Institutional Efficiency and Attraction of Foreign Direct Investment to Developing Countries

Abstract

The paper estimates the impact of institutions' quality on the attraction of foreign direct investment (FDI) to developing countries. Data Envelopment Analysis (DEA) was used to develop a new measure of quality of institutions: Institutional Efficiency Index (IEI). In order to appraise quantitatively the effect of institutional quality on FDI entry, we used a panel data regression analysis on a dataset covering 40 countries from different developing regions for which the necessary data were accessible during the period 2011-2015. The paper argues that the institutional efficiency, as a measure of institutional quality, enhances the attractiveness of developing countries to FDI.The results of this paper suggest that FDI is mainly determined by institutional quality. A host country endowed with a high quality of institutions will be more attractive to foreign investors. In order to improve their competitiveness in term of attraction of foreign investment, developing countries should work more on providing a stable environment as well as on the transparency of policy implementation regarding the entry of multinational companies.Keywords: institutional efficiency index, DEA method, measure of institution's quality, FDI entry Recently, investors have been concentrating more on the quality of institutions as an important determinant of FDI. The paper examines the reasons of differences among countries in their attractiveness and try to understand why some countries are more attractive for investors than others. By developing a new measure of institutional quality, the paper examines the importance of institutional factors over economic ones. The result of this paper is essential in developing new concepts. In addition to the existing literature, we tried to construct a new index called the institutional efficiency index using DEA method. The index measures the quality of institutions and includes various dimensions, as the decisions of foreign investors might depend on different features of institutions. Furthermore, the new measure of institutional quality developed in the paper serves as an explanatory variable for FDI entry. The new measure which is an aggregate index takes into consideration the common institutional factors raised in FDI determinants literature. The rest of the paper is organized as follows. Part 2 affords a brief literature on the impact of institutional quality on FDI entry. Part 3 clarifies the econometric methodology and designates the data. Part 4 presents the econometric findings. Finally, Part 5 concludes by debating policy implications of our findings.

Effects of institutional quality on foreign direct investment inflow in lower-middle income countries

“…The composite index is created by summing up the different proxy variables of institutional quality. Taking all the six governance indicators (control of corruption, government effectiveness, political stability and absence of violence, regulatory quality, rule of law, and voice and accountability), some literature ( Kurul, 2017 ; Sabir et al., 2019 ; Sayari, 2019 ) constructed an institutional quality index by applying Principal Component Analysis (PCA) or Data Envelopment Analysis (DEA) and find a significant positive impact on FDI inflow. On the other hand, Ali et al.…”

“…From the above discussion, one question comes forward that good institutional quality is actually a matter or not to attract FDI inflow. Most of the work followed static panel estimation procedures to find out the answer to the above question while just a few ( Owusu et al., 2017 ; Sayari, 2019 ; Van Bon, 2015 ) have mentioned dynamic panel estimation to estimate this relationship, applying the Generalized Method of Moment (GMM). Whereas FDI flow can be influenced by its past value, we pay more attention to this dynamic panel system GMM model to seek out the answer to the above question by introducing six governance indicators as a proxy of institutional quality developed by Kaufmann et al.…”