International Review of Financial Analysis 21 (2012) 8189

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International Review of Financial Analysis

Foreign direct investment and institutional quality: Some empirical evidence

Bonnie G. Buchanan a,, Quan V. Le b, 1, Meenakshi Rishi b, 2
a
Department of Finance, Albers School of Business and Economics, Seattle University, 901 12th Avenue, Seattle, WA 98122, United States
b
Department of Economics, Albers School of Business and Economics, Seattle University, 901 12th Avenue, Seattle, WA 98122, United States

a r t i c l e i n f o a b s t r a c t

Article history: Based on a panel data analysis of 164 countries from 1996 to 2006, we examine the impact of institutional
Received 27 September 2011 quality on foreign direct investment (FDI) levels and volatility. We nd that good institutional quality mat-
Accepted 3 October 2011 ters to FDI. We provide evidence that institutional quality has a positive and signicant effect on FDI. More
Available online 28 October 2011
specically, we nd that a one standard deviation change in institutional quality improves FDI by a factor
of 1.69. Ceteris paribus, institutional quality is negatively and signicantly associated with FDI volatility
JEL classication:
F21
which may have an adverse effect on economic growth per Lensink and Morrisey (2006). Thus, our results
F23 suggest that if there are institutional determinants of FDI volatility and if such volatility is associated with
F30 lower economic growth, then the usual policy prescription of attracting FDI into countries by offering the
G30 correct macroeconomic environment would be ineffective without an equal emphasis on institutional
reform.
Keywords: 2011 Elsevier Inc. All rights reserved.
Institutions
Corporate governance
FDI

1. Introduction
Foreign direct investment (FDI) is a global phenomenon and is
widely understood to be a major antecedent to economic develop-
ment. In real terms, cross-border capital ows have been increasing
at a rate of about 6% a year since 1980, faster than those of the world's
GDP and trade (Ju and Wei, 2007). More specically, over the
19962006 time period, worldwide trade of goods and services in-
creased by 8% while net inows of FDI surged by 19%. 3 However,
the advantages of FDI do not ensue automatically and are not distrib-
uted evenly across countries. The vast majority of FDI is between
wealthy nations despite the availability of cheaper labor in develop-
ing economies. The poorest, slowest growing nations attract perhaps
2% of all foreign direct investment. Among developing countries, the
largest ows have been to economically dynamic countries. Accord-
ing to Wolf (2008), Capital now ows upstream, from the world's
poor to the richest countries of all. Nevertheless, FDI has been credited
with providing recipient nations with much-needed access to nan-
cial capital, advanced technology and employment. 4
Corresponding author. Tel.: + 1 206 296 5977; fax: + 1 206 296 2486.
E-mail addresses: buchanab@seattleu.edu (B.G. Buchanan), lequ@seattleu.edu
(Q.V. Le), rishim@seattleu.edu (M. Rishi).
1
Tel.: + 1 206 296 5737; fax: + 1 206 296 2486.
2
Tel.: + 1 206 296 2078; fax: + 1 206 296 2486.
3
World Development Indicators (2009). The World Bank: Washington D.C.
4
Among the many benets of FDI is the creation of jobs for women in developing
countries.
It is not a matter of dispute that while the benets of FDI are real,
they do not automatically fall into place. FDI related issues extend
well beyond liberalization of economies. One thing that a nancial cri-
sis brings to the fore is weaknesses in institutional infrastructure that
may have previously been masked during a credit and commodity
boom. For example, in the aftermath of the 1997 Asian nancial crisis,
many countries started to reform their institutional policies, legisla-
tion and institutional arrangements in order to attract more FDI.
In addition, recent reports have highlighted the importance of an en-
abling institutional environment in reaping the maximum benets from
FDI (OECD, 2002). A 2003 Economist article details the slow pace of
structural institutional reforms that were taking place in Russia.5 The
article notes that FDI ows to Russia remained below $3 billion (much
less than what China was getting on a monthly basis). The article further
contends that this awed institutional infrastructure in Russia led to a
slowdown in economic growth and in investment.
Scholarly interest in institutional determinants of FDI coincides
with the growing body of literature that has focused on governance
and economic development over the last two decades (Acemoglu
and Johnson, 2005; IMF, 2003). Broadly speaking, FDI ows to coun-
tries with better quality institutions while poor governance can im-
pede FDI. Indeed the literature on institutions and FDI has
delineated several ways by which institutions matter for FDI inows.
For instance, Daude and Stein (2007) propose two channels through
which poor institutional quality can deter FDI inows. The authors
5
Russia: Reduced Expectations, The Economist, EIU No. 24. April 16, 2003.

