World Development Vol. 40, No. 9, pp.

1798–1809, 2012
Ó 2012 Elsevier Ltd. All rights reserved.
0305-750X/$ - see front matter
www.elsevier.com/locate/worlddev
http://dx.doi.org/10.1016/j.worlddev.2012.04.026

The Institutional Reforms Debate and FDI Flows to the

MENA Region: The “Best” Ensemble
WASSEEM MICHEL MINA *
United Arab Emirates University, United Arab Emirates
Summary. — This paper empirically examines the theoretical debate on the adoption of a best approach to reforming institutions iden-
tified by Rodrik (2008) in the context of property rights protection and FDI flows to eight MENA countries. The first best approach
comprises strengthening domestic institutional functions only, while the second best comprises in addition entering into force bilateral
investment treaties and the interaction between functions and treaties. Empirically both approaches to reducing investment expropria-
tion risk encourage FDI flows. The positive effect of the second best approach depends on the success of the first best approach, sug-
gesting the two approaches are complementary.
Ó 2012 Elsevier Ltd. All rights reserved.

Key words — institutional reforms, property rights protection, FDI, MENA, first best, second best

1. INTRODUCTION
Institutions are defined as the set of rules governing human
behavior (North, 1991). They include both formal and infor-
mal rules. Formal rules are legal in nature and include consti-
tutions, laws, and regulations created and enforced by the
government in response to individuals’ needs to organize inter-
actions in society. Informal rules are social in nature and in-
clude traditions and customs influenced by cultures and
beliefs.
Institutions play an important role in supporting markets
and transactions by protecting property rights, enforcing con-
tracts, and facilitating collective action to provide physical and
organizational infrastructure (Dixit, 2009). They create order,
reduce uncertainty in the exchange of goods and capital, and
help to determine transaction and production costs; thus,
institutions determine the feasibility and profitability of engag-
ing in economic activity (North, 1991).
Among the positive effects of good institutions is the promo-
tion of a country’s integration into the world economy
(Rodrik, 2008). The flow of capital constitutes one important
integration channel. As other studies have shown, Property
Rights Protection (PRP) encourages capital flows and pro-
vides incentives for investment and capital exchange.
In the examination of the influence of domestic institutions
on capital flows, empirical studies have focused mostly on
domestic PRP institutional functions. 1, 2 These studies have
used indicators of the quality of institutional functions, which
assess a country’s actual performance against industrialized
countries’ first best performance.
This assessment approach has been adopted despite diverg-
ing social and political norms between developing and emerg-
ing market economies and developed economies. This
approach implies that institutional reforms should bring the
performance of domestic institutional functions in developing
and emerging market economies in line with that of developed
countries. It may also imply that developing and emerging
market economies should adopt an orthodox approach to
reforming domestic institutions that is believed to achieve
the first best, a point that is discussed further below.
The comparison of a country’s institutional performance
against industrialized countries’ first best is understandable
1798
given the globalization that has occurred in the past quarter-
century and the growing importance of markets in resource
allocation and the conduct of economic activity. The intensifi-
cation of globalization and development of markets have
necessitated the adoption of common institutional functions
and standards, similar to the adoption of a common language
in communications, which facilitate trade and capital mobility.
However, the adoption of an orthodox approach for institu-
tional reform does not take into account a country’s unique
circumstances and the interaction of institutions within the
country. This view is supported by Rodrik (2008) who argues
that institutional reforms promoted by the World Bank, the
IMF or the WTO, to name three examples, presume the exis-
tence of a unique set of appropriate institutional arrangements
to which it is “inherently desirable” that countries conform.
He also warns that the convergence to a first best practice does
not “consider potential interactions with institutional features
elsewhere in the system” and advocates instead for institu-
tional reforms based on the theory of the second best. 3
Acting along the lines of the theory of the second best, many
governments have strengthened PRP through bilateral invest-
ment treaties that act as complements or substitutes to their
domestic institutional functions. A bilateral investment treaty
is an international legal instrument between two contracting
* The author would like to thank three anonymous reviewers, Paul
Alagidede, Luc Christiaensen, Alisa DiCaprio, Suut Dogruel, Imed Drine,
Augustin Fosu, Abdulnasser Hatemi, Magda Kandil, Jorge Martinez-
Vazquez, Wim Naude, Jeffrey Nugent, Aleksander Surdej, and participants
at the Nordic Conference on Development Economics (2010), the African
Econometric Society’s 15th Annual Conference on Econometric Modeling
for Africa (2010), the Third Summer Research Day of the Faculty of
Business and Economics at the United Arab Emirates University (2010),
and the Middle East Economic Association Meetings (2011) for useful
comments and suggestions. The author would also like to thank Lay Poh
Allonen and Ahmed Taha for excellent library services. Part of this research
was conducted while the author was a UNU-WIDER visiting scholar in
summer 2009. The financial support of the Faculty of Business and
Economics at the United Arab Emirates University (through Summer
Research Grant Program) is gratefully acknowledged. Final revision
accepted: November 9, 2011.
 THE INSTITUTIONAL REFORMS DEBATE AND FDI FLOWS TO THE MENA REGION: THE “BEST” ENSEMBLE
countries that establishes clear, simple, enforceable, and reci-
procal rules for foreign investment protection from govern-
ment expropriation. A treaty identifies the circumstances
under which expropriation can take place and the associated
compensation standards, and it establishes dispute settlement
mechanisms that facilitate foreign investment in the presence
of imperfect domestic PRP institutional functions.
This paper explores the policy debate underlying institutional
reforms that is reflected implicitly in the assessment of institu-
tional functions quality and explicitly in Rodrik’s (2008) views
on second best institutions and explores that debate in the con-
text of the Middle East and North Africa (MENA) region. In
particular, this paper empirically examines the influence on
Foreign Direct Investment (FDI) flows to MENA countries
of the second best approach for PRP, which is comprised of
bilateral investment treaties, domestic institutional functions,
and the interaction between them. The paper uses treaties en-
tered into force with high-income OECD countries, which con-
stitute about one-third of the treaties entered into force by eight
high- and middle-income MENA countries, comprising Alge-
ria, Egypt, Jordan, Lebanon, Libya, Morocco, Syria, and Tuni-
sia.
The paper uses panel data for the period of 1992–2008 and
adopts two estimation methodologies to ensure robustness.
The first is the Random and Fixed-Effects (RE/FE) dynamic
panel regression model, which takes into account nonstation-
arity, endogeneity, heteroskedasticity, autocorrelation, and
cross-panel correlation. The second is the dynamic panel
Generalized Method of Moments (GMM) model, along the
lines of Arellano and Bond (1991), which accounts for poten-
tial endogeneity. Both methodologies support the first and sec-
ond best approaches to reducing the risk of investment
expropriation to encourage FDI flows. The GMM methodol-
ogy supports the second best approach of enhancing govern-
ment stability to encourage FDI flows.
The paper contributes to the literature of development eco-
nomics and economic policy literature in two respects. First, in
examining the debate on institutional reform to strengthen
PRP, the paper stresses that the issue is not whether but
how to undertake institutional reform. Second, to the best of
our knowledge, this paper is the first in the empirical literature
to model first and second best approaches to institutional re-
forms and to apply the results in the context of international
capital flows.
The paper proceeds as follows: Section 2 summarizes the
findings of the empirical literature; Section 3 discusses the per-
formance of domestic institutional functions, the proliferation
of bilateral investment treaties, and FDI development in the
MENA region; Section 4 discusses the empirical model and
the testable hypotheses; Section 5 discusses the data challenges
and the resulting modeling approach; Section 6 discusses the
empirical issues and estimation methodology; Section 7 dis-
cusses the empirical results; and, Section 8 provides the con-
clusion.
2. EMPIRICAL LITERATURE: WHAT ARE
THE FINDINGS?
In previous work I survey three strands in the empirical cap-
ital flows literature that are relevant to this paper. 4 In the first
strand, the influence of domestic institutional functions on
capital flows, 5 I find that: (a) the quality of domestic institu-
tional functions positively influences capital flows; (b) better
institutional function quality tilts a country’s capital structure
toward equity and away from debt; (c) a country’s portfolio
1799
investment is more sensitive to institutional function quality
than FDI; and (d) the influence of domestic institutional func-
tions on FDI has been examined in different regions from a
geographical perspective with the exception of the MENA re-
gion. The first and fourth findings are of special importance
and relevance to this paper; the first finding lends major sup-
port to the first best approach to institutional reforms typically
heralded by international organizations, such as the World
Bank and the IMF, and the fourth finding identifies geograph-
ical gap in literature coverage, which this paper attempts to
fill.
In the second strand in the literature, the influence of bilat-
eral investment treaties on FDI, 6 I find: (a) the influence of
bilateral investment treaties depends on the degree of govern-
ment commitment to PRP and is surprisingly not always posi-
tive; (b) domestic institutional functions can complement or
substitute for bilateral investment treaties in attracting FDI;
and, (c) the impact of bilateral investment treaties tends to
diminish as the number of contracted treaties increases glob-
ally. Although some of these studies have explored the nature
of the relationship between bilateral investment treaties and
domestic institutional functions, whether as complements
or substitutes, 7 the perspective of institutional reforms is
explicitly lacking, with the exception of Hallward-Driemeier
(2003). 8 Two policy questions motivate and underlie the
hypotheses examined in this paper: should countries strengthen
PRP by reforming domestic PRP institutional functions
alone—a first best approach—or, should they both reform
domestic institutional functions and contract bilateral invest-
ment treaties—a second best approach?
In the third strand, on the determinants of FDI in the
MENA region, 9 I find that natural resources and human cap-
ital discourage FDI flows in GCC countries while institutional
quality, trade openness, and infrastructure development
encourage FDI flows. In MENA countries I find more gener-
ally that (a) market potential encourages FDI, (b) evidence on
economic growth is inconclusive, and (c) the level and stability
of institutional quality positively influence FDI. The concept
that institutional quality influences FDI in the MENA region
is of particular importance to this research and supports the
first best approach.
3. FDI, BILATERAL INVESTMENT TREATIES
AND INSTITUTIONAL FUNCTIONS IN THE MENA
REGION
FDI flows have varied across the MENA region as Table 1
shows. 10 Egypt has attracted the highest average level of FDI
flows during the period of 1990–2008, amounting to about
$2.6 billion and has also accumulated the highest average level
of FDI stocks, amounting to $22.6 billion. In contrast, Syria
has attracted the lowest average level of less than half a billion
dollars.
With FDI expressed in per capita terms or relative to GDP,
different countries appear to be the primary FDI recipients
during that period. Lebanon had the highest per capita aver-
ages with flows and stocks amounting to about $323 and
$1720 per capita, respectively. Lebanon had the highest aver-
age FDI flow relative to GDP (6%), and Tunisia had the high-
est FDI stock (62%).
The eight MENA countries have entered into force approx-
imately 230 treaties as Table 1 shows, about one-third of
which are with high-income OECD countries. Egypt entered
into force the largest number of treaties (64), followed by
Lebanon (36), and Morocco (35). Libya entered into force
1800 WORLD DEVELOPMENT

