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Foreign direct investment and institutional reform: evidence and an application to Portugal

Abstract

We examine the role of geographic, economic, and institutional factors in attracting Foreign Direct Investment (FDI) in Europe, using a cross-section of inward bilateral investments. We estimate and assess the expected benefits, the required reform efforts, and the efficiency of reform options corresponding to a convergence of Portuguese institutions to EU standards. We conclude that improving home institutions is likely to have a quantitatively very significant role in attracting FDI. Geographical and market size factors also play a role. Reforms promoting the independence of financial institutions and a leaner bureaucracy, lowering political risk and corruption, and improving the investment code may significantly affect the amount of bilateral inward FDI that is targeted to Portugal.

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Fig. 1

Notes

  1. 1.

    In 2010, that percentage fell to below 65 %.

  2. 2.

    Horstmann and Markusen (1992) and Brainard (1997) develop a proximity-concentration model to explain multi-plant multinationals and two-way horizontal FDI, which arise when access to markets becomes less expensive relative to exporting.

  3. 3.

    See Blonigen (2005) and Caves (2007) for a survey of the literature.

  4. 4.

    As with economic factors, the literature is not consensual on the role of institutional variables in explaining FDI. For example, Bevan and Estrin (2004) and Wheeler and Mody (1992) find no significant impact of institutional risk on FDI into Eastern European transition economies and on the location of US foreign affiliates, respectively.

  5. 5.

    See the Appendix for a detailed description of the data and for a list of countries covered.

  6. 6.

    One cannot include per capita GDP and labor costs simultaneously in the model, as these variables are highly correlated. The role of growth on FDI would be more appropriately measured by a variable capturing expected future growth, but coherent estimates of GDP growth across countries are very hard to come by.

  7. 7.

    Market size or market potential, usually measured as GDP, population, or economic growth, is the most extensively discussed economic determinant of FDI. Billington (1999) and Scaperlanda and Balough (1983) find that market size and growth have a statistically significant impact on FDI locations. Using a simultaneous equations model, Tsai (1994) also shows that domestic market size is a key determinant of FDI, while the role of growth is dubious. Janicki and Wunnava (2004) show that GDP positively affected FDI towards EU accession candidate countries. Other studies on the relationship between market size variables and FDI include Love and Lage-Hidalgo (2000), Barrell and Pain (1996), Wheeler and Mody (1992), Culem (1988), and Kravis and Lipsey (1982).

  8. 8.

    While it may be expected that labor costs have a negative impact on inward FDI, as shown in Janicki and Wunnava (2004), Bevan and Estrin (2004), Barrell and Pain (1996), and Culem (1988), several other studies (e.g., Tsai 1994; Wheeler and Mody 1992; Kravis and Lipsey 1982) found insignificant or positive relationships. The mixed evidence is probably due to the role of labor productivity in FDI, which is positively correlated with—and often compensates for—labor costs.

  9. 9.

    The degree of openness has been studied, inter alia, by Bajo-Rubio and Sosvilla-Rivero (1994) and Culem (1988), the former analyzing determinants of FDI in Spain, and the latter FDI inflows among six industrialized countries. Both studies conclude that the degree of openness affects inward FDI positively. Wheeler and Mody (1992), on the other hand, find no statistically significant relationship between openness and FDI, and Grubert and Mutti (1991) find mixed evidence on the effects of trade barriers on FDI.

  10. 10.

    Walsh and Yu (2010) find that education has a negligible or slightly counter-intuitive negative effect on FDI, depending on whether one considers FDI toward industry or services. Altomonte and Guagliano (2003) find that education has a negative effect on a multinational’s probability to invest in Central and Eastern European or in Mediterranean countries if investment is geared toward traditional industries, and a positive and significant impact for investment in services.

  11. 11.

    The statutory tax rate is the relevant variable for companies seeking to shift income towards low tax countries, whereas the effective average tax rate reflects the incentives (such as investment tax credits and accelerated depreciation) that are granted to firms when the investment occurs (Grubert and Mutti 1991). The effective marginal tax rate captures incentives to use new capital once the location choice has been made. Thus, the effective average tax rate should be the most important decision variable for multinationals seeking to invest abroad (Devereux and Griffith 1998). An extensive survey of the relationship between taxes and FDI is provided by de Mooij and Ederveen (2003). The empirical analysis of the effects of taxation on FDI dates back at least to Hartman (1984, 1985), who uncovered a negative relationship between the two variables. Using a panel approach, Cassou (1997) finds that host country corporate tax rates have a significant negative impact on investment flows. Related conclusions are shared by Grubert and Mutti (1991) and Devereux and Griffith (1998). Hines (1996) finds that state taxes significantly influenced the pattern of FDI in the United States.

