How FDI Inflows to Emerging Markets Are Influenced by Country Regulatory Factors: An Exploratory Study

Abstract

Foreign Direct Investment (FDI) inflows to emerging nations exhibit a big variation. To what extent do host-country regulatory and institutional variables attract or repel FDI? We integrate various theoretical perspectives: transaction cost economics, global value chain analysis and liability of foreignness to examine the impact of formal regulations, rule-of-law, property rights, procedural bottlenecks and infrastructure on the attractiveness of an emerging market over a 12 year period. We seek to identify which of the many regulatory variables most influence the FDI decision. We find that countries with more efficient start-up regulations, stronger protection of minority investment, and better procedures and infrastructure for international trade across their borders attract more FDI. These results have important implications for government policy reform in emerging markets, as well as for multinationals selecting which nations to invest in.

Introduction

Starting in the 1990s there was a sea-change reversal in government attitudes towards Foreign Direct Investment. The Foreign Direct Investment (FDI) to GDP ratio which had been declining for 65 years until the late 1980s, then began a sharp increase (Subramanian and Kessler, 2013). Especially in the 21st century, emerging nations have dismantled restrictions on inward FDI and have taken measures to improve their business climate in general — transitioning from a state-centralized approach to a market-based policy (Clague, 1997; Meyer, 2001).¹ Emerging countries' heads of state, from India's Modi to Russia's Putin to China's Xi announced their countries' objective to raise their nation's ranking in the World Bank's ‘Ease of Doing Business’ index (Mishra, 2014).² However, the pattern of this regulatory reform has not been even over the more than 120 emerging nations. While emerging country leaders wish to improve the regulatory climate for foreign investors, their policy makers are unclear as to which specific institutional changes most powerfully affect FDI inflows. According to Daude and Stein (2007) in terms of “…significant effect on FDI, some institutional aspects matter more than others do.” This is clearly a question of importance to government policies and MNC managers who, nowadays, will first carefully assess the business climate across several nations and then decide on which emerging country they will invest in (or shun). A broader examination of host nation regulatory institutions and the foreign firm's FDI decision to invest, therefore, is necessary.

Literatures in international economics and international business on emerging markets have focused on two host nation characteristics. The first focuses on the quality or effectiveness of the nation's rule-of-law or property rights (e.g. Meyer, 2001; Meyer et al., 2009; Jandhyala, 2013), and views MNCs as being concerned about protecting their knowledge and intellectual property rights in emerging countries. The second literature stream focuses more on the initial market entry or establishment of business (e.g. Alesina et al., 2005) – arguing that entry barriers which increase the cost of starting new business can prevent multinational companies from entering emerging markets. These two streams of literature are influenced primarily by transaction cost economics (Williamson, 1975, Williamson, 2010), but they have overlooked how other aspects of institutions play out in the FDI decision. Thus, there is a need to study host country institutions in emerging markets in a multi-pronged approach that includes transaction cost economics, but also examines other criteria in the relationship between FDI decisions and host nation institutions (Peng et al., 2008).

In this study, we ask (i) whether and how country-level regulations and institutions influence the choice made by multinational corporations (MNCs) in choosing between countries as investment destinations, and (ii) which regulatory changes (statistically) have the strongest effect on incoming FDI. We disaggregate a country's institutional climate into eight major sub-indicators using a framework developed by the World Bank: starting business regulations, registering property, getting credit, protection of minority investment, tax regulations, trade across borders, contract enforcement and resolving insolvency. Some of these variables echo a study by Contractor et al. (2020) which did not specifically focus on emerging markets, which this paper does. All eight explanatory variables have not been comprehensively tested before for all 120 to 149 emerging nations, with the objective of identifying which factors matter most. The few previous studies cited above have only sporadically covered selected regions or have tested only a couple of institutional sub-indicators. Contractor et al. (2020) covered all 189 nations, whereas the focus here is on emerging countries only, with additional explanatory variables.

This article applies and reinforces two theories: institutional theory and transaction cost economics (TCE) applicable to the foreign direct investment (FDI) process — from the point of view of both the MNC which has to choose which emerging country to invest in, as well as from the perspective of host government policies that seek to attract FDI. It augments TCE theory by showing several ways in which transaction costs and ‘asset specificity’ affect the MNE's selection of nations to invest in, and how that informs their strategies. In terms of institutional theory, it refutes Van Hoorn and Maseland's (2016) conclusion “…that current institutional research in international business is unable to explain how institutions matter for MNEs…”. This, in fact, is the overall objective of this paper. By disaggregating the institutional and regulatory set up into eight sub-categories, our objective is to identify how each type of regulation affects MNCs, and which regulatory variables particularly affect FDI going to emerging nations more so than others, depending on which of the eight hypotheses is supported or rejected. This follows Ostrom's (2010) work that indicated that a nation's institutional set up involves multiple sub-indicators.

In this paper we focus on ‘regulative’ rather than ‘cognitive’ aspects such as culture or norms, for the following reasons. First, the sub-field of cultural distance in International Business studies has been fraught with ambiguous conclusions so that there is little consensus in the literature (Shenkar, 2012, 2001; Konara and Mohr, 2019). Second, as illustrated by the rate of change of indicators in the World Values Survey, culture, cognition and societal norms only change slowly, at intergenerational rates of change (e.g., Inglehart et al., 2017), whereas our panel data only span 12 years – too short a time to reflect cultural changes. By contrast, governments are able to change regulations or FDI-protectionist barriers at the stroke of a pen – something that has occurred frequently in the 12-year period. Moreover, their measurement³ is less ambiguous compared with measurements of cultural differences or societal value changes. Third, culture and norms are, in any case to a large extent, already incorporated and reflected in the changes a government makes in its formal institutions and regulations (Holmes et al., 2013).

This paper's findings will have obvious policy implications. Governments wish to know which regulatory factors they should focus on to attract more FDI. Similarly, MNCs scan the range of emerging countries' regulations, to decide which nation to select for investment.