Table 1. FDI, bilateral investment treaties, and other indicators in MENA countries (1990–2008) (period average)
FDI flows FDI stocks Treaties Other indicators
Net Per capita % GDP Net Per capita % GDP All OECD OIL LABOR TRADE INFLATION
Algeria 680.9 21 0.8 4838.1 152.5 6.2 15 6 1616.3 6596.7 57.4 11.0
Egypt 2596.0 34.2 2.5 22568.9 313.5 25.6 64 12 806.8 2654.4 52.0 8.9
Jordan 642.8 119 4.9 5289.9 1019.1 46.2 28 10 (0.0) 5464.9 127.1 4.7
Lebanon 1269.6 322.6 6.1 6842.8 1717.7 31.5 36 14 0.1 10973.8 69.0 15.0
Libya 648.2 105.9 1.1 1965.8 338.7 3.8 8 3 1526.1 15273.4 68.4 3.3
Morocco 1146.8 39.4 2.3 13249.9 450.8 25.1 35 13 2.5 3736.5 62.6 3.3
Syria 352.7 18.8 1.2 7289.1 443.8 38 20 5 513.3 3011.3 67.8 6.7
Tunisia 841.1 86.4 3.4 13903.9 1454.4 61.9 25 11 87.7 6040.1 95.0 4.1
Notes: Treaties are counted as of June 2008. World Bank’s 2005 income classification is used in classifying countries. The units for OIL, LABOR, TRADE,
and INFLATION are in thousands of barrels per day, constant 2005 US$, percent of GDP, and percent, respectively. Appendix A to this paper provides
data sources for the different variables.

the least number (8) mainly due to the international embargo
that had been in effect until the first half of the 2000s. Lebanon
ratified the largest number of treaties with OECD countries
(14), followed by Morocco (13), Egypt (12), and Tunisia (11).
To understand the MENA region’s FDI performance and
the proliferation of bilateral investment treaties, we need to as-
sess the performance of domestic institutional functions at the
regional and country levels. We therefore compare the domes-
tic institutional function performance, both PRP and political,
to that of (24) OECD countries using the International Coun-
try Risk Guide’s (ICRG) political risk components. 11 The per-
iod under investigation is 1990–2008 during which bilateral
investment treaties proliferated in the MENA region.
Table 2 shows that, contrary to common perception, the
MENA countries’ average performance with respect to the
risk of investment expropriation (labeled “investment profile”)
and law and order is not far from the OECD average perfor-
mance. The average performance of the MENA countries on
risk of investment expropriation amounted to approximately
80% of the OECD average performance, while law and order
amounted to 72%. The performance on corruption and
bureaucracy quality was poor, however, reaching approxi-
mately 58% and 47% of the OECD averages, respectively.
Comparing political to PRP institutional functions, the
average performance of the former fared better than that of
the latter. The MENA region showed better government sta-
bility than OECD countries, outperforming them by 12%. Per-
formance related to ethnic tensions, external conflict, and
internal conflict amounted to 92%, 90%, and 82% of the
OECD averages, respectively. The worst performance, how-
ever, was on democratic accountability, amounting to approx-
imately 46% of the OECD average.
As we would like to evaluate the domestic PRP performance
of Egypt, Lebanon, and Tunisia in particular, we compare the
MENA countries’ performance in Table 2. Tunisia’s average
performance ranks first on law and order and bureaucracy
quality, second on investment profile and government stabil-
ity, but fifth on corruption. Compared to Tunisia, Lebanon’s
performance lies on the other extreme; it performed worst with
respect to corruption and government stability, second to
worst on investment profile, and fifth on law and order and
bureaucracy quality.