  12. 12.

    See Overesch and Rincke (2009).

  13. 13.

    These are particularly important for GDP and GDP growth (Barrell and Pain 1997; Borensztein et al. 1998).

  14. 14.

    The Index of Economic Freedom is available at www.heritage.org/index. Economic freedom is the right of every citizen to control his or her own labor and property. As put forward by the Heritage Foundation, “In a free society, individuals are free to make their own production and consumption decisions, protected and unconstrained by the state.”

  15. 15.

    The Doing Business report is a co-publication of the World Bank and the International Finance Corporation, and the data are available at www.doingbusiness.org. Data for the nine different areas of Doing Business were first made available in the 2006 report.

  16. 16.

    The min-max standardization method normalized to the 0–10 range implies that each variable is converted to an index according to the formula

    $$\text{Score}_{k} = 10 \frac{\text{factor}_{k} - \text{factor}_{\min}}{\text{factor}_{\max} - \text{factor}_{\min}} $$

    if higher factor values imply better performances (e.g., strength of legal rights, recovery rate when closing a business), or

    $$\text{Score}_{k} = 10 - 10 \frac{\text{factor}_{k} - \text{factor}_{\min}}{\text{factor}_{\max} - \text{factor}_{\min}} $$

    if higher factor values imply poorer performances (e.g., procedures, time, cost).

  17. 17.

    In this case, desired FDI is the latent variable, equaling realized FDI for values above a certain threshold, but unobserved for values below that threshold. Some authors have proposed using log (1 + FDI ij ) or log (a + FDI ij ) (where a is a parameter to be estimated) instead of log (FDI ij ) as the dependent variable in order to estimate Eq. 1 while retaining zero-FDI observations (e.g., Eichengreen and Irwin 1995; Wei 2000). However, this approach is completely ad hoc, and the results become dependent on the measurement unit.

  18. 18.

    Chosen as the minimum value of the average of inward FDI stocks for the 2005–2007 period—1/3 million euros.

  19. 19.

    We are extremely grateful to the editor for pointing out this approach to us.

  20. 20.

    This was preceded by the KMO and Bartlett’s test of sphericity, which indicate whether the PCA is an appropriate approach or not.

  21. 21.

    We report marginal effects for non-logarithmic regressors using the formula \(\exp (\hat {\beta }) - 1\).

  22. 22.

    This may occur as a greater ability to stay in office is sometimes achieved at the expense of lower democratic accountability, e.g., in one-party states or autocracies. See Tavares and Wacziarg (2001) for the possible trade-off between democracy and stability.

  23. 23.

    We report marginal effects for institutional factors using the formula \(\exp (\hat {\beta }) - 1\).

  24. 24.

    Another application can be found in Cavalcanti et al. (2008), where the potential of institutional reforms in Brazil is assessed.

  25. 25.

    As data for Cyprus and Malta are not available in our database, the EU-27 actually comprises only 25 countries. In our computations, we take into account that a change in the Portuguese institutional index also changes the EU average institutional index.

  26. 26.

    Recall that β 3,k evaluates the impact on inward FDI of one standard deviation change in the institutional indicator.

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Acknowledgments

We are extremely grateful to the editor and two anonymous referees for helpful suggestions and recommendations, that led to a significant improvement of this article. We also thank the precious comments of Francisco Veiga and of all participants in the 5th Annual Meeting of the Portuguese Economic Journal (Aveiro, July 2011) and in the 14th INFER Annual Conference (Coimbra, May 2012), and the excellent research assistance provided by Inês Cabo, Marta Campos, and Sara Almeida. José Tavares thanks Nova Forum and the Fundação para a Ciência e Tecnologia for financial support. This article was prepared while Paulo Júlio was employed at the Office for Strategy and Studies of the Portuguese Ministry of Economy and Employment, and the author acknowledges all the support provided therein. The opinions expressed in this article represent the views of the authors and do not necessarily correspond to those of Banco de Portugal or of the Portuguese Ministry of Economy and Employment. A previous version of this article circulated under the title “FDI and Institutional Reform in Portugal.”

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Appendices

Appendix A: Host and source countries

A list of countries used in the econometric model is provided in table.

