FDI inflows and the impact of domestic and international institutions

Abstract

As the importance of Foreign Direct Investment (FDI) in the global economy has grown, scholars have developed theories to explain the determinants of FDI inflows. In this paper, we focus on the role of institutions in attracting FDI. We agree with previous research that both domestic institutions (i.e., rule of law and the protection of property rights) and membership in international institutions (i.e. GATT/WTO) provide a credible commitment to private investors that the country protects the rules of the game, and therefore have a positive impact on FDI inflows (Ahlquist 2006, Choi and Samy 2008, Buthe and Milner 2008, Jensen 2003, 2004, 2006, Li and Resnick 2003). The logic of credible commitments is that if a developing country is vulnerable to the consequences of promise breaking, the effect of institutions should be strong. Therefore, we expect that states with strong domestic institutions and states who are members of international institutions should have higher levels of FDI inflows. However, building on Staton and Reenock (2009) we argue that the two types of institutions are substitutes for each other. Once one type of institution (domestic or international) is implemented, the effect of the other is insignificant. Using the panel-corrected standard error model (PCSE) covering non-OECD countries between1970 to 2000, we test this institutional substitution argument.