Relative Quality of Market-Supporting Institutions at Home and Host Countries of Foreign Direct Investment

What the paper says

ABSTRACT: This article studies how differences in the quality of market-supporting institutions across countries affect the foreign direct investment (FDI) level. This is particularly relevant for developing countries where such institutions are generally weak, while for the same countries, attracting foreign investment from multinationals are so much more critical for their economic development. The article fills the gaps in the literature by considering home country institutions in addition to those of host country, and different dimensions of institutions. These include rule of law, property rights and corruption; size and effectiveness of government; efficiency and quality of regulatory bodies; and international openness of markets. Additionally, not only distances but also directional differences in institutional quality are examined. In the analyses, the standard gravity model is expanded with controls for other distance measures from the literature such as cultural, historical, political and socio-economic distances, in addition to measures of institutional quality, resulting in 5,400 bilateral data points. Analyses show the importance of high-quality institutions that support the markets in both host and home countries, but more importantly at home. While distance in institutional quality reduces the investments, multinationals surprisingly tend to invest more in host countries with underdeveloped market-supporting institutions. This implies that multinationals are not necessarily seeking host countries with stronger rule of law, protection of property rights, etc. Other motivations for FDI such as resource and efficiency seeking seem to supersede the need for market-supporting institutions at hosts. The results also highlight challenges related to the emerging-country multinationals' ability to operate under a more developed formal institutional environment at hosts without the support of informal institutions they are accustomed to at home. Based on these results, policy makers in developing countries should support their domestic firms' internationalization efforts in countries with similar or lower institutional development, when they are considering foreign investment locations. This said, considering rising trade barriers in developed economies, to access their larger markets, policy makers in developing countries should continue with their efforts to improve the quality of their institutions to reduce the institutional distance with developed countries, so that their multinationals can be competitive without governments' active involvement.