Institutional Environment and Foreign Direct Investment: A Review

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Institutional Environment and Foreign Direct Investment: A Review
LIU Shuangqin, XU Xiaoyun, MENG Qingjun
Business School, Hohai University, P.R.China, 211100
[email protected]
Abstract: Institutional environment is no longer just a background and is becoming the key factors that
affect a country’s FDI gradually along with the internationalization process. Since 1990s, many scholars
have analyzed institutional environment’s impacts on a country’s FDI from theoretical and empirical
perspectives. According to the logical relations of the related literatures, this paper analyzes the
development of institutional environment indicators and the relationship between institutional
environment’s quality and FDI which is obtained from different perspectives of study. Finally, this
paper points out several key problems which remain unresolved in this field as well as possible research
directions in the future.
Keywords: Institutional environment, Foreign direct investment, Institutional distance
1 Introduction
In 2011, global FDI flows reached $1.5 trillion, more than the average flow before the financial crisis.
The major economic groups’ FDI inflow had increased. Among them, the FDI flowing to developed
countries had increased 21 percent and reached $748 billion, flowing to developing countries had
increased 11 percent and reached $684 billion, flowing to transition economies had increased 25 percent
and reached $92 billion. Developing countries and transition economies accounted for 45% and 6%
respectively in total global FDI. With the rapid growth of FDI, there appear more and more related
literatures.
The theoretical study on FDI about developed countries started early and was fruitful. There were
Monopolistic Advantage Theory (Hymer, 1960), Internalization Theory (Buckley and Casson, 1976),
The Eclectic Theory of International Production (Dunning, 1977) and so on. With many enterprises in
developing countries joining the wave of FDI, there appeared a number of theories, such as Theory of
Small Scale Technology (Louis J.Wells, 1977) and Technology Innovation and Industry Upgrading
Theory (Cantwell and Tolentino, 1990), which were related to FDI in developing countries. Existing
research has focused on hard environment such as economic scale, factor endowments (national quality,
natural resources, etc.), labor costs and so on. As soft environment, the influence of institutional
environment on FDI has attracted more and more attention recently. Some western scholars have
advocated using institution-based view to study enterprises’ internationalization problems (Buckley et
al., 2007). Compared to “natural capital”, Narula and Dunning (2000) thought that institutional
environment, as a key component of creative assets, played a more and more important role in FDI.
Therefore, with the deepening of globalization and the improvement of people’s awareness on FDI, it
becomes very important to study institutional environment’s impact on FDI. To comply with this trend,
this paper combs the latest literatures which study the relationship between institutional environment
and FDI mainly from the development of institutional environment indicators and different research
angles.
2 Development of Institutional Environment Indicators
For a long time, people evaluate institutional environment mainly on the basis of subjective impression
and description. With the development of quantitative economics, more and more scholars choose to use
mathematical methods to research the relationship between institutional environment and FDI
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empirically. Therefore, it becomes particularly important to quantify institutional environment. La Porta
et al. (1999) adopted efficiency of the public sector, degree of government intervention, size of
government, supply of public goods and political freedom to measure institutional environment [1].
Among them, most indicators such as efficiency of the public sector and degree of government
intervention can be calculated through national statistics. Therefore, the five indicators are suitable for
the study of internal institutional environment (Wu Yiping, 2010). Governance Matters, the first report
of Kaufmann et al., was published in 1999. Kaufmann et al. (2007) constructed the Governance
Indicator which includes three dimensions, i.e. political system, government’s ability to formulate and
implement policies, institution about the relationship between government and citizens. Each of these
dimensions is measured by two indicators so that there are six indicators. They are “Voice and
Accountability”, “Political Stability and Absence of Violence/Terrorism”, “Government Effectiveness”,
“Regulatory Quality”, “Rule of Law” and “Control of Corruption” [2]. On the basis of integrated
information, Kaufmann et al. gave these indicators initial values according to certain methods. Then
they standardized and made the final value of every indicator between -2.5 and 2.5. The significance of
these values lies in providing reference for comparing samples of the same year. The higher value
represents the higher quality of institutional environment. This index system is suitable for international
research. On the basis of Kaufmann, Li (2007) developed institutional environment indicators by adding
widespread public trust and information disclosure system. Transparency International published
Corruption Perception Index annually since 1995. This indicator was used to reflect the quality of
institutional environment in some studies (Papyrakis and Gerlagh, 2004). American Political Risk
Services Group started offering International Country Risk Guide since 1980. This guide will provide
data and analysis about political situation, economic trends and financial risks of 65-80 countries. It
contains 22 quantitative indicators and is updated once a month. Dollar and Krray (2003) had used this
indicator to represent the quality of institutional environment and study institutional environment’s
impact on FDI. Among these types of indicators, Kaufmann Indicator is most commonly used now. The
World Bank has opened up a special area for their research reports and related indicators data on official
website. Six indicators of Kaufmann Indicator are built comprehensively and synthetically. In addition,
in terms of capacity, Kaufmann Indicator covers 211 countries and regions while ICRG Indicator
involves only 65-80 countries and regions. At the same time, CPI Indicator only contains more than 100
countries and regions. Obviously, Kaufmann Indicator provides a higher degree of freedom.
