FDIand Governance

Governance
and
Foreign Direct Investment
Sviatoslav A. Moskalev*
Adelphi University
Abstract:
I study the importance of parent and host country governance, as measured by the Kaufmann, Kraay
and Mastruzzi (2005) worldwide governance indicators, in generating and receiving foreign direct
investment (FDI). Rather than utilizing a standard reduced-form econometric approach, I study the
link between governance and FDI within the framework of the “knowledge-capital” model of FDI. I
document that FDI originates in governance-rich countries and flows to governance-poor countries.
When host country governance regimes improve, these countries enjoy greater FDI inflows, and
when host country governance deteriorates, foreign investment contracts. I demonstrate that the
knowledge-capital model is robust in explaining FDI, not only in the presence of governance
variables but also during periods of banking system instability. I also explore the possibility that FDI
and governance are simultaneously determined, so that foreign multinational corporations respond to
host country governance quality while host country law makers adjust governance regimes in order to
attract and accommodate FDI. Using the Albouy (2006) version of the Acemoglu, Johnson and
Robinson (2001) data on mortality rates experienced by European colonialists as an instrumental
variable for governance quality in 64 former colonies, I document that better governed host countries
enjoy greater FDI inflows.
Keywords: Foreign direct investment; Governance; Knowledge-capital model of FDI

JEL Classification: F21; F23; P16
Current version: February 2007
______________________________
(*)
Assistant Professor of Finance at Adelphi University.
Corresponding author: moskalev@adelphi.edu; Phone: (516)-877-4417; Fax: (516)-877-4607. Mailing address:
School of Business, Adelphi University, 1 South Avenue, Garden City, NY 11530. This paper is based on my
dissertation work done at the University of Georgia.
I am grateful to Kenneth Gaver, William Lastrapes, Jeffrey Netter, Annette Poulsen, Anand Srinivasan and
Bruce Swensen for valuable comments on the earlier draft of the paper. All errors are mine alone.
Electronic copy of this paper is available at: http://ssrn.com/abstract=959905

“The most important factor in creating favorable conditions
to attract foreign direct investment is good governance. (…).
If such conditions prevail, no special incentives are needed
to attract foreign, or indeed domestic, direct investment.”
The OECD’s Business and Advisory Committee,
November 2002 (Arndt and Oman (2006))
1. Introduction
As the OECD has clearly indicated, governance has been recognized as a major determinant
of the flow of foreign direct investment around the world. While it is difficult to describe governance
precisely, a definition proposed by Kaufman, Kraay and Zoido-Lobaton (1999b), who in turn rely on
suggestions from the Institute for Governance, IDEA and IMF, views governance as “the traditions
and institutions by which the authority in a country is exercised.”
Because governance deals with numerous issues related to the execution of institutional
authority within a country 1 , it can be viewed as a subfield of the school of thought known as New
Institutional Economics. This important field of economics (e.g., Coase (1937, 1960, 1988); North
(1990); Williamson (1985, 1996, 2000)) attempts to explain “what institutions are, how they arise,
what purposes they serve, how they change and how – if at all – they should be reformed.” 2
While macro- and micro-level theoretical work on institutions continues (e.g., Coase (1937,
1960, 1988); North (1990); Williamson (1985, 1996, 2000); Schotter (1981); Sobel (2002); Greif
(2000); Dixit (2004)), the empirical literature has shown positive correlations across countries
between features of their institutions and governance and various measures of economic outcomes.
For example, countries with higher quality government institutions have been shown to have more
productive workers (e.g., Hall and Jones (1999)), greater economic growth (Keefer and Knack
(1997); Chong and Calderon (2000); Kaufmann and Kraay (2002)), a smaller informal sector (e.g.,
Loayza (1997); Johnson, Kaufman and Zoido-Lobaton (1998)) and greater private and public
investment (e.g., Mauro (1995), Ades and Di Tella (1997); Tanzi and Davoodi (1997)).