1057-5219/$ see front matter 2011 Elsevier Inc. All rights reserved.
doi:10.1016/j.irfa.2011.10.001
82 B.G. Buchanan et al. / International Review of Financial Analysis 21 (2012) 8189
claim that poor institutions can act like a tax and therefore are a cost
to FDI. Poor institutional quality can also increase the uncertainty as-
sociated with all types of investment, including FDI. In this paper we
propose and empirically investigate a third channel of transmission.
We posit that poor institutional quality can increase the volatility of
FDI inows which can have an adverse impact on economic growth.
The impact of institutions on the volatility of FDI inows is a rela-
tively unexplored topic in the existing literature. An extensive survey
on the topic suggests that only one study by Lensink and Morrissey
(2006) has investigated the association between volatility of FDI
and economic growth but the authors did not focus on any determi-
nants, institutional or otherwise, of volatile FDI. In contrast, this
paper directs attention to the institutional antecedents of FDI volatil-
ity. By focusing on the association between institutions and FDI vola-
tility, we attempt to bridge the existing literature on institutional
quality and FDI with the nascent work on FDI volatility and economic
growth. In other words, a specic concern with institutions and FDI
volatility and not with simply with the institutional determinants of
FDI is what distinguishes our analysis from previous studies on the
subject.
We contribute to the literature in another way. A signicant limi-
tation of the literature on FDI is that it has become rather dated with
many cross-country studies pre-dating the 1997 Asian nancial crisis.
To the best of our knowledge, apart from single country studies, there
has been a dearth of papers that examine FDI in a panel framework. In
this regard, we provide panel data estimates on FDI for a large set of
countries, including both macro variables and institutional variables
as regressors. Our data set includes 164 countries over an 11 year
time-period from 1996 to 2006 the most comprehensive data sam-
ple to date.
Our econometric results show that institutional quality has a pos-
itive and signicant effect on FDI, whereby a one standard deviation
change in institutional quality changes FDI by a factor of 1.69. Our re-
sults also show that institutional quality has a negative and signicant
effect on the volatility of FDI. These ndings are statistically and eco-
nomically signicant. In addition, these ndings suggest that if there
are institutional antecedents of FDI volatility and if such volatility is
associated with lower economic growth, then the usual policy pre-
scription of attracting FDI into countries by offering the correct
macroeconomic environment would be ineffective without an equal
emphasis on institutional reform.
The paper is set out as follows: Section 2 provides an overview of re-
cent trends in FDI. The following section surveys relevant literature and
this critical discussion provides the basis for our hypothesis develop-
ment; Section 4 details the data and sample selection; results are pro-
vided and discussed in Section 5 and Section 6 concludes the paper.
2. Trends in FDI
Global FDI ows have become increasingly more complex over the
last four decades as many poorer countries have been growing at a
faster rate than richer ones. There has also been a geographical shift
in the destination/origin of FDI inows and outows. For example,
the US FDI position has also changed markedly over the last forty -
years. In 1960 the US was the origin of 49% of the world's FDI and
host to just 14%, but by 2002 it was the origin of only 22% but host
to 19% of FDI. 6
As Fig. 1, 7 Panel A indicates, FDI on a worldwide basis surged to-
ward the end of the 1990s but was interrupted during the global
slowdown between 2000 and 2002. Despite the collapse of asset, cur-
rency and internet bubbles at the turn of the decade, the trend in FDI
has continued to remain on the whole, positive and remarkably stable
6
Three Reasons to be Cheerful about the World Economy, Martin Wolf, Financial
Times, 30 June 2004.
7 15
Data for FDI/GDP is taken from the World Development Indicators, 2009.
over the last decade. In 2005, cross border FDI rose by 29% and
reached $916 billion according to an UNCTAD report. 8
One of the FDI success phenomena of the past decade has been the
BRIC (Brazil, Russia, India and China) economies, represented in
Fig. 1, Panel B. In 2005, these four economies attracted US$144.57 bil-
lion, or 16% of total FDI inows in the world. 9 The mining,
manufacturing and service sectors especially automobile, electron-
ics and electrical, oil and gas and mining, metal and steel, power, -
nance, telecommunications and real estate gained the most from
the FDI surge in these four economies. Despite this, the path of FDI
growth has not necessarily been smooth for the BRIC economies. If
we observe the FDI pattern in Brazil we note it is quite volatile, espe-
cially around 2002. Part of this can be explained by the 2002 Presi-
dential election results. Stock and bond markets tumbled and yet
when Lula da Silva pledged that his policies would be market friendly,
FDI rebounded. While China is the top recipient of FDI, research by
Huang (2008) rejects cheap labor and a large domestic market as
the reasons for large FDI ows to China. He suggests that China at-
tracts more FDI than others because of an inefcient domestic nan-
cial sector that cannot allocate household savings efciently. Thus
FDI effectively serves as a tool for Chinese private rms to circumvent
the inefcient domestic nancial sector.
However, if we examine FDI destination on a regional or country
level, rather different patterns start to emerge. A recent World Invest-
ment Projects Survey 10 reinforces a growing trend towards regional-
ization in global FDI patterns. In Fig. 1, Panel C, we observe that FDI in
the Middle East and North Africa rose from 0.5% to 4% of GDP between
1996 and 2006. Yet if we look at individual countries disparate trends
become evident. For example, inows to Tunisia went up because of
privatization in the telecommunications industry, yet FDI inows to
Morocco declined because there was a downturn in privatization
sales.
In 2006, FDI to Africa attracted only 3% of the world's total FDI and
this was down from a peak of 6% in the mid-1970s. 11 With regard to
Sub-Saharan Africa in Fig. 1, Panel D, investment ows to the conti-
nent doubled between 2004 and 2006 and have increased more
than six-fold since 1996. The three largest recipients of FDI were An-
gola, Nigeria and South Africa these three countries absorbed 65%
of FDI ows to the region between 2000 and 2002. 12 But though it ap-
pears that FDI to Sub-Saharan Africa has risen strongly, the region still
ranks at the bottom of investor preferences according to UNCTAD. 13
In Fig. 1, Panel E we note that in Central and Eastern Europe, FDI
rose from 2% to 8% of GDP between 1996 and 2006. A closer investi-
gation 14 reveals FDI inows declined in most of the eight Central Eu-
ropean countries attempting to join the EU at the time. The Western
Balkans, Romania and Bulgaria were the few Central European coun-
tries to witness an increase in FDI.
In Fig. 1, Panel F, East Asia and Pacic FDI exhibit a declining trend
over the same time period. Consider one country in the East Asia re-
gion Japan. Over the last decade, the Japanese government has
tried very hard to court FDI. Such measures included reworking the
commercial code to make it easier for foreign rms to buy Japanese
businesses. 15 Between 2001 and 2005, Japan's inward FDI doubled,
8
Financial Express: FDI Flows in the Emerging Markets. Financial Times. 22 May
2007.
9
FDI Flows in the Emerging Markets. Financial Express. 22 May, 2007.
10
Foreign Investments: Slower Growth Ahead. EIU Business Africa. November 1,
2008.
11
A Glimmer at Last? Sub-Saharan Economies are Growing Faster but are they really
growing stronger? The Economist, June 24, 2006.
12
FDI in Africa: The Role of Natural Resources, Market size, Government and Policy,
Institutions and Political Instability. Elizabeth Asiedu. World Economy. Vol 29. January
2006.
13
Foreign Investments: Slower Growth Ahead. EIU Business Africa. November 1,
