Poverty & Public Policy, Vol. 4, No.

3, 2012

Institutional and Political Determinants of Foreign

Direct Investment: Evidence From BRICS Economies
Pravin Jadhav and Vijaya Katti

This paper explores the role of institutional and political factors in attracting foreign direct
investment (FDI) in the economies of Brazil, Russia, India, China, and South Africa (BRICS) and
the comparative importance of these factors in attracting FDI. This study uses panel data for a
period of 10 years (2000–2010) in order to examine the significant determinants of FDI in BRICS
from a holistic approach. Analysis has been done using the panel unit-root test and multiple
regressions. This study takes into account Macroeconomic Stability (Inflation Rate), Political
Stability/No Violence, Government Effectiveness, Regulatory Quality, Control of Corruption, Voice
and Accountability, and Rule of Law as potential institutional and political determinants of FDI.
These factors are based on their relative importance from previous empirical literature. The overall
results show that two factors, namely Government Effectiveness and Regulatory Quality, are
positively related to FDI inflow in BRICS. Three variables in the model, namely Political Stability,
Voice and Accountability, and Control of Corruption, have a negative impact on FDI inflow in
BRICS economies, which implies that these three factors are not important for attracting more FDI
inflow.

Introduction

Foreign direct investment (FDI) in emerging economies has been phenomenal

and has contributed to the overall economic growth of a country. According
to the World Investment Report (2011), emerging economies together attracted
more than half of global FDI inflows in the year 2010 (World Bank, 2003). As
international consumption and international production have shifted to emerging
economies, multinational corporations (MNCs) are increasingly investing in both
efficiency-seeking and market-seeking projects in these emerging countries. There
are various empirical studies which show that there is a positive relationship
between FDI and economic growth and that FDI is becoming a key component of
the world’s growth engine; hence, countries try to create favorable conditions to
attract more FDI inflow into their economies.
FDI not only raises the level of investment or capital stock but also increases
employment by creating new production capacity and jobs, transfers intangible

49
1944-2858 # 2012 Policy Studies Organization
Published by Wiley Periodicals, Inc., 350 Main Street, Malden, MA 02148, USA, and 9600 Garsington Road, Oxford, OX4 2DQ.
50 Poverty & Public Policy, 4:3

assets such as technology and managerial skills to the host country, and provides
a source of new technologies, processes, products, organizational technologies
and management skills, and backward and forward linkages with the rest of the
economy (National Council of Applied Economic Research, 2009).
Considerable research has been conducted with respect to determinants of
FDI. To attract FDI, the policymakers must streamline the process by identifying
its major determinants. These determinants enable policymakers to understand
the scale and direction of FDI flows.
Although this study gives specific policy recommendations, its primary
objective is to identify country-level institutional and political determinants of
FDI in emerging economies. After identifying the possible institutional and
political factors/determinants, it will empirically test the assumptions about FDI
determinants by using different panel data econometric techniques.
The major objective of identifying these determinants is to provide inputs to
respective governments for suitable changes in policies and aimed toward
positive institutional changes, which will lead to increases in FDI inflow as well
as the attractiveness of these economies. In developing countries such as India,
identifying the determinants of FDI has a high relevance for policymakers. These
determinants will provide suggestions about which policies are worth implement-
ing and to what extent they can be successful in attracting FDI.

Literature on Institutional and Political Determinants of FDI

Institutional and political factors which affect the business climate have a
direct influence on FDI. Generally, it is believed that better governance in the host
country attracts more FDI inflow. Literature on institutional determinants of FDI
suggests that good economic institutions, effective Rule of Law, Government
Effectiveness, Regulatory Quality, Control of Corruption, and intellectual proper-
ty rights all attract more FDI inflow into the host country (Acemoglu & Simon,
2005; Kaufmann & Aart, 2002; Rodrik & Subramanian, 2004). In contrast, poor
institutional environment in terms of corruption and weak enforcement of
contracts imposes additional cost for the foreign investors and deters foreign
investment in the host economy (Shleifer & Vishny, 1993; Wei, 2000). FDI has
huge sunk costs and hence it is very difficult for foreign investors to make
investment decisions. Foreign investors first ensure long-term contracts to reduce
all types of uncertainty. Therefore, government stability and effective Rule of Law
are especially important to attract higher FDI inflow in the host economy (Busse
& Hefeker, 2007; Naude & Waldo, 2007). According to a World Bank study, time
spent by managers dealing with bureaucracy to obtain licenses and permits has a
detrimental effect on FDI inflow across 69 countries. This study controls for other
factors such as human capital, market size, and macroeconomic stability (World
Bank, 2003).
Some of the recent studies examined the role of institutional and political
factors on capital flows from the developing to developing countries, known as
South–South FDI. According to Aleksynska and Havrylchyk (2011), when MNCs
Jadhav/Katti: Institutional and Political Determinants of FDI 51