Researchers have attributed differences in the development and quality of government
institutions and governance across countries to diseases and geographic determinants of the incidence
of the Neolithic revolution (e.g., McNeill (1976); Crosby (1986); Diamond (1997)), settler colonies
(e.g., Robinson and Gallagher (1961); Gann and Duignan (1962); Dennon (1983); Cain and Hopkins
(1993)), settler mortality (e.g., Acemoglu, Johnson and Robinson (2001); Acemoglu, Johnson,
Robinson and Thaicharoen (2003)), legal origin (e.g., Hayek (1960); Lipset (1994); LaPorta, Lopez,
1
Kaufman, Kraay and Zoido-Lobaton (1999b) classify this into “(1) the processes by which the governments
are selected, monitored and replaced; (2) the capacity of the governments to effectively formulate and
implement sound policies; (3) the respect of the citizens and the state for the institutions that govern economic
and social interactions among them.”
2
This summary is from the webpage of the International Society for New Institutional Economics (ISNIE)
(http://www.isnie.org/).

Shleifer and Vishny (1998, 1999)) and factor endowments and inequality (e.g., Engerman and
Sokoloff (1997); Sokoloff and Engerman (2000)).
In this paper, I focus on the relationship between the quality of host country governance and
the amount of foreign direct investment (henceforth FDI) they receive. As the OECD has elegantly
stated, if “the governance is good…no special incentives are needed to attract foreign, or indeed
domestic, direct investment.” One reason why governance is crucial for FDI is that global FDI flows
are driven primarily by cross-border mergers and acquisitions 3 where premiums paid by acquirers are
based on future expected synergies. Given that these synergies are risky, and are typically realized
over a long period of time, low quality host country governance reduces synergies, thereby rendering
cross-border mergers and acquisitions (henceforth M&As) economically infeasible.
A number of researchers have investigated the relationship between governance and FDI.
Wheeler and Mody (1992) utilized principal component analysis in their study of the impact of
numerous risk and policy variables 4 on FDI by U.S. multinationals 5 . Wei (2000) investigated the
effect of taxation and corruption on FDI, and found that an increase in either the tax rate on multi-
national corporations (henceforth MNCs) or the corruption level of host governments reduced FDI
inflows. He further showed that an increase in corruption level from that of Singapore to that of
Mexico would have the same negative impact on inward FDI as would increasing the tax rate by
eighteen to fifty percentage points. Wei (2000) also found that, despite the unique U.S. Foreign
Corrupt Practices Act 6 , American MNCs were not necessarily more averse to host country corruption
than were MNCs from other countries. Hines (1995) demonstrated that the act reduced U.S. FDI in
bribe-prone countries after 1977 and, while it reduced the competitive position of American firms, it
did not significantly reduce the importance of bribery to foreign business transactions. Smarzynska-
Javorcik and Wei (2000) studied the impact of corruption within a host country on foreign investors'
preferences regarding the form of FDI (i.e., joint venture versus wholly-owned subsidiary). They
hypothesize that, while corruption makes local bureaucracy less transparent and increases the value of
a local partner, corruption also decreases the effective protection of foreign investors' intangible
3
In 2003, the IMF reported that: “recorded world inflows of FDI, which increased by an average of 13 percent
a year during 1990-97, surged by an average of nearly 50 percent a year during 1998-2000, driven by large
cross-border mergers and acquisitions. World FDI inflows reached a record US$1.5 trillion in 2000 before
falling to US$0.7 trillion in 2001 as a result of the sharp contraction in cross-border mergers and acquisitions
among industrial countries. Inflows of FDI into developing countries grew by an average of 23 percent a year
during 1990-2000, but declined by 13 percent to US$215 billion in 2001.” Source: IMF “Foreign Direct
Investment Trends and Statistics” report prepared by the Statistics Department in consultation with other
departments and approved by Carol S. Carson (October 28, 2003).
4
BI (Business International Inc.) risk and policy variables: political stability, inequality, corruption, red tape,
quality of the legal system, cultural compatibility, attitude toward foreign capital, general expatriate comfort
and the risk of terrorism.
5
Unfortunately, their analysis failed to produce statistically significant results.
6
This act stipulates tax penalties, fines and even prison terms for executives of American firms that pay illegal
bribes.

