Effects of FDI Flows on Institutional Development: Does It Matter Where the Investors are from?

Highlights

• Examine effects of bilateral FDI flows on institutional development gaps.

• Group FDI into South and North directions.

• Bilateral FDI flows have no effect on institutional development gaps.

• Aggregate South–South flows have a negative effect on host country institutions.

• North–South flows improve institutions in natural resource-rich countries.

Summary

Global FDI flows to and from developing countries have increased significantly since the 1990s. While developing countries saw this as a positive development, many economists and policy makers in developed countries have raised concerns regarding the institutional effects of developing country investments in other developing countries. In this paper we explore the effects of bilateral FDI flows on institutional development gaps between countries and whether such effects are conditional on the direction of flows including South–South, South–North, North–South, and North–North directions. The empirical results using bilateral flows between 134 countries and a variety of institutional development measures during 1990–2009 suggest that the institutional development effects of FDI flows in any direction including the North–South or South–South directions are not significant. In any case we do not find any significant convergence or divergence effect of FDI flows on the institutional distance between host and home countries. We also fail to find any significant effect of aggregate North–South FDI flows on host country institutions. In contrast, we find that aggregate South–South FDI flows have a significantly negative effect on host country institutions. Furthermore, we find some evidence that South–South FDI flows may be harmful to institutional development in natural resource-rich countries while the opposite is true for North–South flows. Overall, the results suggest that there is no strong evidence of any benevolent or malevolent effects of bilateral FDI flows from developed or developing countries to developing countries.

Introduction

“What we have here – in states like China, Iran, Saudi Arabia, and Venezuela – are regimes that have the cash and the will to reshape the world into a place very different from where the rest of us want to live. Although they are not acting in concert, they collectively represent a threat to healthy, sustainable development… If they continue to succeed in pushing their alternative development model, they will succeed in underwriting a world that is more corrupt, chaotic, and authoritarian”.

Naím, 2007

“As the beneficiaries of the blessings of a stable democracy and a robust economy, we, as Americans, have an obligation to ensure that our corporations – and their officers, directors, and employees – are not undermining the promise of democracy and economic development in other parts of the world by paying bribes”.

Deputy Attorney General James M. Cole, 2013

Foreign Direct Investment (FDI) flows to and from developing countries (i.e., the South) have reached $886 and $553 billion in 2013, accounting for 61% and 39% of global flows, respectively. Equally impressive has been the fact that for the first time in 2010 Chinese outward FDI flows exceeded those of Japan, reaching $69 billion in 2010 (and $101 billion in 2013) (UNCTAD, 2015). Furthermore, within aggregate flows to and from the South, South–South FDI flows reached 63% of all outflows from developing countries in 2010 (UNCTAD, 2011). As FDI has become a significant source of investment and capital formation, there has been a global gold rush in many countries to improve and harmonize their institutional environments in order to strengthen their competitiveness. During 2000–12 alone, an average of 55 countries adopted a total of 1,082 institutional policy changes to promote and facilitate a more favorable environment for foreign investors. Likewise, by the end of 2013 a total of 9,175 bilateral investment treaties including features for improving and re-aligning institutional settings of host and home countries have been signed among 201 countries (UNCTAD, 2014).

The growing importance of developing country multinationals in cross-border investments has also created a controversy regarding their impacts on host country institutions. Particularly, Southern investors are often accused of undermining developed country efforts to improve institutional development in the developing world. While how exactly this happens is not very clear, one channel frequently cited in the press is the lower levels of conditionality involved in South–South economic exchanges, which allegedly diminishes Northern countries’ (i.e., the North) bargaining position for institutional and political change in those countries. China, for example, is often criticized for “neglecting human rights offences …, supporting corrupt authoritarian regimes, and undermining Western efforts in these countries to promote good governance” and better economic and political institutional infrastructure (Economist, 2006, Lyman, 2005, Warmerdam, 2012). In addition, Southern investments are argued to have weaker “demonstration” and “professionalization” spillover effects on host country firms and institutions than Northern investments (Kwok & Tadesse, 2006).¹

Despite the controversy, however, there is no empirical study that tests the “China” vs. “Western” effect on developing country institutions. While most research on FDI flows focus on their direct economic effects through technology transfer and productivity spillovers, few have explored their effects on host country institutions. This is particularly surprising given that institutional development is argued to be a source of comparative advantage, affecting long-run development and growth (Acemoglu et al., 2001, Acemoglu et al., 2005, Kaufmann et al., 1999, Knack and Keefer, 1995, Mauro, 1995), productivity and incomes (Hall & Jones, 1999) and trade and capital flows (Alfaro et al., 2008, Dutt and Traca, 2010, Wei, 2000).

In this paper we contribute to this literature by addressing two questions. First, we explore whether bilateral FDI flows affect institutional development gaps (along multiple dimensions) between home and host countries. Second, we test if there is any difference between developed and developing country investors regarding their effects on institutional convergence dynamics in host countries. The empirical results based on bilateral FDI flows among 134 countries during 1990–2009 suggest that the institutional development effects of bilateral FDI flows from developed to developing countries as well as those from developing to developing countries are not significant and are not any different from each other. In either case we do not find any significant institutional convergence or divergence effect of FDI flows between host and home countries. We also do not detect any significant effect of aggregate North–South FDI flows on host country institutions. In contrast, we find that aggregate South–South flows have a significantly negative effect on host country institutions. Furthermore, we find some evidence that South–South FDI flows might be harmful to institutional development in natural resource-rich host countries while the opposite is true for South–North and North–South flows.

The organization of the paper is as follows: The next section provides a brief literature review on the link between FDI flows and institutional development. The third section introduces the methodology and data. The fourth section presents the empirical results followed by extensions in section five. The final section concludes.