2008.
14
Cooling Down, The Economist, December 13, 2003.
Gaijin at the Gates; Japanese Business, The Economist 8/18/2007.
 B.G. Buchanan et al. / International Review of Financial Analysis 21 (2012) 8189
but it still only amounted to approximately 2.4% of national output
(compared with Germany, France and the UK where it is between
30 - 40%). Extending our discussion on the trends relating to FDI,
we proceed to discuss the relevant literature on channels that impact
FDI and its volatility in the next section.
3. Literature survey
The impact of FDI on economic growth has been examined by
many scholars. Zhang (2001) has examined the FDI-economic growth
association for East Asia and Latin America. Makki and Somwaru
(2004) nd a strong and positive interaction between FDI and trade
in advancing economic growth in 66 developing countries. Liu
(2008) focuses on whether FDI generates spillovers that benet do-
mestic rms in the host country. Overall, Liu nds that external ben-
ets associated with FDI in terms of productivity gains accruing to
domestic rms are positive and substantial.
In a slightly different vein, Lensink and Morrissey (2006) reason
that volatile FDI ows may not have a salubrious impact on economic
growth. They incorporate effects due to the volatility of FDI inows
using cross-sectional panel data and instrument variable techniques.
Utilizing data from 87 countries from 1990 to 1997, the authors con-
clude that volatility of FDI matters (it has a negative inuence on
growth) but is not as important a determinant of growth as other
factors such as the level of FDI and initial income.
In terms of standard host country determinants of FDI, market size
emerges as important variable in many studies. Market size is typical-
ly proxied by per capita GDP and the premise for it as an explanatory
variable is that market growth is contingent on efcient utilization of
resources and exploitation of economies of scale (Scaperland and
Mauer, 1969; Schneider and Frey, 1985).
Trade is considered another important macroeconomic determi-
nant of FDI. Torissi (1985) nds that a trade surplus is indicative of
a dynamic and healthy economy with export potential and thereby
more likely to attract FDI. Another traditional variable that enters
specications is ination which is sometime indicative of internal
economic tension and of the inability of the central bank and govern-
ment to restrict the money supply and balance the budget. The tradi-
tional hypothesis in the literature is that the higher the rate of
ination, the lower FDI.
Institutional quality has been unambiguously associated with eco-
nomic growth in the theoretical literature (North, 1981, 1990). Em-
pirical literature on the topic has also demonstrated a positive link
between the quality of institutions and economic growth in a society
(Acemoglu and Verdier, 1998). Noteworthy among these are studies
that examine the growth enhancing effect of institutional variables
such as the security of property rights, the strength of the rule of
law, and the control of corruption, and nancial intermediary devel-
opment (Ali, Fiess, and MacDonald, 2010; King and Levine, 1993;
Knack and Keefer, 1995; Mauro, 1995; North, 1990). Benassy-Quere,
Coupet, and Mayer (2007) have examined the impact of the above in-
stitutional variables on bilateral FDI and conclude that institutional
distance tends to reduce bilateral FDI, i.e., between the home country
and the source country.
Some FDI studies have focused attention on how home country in-
stitutional variables impact FDI. One of the rst variables to be exam-
ined in this regard was the importance of political factors as crucial
determinants of FDI (Levis, 1979; Root and Ahmed, 1979; Schneider
and Frey, 1985; Stevens, 1969; Wei, 1997). Jensen (2003) nds that
democratic governments attract as much as 70% more FDI (measured
as a percentage of GDP) than their authoritarian counterparts. How-
ever, Green and Cunningham (1975) and Wheeler and Mody (1992)
nd the impact of political environment indicators on FDI to be insig-
nicant. Li and Resnick (2003) nd a negative impact of democracy
on FDI inows in 53 countries.
83
With regards to other institutional variables, Aizenman and
Spiegel (2006) focus on the role of strength in the enforcement of
property rights on the pattern and behavior of MNCs. They nd that
institutional efciency is robustly correlated with the ratio of FDI to
total domestic investment. The importance of property rights for
boosting FDI has also been emphasized by Knack and Keefer (1995)
and Lee and Manseld (1996). The impact of corruption by substan-
tially reducing FDI has also been noted in Wei (2000).
Huang (2003) notes that poor institutions reduce the supply of local
entrepreneurship; high quality institutions increase local entrepre-
neurship. FDI is determined in part by the strength or weakness of
local entrepreneurship in host countries. By this reasoning, controlling
for other macro and political factors, a country with a poor entrepre-
neurial climate may succeed in attracting more FDI as local rms
pose no threats to foreign rms.
Recent studies have directed attention to composite measures of
institutional quality (governance) and their impact on FDI.
Globerman and Shapiro (2002) focus on the linkage between gover-
nance structure and FDI ows and nd that the returns to good gov-
ernance are greater for developing/transition economies as compared
to others. In a sample of countries drawn from Asia, Latin America and
the Caribbean regions, Gani (2007) notes that rule of law, control of
corruption, regulatory quality, government effectiveness and political
stability are all positively correlated with FDI.
An exhaustive review of the literature reveals a substantial num-
ber of studies on the quality of institutions and FDI. However, the as-
sociation between institutions and the volatility of FDI has not
received commensurate attention. Addressing this gap in the litera-
ture is particularly signicant in light of Lensink and Morrissey
(2006) who have empirically demonstrated that volatile FDI ows
can lower the productivity of such investment and thus adversely im-
pact economic growth. Thus, in this paper we propose that the insti-
tutional environment not only matters for the level of FDI but is also
associated with the volatility of FDI. Refocusing the institutional qual-
ity and economic growth linkage to an examination of FDI volatility is
important for emerging markets that yearn to attract FDI into their
economies.
In the following section, we provide details regarding the panel
data sample that is the basis for the subsequent econometric testing
in Section 5.
4. Data and sample selection
Overall, the nal sample includes panel data over the period
19962006 and covers 164 developed and developing countries. A
unique feature of our data set is that it is buffered by two major nan-
cial crises, the 1997 Asian nancial crisis and the recent global nan-
cial crisis. We end our sample in 2006 due to data constraints (the
World Development Indicator data ends at this point) and uncharac-
teristically mercurial world markets. Given the wide-spread turmoil
in global markets in 20072009, any analysis involving this period
would likely show abnormal patterns. A list of countries, summary
statistics, and correlations matrix for all variables are provided in
the Appendix 1 and Tables 1 and 2, respectively.
Foreign direct investment (FDI), measured as net inows (% of
GDP) is taken from the World Development Indicators, 2009 (WDI)
database. The volatility of FDI is measured by the variance of FDI. 16
From Table 1, one can observe that FDI net inows have a mean of
6% of GDP and up to a maximum of 500% of GDP. However, the vola-
tility of FDI ranges between 60 and greater than 20000 with a very
high standard deviation. The standard deviation of FDI is 23, while
the standard deviation of the volatility of FDI is 764, indicating that
year-on-year changes in FDI inows are highly volatile.
The empirical analysis for this paper utilizes a governance dataset
developed by the Worldwide Governance Indicators (WGI) that
reports indicators for several countries over 19962006, for six
84 B.G. Buchanan et al. / International Review of Financial Analysis 21 (2012) 8189