assets. Using a firm-level data set from post-Soviet countries, they showed that increased corruption
reduces inward FDI and shifts the ownership structure towards joint ventures (henceforth JVs).
According to their results, an increase in corruption from the Hungarian level to that of Azerbaijan
decreases the probability of a wholly-owned subsidiary by ten to twenty percent.
In this paper I take a different approach to analyzing the relationship between governance and
FDI. I utilize the worldwide governance indicators developed by Kaufmann, Kraay and Mastruzzi
(2005) (henceforth KKM) and study the importance of these indicators for FDI within the framework
of the “knowledge-capital” model of FDI (Markusen et al., (1996); Markusen (1997, 2002)). Given
that researchers have previously linked FDI to governance in general, and to KKM measures in
particular (Globerman and Shapiro (2002)) 7 , my primary research issue is to determine the extent to
which governance explains FDI once the general-equilibrium model of FDI is established.
I address this issue by performing tests which incorporate the KKM measures into the
knowledge-capital regressions of Carr, Markusen and Maskus (2001), which I first replicate with a
larger and newer FDI dataset. I use the knowledge-capital model as a benchmark for FDI because it
combines the two primary theories of FDI, i.e., the vertical (Helpman (1984, 1985); Helpman and
Krugman (1985)) and horizontal (Markusen (1984)) motives for MNC activity. My rationale for
using the KKM measures as a benchmark for governance is the breadth and consistency of these
measures. The KKM measures have been compiled since 1996, and they measure the quality of six
dimensions of governance for more than 200 countries, based on 31 data sources produced by 25
different organizations worldwide.
I propose that my approach is useful for a couple of reasons. First, I provide a stronger check
of the validity of the impact of governance on FDI. Given that governance is correlated with
economic fundamentals, it is not unreasonable to expect that regressing FDI on governance in a
reduced-form econometric framework will yield statistically significant coefficients. While the
importance of such regressions must not be underestimated, they do not tell us whether governance
will remain significant once powerful, theoretically-driven control variables are included, variables
such as size, trade and investment barriers, skills and distance (i.e., the components of the knowledge-
capital model of FDI). Second, my approach provides a check on the robustness of the knowledge-
capital model itself. Since this model does not include governance as a parameter, adding the KKM
measures to the knowledge-capital regressions allows me to judge the robustness of the model as a
whole.
My results reveal a number of interesting regularities regarding the relationship between
governance and FDI. First, using a newer and larger FDI dataset, I am able to re-confirm, and even
7
Globerman and Shapiro (2002) utilized an earlier version of these measures, originally reported in Kaufman,
Kraay and Zoido-Lobaton (1999a).
4
improve upon, the original estimation of the knowledge-capital model derived by Carr, Markusen and
Maskus (2001). I document that the model is sufficiently robust in explaining FDI, even in the
presence of governance variables and during periods of instability. I suggest that the theoretical
framework of the model be extended in order to accommodate the importance of governance in
generating and attracting FDI.
Second, my results demonstrate that FDI flows from governance-abundant to governance-
poor countries. FDI originates in governance-rich countries and flows to locations with poor
governance; further, when host country governance improves, FDI inflows increase, and when host
country governance deteriorates, foreign MNCs reduce investment.
Lastly, I explore the possibility that FDI and governance are simultaneously determined, in
that foreign MNCs respond to governance quality in host countries, and host country law makers
adjust laws, and possibly governance in general, in order to attract and accommodate FDI. Following
Acemoglu, Johnson and Robinson (2001) and Albouy (2006), I use the mortality rate experienced by
European colonialists as an instrumental variable for the quality of governance in 64 former colonies.
The results of my instrumental variable regressions provide partial evidence that, once I control for
simultaneity bias, better governed host countries enjoy greater FDI inflows.
The rest of my paper is organized as follows. In Section 2 I describe my data, sources and
methodology. Section 3 describes my empirical results and Section 4 concludes.