Table 9 Host and source countries

Appendix B: Geographic and economic variables

The following geographic and economic variables are used.

  • FDI stock: Bilateral inward FDI stocks in Millions of Euros. Source: Eurostat.

  • Accumulated FDI: Bilateral FDI inflows in Millions of Euros. Source: Eurostat.

  • Border: Dummy variable which takes the value of 1 only if the source and host countries share a common border. Source: Authors’ calculations.

  • Distance: Distance, in Kilometers, between source and host countries’ capitals, calculated using the great circle distance. Data is freely available on the Internet.

  • GDP: Gross Domestic Product inMillions of Euros at current market prices. Source: Eurostat.

  • GDP growth: Real GDP growth rate (percentage) relative to the previous. Source: Eurostat.

  • Labor cost: Yearly nominal compensation per employee in thousands of Euros. Source: Eurostat.

  • Openness: Degree of openness, measured by the ratio of exports plus imports over GDP. Source: Eurostat.

  • Education: Mean years of schooling. Source: Barro and Lee (2010).

  • EATR: Effective average tax rate in the host country (percentage). The data was kindly provided by Michael Overesch (see Overesch and Rincke (2009).

Appendix C: Index of economic freedom

The Index of Economic Freedom is computed by the Heritage Foundation, and the data can be found on their website (www.heritage.org/index). The overall index of economic freedom is constructed by taking the simple average across 10 different indicators.

  • Business Freedom: Measures the ability to start, operate, and close a business for a medium-sized company, thus representing the overall burden from regulation and government efficiency in the regulatory process.

  • Trade Freedom: Composite measure of the absence of tariff and non-tariff barriers that affect imports and exports of goods and services. It is based on the trade-weighted average tariff rate and on non-tariff barriers.

  • Fiscal Freedom: Measures the tax burden—on both individual and corporate incomes, and others—imposed by the government, as a percentage of GDP.

  • Government Freedom: Assesses the level of government expenditures on GDP, higher expenditures being associated with lower scores.

  • Monetary Freedom: Measures price stability (the weighted average inflation rate for the last three years) and price controls. More inflation and price controls yield lower scores.

  • Investment Freedom: Evaluates a variety of restrictions imposed on investment, namely restrictions on FDI, transparency and bureaucracy in the foreign investment code, restrictions on land ownership, sectoral investment restrictions, expropriation of investments without fair compensation, foreign exchange controls, and capital controls.

  • Financial Freedom: Measures bank security and the independence of the financial system from government control. This score comprises the extent of government regulation in the financial system, the extent of state intervention in banks, the difficulty of operating financial services, and the government influence on the allocation of credit.

  • Property Freedom: Assesses the ability of individuals to accumulate private property, secured by clear laws that are fully enforced by the state. It measures the extent to which laws protect private property, the degree of enforcement of those laws, the likelihood of expropriation, the independence of the judiciary system and the level of corruption within it, and the ability of individuals and business men to enforce contracts.

  • Freedom from Corruption: Measures the degree of corruption within a country.

  • Labor Freedom: Measures several aspects of the legal and regulatory framework of a country’s labor market, such as regulations on the minimum wage, laws inhibiting layoffs, regulatory burdens on hiring, among others.

A higher score always indicates a better performance.

Appendix D: Political risk rating

The International Country Risk Guide computes 22 variables in three categories of risk: political, financial, and economic. The Political Risk Rating includes 12 variables, covering political and social attributes. Although some of them are more related with inward FDI than others, all are used in the principal components analysis, as explained in the main text.

  • Government stability: Assesses the government’s ability to carry out its declared program and to stay in office. It is constructed from three subcomponents: government unity, legislative strength, and popular support.

  • Socioeconomic conditions: Assesses the pressures that could constrain government action or fuel social dissatisfaction. It is constructed from three subcomponents: unemployment, consumer confidence, and poverty.

  • Investment profile: Assesses the risks to investment that are not covered by other economic, political, and financial risk components. It is constructed from three subcomponents: contract viability/expropriation, profile repatriation, and payment delays.

  • Internal conflict: Assesses the political violence and its potential impact on governance. It is constructed from three subcomponents: civil war/coup threat, terrorism/political violence, and civil disorder.

  • External conflict: Assesses the risk to the government from foreign action, originating from both non-violent and violent pressures. It is constructed from three subcomponents: war, cross-border conflict, and foreign pressures.

  • Corruption: Assesses the level of corruption in the political system, including bribes, exchange controls, and tax assessments, among others.

