Institutional Distance and Foreign Direct Investment

Abstract

This paper studies the link between Foreign Direct Investment (FDI) and institutional distance. Using a heterogeneous firms framework, we develop a theoretical model to explain how institutional distance influences FDI and it is shown that institutional distance reduces both the likelihood that a firm will invest in a foreign country and the volume of investment it will undertake. We test our model, using inward and outward FDI data on OECD countries. The empirical results confirm the theory and indicate that FDI activity declines with institutional distance. In addition, we find that firms from developed economies adapt more easily to institutional distance than firms from developing economies.

Foreign Land Acquisitions and Institutional Distance

“…Indeed, while the number of contracts can be considered as a proxy for the number of firms involved in FLA, the amount of land proxies the size of the investments. The literature has shown that institutional distance reduces FDI through two distinct channels: by reducing the number of firms involved -the so-called extensive margin -and the size of investments -the intensive margin (Cezar, Escobar, 2015). We, therefore, check whether this also holds for FLA.…”

“…The literature has also shown that this impact differs depending on the country of origin of the investing firm and the destination country (developed versus developing countries). Indeed, this negative effect has been found to be lower for South-South FDI (Demir, Hu, 2016), for inward -with respect to outward -FDI in OECD countries (Cezar, Escobar, 2015), and for those developing countries endowed with large reserves of natural resources (Aleksynska, Havrylchyk, 2013).…”

“…More recent evidence has shown that FDI is also negatively affected by the institutional "distance", measured as the absolute difference of institutional quality between the origin and the destination countries (e.g. Bénassy-Quéré et al 2007; Aleksynska, Havrylchyk, 2013;Cezar, Escobar, 2015;Demir, Hu, 2016).…”

“…The basic idea behind the inclusion of institutional distance among the FDI determinants is that firms from countries with weak institutions are likely to face lower costs -when investing in countries with weak institutions -than investors from countries with strong institutions (Bénassy-Quéré et al, 2007;Aizenman, Spiegel, 2006). Recently Cezar and Escobar (2015) have more formally analysed the impact of institutional distance on FDI within a Melitz-type heterogeneous firms framework (Melitz, 2003). Institutional distance influences the adaptation (fixed) cost for foreign firms: the more similar the institutional environment, the lower the adaptation cost.…”

“…Previous literature on FDI found that, as multinational firms prefer a similar institutional environment, the greater the institutional distance, the lower the foreign investments (e.g. Bénassy-Quéré et al 2007; Aleksynska, Havrylchyk, 2013;Cezar, Escobar, 2015;Demir, Hu, 2016). Does institutional distance matter for FLA as well?…”