Academic journal article Economic Inquiry

Climbing to the Top? Foreign Direct Investment and Property Rights

Academic journal article Economic Inquiry

Climbing to the Top? Foreign Direct Investment and Property Rights

Article excerpt

I. INTRODUCTION

The impact of foreign direct investment (FDI) on host countries is a well-researched topic and the bulk of the literature focuses on the impact of FDI on economic growth. However, with the rapid growth of FDI inflows during the 1990s and the growing competition among countries to attract FDI inflows, researchers are showing substantial interest in studying new aspects of the impact of FDI on host countries. Most of the work in this area argues that greater competition to attract FDI has led to "bidding wars" where governments in host countries have been forced to adopt policies with an adverse economic impact, such as a reduction in tax rates, deterioration in environmental standards, and of workers' rights (see e.g., Oman 2000). Some of these adverse impacts, known as the "race to the bottom" effects, are supported by empirical evidence. For example, Garretsen and Peeters (2007) find that FDI inflows promote lower corporate tax rates. However, foreign investors not only search for lower tax rates but also demand better institutional quality. Governments competing to attract FDI may therefore have an incentive to supply a more efficient institutional framework. FDI may therefore contribute to economic development through improving institutional quality in the host country. This aspect of FDI effects has to our knowledge not been studied previously.

Institutional quality has been identified as one of the most important, if not the most important, determinant of economic growth. Hall and Jones (1999) find that differences in income growth are largely explained by differences in institutional quality. Knack and Keefer (1995) identify property rights as crucial for growth and investment. Although there is general consensus that institutions matter for growth, little is known about how efficient institutions are created and what explains differences in institutional quality between and within countries. The empirical evidence on the determinants of property rights links institutions to culture, history, and geography (see e.g., Levine 2005). If property rights are mainly determined by culture, history, or geography, what then explains institutional changes over time? Or, put differently, if property rights were only determined by time-invariant factors, there would be little scope for developing countries to achieve high-quality institutions. There appears to be a clear need to link institutions to time varying, if not controllable, variables. Such evidence would provide a basis for institutional reform that enables developing countries to build high-quality institutions.

The hypothesis that this article introduces and empirically investigates is whether FDI inflows have a positive impact on property rights in the host country. Testing this hypothesis has both academic and practical merit. First, it explores a new dimension of how FDI impacts the host country. Second, it provides an explanation as to why property rights differ across countries.

The rest of the article is organized as follows. Section II introduces arguments that link property rights to FDI inflows. Our empirical results are presented in Section III and Section IV concludes.

II. FDI AND PROPERTY RIGHTS

There is growing evidence that greater integration into the global economy impacts institutional quality. For example, Bonaglia, Braga de Macedo, and Bussolo (2001) provide robust empirical support that higher import openness lowers corruption. Li and Reuveny (2003) establish that trade openness and portfolio investment have a negative impact on democracy, whereas FDI has a positive one. Larrain and Tavares (2004) present evidence that FDI is a robust predictor of corruption and that larger FDI inflows reduce the level of corruption in the host country. A1-Marhubi (2004) finds that trade openness has a positive impact on governance indictors and concludes that openness may encourage governments to adopt better governance to reap the full benefits of the integration into the world economy. …

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