  • Military in politics: Measures the involvement of military in politics, which distorts government policy and diminishes democratic accountability.

  • Religious tensions: Measures the involvement of religious groups—which often seek to replace civil laws with religious laws, thus distorting and constraining government action—in politics.

  • Law and order: Measures the strength and impartiality of the legal system and the popular observance of the law.

  • Ethnic tensions: Measures racial, nationality, and language tensions, which give rise to intolerance and unwillingness to make compromises.

  • Democratic accountability: Measures the responsiveness of the government to its people. The score for this component is based on the following types of governance: alternating democracy, dominating democracy, de facto one-party state, de jure one-party state, and autarchy.

  • Bureaucracy quality: Measures the institutional strength and quality of the bureaucracy, and the extent to which bureaucracy is autonomous from the political pressure and has a well-established mechanism for recruitment and training.

Appendix E: Ease of doing business

The World Bank’s Doing Business database measures business regulations and thereby the cost of a firm operating in a country. More specifically, it provides quantitative assessment for starting a business, dealing with construction permits, registering property, getting credit, protecting investors, paying taxes, trading across borders, enforcing contracts and closing a business, in a total of 33 raw factors, described below. For the analysis, these factors were aggregated into nine indexes ranging from 0 to 10, each summarizing a specific topic of doing business. We proceeded as follows. First, we represented each raw factor by an index, ranging from 0 to 10, according to the min-max standardization method,

$$\text{Score}_{k} = 10 \frac{\text{factor}_{k} - \text{factor}_{\min}}{\text{factor}_{\max} - \text{factor}_{\min}} $$

if higher factor values imply better performances (e.g., strength of legal rights, recovery rate when closing a business), or

$$\text{Score}_{k} = 10 - 10 \frac{\text{factor}_{k} - \text{factor}_{\min}}{\text{factor}_{\max} - \text{factor}_{\min}} $$

if higher factor values imply poorer performances (e.g., procedures, time, cost).

This was done for all countries in the database. According to these formulas, all scores are organized such that higher values always indicate better performances. The topic score is the simple average of all factors that comprise that topic. An overall ease of doing business index is created by taking the simple average of the nine topic scores.

E.1 Starting a business

The starting a business index measures all procedures, costs, and time that are formally required for an entrepreneur to start up and formally operate an industrial or commercial business. It includes the following factors.

  • Procedures: Number of interactions of the company founders with external parties in order to formally start operating a business.

  • Time: Median duration in calendar days, indicated by lawyers, that is necessary to complete a procedure with minimum follow-up with government agencies and no extra payments.

  • Cost: All official fees and fees for legal or professional services if such services are required by law in order to start operating a business. It is recorded as a percentage of the economy’s income per capita.

  • Minimum Capital: The amount that the entrepreneur needs to deposit in a bank or with a notary before registration and up to three months following incorporation in order to start operating a business. It is recorded as a percentage of the economy’s income per capita.

E.2 Dealing with construction permits

The dealing with construction permits index measures all procedures required for a business in the construction industry to build a standardized warehouse, as well as the costs and time required to complete the procedures. It includes the following factors.

  • Procedures: Number of procedures required for a business in the construction industry to build a standardized warehouse.

  • Time: Median duration in calendar days that is necessary to complete the required procedures, as indicated by local experts.

  • Cost: All fees associated with completing the procedures to legally build a warehouse. The cost is recorded as a percentage of the economy’s income per capita.

E.3 Registering property

The registering a property index records the necessary procedures that a businessperson must incur to purchase a property from another businessperson and to transfer the property title to his name, as well as the associated costs and time. It includes the following factors.

  • Procedures: Number of procedures that are legally or in practice required for registering a property.

  • Time: Median duration indicated by property lawyers, notaries, or registry officials to complete the procedures for registering a property.

  • Cost: All the necessary fees to register a property. This variable is recorded as a percentage of the property value.

E.4 Getting credit

The getting credit index measures the legal rights of borrowers and lenders with respect to secured transactions and the sharing of credit information. It includes the following factors.

  • Strength of legal rights: Index that measures the degree to which collateral and bankruptcy laws protect the rights of borrowers and lenders and thus facilitate lending. It ranges from 0 to 10.

  • Depth of credit information: Index that assesses the rules and practices affecting the coverage, scope, and accessibility of credit information, regardless of whether this information is available through a public credit registry or through a private credit bureau. It ranges from 0 to 6.