Table 2. Domestic institutional functions in MENA (1990–2008) (period average)

Function Property rights protection Political
IP C L&O BQ GS ET IC EC MP RP DA
Regional level
Max Institutional Score 12 6 6 4 12 6 12 12 6 6 6
MENA 7.23 2.77 4 1.79 9.2 4.56 9.11 9.96 3.03 3.51 2.64
OECD 9.09 4.77 5.57 3.78 8.25 4.97 11.1 11.04 5.77 5.62 5.73
MENA–OECD ratio 0.795 0.581 0.718 0.474 1.115 0.918 0.821 0.902 0.525 0.625 0.461
Country level
Algeria 6.8 2.3 2.4 1.8 8.3 3.1 5.7 10.4 1.1 1.2 3.2
Egypt 7 2.2 3.6 2 9.2 5.4 8.4 10.1 3.0 2.5 2.8
Jordan 7.8 3.4 4 2.2 9.2 4.7 9.4 10.3 4.6 3.3 4.0
Lebanon 6.6 1.5 3.6 1.5 7.7 4.4 7.8 6.3 2.7 2.6 4.1
Libya 7.4 3 4 1.3 8.8 4.2 9.6 9.4 2.8 4.1 1.4
Morocco 8 3 5 2 9.6 4.7 9.4 9.9 3.9 4.1 3.3
Syria 5.6 2.8 4.5 1.3 9.8 5.0 10.7 8.9 2.0 4.6 1.4
Tunisia 7.9 2.6 4.5 2 9.6 4.9 10.7 10.7 3.9 4.8 2.3
Notes: “IP,” “C,” “L&O,” “BQ,” “GS,” “ET,” “IC,” “EC,” “MP,” “RP” and “DA” are investment profile, corruption, law and order, bureaucracy
quality, government stability, ethnic tensions, internal conflict, external conflict, military in politics, religion in politics, and democratic accountability,
respectively. A higher score indicates a lower risk. The list of OECD countries is based on the World Bank’s 2005 income classification. It comprises 24
countries: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Japan, Korea, Luxembourg,
Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom, and United States. Source: Author calculations based on
ICRG data.
 THE INSTITUTIONAL REFORMS DEBATE AND FDI FLOWS TO THE MENA REGION: THE “BEST” ENSEMBLE
One important observation emerges from the assessment of
institutional function performance at the regional and country
levels. Although investment expropriation risk is believed to
be the main reason for signing bilateral investment treaties,
there are other institutional functions, such as corruption
and bureaucracy quality, which may be associated with sign-
ing bilateral investment treaties and should be considered
when assessing institutional reforms. The average total PRP
country performance for Lebanon, which is ranked last in
the region, appears to support this observation.
Finally, in looking beyond domestic institutional perfor-
mance and bilateral investment treaties, we see that common
characteristics of high FDI countries are their relatively low
oil production and high trade openness. Oil production is
moderate in Egypt, nonexistent in Lebanon, and limited in
Tunisia, as Table 1 shows. On the other hand, trade openness
is highest in Lebanon and Tunisia, with trade accounting for
approximately 70% and 95% of GDP, respectively.
4. EMPIRICAL MODEL AND TESTABLE HYPOTHESES
(a) Empirical model
Gravity models have been increasingly used in empirical
studies to explore bilateral FDI flows, such as Bellack, Leibr-
echt, and Riedl (2008), Bevan and Estrin (2004), Desbordes
and Vicard (2009), Frenkel, Funke, and Stadtmann (2004),
Hallward-Driemeier (2003), and Wei (2000). However, in the
absence of data on bilateral FDI flows for MENA countries,
it is infeasible to adopt a typical gravity model.
We should note, however, that gravity models in essence
constitute an extension of the location advantage hypothesis
of Dunning’s (1981) Ownership–Location–Internalization
(OLI) paradigm. The location advantage hypothesis argues
that location advantages have to exist in the host market for
a multinational corporation to invest in the location. These
advantages include natural and human resource endowments,
market size and potential, the degree of economic develop-
ment, the degree of openness of the economy, macroeconomic
stability, and PRP.
Of the many location advantages that characterize the
MENA region, natural resource endowments are of particular
importance because, in the MENA region, it is believed that
natural resource endowments, which include oil and natural
gas reserves, attract resource-seeking FDI. Resource-rich
MENA countries include Algeria and Libya, which are
rich in both oil and natural gas reserves, and Egypt, which
is rich in natural gas reserves. In addition some MENA coun-
tries enjoy a large population size, which is potentially a
human resource endowment when combined with education
and training. 12, 13 The respective population sizes of Egypt,
Algeria, and Morocco are approximately 84 million, 35 mil-
lion, and 32 million in 2010. We account for natural resource
endowments and human capital in the empirical model.
The empirical model expresses FDI as:
FDI it ¼ b0 þ b1 FDI itl þ b2 INSTITFN it þ b3 BIT it
þ b4 BITINSTITFN it þ b5 OILit þ b6 PRICEit
þ b7 LABORit þ b8 TRADEit þ b9 INFLATION it
þ b10 WFDIFLOWS it þ it ð1Þ
Here, FDI is FDI flows per capita, FDIit-l lagged dependent
variable, INSTITFN domestic PRP institutional function,
1801
BIT bilateral investment treaty entered into force, BIT-
INSTITFN is an interaction term between the natural loga-
rithm of domestic PRP institutional function on the one
hand and bilateral investment treaties on the other, OIL is
oil production, PRICE is oil price, LABOR is labor productiv-
ity, TRADE is trade openness, INFLATION is inflation rate,
WFDIFLOWS is world FDI flows, and e is an error term. 14
The subscripts i, t, and l are country, time, and lag indicators
with i = 1, . . . , N; t = 1, . . . , T; and l = 1,. . ., T  1. The
model is double logarithmic except for BIT and BIT-
INSTITFN. Appendix A to this paper provides more informa-
tion on variable definition and data sources.
The decision to use FDI flows as opposed to FDI stock per
capita is based on the presence of unit roots in the time series,
as discussed further in Section 6. We expressed FDI flows in
per capita terms, rather than relative to GDP, in order to
account for PRP influence on FDI flows directly and not
on FDI’s relative weight in the host country. This is similar
to the strategies used by Hallward-Driemeier (2003) and
Neumayer and Spess (2005).
The inclusion of the lagged dependent variable, FDIit-l, in
the empirical model serves two purposes. First, it accounts
for the persistence in FDI flows, especially when FDI is related
to natural resources; natural resources require flows of foreign
investment over time. Second, it mitigates the likely upward
bias in the influence of bilateral investment treaties and
domestic PRP institutional functions on FDI. This bias likely
results from the lack of bilateral FDI data and the consequent
modeling of bilateral investment treaties as discussed in the
next section. We expect its coefficient to be positive.
INSTITFN is domestic PRP institutional function. Because
PRP is a multidimensional process, we model PRP using four
ICRG political risk components: investment profile, corrup-
tion, law and order, and bureaucracy quality. These four func-
tions are outcomes of the legal and judicial systems and
government bureaucracy and are essential to PRP. The invest-
ment profile refers to the risk of investment expropriation, prof-
its repatriation, and payment delays, which clearly influence
PRP. Corruption is a threat to PRP as it enables people to as-
sume positions of power through patronage rather than ability.
Patronage threatens the rights of foreign investors because it
facilitates government expropriation of investment or can cause
direct conflicts with patrons and investors. Law and order refers
to the strength and impartiality of the legal system as well as the
popular observance of the law. Quality of bureaucracy refers to
whether the bureaucracy continues to function without drastic
changes in policy when there is a change in government leader-
ship. Higher scores indicate better performance. 15 A positive
coefficient for each of these functions is expected, and an
improvement in the performance of each of these functions is
expected to be associated with more FDI flows.
In addition to the four PRP institutional functions, we also
add government stability, which is a political institutional
function based on the correlation between FDI, the different
domestic institutional coefficients, and bilateral investment
treaties. 16 Government stability refers to the ability of the
government to carry out its declared program(s) and remain
in office. A positive coefficient of government stability is also
expected.
BIT is the annual number of bilateral investment treaties en-
tered into force. We use bilateral investment treaties entered
into force as opposed to signed treaties to account for the
actual commitment to PRP by MENA countries. Treaties
protect and promote foreign investments, compensate for
losses, and create mechanisms for dispute settlements between
1802 WORLD DEVELOPMENT
contracting parties. Therefore, the coefficient of BIT is ex-
pected to be positive.
BITINSTITFN is an interaction term that models the policy
interaction between domestic institutional functions and bilat-
eral investment treaties. A positive coefficient indicates that
bilateral investment treaties complement domestic institu-
tional functions; a negative coefficient indicates substitution.
OIL and PRICE are the oil production and price variables,
respectively. OIL is measured in thousands of barrels per day.
PRICE is the crude oil price measured as the price of Saudi
Arabian Light 34 in US$ per barrel. Because oil production re-
quires capital and technology, we expect OIL coefficient to be
positive. Similarly higher oil prices encourage the supply of oil,
at least up to the limit enforced in OPEC countries; thus, we
expect a positive PRICE coefficient. 17
We include LABOR to account for the productivity of hu-
man capital in MENA countries. The more educated the labor
force, the more productive it is. We measure labor productiv-
ity as real GDP per person employed. 18 We would expect a
positive coefficient reflecting the positive productivity influ-
ence on FDI in MENA countries.
TRADE is the degree of trade openness of the economy. It is
measured as the sum of exports and imports as a percentage of
GDP. An open economy is conducive for FDI flows; FDI
flows toward the tradable sector with potential foreign ex-
change earnings. Thus, we expect a positive coefficient.
INFLATION is a proxy for macroeconomic stability in the
economy. It is measured by the inflation rate based on either
the consumer price index or the GDP deflator. A higher infla-
tion rate is an indicator of lower macroeconomic stability and
real incomes. It therefore discourages market-seeking, but not
necessarily resource-seeking, FDI flows. A negative coefficient
is expected.
We include WFDIFLOWS to account for the business cycle
in the global economy. It is measured as world FDI inflows in
millions of US$. MENA countries are likely to obtain more
FDI flows with the expansion of the world economy and the