dimensions of governance, viz., Voice and Accountability, Political
Stability and Absence of Violence, Government Effectiveness, Regula-
tory Quality, Rule of law, and Control of Corruption (Kaufmann,
Kraay, and Mastruzzi, 2007). Indicators measuring various aspects of
the political process, civil liberties and political rights, and indepen-
dence of the media are captured by the Voice and Accountability
index. The Political Stability and Lack of Violence index measure in-
clude several indicators which gauge perceptions of the probability
of an unconstitutional government change, domestic violence, and
terrorism. The Government Effectiveness index includes indicators
that capture the quality of public service provision, the quality of
the bureaucracy, the competence of civil servants, the independence
of the civil service from political pressures, and the credibility of the
government's commitment to policies. The Regulatory Quality index
includes price controls, inadequate bank supervision, and the percep-
tions of the burdens imposed by excessive regulation in the areas
such as foreign trade and business development. The Rule of Law
index measures perceptions of the incidence of crime, the effective-
ness and predictability of the judiciary, and the enforceability of con-
tracts. The Control of Corruption index measures perceptions of
corruption ranging from petty corruption to grand corruption.
Globerman and Shapiro (2002) have argued that these indices are
highly correlated with each other, thus it is very difcult to use them
all in a single regression equation. Appendix 2 presents correlations
on the six governance indicators described above. Our results vindi-
cate Globerman and Shapiro (2002) and Daude and Stein (2007) in
that the variables are indeed highly correlated. In some instances
the correlations are approximately the same as those observed in
Daude and Stein (2007) (such as those correlations involving political
stability and voice and accountability). In some instances (such as the
correlation of voice and accountability with government effectiveness
and rule of law) we observe a higher correlation than Daude and Stein
(2007) and Globerman and Shapiro (2002).
As a result, we follow Globerman and Shapiro (2002) by extracting
the rst principal component of the six indicators of governance using
employing factor analysis. We refer to this aggregated measure as Gov-
ernance and descriptive statistics on the same are reported in column 3
of Table 1. As displayed in Table 1, the governance indicator used in our
benchmark model ranges from 2.421 to 2.192. The observed mean
value of 0 and standard deviation of 1.0 compares quite favorably
with Globerman and Shapiro (2002) estimates of 0.01 and 0.96 respec-
tively. All other macroeconomic independent variables are drawn from

