quality of Institutions and FDI Inflow • 45

Table 3: Regression Results Using FE, FGLS and Prais-Winsten Explanatory Variables Voice and Accountability Political Stability and Absence of Violence Government Effectiveness Regulatory Quality Rule of Law Absence of Corruption Human Capital Domestic Capital Infrastructure Lending Interest Rate Openness Log (GDP) Log (Population Size) with in GDP Arable Land Ratio Constant Number of Observations Number of Groups R-square

FE 1.142 (1.033) .2452*** (.0857) .2494** (.1112) .1405 (.0936) .4031* (.2169) .1032 (.0803) .0025 (.0546) .0017 (.0501) .0538** (.0157) .1528* (.0896) .0101** (.0041) 3.6965 (3.693) 21.423 (15.535) .685 (.0595) -.2406 (.263) 131.081 (96.218) 178 15 0.3107

FGLS -.0651 (.0446) .0489** (.248) .3908*** (.1074) -.0015 (.0353) .1156** (.0555) .2058*** (.0367) .0099*** (.0030) .0087* (.0052) .0049** (.0021) .1338*** (.0113) .0011 (.0011) -.4204 (.2983) .8703*** (.2540) .1569*** (.0105) -.0045 (.0152) 7.0202 (1.8576) 178 15 .2765

Prais Winsten -.4099 (.3078) .1650* (.0877) .4705* (.2621) .0372 (.1167) .2617*** (.1037) .1961** (.0876) .0122* (.0074) .0094 (.0271) .0245* (.0137) .1348** (.0625) -.0010 (.0040) -.6795 (1.0610) .9181 (.8443) .1764*** (.0672) .0023 (.0120) 9.1316 (6.0892) 178 15 0.2852

governments past policies are most useful in predicting the future. This phenomenon has been observed in many countries. In China, for instance, despite all its government deficiencies regarding good governance, GDP growth for the last two decades was so impressive and this contributed to foreign firms becoming confident in investing in China. In line with this, domestic investment is found to be a positive and significant determinant for inward FDI. Interestingly, this finding disproves some arguments which warn that foreign investment can displace local firms/investments. Rather, it can be argued that domestic investment and FDI are indeed complementary. On the other hand,

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the positive and significant relationship between lending rates and FDI inflows indicate that the higher the ratio of the host country borrowing costs to the home country costs, the higher will be inward FDI in the host country. However, no evidence has been found that supports natural resource endowments, such as the abundance of arable land, to be a significant factor for FDI inflow. This is consistent with the general trend of growth performance including FDI inflow in East Asia countries, which are characterized by scarce natural resources such as arable land and yet saw higher FDI inflow compared to other natural resource abundant regions such as Africa and Latin America.

VII. Conclusion and Policy Suggestions It is widely argued that a country’s economic performance over time is determined to a great extent by its political, institutional and legal environment (OECD, 2001). Because the investment environment of a country affects both domestic and foreign investors, and because host countries can significantly benefit from inward FDI through the resource transfer effect, the employment effect, the balance of payments effect and the effects on competition and economic growth. Similarly, increased competition can lead to increased productivity growth, product and process innovation, and greater economic growth. This study, therefore, analyzed the impact of “quality of institutions” on FDI inflow in Asian economies. Accordingly, the empirical results from this study have confirmed that government effectiveness, political stability and absence of violence, rule of law, and absence of corruption are found to be robust determinants to enhance a high level of FDI. It implies that states that have higher quality governance institutions would attract more FDI inflows than states with poor quality governance institutions. Thus, while regime type and favorable policy-mix may still play significant roles in attracting FDI inflows, the quality level of governance that enhances rule of law, fights corruption, maintains political stability is a much greater factor in determining the level of FDI it attracts. Similarly the empirical evidence reveals that good governance efforts to improve the education levels and skills of the people are also quite important to speed up FDI inflow into the host economy. This is because as increasing amounts of FDI become skill and efficiency seeking, access to an educated and skilled workforce becomes essential. Moreover, a relatively well-developed infrastructure, stable and predictable policy and macroeconomic environments, higher GDP growth rates over the past decade, favorable trade policies, dynamic domestic capital formation, and cheap labor are also of paramount importance in speeding up FDI inflow. Moreover, the East Asian experience, mainly that of Singapore, Hong Kong and South Korea, shows that the state has to create a stable macroeconomic and institutional environment to develop greater confidence for local as well as foreign investors. By studying past experiences and contemporary outcomes from this empirical study, it is possible to draw lessons for the future such that “quality of institutions” is indispensable to facilitate FDI inflow, entrepreneurship, and economic growth at large to a host country. In other words, although a country cannot copy a system or policy measure, it can be a source of inspiration to create new or adapted measures.

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