from the emerging/developing (South) countries invest in countries with superior

institutions, the institutional distance can be viewed as a motivating force as most
of the emerging countries obtain new technologies, patents, IPRs, trademarks,
and brands. MNCs believed that these ownership-specific advantages will be
protected in good institutional environments. They also found that FDI inflow is
discouraged when emerging countries invest in countries with worse/incompe-
tent institutions. The main reason behind this normally weak effect is that
investors or MNCs, having had previous experience with weak or incompetent
institutions, may have a comparative advantage in investing in other emerging or
developing economies which suffer from the weak institutions like ineffective
Rule of Law, corruption, and political instability. To take advantage of the
previous experience with corrupt environments, investors from countries with a
high prevalence of corruption and lack of enforcement of anticorruption laws
internalize their production with countries that have similarly corrupt environ-
ments (Cuervo-Cazurra, 2007).
Habib and Zurawicki (2002) and Bénassy-Quéré, Coupet, and Mayer (2007)
used the concept of psychic distance, which states that MNCs tend to enter a
market where they found psychological closeness. Accordingly, they found that
the larger institutional distance decreases FDI flows between the countries.
Claessens and Van Hor (2008) found that FDI flow in the banking industry is
affected adversely by large distances among institutions. According to Darby,
Desbordes, and Wooton (2009), MNCs which have very little experience of
imperfect institutions in the home economy are discouraged by institutional
deficiencies abroad. These studies suggest that different investors have different
motivations to invest in particular locations. Weak institutions do not always
deter the FDI inflow in a host country; it therefore is not always necessary for
these countries to improve their quality of institutions in order to attract foreign
investment.
Empirical studies also demonstrate that increasing the flow of South–South
FDI is driven by natural resource-seeking purposes (Aleksynska & Havrylchyk,
2011). Countries that are endowed with natural resource availability have a very
poor quality of institution; still, there is significant FDI inflow into these countries.
Most African countries have poor institutions, but recently much FDI from China
has been flowing to these countries to take advantage of their natural resources.
Asiedu (2006) found that large market size, natural resource endowment,
macroeconomic stability, an efficient legal system, and a good investment
framework promote FDI in African countries.
Specific institutional determinants of FDI inflow may of course be different
for different economies. According to Duanmu and Guney (2009), FDI outflow
from China and India show important dissimilarities. Chinese encourage FDI by
open economic regimes, depreciated host currency, and a better institutional
environment, but these factors are not important for Indian FDI outflow in other
countries. Mohamed and Sidiropoulos (2010) concluded that the key determinants
of FDI inflows in MENA countries are the size of the host economy, the
government size, natural resources, and institutional variables.
52 Poverty & Public Policy, 4:3

Gaps in Existing Literature

There are various empirical studies that explore the economic determinants of
FDI flows to developing countries, but there are fewer studies with respect to
institutional and political determinants of FDI.
Most of the research focused on institutional and political determinants of
FDI flows consists of international cross-country studies. These cross-country
studies find various political and institutional factors, such as the role of
corruption, Political Stability, and effective Rule of Law on FDI, which vary across
the countries but not over time. Thus, the results of these studies may not apply
to relevant changes in policy-related variables over time. In principle, the bias in
the estimates of such effects could be in either direction and it is therefore
important to supplement the cross-sectional studies with time-series estimates, as
empirical evidence regarding the political and institutional determinants of FDI
are mixed depending on the choice of country, time periods, and applied
methodology.

FDI Inflow in BRICS

In recent years, the economies of Brazil, Russia, India, China, and South
America (BRICS) economies have attracted most of the FDI, but the growth rate
and comparative inflows in these economies are not the same. From Figure 1, we
can see that China grew the fastest among the BRICS from 2000 to 2010, and
reached about US$185.08 billion in 2010. Brazil had a rapid decline from 2001 to
2003 and then increased slowly. Russia and India both have developed smoothly
and experienced increases in FDI inflow since 2005. In 2009, there was a sharp
decline in FDI inflow in all the BRICS economies because of the global economic
crisis. In 2010, FDI inflow increased tremendously in China.