A
World, FDI % of GDP
6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%

B
Brazil, FDI % of GDP Russian Federation, FDI % of GDP
6.0% 3.5%

5.0% 3.0%

2.5%
4.0%
2.0%
3.0%
1.5%
2.0%
1.0%
1.0%
0.5%

0.0% 0.0%

India, FDI % of GDP China, FDI % of GDP

2.5% 5.0%
4.5%
2.0% 4.0%
3.5%
1.5% 3.0%
2.5%
1.0% 2.0%
1.5%
0.5% 1.0%
0.5%
0.0% 0.0%

Fig. 1. FDI inows as percent of GDP.

 B.G. Buchanan et al. / International Review of Financial Analysis 21 (2012) 8189 85

C D
Middle East & NorthAfrica, FDI % of GDP Sub-Saharan Africa, FDI % of GDP
4.5% 4.5%
4.0% 4.0%
3.5% 3.5%
3.0% 3.0%
2.5% 2.5%
2.0% 2.0%
1.5% 1.5%
1.0% 1.0%
0.5% 0.5%

0.0% 0.0%

E F
Central & Eastern Europe, FDI % of GDP East Asia & Pacific, FDI % of GDP
9% 4.5%
8% 4.0%
7% 3.5%
6% 3.0%
5% 2.5%
4% 2.0%
3% 1.5%
2% 1.0%
1% 0.5%
0% 0.0%

Fig. 1 (continued)

the WDI database. We initially collected data on 20 macroeconomic var-
iables such as ination, interest rate, human capital, consumption, cap-
ital formation, trade, GDP per capita growth, etc. As suggested by the
previous literature on FDI determinants, we rst utilize the most impor-
tant of these explanatory variables viz., GDP per capita growth (annual
%), to indicate economic growth and standards of living, and Trade (%
of GDP), to measure an outwardly oriented trade policy. Another vari-
able we employ in the FDI regression analysis is Domestic investment,
proxied by Gross capital formation (% of GDP), to represent a country's
domestic investment climate. We reason that private domestic inves-
tors receive more information regarding the host country's business en-
vironment than foreign investors. In the presence of asymmetric
information, domestic investment acts as a signal about the state of
the host economy to foreign investors. Thus, we expect to see domestic
investment crowd-in foreign direct investment.
In the volatility of FDI regression analysis we utilize Money and
quasi money growth (annual %) a variable controlled by monetary
policymakers, to proxy for monetary policy distortions. Russ (2007) as-
serts that the growth rate of money supply leads to uncertainty in the
exchange rate affecting the ows of FDI. We also expect that money sup-
ply growth would lead to higher volatility of foreign direct investment.
The following section reports our regression results on the associ-
ation between institutional quality and FDI levels as well as FDI
volatility.
5. Regression results
5.1. FDI determinants
We estimate the following model specication describing the de-
terminants of FDI:
FDI a0 a1 Governance a2 Trade a3 DomesticInv a4 GDPPCG
e: 1

Table 1
Descriptive statistics.

FDI Volatility of FDI Governance Trade Domestic investment GDP per capita growth Money and quasi money growth

Mean 5.727 60.909 0.000 89.195 22.929 3.026 24.460

Maximum 523.377 22360.300 2.192 473.510 113.578 86.345 4105.573
Minimum 82.892 0.000 2.421 14.933 23.763 31.645 64.698
Std. dev. 23.004 764.296 1.000 51.262 8.601 5.137 131.061
No. of observations 1290 1126 1272 1220 1214 1290 1175
No. of countries 164 164 164 163 162 164 150

Note: This table summarizes the descriptive statistics for the major variables in this study. FDI is measured as net inows (as a % of GDP). Volatility is measured as the variance of
FDI. GDP per capita (annual %) indicates economic growth and standards of living. Trade (measured as a % of GDP) describes the openness of the economy. Domestic investment
proxies for gross capital formation (as a % of GDP) and represents the commitment to invest in capital. Money and quasi Money growth (annual %) measures monetary policy
distortions.
Source: World Development Indicators, 2009 (WDI) database.
86 B.G. Buchanan et al. / International Review of Financial Analysis 21 (2012) 8189

Table 2
Correlations matrix.

FDI Volatility of FDI Governance Trade Domestic Investment Money and quasi money growth GDP per capita growth

FDI 1.000
Volatility of FDI 0.609 1.000
Governance 0.132 0.038 1.000
Trade 0.334 0.137 0.239 1.000
Domestic investment 0.125 0.039 0.060 0.247 1.000
Money and quasi money growth 0.002 0.069 0.125 0.040 0.044 1.000
GDP per capita growth 0.045 0.016 0.021 0.138 0.319 0.040 1.000

Note: This table summarizes the correlations for the major variables used in this study. FDI is measured as net inows (as a % of GDP). Volatility is measured as the variance of FDI.
GDP per capita (annual %) indicates economic growth and standards of living. Trade (measured as a % of GDP) describes the openness of the economy. Domestic investment proxies
for gross capital formation (as a % of GDP) and represents the commitment to invest in capital. Money and quasi Money growth (annual %) measures monetary policy distortions.
Source: World Development Indicators (2009) database.

