Institutions and FDI: Impact Analysis by Countries’ Income Level
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Abstract
This paper scrutinises the relationship between foreign direct investment (FDI) and institutional quality using panel data for 44 high-, 39 upper middle-, 23 low- and 35 lower middle-income countries over the period 2000 to 2017. We revisit the relationship by using a composite institutional index of World Governance Indicators (WGI), constructed using principal component analysis (PCA). Further, we extend the analysis to estimate the impact of the different dimensions of WGI indicators on FDI flows, using the generalised methods of moments (GMM). Our empirical findings for developed countries suggest that the institutional index is a robust determinant of FDI inflows in high income countries, whereas it is not significant in upper-middle income countries. Dimensions, such as rule of law, regulatory quality and control of corruption are key determinants of FDI flows to high-income countries, whereas none of the dimensions is significant in upper middle-income countries. Findings for developing countries, specifically lower middle-income countries, indicate that the overall index as well as individual dimensions are insignificant because of the poor quality of institutional framework. Ceteris paribus, politically stable economies endowed with an efficient and a credible government and strong regulatory framework tend to attract FDI flows into low-income countries.
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