In addition to those institutional environment indicators introduced above, some unusual indicators were
used. Hofstede (1990) collected one hundred thousand IBM employees’ questionnaires in more than 50
countries and used factor analysis method to divide culture into four basic dimensions, namely, Power
Distance, Individualism/Collectivism, Masculinity/Femininity, Uncertain Avoidance. Many scholars
(Bhardwaj et al., 2007) used Hofstede’s four dimensions when studying the relationship between
informal institutional culture and FDI. According to Scott’s definition, Gaur (2007) decomposed
institution into Normative, Regulative and Cognitive. Gaur used principal component factor method and
extracted a formal institution’s comprehensive indicators from the sub-indicators covering all aspects of
institution. In addition, Jiang Dianchun and Zhang Yu (2008) used marketization index in their study
which was calculated by Fan Gang et al. They used marketization index as institutional environment
variable and examined related problems. However, marketization index is macro and reflects the process
of China’s overall economic institution’s change rather than special institutional constraints existing in
China’s economy currently. In “Global Competitiveness Report 2008-2009”, Poter (2009) counted
indicators of institution’s all aspects in various countries and regions. Poter took arithmetic average of
indicators which were involved and obtained institutional environment comprehensive index [3].
However, the institutional index which was calculated by taking arithmetic average of all indicators
lacked sufficient scientificity.
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3 Institutional Environment’s Impact on FDI
3.1 Host country’s perspective and home country’s perspective
Institutional factors come from host countries and home countries. Most of the existing literatures
examined institutional environment’s effects on FDI from the perspective of host countries. Firstly, the
existing literatures are not consistent in the impacts that corruption puts on FDI. Demekas et al. (2007)
found no significant relationship between host countries’ corruption and FDI. However, Voyer and
Beamish’s (2004) empirical results showed that host countries’ corruption would reduce FDI flowing
from Japanese enterprises [4]. Egger and Winner (2005) indicated that host countries’ low-quality
institutional environment such as corruption would promote FDI inflows when the income of
“institutional hand” was greater than the cost of “grabbing hand”. Among them, the lower quality of
institutional environment was FDI’s “grabbing hand”, for example, corruption would increase the costs
of bribery and rent-seeking and improve the uncertainty of contract execution, etc. At the same time,
corruption would become FDI’s “helping hand” when some investors might be willing to bribe to speed
up lengthy bureaucratic process such as administrative approval or be close to public funded projects in
host countries. Secondly, in the aspect of legal institution, Lu Minghong (1999) showed that institutional
factors were more important than economic factors and hard environment through the method of
regression. A clean and efficient government, a good operation system and perfect legal institutions in
host countries would provide superior institutional environment for FDI. FDI usually flows to those
countries and regions which can provide effective legal protection. Henisz and Delios (2001) found that
enterprise, in order to protect property rights, tended to invest in host countries with political stability
and mature legal system. Wang Gangnong (2007) thought that one of the important reasons affecting
China’s enterprises “going out” successfully was that they didn’t pay enough attention to host countries’
legal institutions. For general institutions, research showed that the higher quality of host countries’
institutional environment was helpful to attract FDI. Kahai (2004) carried on empirical study based on
55 developing countries’ panel data from 1980 to 2000. Kahai found that countries with higher
government governance could reduce foreign-invested enterprises’ transaction costs, thus it could attract
more FDI. Zhou Jian et al. (2010) used principal component factor analysis method and indicated that
the quality of host countries institutional environment was positively related to China’s FDI flows
significantly. However, not all FDI flows to countries have high-quality institutional environment. Many
developing countries with low-quality institutional environment also attracted a large number of FDI
(Buckley et al., 2007). Li Meng and Yu Jinping’s (2011) study also found that host countries’ good
institutions had an adverse effect on China’s foreign direct investment.