increase in global FDI flows; thus, a positive coefficient is ex-
pected.
(b) Testable hypotheses
We use the above empirical model to test whether a second
best approach, as opposed to a first best approach, to PRP
institutional reform has a positive influence on attracting
FDI flows to MENA countries. As mentioned in the introduc-
tion, a first best approach comprises reforms to PRP domestic
institutional functions only, whereas a second best approach
comprises reforms to domestic PRP institutional functions in
addition to entering into force bilateral investment treaties,
and the interaction between the two.
(i) First hypothesis:
A first best approach to PRP institutional reform has a po-
sitive influence on FDI flows to MENA countries.
H0 : b2 6 0
H1 : b2 > 0
(i) Second hypothesis:
A second best approach to PRP institutional reform has a
positive influence on FDI flows to MENA countries.
H0 : b2 6 0; b3 6 0; b4 6 0
H1 : b2 > 0; b3 > 0; b4 > 0
5. DATA AND MODELING APPROACH
(a) Data and issues
FDI data are obtained from UNCTAD’s FDI online data-
base. Because of the variation in FDI flows per capita across
countries, we take the natural logarithm as stated in the empir-
ical model. To get around zero and negative values of FDI
flows, we use the same approach adopted by Blonigen and
Davies (2004) and Neumayer and Spess (2005) as discussed in
Kerner (2009). If the value of FDI flows is zero, we add one dol-
lar and take the natural logarithm, which results in a value of
zero. If the value of FDI flows is negative, we take the negative
of the natural logarithm of the absolute value of FDI flows. The
same approach is used with INSTITFN and OIL. Data on bilat-
eral investment treaties are also obtained from UNCTAD’s
FDI online database. We select the high-income OECD partner
countries for each of the MENA countries.
(b) Modeling approach
The lack of bilateral FDI flows data has constituted an
empirical challenge for this study. Unlike previous studies,
which used bilateral FDI flows data and adopted gravity mod-
els, this study uses aggregate-level FDI data. The unavailabil-
ity of bilateral FDI data has affected the modeling approach of
bilateral investment treaties; thus, we must use a count of the
number of treaties entered into force.
This approach has its pros and cons. It is a simple and
straightforward solution to the absence of bilateral FDI data.
However, it may result in an upward BIT coefficient bias if
there are positive FDI flows from countries with which treaties
have been signed but not entered into force or with which
there are no treaties. Second, the adopted modeling approach,
which is based on the number of treaties that each country en-
ters into force, implies that treaties are weighted equally in
terms of promoting and protecting foreign investment.
This assumption is not totally unrealistic from empirical and
legal perspectives. Although in principle the number of bilat-
eral investment treaties is related to the size of economy and
should be weighted accordingly, the correlation coefficients
of GDP, population size, labor force, and natural resources
are small. 19 Additionally, the number of OECD countries lim-
its the number of treaties that MENA countries can enter into
force. Further, from a legal perspective, the assumption is not
unrealistic given the tendency in many cases for countries to
adopt bilateral investment treaties as models with standard-
ized articles and clauses and to broadly define investment in
such a way that reflects the interest in protecting and encour-
aging foreign investment in all its forms, present and
future. 20, 21
6. EMPIRICAL ISSUES AND ESTIMATION
METHODOLOGY
In constructing the empirical model, a number of issues
should be considered: nonstationarity, endogeneity, heteroge-
neity, and serial correlation. 22 We address these issues by
adopting RE/FE and GMM estimators.
(a) Nonstationarity
In the presence of nonstationarity, we could end up with
spurious regressions. Therefore, to detect nonstationarity, we
 THE INSTITUTIONAL REFORMS DEBATE AND FDI FLOWS TO THE MENA REGION: THE “BEST” ENSEMBLE
use a battery of panel unit root tests. The first test is the Levin,
Lin, and Chu (LLC) unit root test, which assumes identical
first-order autoregressive coefficients across countries. The test
involves the following regression equation:
X
k
Dy it ¼ ai þ ci y it1 þ aj Dy itj þ eit
j¼1
The subscripts i and t are country and time indicators with
i = 1, . . . , N and t = 1, . . . ,T. The null hypothesis H0: ci ¼
c ¼ 0; 8 i against the alternative hypothesis H1: c1 ¼ c2 ¼
   ¼ cN < 0; 8i:
We also use the Im, Pesaran, and Shin (IPS) W-stat and the
Augmented Dickey Fuller–Fisher Chi-squared tests, which al-
low the first-order autoregressive coefficients to vary across
countries under the alternative hypothesis H1: ci < 0; 8i. 23
(b) Endogeneity
Endogeneity is defined in terms of the correlation between
the explanatory variables and the error term. It results in
inconsistent Ordinary Least Squares (OLS) estimates. Endoge-
neity may result from unobservable country-specific effects,
simultaneity, and variable omission.
In panel data, endogeneity may result from the presence of
time-invariant, unobservable, country-specific effects. Such
unobservable effects result in a correlation between the explan-
atory variables or lagged dependent variable and the error
term. In the presence of unobservable country-specific effects,
one can adopt Fixed Effects (FE) or Random Effects (RE) esti-
mators. If the individual country effects are assumed to be a
fixed constant over time and can be estimated, then one can
adopt the fixed effects estimator. Alternatively, if they are as-
sumed to be randomly distributed, then one can adopt a RE
estimator. To confirm the selection of one type of model over
the other, we use a Hausman specification test.
Endogeneity may also result from simultaneity, variable
omission, and measurement error. Simultaneity arises from
the reverse causality between FDI inflows on the one hand
and bilateral investment treaties entered into force and domes-
tic institutional functions on the other. In dealing with simul-
taneity, we conduct a Granger-causality test on the stationary
time series to identify whether FDI Granger causes INSTI-
TFN, BIT, or any of the explanatory variables. If we identify
any reverse causality, we lag that explanatory variable.
Lagging the explanatory variable is one way to deal with
endogeneity, as Neumayer and Spess (2005) and Tobin and
Rose-Ackerman (2006) have shown.
Variable omission can be associated with unobservable
country-specific effects such as the strength of a MENA coun-
try’s relations with a bilateral investment treaty partner or
with variables that can influence FDI flows but cannot be in-
cluded in the empirical model due to data unavailability, such
as the ownership advantages of foreign corporations.
In facing this and other sources of endogeneity, we adopt a
dynamic panel GMM approach in estimating the empirical
model given in Eqn. (1) following Arellano and Bond
(1991). To explain the GMM estimator, consider the following
empirical model:
y i;t ¼ ay i;t1 þ b0 X i;t þ li þ mi;t i ¼ 1; . . . ; N t ¼ 1; . . . ; T
where yi,t is the dependent variable and Xi,t is the vector of
explanatory variables, and the subscripts i and t denote coun-
try and time periods. The error term comprises unobservable
1803
country effect, li , in addition to a disturbance term mi;t . The
lagged dependent variable is correlated with the country effect
li and thus the error term li þ mi;t . To eliminate the unobserv-
able country effect, the GMM estimator takes the first differ-
ence:
ð2Þ Dy i;t ¼ aDy i;t1 þ b0 DX i;t þ Dmi;t ð4Þ
Although the unobservable country effect is eliminated with
differencing, an endogenous bias may still arise from the cor-
relation between the lagged difference of the dependent vari-
able and the error term. In this case we use instrumental
variables. The difference GMM estimator uses the lagged levels
of the explanatory variables as instruments on two conditions:
that the error term of the differenced equation is not serially
correlated and that the lagged levels of the explanatory vari-
ables are weakly exogenous. We write the moment conditions
as follows:
E½y i;ts ðmi;t  mi;t1 Þ ¼ 0 for s P 2; t ¼ 3; . . . ; T ð5Þ
E½X i;ts ðmi;t  mi;t1 Þ ¼ 0 for s P 2; t ¼ 3; . . . ; T ð6Þ
To ensure that these moment conditions are satisfied, we test
the lack of second-order serial correlation and use a Sargan
test of over-identifying restrictions to test for instrument valid-
ity.
(c) Heterogeneity and serial correlation
The performance of MENA countries is heterogeneous with
respect to FDI inflows, domestic institutional functions, and
the number of bilateral investment treaties entered into force,
as well as the natural and human resource endowments, as dis-
cussed in Section 3. This is likely to generate heteroskedasticity
in the error term. In the presence of heteroskedasticity, coeffi-
cient estimates are consistent but inefficient, and their standard
errors will be biased and result in inference problems. We con-
duct a Wald test for panel heterogeneity on the empirical mod-
els containing a stationary time series, and the lagged
explanatory variables that the Granger-causality tests detected
were endogenous.
In the presence of serial correlation, coefficient estimates are
consistent but inefficient, and the standard errors are biased.
To detect the presence of serial correlation, we conduct a test
for serial correlation in the idiosyncratic errors of a linear pa-
nel-data model as demonstrated by Wooldridge (2002). Final-
ly, we test whether the panels are correlated or independent of
each other using the Breusch–Pagan LM test of independence.
7. EMPIRICAL RESULTS
We report the panel unit root test results in Table 3. The re-
sults indicate that FDI is stationary in the level. We also see
that not all domestic institutional functions INSTITFN are
stationary in the levels. Corruption, law and order, and gov-
ernment stability are stationary in level. However, for invest-
ment profile and bureaucracy quality, the LLC test indicates
their stationarity based on a rejection of the null hypothesis
of a common unit root in the panel of eight countries. IPS
and ADF-Fisher tests, on the other hand, fail to reject the null
ð3Þ hypothesis of individual unit roots. However, the three tests
do indicate the stationarity of the two series in difference form.
We therefore use these two variables in difference form. 24 The
stationarity results of WFDIFLOWS are similar to those of
the investment profile and bureaucracy quality. BIT and the
1804 WORLD DEVELOPMENT

