Does Improved Governance Lead to a Higher Share of FDI in Foreign Equity Investments?

• Date: 01 August 2019
• Published date: 01 August 2019
• DOI: http://doi.org/10.1111/ajfs.12272
• Author: Laura S. Miller,Pankaj K. Maskara,Hyungkee Young Baek

Does Improved Governance Lead to a

Higher Share of FDI in Foreign Equity

Investments?

Hyungkee Young Baek*

Huizenga College of Business, Nova Southeastern University, United States

Pankaj K. Maskara

Huizenga College of Business, Nova Southeastern University, United States

Laura S. Miller

Rufus, Miller & Associates, A.C., United States

Received 9 December 2018; Accepted 13 May 2019

Abstract

We investigate the relationship between a country’s share of FDI in its foreign equity invest-

ments (FDI plus foreign portfolio investment (FPI)) and its governance quality relative to

that of the investor’s country. Poorly governed countries are often advised to improve their

governance structures to attract FDI. Contrary to this prescription, we find that as the gover-

nance quality of poor-governance host countries improves, FDI share of foreign equity

investments declines, because of a relatively higher increase in FPI than FDI. Only after a sus-

tained and meaningful improvement in governance quality, do low-quality host countries

reap the benefits of attracting greater FDI from investors in high-quality countries.

Keywords Governance quality; FDI; FPI

JEL Classification: F21, F23, O43

1. Introduction

External debt financing (especially short-term debt) to a country is driven by specu-

lative considerations regarding interest rates and exchange rates and is considered

less desirable (Hausmann and Fernandez-Arias, 2000). In contrast, equity financing

facilitates risk-sharing between domestic producers and foreign investors (Rogoff,

1999), thereby helping to stabilize domestic consumption and improve domestic

producers’ ability to pursue projects with higher risk and return. Equity investment

*Corresponding author: Huizenga College of Business, Nova Southeastern University, 3301

College Ave., Ft Lauderdale, FL 33314, United States. Tel: +1-954-262-5103, Fax: +1-954-262-

3822, email: hybaek@nova.edu.

Asia-Pacific Journal of Financial Studies (2019) 48, 561–586 doi:10.1111/ajfs.12272

©2019 Korean Securities Association 561

can take the form of FDI or foreign portfolio investment (FPI). While both forms

of equity contribute to economic growth and are thus preferable to debt, they react

differently to external shocks and financial crises. FDI is generally preferred because

it is more stable and better facilitates technological transfer (Borensztein et al.,

1998).

Given the importance of foreign equity investment, understanding the factors

that explain the composition of a country’s external equity financing is worth inves-

tigating. One such factor, governance quality, has received substantial attention in

the recent literature. The governance quality of a country largely defines its invest-

ment environment, and thus its potential for economic growth (Globerman and

Shapiro, 2002). Studies have produced seemingly contradictory results, with some

identifying FDI as the preferred mode of investment when the host country suffers

from poor governance and others finding that good governance attracts FDI. We

contribute to the literature by presenting a unifying theory that explains the contra-

dictory results of previous studies in a broader context.

Unlike most previous studies that utilize country totals, we examine foreign

investment positions between pairs of individual countries (i.e. bilateral investment

positions). This is important because policy initiatives aimed at influencing a coun-

try’s external capital structure will impact investments from individual countries.

While existing studies have largely examined only the level of the host country’s

governance quality, we consider the host country’s governance quality relative to

that of the source country. Foreign investors naturally compare the governance

environment of a host country to the environment they have experienced at home,

which has the appeal of familiarity. Our approach is supported by Andres et al.’s

(2013) finding that location choices of FDI investors from different countries

(specifically, developed vs. developing countries) are based on different pull factors.

By examining bilateral investment positions and relative governance quality, we are

able to investigate how a policy change can separately impact investments from

individual countries. The potential for offsetting effects at the individual country

level challenges the notion of universal policy prescriptions.

For countries that already have an adequate level of governance quality, we find

that improvement in governance quality increases FDI activity. Such a relationship,

however, is not evident for countries with poor governance quality. For such coun-

tries, we find that improvement in governance quality is actually likely to decrease

the proportion of FDI in total foreign equity investment. This is because improve-

ment in governance quality decreases information asymmetry, making it more diffi-

cult for controlling shareholders to enjoy the benefits of private control. This

discourages additional investment from existing FDI investors, whose familiarity

with weak institutions in their home countries (a competitive advantage) allows

them to maximize such control benefits. At the same time, marginal improvement

in the governance quality of the host country is insufficient to attract new investors

from countries with high governance quality, who continue to perceive the host

country’s relatively weak institutions as a disadvantage. Only after a sustained and

H. Y. Baek et al.

562 ©2019 Korean Securities Association