Governance Indicators in BRICS

To capture the overall comparison of governance in BRICS economies,

percentage rank of governance indicators (Table 1) in BRICS economies for the

200.00

150.00
Brazil

100.00 China
India
50.00 Russian Federaon
South Africa
0.00
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
-50.00

Figure 1. Net Inflow of FDI in BRICS, Values Are in Billion US$.

Source: World Bank (2003).
Jadhav/Katti: Institutional and Political Determinants of FDI 53

Table 1. Governance Indicators in BRICS

South Africa Russia India China Brazil

Governance Percentile Percentile Percentile Percentile Percentile
Indicators Rank Rank Rank Rank Rank
Voice and 65.4 20.9 59.2 5.2 63.5
Accountability
Political 44.3 18.4 10.8 24.1 48.1
Stability/Absence
of Violence
Government 65.1 41.6 55 59.8 56.9
Effectiveness
Regulatory Quality 62.7 38.3 39.2 45 56
Rule of Law 57.8 26.1 54.5 44.5 55.5
Control of 60.8 12.9 35.9 32.5 59.8
Corruption

90th-100th % 50th -75th % 10th-25th %

75th-90th % 25th - 50th % 0th - 10th %

Source: Worldwide Governance Indicators (2012).

year 2010 has been taken from Worldwide Governance Indicators (WGI) of the
World Bank. The WGI cover more than 200 countries and territories, and measure
six dimensions of governance, namely Voice and Accountability, Political Stability
and Absence of Violence/Terrorism, Government Effectiveness, Regulatory
Quality, Rule of Law, and Control of Corruption from 1996 to 2010 (detailed
definition at Annexure 1).
From this World Governance Dataset, we estimate that governance conditions
in the BRICS economies are not up to the mark. Voice and Accountability factors
in the case of China have the lowest scores, whereas in South Africa, the same
factor has the highest score. Overall, these data indicate that conditions in BRICS
economies as compared to other developed economies are not satisfactory. It is
evident from the dataset that governance indicators in these five economies have
different effects. In this study, we seek to document whether better governance
attracts more FDI, or vice versa.

Potential Determinants of FDI

Potential institutional and political determinants of FDI have been taken from
the literature review mentioned earlier. These determinants influence FDI flows
in BRICS. In order to remove data discrepancy, all data have been collected from
the single secondary source. Table 2 explains the set of explanatory variables,
their indicators with expected positive and negative effects of these indicators,
and sources of data.
54 Poverty & Public Policy, 4:3

Table 2. Potential Determinants of FDI

Explanatory Indicators Expected Data Sources

Variables Sign

Institutional Control of Corruption /þ World Governance Indicators, World Bank

variables Rule of Law þ World Governance Indicators, World Bank
Voice and Accountability þ World Governance Indicators, World Bank
Political risk Political Stability/No Violence þ World Governance Indicators, World Bank
variables Government Effectiveness þ World Governance Indicators, World Bank
Regulatory Quality þ World Governance Indicators, World Bank

Data and Model Specification

The dataset consists of panel data from 2001 to 2010 for the five emerging
economies, namely BRICS. The required dataset for the selected countries was
obtained from the World Bank, and from World Governance Indicators.
The dependent variable in our study is the Net FDI inflow in billions of
dollars, and the independent variables that are expected to determine FDI flows
are carefully chosen, based on previous literature and availability of data for the
selected period. The independent variables in our estimation include Corruption,
Rule of Law, Voice and Accountability (institutional variables), Political Stability,
Absence of Violence, Government Effectiveness, and Regulatory Quality (political
risk variables).
In connection with discussions of the previous section, we propose an
estimation model as follows, where the selected variables are expected to
determine the FDI inflows:

FDIit ¼ a þ uðInstitutional VariablesÞit þ mðPolitical Risk VariablesÞit þ eit

where

FDIit ¼ Net FDI inflow in countryitime period t

Institutional Variables ¼ Corruption; Rule of Law; Voice and Accountability

Political Risk Variables ¼ Political Stability; Absence of Violence;

Government Effectiveness; Regulatory Quality

Results

This study uses different panel data analysis techniques to estimate the role
of political and institutional determinants of FDI inflow in BRICS. But before
proceeding to estimate with panel data analysis, stationarity of the data has been
checked. In order to investigate the possibility of non-stationarity in the dataset, it
is first necessary to determine the existence of unit roots in the data series. The
Jadhav/Katti: Institutional and Political Determinants of FDI 55

Table 3. Results for Institutional Determinants of FDI

Variable Coefficient SE t-Statistic Prob.