In Table 3, we report a simple OLS regression with FDI as a depen-
dent variable in column (1). The result shows that Governance has a
positive signicant effect on FDI, as hypothesized. The coefcient of
Trade is positive and signicant, supporting the evidence that countries
that are more open can attract more FDI inows. The coefcient of
Domestic investment is also positive, indicating that countries that are
capable of mobilizing domestic resources are attractive to FDI; however,
it is insignicant. The coefcient of GDP per capita growth (GDPPCG)
is negative, suggesting that higher growth deters FDI because the
costs of doing business (labor and physical capital) are higher as the
standards of living start to rise. However, it is also not signicant.
In accordance with the literature on endogeneity, we recognize a
potential bias within our OLS results (Benassy-Quere et al., 2007;
Daude and Stein, 2007; Hall and Jones, 1999; Mauro, 1995). Countries
are not exogenously endowed with institutions that promote good
governance. Indeed governance is determined endogenously depend-
ing on the legal origins, the type of law that governs the country, and
the level of economic development. An instrument variable (IV)
estimation can be used to correct for such endogeneity, given the ap-
propriate instruments. According to Wooldridge (2000, p.472), IV
methods are intended to provide better estimates of the model.
Mauro (1995), Hall and Jones (1999), Daude and Stein (2007), and
Benassy-Quere et al. (2007) all use instrument variables in their ana-
lyses. Further, the Hausman test for endogeneity of the Governance
variable marginally rejects the hypothesis of consistent OLS estimates
(t-statistic = 1.872). Accordingly we report both OLS and IV estimates
in Table 3. Econometric tests indicate that a one standard deviation
change in institutional quality changes FDI by a factor of 1.69.
La Porta, Lopez-de Silanes, Shleifer, and Vishny (1997), La Porta,
Lopez-de Silanes, Shleifer, and Vishny (1998), La Porta, Lopez-de Silanes,
Shleifer, and Vishny (2000), and hereafter known as LLSV, have estab-
lished a link between legal environment and nancial markets. LLSV
argue that legal code origin is a signicant determinant of the quality
of governance as well as the size and scope of a country's nancial mar-
ket. For example, secure property rights, through legal enforcement and
strength of legal claims, are necessary to attract potential foreign inves-
tors. According to David and Brierley (1985), legal foundations can be
separated into several families (English, French, Scandinavian, and Ger-
man) and two primary legal systems (civil and common). LLSV nd that
French civil law countries tend to offer the weakest investor protection
and have the least developed capital markets whereas common law
countries offer stronger protection and have larger capital markets.
Our instruments are associated with the Western European inu-
ence: UK, French, Scandinavian, and German legal origins. We argue
that if the legal environment improves (this could be protecting
investors against possible expropriation) then nanciers are more
likely to invest in those markets, so FDI would likely increase. The cor-
relations between all the instruments and the grouped variables are
presented in Appendix 3. Table 3 reports the results of our IV estima-
tions. Column (2) reports the IV estimate using legal origins as instru-
ments. We note that the IV estimate of Governance has a positive and
signicant effect on FDI. The signicance of Trade remains unchanged.
The coefcient of Domestic investment has a negative sign, but is not
signicant. The coefcient of GDP per capita growth remains negative
and insignicant.
We also use Common law and lagged values of the independent vari-
ables as instruments for governance. These results are also in Table 3
(column 3). LLSV (1998) suggest the differences in legal traditions
impact market capitalization on a scaled basis with GDP. They show
that English common law countries appear to have greater market

Table 3
FDI and governance Panel regressions.

Independent variables OLS IVa IVb Fixed effects Random effects

(1) (2) (3) (4) (5)

Constant 9.628*** 6.897*** 6.374* 9.735*** 11.286***

( 4.525) ( 2.616) ( 1.847) ( 4.752) ( 4.538)
Governance 1.440** 1.691** 1.480 1.025 2.199*
(2.078) (2.248) (1.426) (0.578) (1.786)
Trade 0.150*** 0.172*** 0.159*** 0.045** 0.0845***
(10.888) (11.431) (8.649) (2.106) (4.712)
Domestic investment 0.116 0.083 0.010 0.535*** 0.475***
(1.327) ( 0.681) ( 0.066) (8.631) (4.712)
GDP per capita growth 0.101 0.129 0.405* 0.163*** 0.175***
( 0.749) ( 0.449) ( 1.671) ( 2.545) ( 2.779)
No. of countries 162 162 155 162 162
No. of observations (unbalanced sample) 1151 1151 561 1151 1151
Adjusted R2 0.12 0.11 0.14 0.86 0.08
F Statistic 39.99 40.87 23.01 45.34 27.17
[0.000] [0.000] [0.000] [0.000] [0.000]

Notes: The dependent variable is Foreign direct investment, net inows (% of GDP), 19962006 (excluded 1997, 1999, 2001). t-statistics are in parentheses. ***, **, * statistically
signicant at the 1%, 5%, 10% levels, respectively. White's heteroscedasticity correction is applied to the regression. aInstrument variables are legal origins. b Instrument variables
are common law, and lagged values of the independent variables. Goodness-of-t is not a factor; p-values are in parentheses.
 B.G. Buchanan et al. / International Review of Financial Analysis 21 (2012) 8189 87

capitalization per GDP than French law or civil law countries. Buchanan
and English (2007) show that English common law countries tend to
have lower growth rates in market capitalization and higher levels of
market capitalization scaled by gross domestic product. They suggest
that investors seeking the benets of emerging market returns select
their investments based in part on the legal foundation of the countries
in which they invest. Column 3 reports that the IV estimate of Gover-
nance has a positive sign, but it is no longer signicant. The coefcient
of Trade is robustly signicant. The coefcient of Domestic investment
remains negative, and it is not signicant. The coefcient of GDP per
capita growth has a negative and signicant effect on FDI.
The results for xed effects model and the random effects model
are presented in columns (4) and (5), respectively. The Hausman
test conrms that the random effects is applicable and its GLS estima-
tor is consistent and efcient (Chi-sq. statistic = 16.807). As displayed
in column 5, the coefcient of the Governance has a positive and signif-
icant effect, as predicted. The coefcients of Trade, Domestic investment,
and GDP per capita growth are all signicant with the expected signs.
In sum, the results in Table 3 reveal that Governance has a positive
signicant effect on FDI in three regressions out of ve specications
(viz. Columns 1, 2 and 5) suggesting that countries with good institu-
tional quality can attract more foreign investors.
5.2. Volatility of FDI results
Next we turn our attention to the volatility of FDI. The volatility of FDI
(VFDI) is the dependent variable in the following model specication:
VFDI a0 a1 Governance a2 Trade a3 M2Growth a4 GDPPCG
e 2
We also perform the Hausman test for endogeneity of the
Governance variable. The test rejects the hypothesis of consistent
OLS estimates (t-statistic = 2.376). Thus, we report both OLS and IV
estimates. Similar to the IV estimate reported in Table 3, we employ
the country legal origins as instruments in column (7) of Table 4.
The result reveals that Governance has a negative and signicant ef-
fect on the volatility of FDI. The coefcient of Trade remains positive
and signicant. The coefcients of Money and quasi money growth
and GDP per capita growth have the correct signs, but they are insig-
nicant. When we select Common law and lagged values of the inde-
pendent variables as instruments, Governance still has a negative and
signicant effect on the volatility of FDI as reported in column (8).
The coefcient of Trade is no longer signicant. The signs on the coef-
cients of Money and quasi money growth and GDP per capita growth
change from positive to negative.
The results for xed effects model and the random effects model
are presented in columns 9 and 10, respectively. The Hausman test
rejects the null hypothesis of no correlation between the error and
the regressors (Chi-sq. statistic = 3.515), thus the pooled OLS estima-
tor of the xed effects model is consistent. The xed effects model
reported in column 9 indicates that Governance has a negative and
signicant effect on the volatility of FDI. The coefcients of the control
variables remain robust.
Taken together, the results displayed in Tables 3 and 4 indicate
that Governance has a positive and signicant effect on FDI, but it
has a negative and signicant effect on the volatility of FDI in our
sample of 164 countries covering the period 19962006. This sug-
gests that good governance not only attracts more FDI inows, but
it also reduces the volatility of the inows.
6. Conclusion