2. Background, Data and Empirical Methodology

In order to analyze the relationship between governance and FDI, I use the outward FDI
stock positions of 30 OECD reporting countries (i.e., parents) to 229 OECD and non-OECD partner
countries (i.e., hosts) for the period 1996 to 2004, available from the “SourceOECD” database. I
deflate these data by the 2000 base year GDP deflator, obtained from the World Development
Indicators (WDI) CD-Rom, and convert to year 2000 U.S. dollars. The appendix describes my
variables and the sources from which they are derived.
I believe the OECD FDI stock data are better suited for studying the link between governance
and FDI than are the U.S. affiliate sales data which have often been used by researchers in this field.
Since U.S. MNCs have evolved in a stable political and legal environment, their response to host
country governance quality might be very different from that of MNCs from other OECD countries.
Thus, using OECD outward FDI stock data should allow me to better generalize the way in which
MNCs respond to governance. Additionally, since I utilize the latest version of the OECD data, I
believe some previously identified problems with these data (i.e., variation in coverage and
measurement of FDI (e.g., Blonigen, Davies and Head (2003))) have been mitigated to some extent.
5
I use the knowledge-capital model (Markusen et al., (1996); Markusen (1997, 2002)) as a
benchmark for FDI. This model combines both the horizontal (Helpman (1984, 1985); Helpman and
Krugman (1985)) and vertical (Markusen (1984)) models of FDI, and allows for multi-plant scale
economies and exploitation of factor-price differences 8 . The model assumes that knowledge is
geographically mobile and that headquarter services use skilled labor more intensively than do other
activities. It views MNCs as important in industries where intangible, firm-specific assets are
prevalent so that FDI arises as a result of differences in skills among countries. The model’s primary
prediction is that countries tend to interact by FDI when they are relatively similar in size and
endowment (i.e., horizontal investment), or when one country is smaller but skilled-labor abundant
(vertical investment).
Empirical tests of the three general-equilibrium models of FDI provide mixed results.
Brainard (1993a,b) investigated whether U.S. affiliate sales back to their U.S. parents are sensitive to
factor proportion differences, and found results consistent with the horizontal model of FDI but found
little support for the vertical model. Later, Brainard (1997) hypothesized that the proportion of an
MNC’s exports to its total foreign sales should be negatively related to export frictions such as tariffs
and transportation costs, and positively associated with plant-related fixed costs. She supported this
“concentration-proximity trade-off” hypothesis with U.S. affiliate sales and export data. Ekholm
(1995, 1997, 1998a, b) provided indirect support for the knowledge-capital model. Carr, Markusen
and Maskus (2001), and Markusen and Maskus (2001) reported results consistent with the
knowledge-capital model 9 . Markusen and Maskus (2002) attempted to empirically discriminate
among the three models, and found greater support for the knowledge-capital and horizontal models
than for the vertical model.
I follow Carr, Markusen and Maskus (2001) (henceforth CMM) and estimate the knowledge-
capital model by explaining OECD member countries’ outward FDI stock positions as a function of
joint market size (the sum of parent and host country real GDP), squared difference of real GDP,
difference in a measure of skilled-labor abundance, product of differences in economic size and skill
8
Departures from these models have been proposed in the literature. For example, Eckholm, Forslid, and
Markusen (2003), and Bergstrand and Egger (2004) study export platform FDI, where an MNC places FDI into
a host country so that it serves as a production platform for exports to neighboring countries. Baltagi, Egger
and Pfaffermayr (2004) study a complicated interaction whereby affiliates of an MNC in a number of host
countries ship intermediate goods among themselves for further production, before sending finished products
back to the parent.
9
Blonigen, Davies and Head (2003) criticized the results of Carr, Markusen and Maskus (2001). They
identified a significant error in variable specification (i.e., the skill difference variable is always negative in
Carr, Markusen and Maskus (2001)) and, after resolving this issue, showed that the Carr, Markusen and Maskus
(2001) support for the vertical motivation of FDI is no longer valid. Carr, Markusen and Maskus (2003) replied
to this criticism, stating that “the proposed alternative ‘absolute difference’ estimating equation makes no sense
from the point of view of the theory. It proposes relationships that cannot be consistent with (i.e., are
misspecified with respect to) any existing theory…. It can, however, be interpreted as a crude test to choose
between a horizontal and the vertical model, but certainly not the KK (knowledge-capital) model.”