Relatively speaking, less literatures study institutional environment’s influences on FDI from home
countries’ perspective. Some scholars put forward Springboard Perspective and Institution-Escaping
Perspective from home countries’ perspective with the increase of developing countries’ FDI.
Springboard Perspective [5] thought enterprises could obtain little institutional support when home
countries’ institutional environment limited too much. So enterprises took FDI as springboard and
invested to host countries with open markets and abundant strategic resources to avoid risks (Luo and
Tung, 2007). However, Institution-Escaping Perspective (Witt and Lewin, 2007) argued that the
development of enterprises would be limited when home countries’ institutional environment
constrained too much and enterprises would escape from home countries’ institutional environment
through FDI [6]. The greater home countries’ political environment risk, the greater foreign enterprises
risk becomes. In this case, there is more prone to escape investment. In addition, in the study of China’s
FDI, Buckley et al. (2007) put forward that FDI’s motivation and ability depended on home countries’
institutional environment. Narhetali (2008), from home countries’ perspectives, examined the influence
of Asian countries’ unique cultural atmosphere on OFDI in the process of south-south investment and
civil investment. He, taking Chinese family enterprises as an example, demonstrated the impacts that
interpersonal relationship, which was very important in China, put in the process of China’s FDI. The
results showed that Chinese strong interpersonal relationship became a stumbling block to China’s
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foreign direct investment.
3.2 Two countries’ institutional distance perspective
Buckley and Casson (1976), when putting forward the internalization theory, pointed out that the
institutional and cultural differences between home countries and host countries would increase the
transaction costs of enterprises’ FDI and affect the decisions of enterprises’ FDI. Dunning (1977)
emphasized the influence of cultural distance when he put forward the eclectic theory of international
production. He believed that multinational companies tended to invest in countries or regions with small
political and cultural distance. Institutional distance is the difference between two countries’ institution
about norms, cognition and standards. It was put forward by Kostova in 1999. Lorre and Guisinger
(1995) found that cultural difference was one of the important institutional factors which affected
American FDI. He Shufeng and Guo Yudan’s (2009) empirical results showed that China tended to
invest in countries or regions that had the same political belief and international status with China. In
addition, some scholars found that developed countries tended to invest in countries whose cultural,
psychological and institutional distances were close to home countries at the beginning of
internationalization in order to embed into host countries’ institutional environment successfully and
reduce the cost of organization, coordination and adaptation (Johanson and Vahlne, 1977; Kogut and
Singh, 1988; Kostova, 1999; Xu and Shenkar, 2002; Yang Zhong, Zhang Xiao, 2009). However,
developing countries showed strong adaption ability and often invested in countries with different
institutional distances for the purpose of seeking strategic assets (Guillén and Garcí
a-Canal, 2009).
4 Conclusion
Numerous Chinese and foreign literatures used different institutional environment indicators,
respectively from the angle of host countries, home countries and institutional distance, analyzing the
relationship between institutional environment and FDI theoretically and empirically. However, there
are still several key problems unsolved. Firstly, research on the impact that institutional environment
puts on FDI is relatively small, and mainly concentrates on developed countries so far. Study on
developing countries is in a fledging period and is not comprehensive. Secondly, existing literatures
focus on the relationship between only one aspect of institutional environment variables and FDI.
Variables are not comprehensive and don’t cover all aspects of institutional environment. Even using the
same indicators may get conflicting conclusions due to different sample selection, institutional
quantitative methods and data sources. Therefore, further study may focus on the impacts that
developing countries’ institutional environment puts on FDI. Besides, how to make institutional
environment indicators more comprehensive is one of future research directions.
Acknowledgment:
This research is supported by The Key Project of Philosophy and Social Science Research of Colleges
and Universities, Department of Education of Jiangsu Province(2010ZDIXM004) and Project of
Research Planning Fund of Humanities and Social Science, Ministry of Education of the P.R.China:
“The impact of FDI in service sectors on productivity of local manufacturing industry: mechanisms and
vertical spillovers (11YJA790031)”.
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