We begin with the simple OLS regression reported in Table 4, col-
umn (6) which shows that Governance has a negative and signicant ef-
fect on the volatility of FDI, suggesting that countries with good
governance can reduce volatility, and therefore the uncertainty around
FDI. The coefcient of Trade is positive and signicant, per expectation.
The coefcient of Money and quasi money growth is also positive,
indicating that monetary policy distortions increase the volatility of
FDI. However, it is insignicant. Interestingly, GDP per capita growth
(GDPPCG) has a positive signicant and signicant effect on the
volatility of FDI, pointing out that in countries with high economic
growth, FDI inows are somewhat volatile, signifying considerable
uncertainty.
Foreign direct investment (FDI) is integrally associated with the
process of globalization and is widely understood to be a major ante-
cedent to economic development. In this paper we survey worldwide
and regional trends in FDI and nd that the trend in global FDI has
continued to remain on the whole, positive and remarkably stable be-
tween 1996 and 2006. On a regional basis, FDI has continued an up-
ward trend in the Middle East and North Africa and Sub-Saharan
regions. Yet even though FDI to Sub-Saharan Africa has risen strongly,
the region continues to rank poorly in terms of investor preferences.
Using panel data for 164 countries from 1996 to 2006, we also em-
pirically examine the impact of institutional quality on foreign direct
investment (FDI). In particular, we examine the association between

Table 4
Volatility of FDI and Governance Panel regressions.

Independent variables OLS IVa IVb Fixed effects Random effects

(6) (7) (8) (9) (10)

Constant 38.484 39.228 40.180** 85.371 41.101

( 1.505) ( 1.371) (2.075) ( 1.124) ( 1.136951)
Governance 52.468*** 60.818*** 31.210*** 180.690** 52.984***
( 3.647) ( 3.744) ( 2.950) ( 2.317) ( 2.557)
Trade 0.448* 0.434* 0.367** 0.696 0.457
(1.858) (0.0968) (2.254) (0.823) (1.343)
Money and quasi money growth 0.344 0.118 0.205 0.514 0.471
(1.025) (0.219) ( 0.798) (1.318) (1.360)
GDP per capita growth 4.9697** 6.558 13.238*** 4.776* 4.636*
(2.025) (1.546) ( 6.898) (1.699) (1.853)
No. of countries 149 149 141 149 149
No. of observations (unbalanced sample) 922 922 499 922 922
Adjusted R2 0.02 0.02 0.08 0.26 0.01
F Statistic 5.77 4.69 13.60 3.12 3.74
[0.0001] [0.000] [0.000] [0.000] [0.005]

Notes: The dependent variable is Volatility of Foreign direct investment, net inows (% of GDP), 19982006 (excluded 1999, 2001). t-statistics are in parentheses. ***, **, * statis-
tically signicant at the 1%, 5%, 10% levels, respectively. White's heteroscedasticity correction is applied to the regression. a Instrument variables are legal origins. b Instrument vari-
ables are common law, and lagged values of the endogenous variables. Goodness-of-t is not a factor; p-values are in parentheses.
88 B.G. Buchanan et al. / International Review of Financial Analysis 21 (2012) 8189

