Institutional Differences and the Direction of Bilateral Foreign Direct Investment Flows: Are South–South Flows any Different than the Rest?

• Author: Chenghao Hu,Firat Demir
• Date: 01 December 2016
• DOI: http://doi.org/10.1111/twec.12356
• Published date: 01 December 2016

Institutional Differences and the Direction

of Bilateral Foreign Direct Investment

Flows: Are South–South Flows any

Different than the Rest?

Firat Demir

1

and Chenghao Hu

2

1

Economics, University of Oklahoma, Norman, OK, USA and

2

Economics, University of California-

Davis, Davis, CA, USA

1. INTRODUCTION

FOREIGN direct investment (FDI) flows to and from developing countries (i.e. the South)

increased significantly reaching $886 and $553 billion in 2013, corresponding to 61 and

39 per cent of global inflows and outflows, respectively.

1

There were six developing countries

among the top 20 investors in the world in 2013, and China ranked number two in global

FDI inflows and outflows, right after the United States (UNCTAD, 2014a). In the case of

Merger and Acquisitions, 53 per cent of global flows came from developing countries, and of

this, 72 per cent went to other developing countries in 2013 (UNCTAD, 2014b). Furthermore,

South–South FDI flows reached around 63 to 65 per cent of all outflows from developing

countries in 2010 (UNCTAD, 2011; World Bank, 2011).

The empirical research on FDI identifies various economic variables as its determinants

including income level, distance, institutional development, natural resource base and market

size, among others. Particularly, institutional differences and development levels (including

legal codes, transparency, political stability, financial system, corruption, law and order, etc.)

are found to work as significant entry barriers for foreign investors (Shleifer and Vishny,

1993; Wei, 2000; Alfaro et al., 2008; Javorcik and Wei, 2009; Papaioannou, 2009; Kinda,

2010; Holmes et al., 2013). As a result, there has been a significant push in many countries to

improve and synchronise their institutional environments with those of developed countries in

order to enhance their global competitiveness. For example, every year between 2000 and

2013, an average of 56 countries adopted a total of 1,147 institutional policy changes to pro-

mote and facilitate a more favourable environment for foreign investors (UNCTAD, 2014a).

Nevertheless, within this literature, the effect of country heterogeneity based on devel opment

levels is an issue that remains relatively unexplored. In particular, whether institutional barri-

ers have the same deterrence for foreign investors from developed versus developing countries

is a question that needs to be explored further. This subject has received considerable atten-

tion recently in the press and from policymakers with regard to increasing Chinese invest-

ments in developing countries, especially in Latin America and Africa (Strange et al., 2013).

We thank Paul Bergin, Mustafa Caglayan, Tatiana Didier, Amitava K. Dutt, Kevin Gallagher, Ilene Gra-

bel, Jeffrey B. Nugent, Arslan Razmi, Alan Taylor, the session participants at the ASSA 2015 meeting

in Boston, and seminar participants at KocßUniversity, and the World Bank for their comments and sug-

gestions. We thank Xiaoman Duan, Xiaokai Li and Ying Zhang for their excellent research assistance.

All remaining errors and omissions are ours.

1

The figures include transition economies.

©2015 John Wiley & Sons Ltd

2000

The World Economy (2016)

doi: 10.1111/twec.12356

The World Economy

In particular, the increasing importance of developing countries as a source of foreign invest-

ment in other developing countries, and the lower levels of conditionality involved therein are

argued to weaken developed countries’ bargaining position for institutional and political

change in developing countries. China, for example, is often criticised for ignoring human

rights concerns or corruption in host countries and thus allegedly undermining Western efforts

to foster good governance and better institutional development in the South (Lyman, 2005;

The Economist, 2006; Mbaye, 2011; Warmerdam, 2012).

In the light of these debates, the primary aim of this paper was threefold: first, we study

whether institutional differences across countries affect bilateral FDI flows. Second, we explore

whether the effect, if any, depends on the level of institutional and economic development of

host and home countries. That is, whether institutional distance works more in one direction,

such as moving from a high to a low institutional environment, or moving between any of four

directions, South–South, North–South, South–North and North–North. We also investigate

whether Southern investors have any comparative advantage operating in other Southern coun-

tries with poor institutional development. Third, we test the learning-by-doing effect by taking

into account the experience levels of foreign investors through bilateral trade or direct invest-

ment channels. The empirical analysis is based on a theoretically consistent gravity model using

a comprehensive data set of bilateral FDI flows with 37,910 country-year observations from 134

countries during 1990–2009. Our empirical findings suggest that bilateral institutional differ-

ences do indeed work as an entry barrier for foreign investors. However, this effect is detected to

be present only in North–South and South–North directions, and more so for the former than the

latter. Moreover, developing country investors are found to have a comparative advantage in

operating in institutionally different and less developed countries. Last but not least, we do not

find any evidence that past experiences in different institutional environments or existing bilat-

eral trade linkages help reduce the negative effect of institutional distance.

The rest of the paper is organised as follows: Section 2 provides a brief literature review

on FDI and institutional development. The third section introduces the methodology and data.

The fourth section presents the empirical results followed by extensions and robustness tests.

The final section concludes.

2. LITERATURE REVIEW

The Google scholar search finds 7,200 articles on the issue of determinants of FDI, and Econ-

Lit lists 157 journal articles including the keywords of ‘determinants of FDI’ in its abstract or

title published since 1990.

2

Previous work on the topic points out several variables that affect

FDI flows including incomes, exchange rates, market size, labour costs, distance, cultural differ-

ences, trade openness and trade linkages, etc. Among these, the work on the effects of institu-

tional differences has grown substantially in recent years, finding that they create significant

entry costs for foreign investors (Shleifer and Vishny, 1993; Wei, 2000; Bera and Gupta, 2009;

Kinda, 2010; Holmes et al., 2013). This finding is also used to explain the Lucas Paradox, the

fact that capital does not flow from rich to poor countries (Alfaro et al., 2008).

What is missing in this literature, however, is an in-depth analysis of the FDI flows within

and between developing and developed countries. Particularly, the causes and effects of South–

South FDI flows compared to flows in other directions have received only limited attention.

2

Searched on 9 March 2014.

©2015 John Wiley & Sons Ltd

INSTITUTIONAL DIFFERENCES AND BILATERAL FDI FLOWS 2001