Government Effectiveness 96.86040 31.98454 3.028351 0.0043

Political Stability 38.53208 15.66973 2.459013 0.0185
Regulatory Quality 54.21118 27.87333 1.944912 0.0590
Rule of Law 0.525092 30.85340 0.017019 0.9865
Voice and Accountability 52.44426 20.87154 2.512716 0.0162
Control of Corruption 56.41828 28.62316 1.971071 0.0558
C 13.73435 13.39296 1.025491 0.3115

Effects Specification

Cross-Section Fixed (Dummy Variables) SD Rho

Period random 13.00370 0.4035

Idiosyncratic random 15.80909 0.5965

Weighted Statistics
2
R 0.871424 Mean dependent var. 36.54009
Adjusted R2 0.838456 SD dependent var. 42.21456
SE of regression 16.96709 Sum squared resid. 11,227.40
F-statistic 26.43235 Durbin–Watson stat. 1.589248
Prob(F-statistic) 0.000000

Unweighted Statistics

R2 0.780544 Mean dependent var. 36.54009

Sum squared resid. 22,365.16 Durbin-Watson stat. 1.251158

results of the panel unit-root test by using the Levin, Lin and Chut test found that
all variables are I(1).
Results of the OLS regression using period random effects and cross-section
fixed effects models are shown in Table 3. This study uses cross-section fixed
effects as the random effects estimation requires the number of cross-section to be
greater than the number of coefficient for between estimators for the estimate of
random effects innovation variance.
The empirical results (Table 3) obtained from panel OLS regression show
that the regression model explains 78 percent (R2) of the variation in FDI inflows
in BRICS economies. This result indicates that the explanatory variables included
in the equation explain most of the variation in the dependent variable. The
F-statistic is 26.43, and the probability of the F-statistic is 0.0000, which shows
that the results are statistically significant and the null hypothesis of the
independent variables having no effect on FDI inflow in BRICS economies is
rejected. The results explain that all the variables in the model are statistically
significant except Rule of Law. Government Effectiveness and Regulatory Quality
variables have the expected positive sign. All other independent variables have
negative signs, meaning FDI inflows are impacted negatively by these indepen-
dent variables. These results are quite surprising with respect to BRICS
economies. They indicate that though the quality of Political Stability, Voice and
Accountability, and Control of Corruption was not good in BRICS, FDI inflow in
56 Poverty & Public Policy, 4:3

these economies was not affected. These results point out that FDI inflow in
BRICS was not influenced by Political Stability, Voice and Accountability, and
Control of Corruption. Thus, most of the FDI inflow is influenced by the other
variables rather than by political and institutional variables.

Conclusion

This study explains the role of institutional and political determinants of FDI
in BRICS economies in more generic and holistic ways than have been customary
for the last decade (2000–10). The overall results indicate that apart from Rule of
Law, all independent variables are statistically significant. Two factors, namely
Government Effectiveness and Regulatory Quality, are positively related to FDI
inflow in BRICS. Government Effectiveness includes quality of public services,
quality of the civil service, degree of independence from political pressures,
quality of policy formulation and implementation, and lastly, the credibility of
the government’s commitment to such policies. Similarly, Regulatory Quality
includes the ability of the government to formulate and implement sound policies
and regulations that permit and promote private-sector development.
Three variables in the base model, namely Political Stability, Voice and
Accountability, and Control of Corruption, have adverse effects on FDI inflow in
BRICS economies, which implies that these three factors are not important for
attracting more FDI inflow. These results support the empirical evidence drawn
by Cuervo-Cazurra (2007), who states that investors from countries with high
corruption and the lack of enforcement of anticorruption laws select similar
countries when they internationalize in order to exploit their familiarity with
corrupt environments and also because they face lower costs of operating as
opposed to other investors.
The results from the above study suggest that policy planners in the various
governments should take several measures to increase the quality of Government
Effectiveness and regularize quality in terms of sound policies and quality of
public services and civil services, if they wish to attract more FDI.

Mr. Pravin Jadhav, Assistant Professor, University of Petroleum and Energy

Studies.
Dr. Vijaya Katti, Chairperson (GSD), Indian Institute of Foreign Trade.

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