Table 3. Panel unit root tests

Variable (log) Variable form LLC IPS ADF-Fisher Decision
FDI Level 11.344a 3.504a 34.016a Stationary
INSTITFN
Investment profile Level 2.483a .890 18.254 Mixed
Difference 7.783a 5.505a 58.647a Stationary
Corruption Level 19.454a 7.897a 23.246c Stationary
Law and order Level 7.742a 6.330a 65.190a Stationary
Bureaucratic quality Level 2.360a .763 11.501 Mixed
Difference 2.820a 2.424a 12.986a Stationary
Government stability Level .8.791a 5.410a 55.388a Stationary
BIT Level 7.185a 6.024a 58.498a Stationary
BITINSTITFN
Investment profile Level 2.660a 2.623a 29.447a Stationary
Corruption Level 3.732a 3.032a 30.400a Stationary
Law and order Level 2.553a 2.762a 30.574a Stationary
Bureaucratic quality Level 1.386c 1.933b 20.825c Stationary
Government stability Level 2.461a 2.651a 29.579a Stationary
OIL Level .474 1.439 13.69 Nonstationary
Difference 6.223a 5.297a 52.034a Stationary
PRICE Level 11.534 8.559 0.012 Nonstationary
Difference 12.421a 9.539a 97.011a Stationary
LABOR Level 2.636 4.73 7.426 Nonstationary
Difference 10.344a 8.058a 77.353a Stationary
TRADE Level 1.493 2.174 10.604 Nonstationary
Difference 6.981a 5.189a 55.009a Stationary
INFLATION Level 0.882 0.605 15.335 Nonstationary
Difference 13.042a 10.816a 104.52a Stationary
WFDIFLOWS Level 2.061b 0.599 12.512 Mixed
Difference 1.539c 4.052a 43.080a Stationary
Notes: LLC tests for common unit root, while IPS and ADF-Fisher test for individual unit roots. Panel unit root tests include individual intercept,
respectively. BITINSTITFN is in level.
a
Significance at p < 0.01 level.
b
Significance at p < 0.05 level.
c
Significance at p < 0.1.

interaction terms are stationary in level. The remaining Table 4. Granger causality test results
explanatory variables OIL, PRICE, LABOR, TRADE, and Variable Variable form Test statistic
INFLATION are stationary in difference form.
INSTITFN
We report in Table 4 the results of the Granger-causality
Investment profile Level 0.927
tests assessing whether FDI Granger-causes INSTITFN, Investment profile Difference 0.071c
BIT, or any of the explanatory variables. The results are re- Corruption Level 0.43
ported for one lag. Test statistics indicate the rejection of the Law and order Level 0.256
null hypothesis of FDI not Granger-causing investment pro- Bureaucracy quality Level 0.033b
file, government stability, BIT, PRICE, LABOR, and INFLA- Bureaucratic quality Difference 0.572
TION. Test statistics also indicate the rejection of the null for Government stability Level 0.035b
the interaction terms, except for that between bilateral invest- BIT Level 0.031b
ment treaties and corruption. Accordingly, we lag these vari- BITINSTITFN
ables twice in the empirical model. Investment profile Level 5.391b
In Table 5, we report the results of heteroskedasticity, serial Corruption Level 1.008
correlation, and panel independence. The results of the Wald Law and order Level 4.974b
test for panel heterogeneity indicate that the null hypothesis Bureaucratic quality Level 7.338a
of homoskedasticity is rejected at the 1% level. The results Government stability Level 4.825b
of the Wooldridge test of serial correlation indicate the rejec- OIL Difference 0.816
tion of the null hypothesis of no serial correlation at the 1% PRICE Difference 0.047b
level. Finally, the results of the Breusch–Pagan LM test of LABOR Difference 0.014b
independence also indicate the rejection of independence at TRADE Difference 0.367
the 10% level. INFLATION Difference 0.038b
When the Hausman specification tests recommend the adop- WFDIFLOWS Difference 0.331
tion of the RE model in most specifications, we adopt the fea- Notes: Null hypothesis: FDI does not Granger-cause the explanatory
sible Generalized Least Squares (GLS) estimation variable. Granger causality test results are reported for one lag. Variable
methodology. We also take into account the results of heter- form, whether level or difference, is based on the panel unit root tests
oskedasticity, serial correlation, and panel independence tests. reported in Table 3. p values reported in test statistic.
a
When Hausman specification tests suggest the adoption of an Significance at p < 0.01 level.
b
FE model, we report the robust estimates. Significance at p < 0.05 level.
c
Significance at p < 0.1 level.
 THE INSTITUTIONAL REFORMS DEBATE AND FDI FLOWS TO THE MENA REGION: THE “BEST” ENSEMBLE 1805