  • Public registry coverage: Reports the number of individuals and firms listed in a public credit registry with information on their borrowing history over the past five years. It is measured as a percentage of adults aged 15 and above.

  • Private bureau coverage: Reports the number of individuals and firms listed by a private credit bureau with information on their borrowing history over the past five years. The number is expressed as a percentage of the adult population aged 15 and above.

E.5 Strength of investor protection

The strength of investor protection index measures the strength of minority shareholder protection against directors’ misuse of corporate assets for personal gain. It includes the following factors.

  • Extent of disclosure: Index that assesses who can approve related-party transactions and the requirements for external and internal disclosure in case of related-party transactions. It ranges from 0 to 10.

  • Extent of director liability: Index that measures the ability of shareholders to hold the interested party and the approving body liable in case of a prejudicial related-party transaction, the availability of legal remedies (damages, repayment of profits, fines, imprisonment, and rescission of the transaction), and the ability of shareholders to sue. It ranges from 0 to 10.

  • Ease of shareholder suits: Index that measures the documents and information available during trial and the access to internal corporate documents. It ranges from 0 to 10.

E.6 Paying taxes

The paying taxes index measures the tax burden and mandatory contributions that a medium-size company must pay in a given year, as well as the administrative burden of paying taxes and contributions. It includes the following factors.

  • Payments: Reflects the total number of taxes and contributions paid, including consumption taxes, as well as the method of payment, the frequency of payment, and the frequency of filing, for a company during the second year of operation.

  • Time: Measures the hours per year a company spends to prepare, file, and pay the corporate tax, the value added tax, and social contributions. It includes the time spent to collect information and to compute the amount payable.

  • Total tax rate: Measures all taxes and contributions (corporate taxes, social contributions, labor taxes, property taxes, and other taxes) paid by firms as a percentage of total profits.

E.7 Trading across borders

The trading across borders index measures procedural requirements for exporting and importing a standardized cargo of goods by ocean transport. It includes the following factors.

  • Documents to export: Number of bank documents, customs clearance documents, port and terminal handling documents, and transport documents required for exporting.

  • Documents to import: Number of bank documents, customs clearance documents, port and terminal handling documents, and transport documents required for importing.

  • Time to export: Time (in calendar days) to obtain all documents required for inland transport and handling, for customs clearance and inspections, and for port and terminal handling for exporting a standardized cargo.

  • Time to import: Time (in calendar days) to obtain all documents required for inland transport and handling, for customs clearance and inspections, and for port and terminal handling for importing a standardized cargo.

  • Cost to export: Measures the costs (in US dollars per container) of all documentation, inland transport and handling, customs clearance and inspections, and port and terminal handling for exporting a standardized cargo.

  • Cost to import: Measures the costs (in US dollars per container) of all documentation, inland transport and handling, customs clearance and inspections, and port and terminal handling for importing a standardized cargo.

E.8 Enforcing contracts

The enforcing contracts index measures the efficiency of the judicial system in resolving a commercial dispute. It includes the following factors.

  • Procedures: Number of procedures resulting from a commercial dispute, either between the parties or between them and the court officer. It comprises the steps to file the case, the steps for trial and judgment, and the steps to enforce the judgment.

  • Time: Number of calendar days, from the moment the lawsuit is filed in court until settlement. It includes the necessary time to file and serve the case, the time of the trial, and the time to enforce the judgment.

  • Cost: Average attorney fees, court costs (including expert fees) and enforcement costs a firm must bear if a commercial dispute goes to trial. It is measured as a percentage of claims.

E.9 Closing a business

The closing a business index measures the time, cost, and outcome of insolvency proceedings involving domestic entities. It includes the following factors.

  • Time: Calendar years required for creditors to recover their credit.

  • Cost: Court fees, fees of insolvency administrators, lawyers’ fees, and assessors’ and auctioneers’ fees required to close a business. It is measured as a percentage of the debtor’s estate value.

  • Recovery rate: Measures the percentage recovered by creditors, i.e., the present value of debt that can be recovered.

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Júlio, P., Pinheiro–Alves, R. & Tavares, J. Foreign direct investment and institutional reform: evidence and an application to Portugal. Port Econ J 12, 215–250 (2013). https://doi.org/10.1007/s10258-013-0093-z

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Keywords

  • Foreign direct investment
  • Institutions
  • Institutional reform
  • Portugal
  • European union

JEL Classification

  • F30
  • H00