institutional quality and the level of FDI as well as on the volatility of Appendix A (continued)
(continued)
FDI inows. A major contribution of this paper is to refocus the liter- No. Country Code No. Country CODE
ature toward volatility of FDI inows and the role of institutional 13 Belize BLZ 55 Georgia GEO
quality. Our paper thus extends the research of Lensink and 14 BENIN BEN 56 Germany DEU
Morrissey (2006) and Daude and Stein (2007). Another novelty of 15 Bhutan BTN 57 Ghana GHA
our analysis is the utilization of an aggregate measure of governance 16 Bolivia BOL 58 Greece GRC
17 Bosnia-Herzegovina BIH 59 Grenada GRD
to avoid multicollinearity issues. 18 Botswana BWA 60 Guatemala GTM
Our econometric results lead us to conclude that institutional quality 19 Brazil BRA 61 Guinea GIN
matters to FDI. Econometric tests indicate that a one standard deviation 20 Bulgaria BGR 62 Guinea-Bissau GNB
change in institutional quality changes FDI by a factor of 1.69. Even 21 Burkina FASO BFA 63 Guyana GUY
22 Burundi BDI 64 Haiti HTI
though scholars have touted the stability of FDI ows as compared
23 Cambodia KHM 65 Honduras HND
to portfolio investment for instance, we nd that FDI can be volatile 24 CAMEROON CMR 66 Hong Kong HKG
and that such volatility has signicant institutional antecedents. Our 25 Canada CAN 67 Hungary HUN
ndings indicate that Governance (our proxy for institutional quality) 26 Cape Verde CPV 68 Iceland ISL
has a negative and signicant effect on the volatility of FDI. We address 27 Central African CAF 69 India IND
Republic
the potential endogeneity problem between Governance and 28 Chad TCD 70 Indonesia IDN
FDI by using instrument variables (IV). A battery of econometric 29 Chile CHL 71 Iran IRN
tests including IV estimations conrms the robustness of our 30 China CHN 72 Ireland IRL
results. 31 Colombia COL 73 Israel ISR
32 Comoros COM 74 Italy ITA
There are a number of possibilities for further research. The
33 Congo COG 75 Jamaica JAM
most recent nancial crisis that started in 2007 (and is still con- 34 Congo, Dem. Rep. ZAR 76 Japan JPN
tinuing) will in the future provide a possible laboratory to examine 35 Costa Rica CRI 77 Jordan JOR
the impact of governance on the level and volatility of FDI as insti- 36 Cote d'ivoire CIV 78 Kazakhstan KAZ
tutional reform is pursued. A nancial crisis often exposes weak- 37 Croatia HRV 79 Kenya KEN
38 Cyprus CYP 80 Korea, South KOR
nesses in institutional infrastructure that may have previously 39 Czech Republic CZE 81 Kuwait KWT
been masked during a credit and commodity boom. For example, 40 Denmark DNK 82 Kyrgyzstan KGZ
in the aftermath of the 1997 Asian nancial crisis, many countries 41 Djibouti DJI 83 Laos LAO
identied governance weaknesses and started to reform their 42 Dominica DMA 84 Latvia LVA
institutional policies, legislation and institutional arrangements
No. Country Code No. Country Code
in order to attract more FDI. As more data becomes available, re-
searchers will be able to examine whether appropriate institutional 85 Dominican Republic DOM 125 Lebanon LBN
86 Lesotho LSO 126 Senegal SEN
quality beneted FDI (and thereby economic growth) and reduced 87 Liberia LBR 127 Seychelles SYC
the volatility of FDI. 88 Lithuania LTU 128 Sierra Leone SLE
In summary, our results provide empirical support of the existing 89 Luxembourg LUX 129 Singapore SGP
theory on governance and FDI. Our ndings suggest that if there are 90 Macao MAC 130 Slovakia SVK
91 Macedonia MKD 131 Slovenia SVN
institutional antecedents of FDI volatility and if such volatility is asso-
92 Madagascar MDG 132 Solomon Islands SLB
ciated with lower economic growth, then the usual policy prescrip- 93 Malawi MWI 133 South Africa ZAF
tion of attracting FDI into countries by offering the correct 94 Malaysia MYS 134 Spain ESP
macroeconomic environment would be ineffective without an equal 95 Maldives MDV 135 Sri Lanka LKA
emphasis on institutional reform. 96 Mali MLI 136 St. Kitts and Nevis KNA
97 Mauritania MRT 137 St. Lucia LCA
98 Mauritius MUS 138 St. Vincent and the VCT
Grenadines
Acknowledgment 99 Mexico MEX 139 Sudan SDN
100 Moldova MDA 140 Swaziland SWZ
101 Mongolia MNG 141 Sweden SWE
The authors would like to thank participants at the 2010 ASSA
102 Morocco MAR 142 Switzerland CHE
Meetings in Atlanta, the 2010 Financial Management Meetings in 103 Mozambique MOZ 143 Syria SYR
New York and Ivo Georgiev for his excellent research support. The 104 Nepal NPL 144 Tajikistan TJK
usual disclaimers apply. 105 Netherlands NLD 145 Tanzania TZA
106 New Zealand NZL 146 Thailand THA
107 Nicaragua NIC 147 Togo TGO
108 Niger NER 148 Tonga TON
Appendix 1. List of countries 109 Nigeria NGA 149 Trinidad and Tobago TTO
110 Norway NOR 150 Tunisia TUN
111 Oman OMN 151 Turkey TUR
112 Pakistan PAK 152 Turkmenistan TKM
113 Panama PAN 153 Uganda UGA
No. Country Code No. Country CODE
114 Papua New Guinea PNG 154 Ukraine UKR
1 Albania ALB 43 Ecuador ECU 115 Paraguay PRY 155 United Kingdom GBR
2 Algeria DZA 44 Egypt EGY 116 Peru PER 156 United States USA
3 Angola AGO 45 El Salvador SLV 117 Philippines PHL 157 Uruguay URY
4 Argentina ARG 46 Equatorial Guinea GNQ 118 Poland POL 158 Uzbekistan UZB
5 Armenia ARM 47 Eritrea ERI 119 Portugal PRT 159 Vanuatu VUT
6 australia AUS 48 Estonia EST 120 Romania ROM 160 Venezuela VEN
7 Austria AUT 49 Ethiopia ETH 121 Russia RUS 161 Vietnam VNM
8 Azerbaijan AZE 50 Fiji FJI 122 Rwanda RWA 162 Yemen YEM
9 Bangladesh BGD 51 Finland FIN 123 Samoa SAM 163 Zambia ZMB
10 Barbados BRB 52 France FRA 124 Sao Tome and Principe STP 164 Zimbabwe ZWE
11 Belarus BLR 53 Gabon GAB
12 Belgium BEL 54 Gambia GMB
 B.G. Buchanan et al. / International Review of Financial Analysis 21 (2012) 8189 89

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