Table 5. Diagnostic tests The first lag of the dependent variable has a positive, and
INSTITFN Homoskedasticitya Serial Independencec mostly unitary, influence on FDI flows, which implies the per-
correlationb sistence of FDI flows to the region. As column 1 suggests, a
1% increase in the last period’s FDI flows increases current
Investment profile 0.000 0.000 0.088
FDI flows by 0.92%.
Corruption 0.000 0.000 0.093
Among the different domestic institutional functions that
Law and order 0.000 0.000 0.08
influence FDI flows, a lessening in the risk of investment expro-
Bureaucratic quality 0.000 0.000 0.086
priation and improvement in government stability have a posi-
Government stability 0.000 0.000 0.037
tive influence, while an improvement in corruption (i.e., less
Notes: Test statistics are reported for models containing the domestic corruption) has a surprisingly negative influence. As the invest-
institutional function in the first column. ment profile is in difference form, a 1% improvement in the
a
Modified Wald test for groupwise heteroskedasticity; the null hypothesis
growth rate of the investment profile results in an increase in
is homoskedasticity.
b
Wooldridge tests for autocorrelation in panel data; the null hypothesis is FDI flows of 0.7%. This positive influence holds regardless of
that no autocorrelation exists. the inclusion of the interaction term in the model. Government
c
Breusch–Pagan LM test of independence of cross-section residuals; the stability on the other hand has a striking but nonrobust posi-
null hypothesis is independence. p values reported. tive influence on FDI flows. With government stability in level
rather in difference, an improvement in government stability by
1% results in an increase in FDI flows of more than 3%. How-
(a) RE and FE estimates ever, this positive influence becomes statistically insignificant
when the interaction term is included in the model.
Table 6 reports the RE and FE estimates. Unless otherwise In contrast to investment profile and government stability, a
noted in the column heading, the RE estimates are reported. decrease in corruption has a surprisingly negative and robust

Table 6. Institutional functions, bilateral investment treaties, and FDI flows to nonGCC countries—RE (FGLS) and FE estimation (based on common and
individual panel unit roots and Granger-causality test statistics). Dependent variable: log of FDI inflows per capita
Variables (form) (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)
IP IP+ C C/FE C+ L&O L&O+ BQ BQ+ GS/FE GS+/FE
FDI (L) 0.918a 0.909a 0.848a 0.541a 0.851a 0.893a 0.845a 0.891a 0.867a 0.509a 0.505a
(0.059) (0.060) (0.062) (0.173) (0.064) (0.061) (0.068) (0.063) (0.064) (0.157) (0.153)
FDI (L2) 0.141b 0.139b 0.124b 0.038 0.122b 0.124b 0.082 0.115c 0.097 0.047 0.071
(0.056) (0.058) (0.059) (0.145) (0.062) (0.059) (0.067) (0.062) (0.063) (0.141) (0.136)
INSTITFN (*) 0.700b 0.695c 0.699a 1.761b 0.782a 0.069 0.156 0.034 0.041 3.151b 2.245
(0.356) (0.370) (0.133) (0.708) (0.143) (0.371) (0.435) (0.388) (0.399) (1.388) (1.480)
BIT (L2) 0.142a 0.462 0.113b 0.054 0.124b 0.136b 0.274 0.131b 0.035 0.028 3.430
(0.055) (0.675) (0.052) (0.115) (0.054) (0.056) (0.529) (0.058) (0.205) (0.128) (3.842)
BITINSTITFN (**) 0.165 0.152b 0.264 0.292 1.496
(0.332) (0.065) (0.347) (0.304) (1.672)
OIL (D) 0.154 0.144 0.102 0.008 0.161 0.100 0.100 0.099 0.092 0.037 0.070
(0.131) (0.135) (0.135) (0.210) (0.151) (0.134) (0.153) (0.135) (0.139) (0.207) (0.217)
PRICE (L2.D) 0.530a 0.603a 0.262b 0.239 0.302b 0.398a 0.356b 0.399a 0.405b 0.502 0.487
(0.136) (0.152) (0.134) (0.343) (0.135) (0.136) (0.160) (0.153) (0.159) (0.363) (0.367)
LABOR (L2.D) 3.636a 3.888a 6.415a 3.241 6.305a 4.338a 4.382a 4.481a 4.139a 1.972 1.490
(1.319) (1.421) (1.138) (2.966) (1.240) (1.263) (1.289) (1.256) (1.323) (2.844) (3.034)
TRADE (D) 2.933a 2.913a 2.283a 2.749 2.415a 2.686a 2.962a 2.538a 2.385a 2.148 2.474
(0.545) (0.570) (0.518) (1.943) (0.544) (0.542) (0.558) (0.549) (0.568) (1.800) (1.654)
INFLATION (L2.D) 0.154b 0.158b 0.048 0.006 0.054 0.150b 0.145c 0.155b 0.144c 0.075 0.102
(0.074) (0.078) (0.070) (0.144) (0.072) (0.074) (0.077) (0.076) (0.077) (0.157) (0.165)
WFDIFLOWS (D) 0.268 0.218 0.269 0.726 0.412b 0.275 0.412c 0.264 0.300 0.916 0.893
(0.182) (0.195) (0.168) (0.560) (0.178) (0.185) (0.220) (0.198) (0.212) (0.599) (0.586)
Constant 0.607a 0.636a 1.412a 2.842b 1.380a 0.750 0.880 0.637a 0.666a 5.522b 3.541
(0.147) (0.151) (0.220) (1.163) (0.232) (0.631) (0.697) (0.138) (0.143) (2.704) (3.059)
Observations 120 120 120 120 120 120 120 120 120 120 120
R-squared 0.644 0.648 0.654
Wald test v2 756.51a 687.1a 942.4a 11.66a 995.34a 793.6a 576.9a 803.32a 786.62a 9.99a 10.24a
t statistic
H0: b2 6 0 1.966b 1.878b 5.256 2.487 5.469 0.186 0.359 0.088 0.103 2.270a 1.517c
H0: b2 + b3 + b4 6 0 1.835b 3.352 0.305 0.515 0.101
Notes: “IP,” “C,” “L&O,” “BQ,” and “GS” are investment profile, corruption, law and order, bureaucracy quality, and government stability, respectively.
+ indicates the inclusion of BITINSTIFN in the regression model. L, L2, and D refer to the first lag, second lag, and difference, respectively. RE (FGLS)
estimation is used unless otherwise noted. Robust standard errors are in parentheses. Heteroskedasticity and within (panel specific AR1) and across
correlations are accounted for. The one-sided critical t values at the 1%, 5%, and 10% levels for df = 120 are 2.358, 1.658, and 1.289, respectively.
*
The second lags of the difference of IP and BQ are used, while for GS the second lag is used. BIT is the annual number of bilateral investment treaties.
**
The second lags of the interaction term with IP, L&O, BQ, and GS are used.
a
Significance at p < 0.01 level.
b
Significance at p < 0.05 level.
c
Significance at p < 0.1 level.
1806 WORLD DEVELOPMENT

