This study investigates the cointegrating and causality relationships between foreign direct investment (FDI), foreign portfolio investment (FPI) and institutional quality in a sample of 12 emerging market economies for the period from 2007 to 2017. A composite index for institutional quality composed of the Worldwide Governance Indicators was constructed using the Principal Components Analysis (PCA) method. The panel autoregressive distributed lag (ARDL) model and the error correction model (ECM) were applied to assess the cointegrating and causal relationships between the key variables. In addition to finding significant cointegrating relationships between institutional quality and the foreign capital inflows (FDI and FPI), the results confirmed unidirectional causality from FDI and FPI to institutional quality in the long run. The results further suggested that the long-run relationship between the two foreign capital inflows was more of a trade-off nature, dependent upon the dynamics of the institutional environment in the host economy. The recommendations suggested include that emerging markets should continue to open their economies in pursuit of capital inflows, which will reciprocally strengthen their domestic institutional environment. Strengthening institutions could curtail the persistence of institutional weaknesses and insulate emerging economies from the adverse effects of volatile capital flows and, over the long run, enhance capital inflows.
Purpose: The purpose of the study was to examine the key determinants of foreign direct investment (FDI) and foreign portfolio investment (FPI) in emerging market economies, with greater emphasis placed on the impact of institutional quality. Design/Methodology/Approach: The study applied a panel data system generalised method of moments (GMM) model using annual data spanning the period 2007 to 2017, in respect of 12 emerging market economies. To measure institutional quality, the study adopted the Worldwide Governance Indicators, and constructed a composite index for institutional quality using the Principal Components Analysis (PCA) method. Findings: The results revealed that FDI in the selected emerging markets was attracted by institutional quality and economic growth. Capital account openness, institutional quality and economic growth were positive determinants of FPI. However, stock market development stood out as the key determinant factor for foreign capital inflows. Implications/Originality/Value: The implications of these findings are that, in their pursuit of foreign capital inflows, these emerging markets should continue to liberalise their economies and develop their financial markets. Importantly, such developments must be coupled with the strengthening of the formal governance institutions. Robust institutions would not only curb institutional weaknesses that deter international capital inflows, but would also insulate emerging markets from unfavourable effects of volatile capital flows.
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