Inward FDI and the quality of domestic institutions: A cross-country panel VAR analysis

Highlights

• Quality of institutions helps countries attract FDI, but FDI can also affect domestic institutions.

• We use a panel VAR approach on a sample of 102 developing and transition countries across 25 years.

• Larger (greenfield) FDI inflows Granger cause voice and accountability and control of corruption in developing countries.

• Larger (greenfield) FDI inflows Granger cause voice and accountability, control of corruption, rule of law, and regulatory quality in transition economies.

Abstract

Domestic institutions are recognized as important factors in attracting foreign direct investment (FDI), and spurring economic development in host countries. There is increasing evidence, however, that FDI may in turn affect and shape domestic institutions, and it is generally difficult to disentangle these two effects. The present paper aims to shed light on this issue using extensive data on the quality of institutions and on inward FDI in 102 countries over a period of 25 years. We distinguish between different types of institution, FDI, and country, and we adopt a panel vector autoregression (VAR) approach to identify the direction of causality between the two variables. Our findings suggest that the quality of institutions matters for attracting FDI, but also that higher inflows of FDI have a significant short-term impact on the institutional quality of recipient economies. We also find that such a relationship varies with the type of FDI considered, and differs between transition and developing economies.