influence. As the RE and FE estimates show in columns 3, 4, ens. In other words, there is institutional complementarity be-
and 5, an improvement or lessening in corruption by 1% de- tween corruption and bilateral investment treaties.
creases FDI flows by approximately 0.7% and 1.8% and by Finally LABOR, TRADE, and PRICE have positive and
approximately 0.8% when an interaction term is included in statistically significant coefficients suggesting that more labor
the empirical model. This result may suggest that less corrup- productivity, trade openness, and higher oil prices result in
tion is associated with better economic policies, which pro- more FDI flows. The LABOR and TRADE coefficients are
mote more domestic savings and investment and reduce the largest, suggesting that labor productivity and trade open-
reliance on foreign capital. The influence of law and order ness are the most influential FDI drivers in MENA countries.
and bureaucracy quality is statistically insignificant.
The influence of bilateral investment treaties seems mixed, (b) GMM estimates
however the statistically significant influence is positive. This
positive influence is observed in some of the specifications Given the nature of the difference GMM estimator, and to
containing investment profile, corruption, and law and or- examine the influence of the annual number of bilateral invest-
der. Bilateral investment treaties with OECD countries can ment treaties, we include in the estimation the total (cumula-
therefore be considered useful in the promotion of FDI tive) number of bilateral investment treaties. Additionally, in
flows. all specifications, we fail to reject the null hypotheses of the
The interaction between bilateral investment treaties and Sargan over-identification and serial correlation tests and con-
domestic institutional functions is statistically insignificant, clude that instruments are not correlated with the residuals,
with the exception of the interaction with corruption. Such and errors in first difference regression exhibit no second-order
interaction is positive and statistically significant at the 5% le- serial correlation.
vel. This suggests that bilateral investment treaties increase GMM estimates are mostly similar to the RE/FE estimates.
FDI flows per capita as corruption in MENA countries less- We should keep in mind that the dependent variable is now the
Table 7. Institutional functions, bilateral investment treaties, and FDI flows to nonGCC countries—GMM estimation. Dependent variable: log of FDI inflows
per capita
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
IP IP+ C C+ L&O L&O+ BQ BQ+ GS GS+
FDI (L.D) 0.327a 0.313a 0.362a 0.362a 0.379a 0.355a 0.349a 0.342a 0.350a 0.343a
(0.107) (0.111) (0.101) (0.103) (0.093) (0.092) (0.074) (0.083) (0.101) (0.104)
FDI (L2.D) 0.126 0.125 0.125 0.113 0.141 0.120 0.075 0.058 0.166 0.155
(0.149) (0.135) (0.175) (0.177) (0.184) (0.179) (0.230) (0.211) (0.153) (0.150)
INSTITFN (D) 2.911a 4.089a 0.735 0.498 0.248 0.210 1.707 2.484 4.332b 6.253a
(0.700) (0.848) (0.658) (0.614) (0.623) (0.582) (1.334) (1.548) (2.027) (2.402)
BIT (D) 0.073 0.941a 0.043 0.000 0.043 0.432a 0.110 0.307a 0.022 1.038b
(0.058) (0.236) (0.067) (0.083) (0.071) (0.098) (0.088) (0.115) (0.072) (0.436)
BITINSTITFN (D) 0.471a 0.120b 0.329a 0.608a 0.474b
(0.107) (0.060) (0.086) (0.201) (0.196)
OIL (D) 0.173 0.301b 0.437b 0.560b 0.352b 0.407a 0.495c 0.565b 0.349b 0.380b
(0.173) (0.152) (0.185) (0.222) (0.165) (0.126) (0.260) (0.252) (0.176) (0.162)
PRICE (D) 0.955a 0.991a 0.483a 0.383b 0.484a 0.445a 0.473b 0.492b 0.981a 0.830b
(0.237) (0.194) (0.174) (0.158) (0.164) (0.156) (0.187) (0.215) (0.361) (0.367)
LABOR (D) 0.369 0.337 1.062 0.559 1.761 0.920 1.124 0.694 2.087 0.137
(1.485) (1.224) (1.760) (2.070) (1.286) (1.456) (1.808) (1.684) (1.787) (2.107)
TRADE (D) 2.844b 3.375a 2.571 2.918 2.361 2.698 2.983c 3.107b 2.632c 2.829b
(1.370) (1.071) (1.768) (1.857) (1.834) (1.774) (1.738) (1.391) (1.487) (1.395)
INFLATION (D) 0.254b 0.253b 0.253b 0.212b 0.267b 0.259b 0.244a 0.331a 0.115b 0.070
(0.100) (0.113) (0.107) (0.098) (0.104) (0.110) (0.071) (0.102) (0.050) (0.058)
WFDIFLOWS (D) 0.219 0.362 0.414 0.509 0.309 0.386 0.266 0.259 0.090 0.226
(0.414) (0.435) (0.477) (0.498) (0.430) (0.403) (0.473) (0.444) (0.379) (0.428)
Constant 0.050 0.125 0.004 0.004 0.063 0.040 0.097 0.064 0.046 0.057
(0.123) (0.113) (0.161) (0.161) (0.126) (0.125) (0.137) (0.125) (0.137) (0.135)
Observations 136 136 136 136 136 136 136 136 136 136
Wald test v2 89.7a 260.28a 159.2a 60.63a 267.91a 182.8a 738.9a 638.7a 110.3a 153.4a
Sargan test v2 143.66 140.32 139.8 138.7 140.4 140.2 138.55 134.8 134.4 128.2
Serial correlation test (p values) 0.429 0.445 0.437 0.426 0.439 0.426 0.38 0.371 0.575 0.61
t statistic
H0: b2 6 0 4.159a 4.822a 1.117 0.811 0.398 0.361 1.280 1.605 2.137b 2.603a
H0: b2 + b3 + b4 6 0 4.803a 0.998 0.550 1.521 2.602a
Notes: “IP,” “C,” “L&O,” “BQ,” and “GS” are investment profile, corruption, law and order, bureaucracy quality, and government stability, respectively.
+ indicates the inclusion of BITINSTIFN in the regression model, respectively. One-step GMM estimator results are reported. Robust standard errors are
in parentheses. L, L2, and D refer to the first lag, second lag, and difference, respectively. BIT is the cumulative rather than the annual number of bilateral
investment treaties entered into force. H0 for Sargan over-identification test: instruments not correlated with residuals. H0 for serial correlation test: errors
in first-difference regression exhibit no second-order serial correlation. The one-sided critical t values at the 1%, 5%, and 10% levels for df = 120 are 2.358,
1.658, and 1.289, respectively.
a
Significance at p < 0.01 level.
b
Significance at p < 0.05 level.
c
Significance at p < 0.1 level.
 THE INSTITUTIONAL REFORMS DEBATE AND FDI FLOWS TO THE MENA REGION: THE “BEST” ENSEMBLE
growth rate of FDI flows. The lagged growth rate has a posi-
tive influence on the current growth rate, suggesting the persis-
tence of growth rates.
The risk of investment expropriation and government stabil-
ity positively influence FDI flows, as Table 7 shows. An
improvement in the growth rate of investment profile by 1%, re-
sults in a tripling or quadrupling of the growth rate of FDI flows,
with an even higher magnitude for government stability. The po-
sitive influence of bilateral investment treaties is observed in
some of the specifications containing investment profile, law
and order, bureaucracy quality, and government stability.
The coefficients of the interaction terms between bilateral
investment treaties and domestic institutional functions are
negative in all specifications. Thus, the dynamic panel GMM
estimator suggests that bilateral investment treaties are substi-
tutes for domestic institutional functions in MENA countries.
Similar to most OIL estimates obtained in the RE/FE mod-
el, OIL coefficients are positive, but are statistically significant
and with much higher magnitude. PRICE coefficients are also
much higher than the RE/FE estimates. TRADE coefficients
are similarly positive and statistically significant.
Unlike the RE/FE estimates, LABOR coefficients are statis-
tically insignificant in all specifications. Also INFLATION
coefficients are negative and suggest that the growth in infla-
tion rate discourages the growth rate in FDI flows.
(c) Institutional reform hypotheses
The two hypotheses regarding a first best or a second best
approach to PRP institutional reforms can now be tested
based on the estimates obtained under both methodologies
in Tables 6 and 7. Both methodologies reject the null hypoth-
esis that a first best approach to reducing the risk of invest-
ment expropriation and government stability has no
influence on FDI flows to MENA countries; the strengthening
of these two domestic PRP institutional functions has a posi-
tive influence on FDI flows. Both methodologies also reject
the null hypothesis that a second best approach to reducing
the risk of investment expropriation has no influence; PRP
can be strengthened by entering into force bilateral investment
treaties with OECD countries in addition to increasing inves-
tor protection domestically.
The GMM estimates reject the null hypothesis that a second
best approach to enhancing government stability has no influ-
ence on FDI flows. FE estimates do not reject this null hypoth-
esis.
NOTES
1. By PRP institutional functions we refer to the outcomes of domestic
institutions, mainly the legal and judicial systems and the government
bureaucracy, which influence the PRP process. Examples of these
functions are the issuance of laws, the enforcement of laws, contracts
and order, the restriction of government’s power to expropriate and
extract rents, and the control of corruption.
2. See, for example, Alfaro, Kalemli-Ozcan, and Volosovych (2008),
Asiedu (2006), Busse and Hefeker (2007), Daude and Fratzscher (2008),
Daude and Stein (2007), Du, Lu, and Tao (2008), Faria and Mauro
(2009), Kraay and Nehru (2006), Lane (2004), Mina (2006), Mina and
Martinez-Vazquez (2006), Mishra and Daly (2007), Naude and Krugell
(2007), and Wei (2000).
3. Using Ghana and Vietnam as examples, Rodrik (2008) argues that
despite the presence of commercial laws, courts are highly inefficient,
1807
8. CONCLUSION AND POLICY IMPLICATIONS
In this research we explore how MENA countries can ap-
proach institutional reforms that strengthen PRP. A first best
approach is to strengthen their domestic institutional func-
tions to approach the performance of industrialized countries.
Alternatively, countries may elect to sign and enter into force
bilateral investment treaties in tandem with improving their
institutional functions—a second best approach.
We examine this institutional reform debate in the context
of FDI flows to MENA countries. The results confirm that
reducing the risk of investment expropriation and improving
government stability have a positive influence on FDI flows
to MENA countries.
The results also confirm the joint positive influence of
domestically reducing the risk of investment expropriation
and entering into force bilateral investment treaties with
OECD countries. However, the interaction between domestic
institutional strengthening and entering into force bilateral
investment treaties to strengthen PRP has a negative influence
on FDI flows.
The policy implications of the results of this paper are
important. First, to continue attracting FDI flows, MENA
countries need to protect investors and enhance government
stability. Government expropriation of foreign investment cre-
ates uncertainty about the return on investment and deters
investment. Similarly, government instability generates uncer-
tainty about the economic and political principles of the coun-
try, which essentially govern foreign investments.
Second, when the attempt to strengthen domestic institu-
tional functions is fraught with challenges and/or MENA gov-
ernments wish to speed reforms and send strong signals about
their commitment to PRP, it is beneficial to sign and enter into
force bilateral investment treaties. However, the influence of
bilateral investment treaties is not as strong as that of domestic
institutional strengthening. The adoption of a second best ap-
proach to strengthening PRP encourages FDI flows, but its suc-
cess or positive influence is dependent on the success of the first
best approach. The reform of domestic institutional functions is
inevitable for the success of bilateral investment treaties.
Finally, the question of whether MENA countries should
adopt a first or a second best approach to institutional reforms
is a mere theoretical question. The empirical results indicate
that the success of the second best approach is dependent on
the success of the first best approach, thus the two bests be-
come an ensemble.
costly to use, and potentially corruptible. In response, firms resort to
relational contracting as an alternative, building long-term relationships
with each other and sustaining cooperation through repeated interaction.
Long term relational contracting is regarded as (better) informal substitute
to the (weak) formal PRP institutions.
4. For the sake of brevity, we focus on the main messages of the
literature and leave the literature survey to Mina (2010, 2011).
5. Findings are based on the surveys of Alfaro et al. (2008), Asiedu
(2006), Busse and Hefeker (2007), Daude and Fratzscher (2008), Daude
and Stein (2007), Du et al. (2008), Faria and Mauro (2009), Kraay and
Nehru (2006), Lane (2004), Mina (2006), Mina and Martinez-Vazquez
(2006), Naude and Krugell (2007), Mishra and Daly (2007), and Wei
(2000).
1808 WORLD DEVELOPMENT
6. Findings are based on the surveys of Desbordes and Vicard (2009),
Egger and Pfaffermayr (2004), Egger and Merlo (2007), Hallward-
Driemeier (2003), Kerner (2009), Mina (2009), Neumayer and Spess
(2005), Tobin and Rose-Ackerman (2006), and UNCTAD (1998).
7. This relationship has been examined in Desbordes and Vicard (2009),
Hallward-Driemeier (2003), Mina (2009), and Neumayer and Spess
(2005).
8. Hallward-Driemeier (2003) finds that bilateral investment treaties are
more effective in higher institutional quality settings and where institutions
are already being strengthened. She argues that, “This undermines a central
rational for some of the less developed countries that enter into these
agreements hoping to bypass the need to strengthen property rights and
institutions more generally. Put differently, if host countries are committed
to trying to attract more FDI, BITs have not provided a short-cut from the
need to implement broader reforms of domestic institutions” (italics added;
pp. 21–22).
9. Findings are based on Chan and Gemayel (2004), Hisarciklilar,
Kayam, and Kayalica (2007), Kamaly (2002), Onyeiwu (2003), and Mina
(2007).
10. A table that shows the growth in the (5-year) average level of FDI in
1980–2008 is available from the author. The growth in FDI over time
obliges the empirical methodology to consider its nonstationarity, as
discussed further in Section 5.
11. A higher score indicates a lower risk. More information on the
political risk components is provided in Section 4.
12. World Bank (2008) argues that the average level of education,
and thus the level of human capital, is low in MENA relative to East
Asia and Latin America. The average gross enrollment rate in
secondary education amounted to 75% in 2003 in MENA, compared
to 78% and 90% for East Asia and Latin America. Similarly, the
average gross enrollment rate in higher education in MENA was only
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Table 8. Variables, definitions, and data sources
Variable Definition
FDI FDI annual flows per capita in US$ (in log form)
BIT Annual number of bilateral investment treaties entered
into force
INSTITFN Domestic PRP institutional functions. These are (a)
investment profile, (b) corruption, (c) law and order, and
(d) bureaucracy quality (in log form)
BITINSTITFN Interaction term between BIT and INSTITFN constructed
as the product of INSTITFN (in log form) and BIT
OIL Oil production in thousands of barrels per day (in log
form)
PRICE Crude oil price measured by the price of Saudi Arabian
Light 34 in US$/barrel (in log form)
LABOR Real GDP per person employed (in log form)
TRADE Sum of exports and imports as a percentage of GDP (in
log form)
INFLATION Inflation rate in percentage (in log form). Rate is
calculated based on the consumer price index, except for
Oman and UAE where it is based on GDP deflator
WFDIFLOWS World FDI inflows in millions of US$ (in log form)
1809
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APPENDIX A
See Table 8.
Source
UNCTAD’s FDI online database
Author’s calculation based on UNCTAD’s bilateral
investment treaties online database (as of June 1, 2008)
ICRG political risk index
Author’s calculation
Energy Information Administration
Energy Information Administration
Author’s calculation based on UNCTAD’s bilateral
investment treaties online and World Development Indicators
databases
World Bank’s World Development Indicators
World Bank’s World Development Indicators
Author’s calculation based on UNCTAD’s bilateral
investment treaties online database