6
endowments, cost of investing in and exporting to the host country, product of host-country trade cost
and squared endowment difference, trade cost of exporting to the parent country, and geographic
distance between parent and host countries.
I utilize various data sources in order to obtain the components of the model. Parent and host
country real GDP are derived from the Penn World Tables by calculating the product of chain-series
real GDP per capita and population size. I acquire from the International Labour Organization’s
(ILO) LABORSTA internet resource parent and host country skilled labor abundance figures, which I
calculate as the ratio of skilled to total labor force. I measure skilled labor force as the sum of
occupational categories 1 (legislators, senior officials and managers), 2 (professionals) and 3
(technicians and associate professionals), as reported in the ISCO-88 employment survey. The cost
of investing in host counties is from the Heritage Foundation’s Index of Economic Freedom; I use the
“Cash Flow and Foreign Investment” factor, which “scrutinizes each country’s policies toward
foreign investment in order to determine its overall investment climate.” The cost of trading with
host and parent countries is from the Index of Economic Freedom as well; here, I use the “Trade
Policy” factor which is derived from each country’s weighted average tariff rate. The scores for each
factor are on a scale from 1 to 5, where higher scores represent greater investment and trade
restrictions. Finally, I obtain bilateral distance (in kilometers) between parent and host country from
the CEPII (Centre d'Etudes Prospectives et d'Informations Internationales) database.
For my measures of governance I use the Worldwide Governance Indicators, created by a
research program at the World Bank Institute and the Research Department of the World Bank. The
program was initiated by Daniel Kaufmann and Aart Kraay, with assistance from Pablo Zoido-
Lobatón and Massimo Mastruzzi, and the results of the program have been published in a series of
papers (Kaufmann, Kraay and Zoido-Lobaton (1999a,b, 2002), Kaufmann, Kraay and Mastruzzi
(2004, 2005, 2006)). In my study, I utilize the Kaufmann, Kraay and Mastruzzi (2005) version of
these indicators 10 (henceforth KKM).
The uniqueness of the KKM indicators derives from the fact that they systematically
aggregate 37 data sources, compiled by 31 organizations worldwide, into six key dimensions of
governance. The authors utilize an extension of the standard unobserved components model (e.g.,
Goldberger (1972); Efron and Morris (1971, 1972)) in order to express the observed data in each
dimension as a linear function of the unobserved common component of governance. The indicators
are available for 209 countries, on a bi-annual basis for the years 1996 through 2004. For the years
10
The 2006 version of these indicators (KKM 2006) was published after my paper was completed. The KKM
2006 indicators differ from the 2005 version by virtue of their inclusion of data for the years 2003 and 2005.
Using the KKM 2005 indicators, rather than the KKM 2006 data, would not affect my results for two reasons.
First, the KKM data for 2005 are not relevant to us since I do not possess FDI data for 2005. Second, even
though the KKM data for the year 2003 might be useful, these data have a 99% correlation with the 2003 data I
calculated by averaging data for the years 2002 and 2004.
7
when the governance scores are unavailable (i.e., 1997, 1999, 2001 and 2003), I use the average of
the surrounding years. Although this approach allows me to increase the size of my dataset, it is
possible that the assumption of linearity introduces a bias. I believe this bias is mitigated however by
the fact that governance around the globe changes very slowly.
For each of the 209 countries, the KKM indicators measure six dimensions of governance:
(1) Voice and Accountability measures political, civil and human rights; (2) Political Instability and
Violence measures the likelihood of violent threats to, or changes in, government, including
terrorism; (3) Government Effectiveness measures the competence of the bureaucracy and the quality
of public service delivery; (4) Regulatory Burden measures the incidence of market-unfriendly
policies; (5) Rule of Law measures the quality of contract enforcement, the police and the courts, as
well as the likelihood of crime and violence; (6) Control of Corruption measures the exercise of
public power for private gain, including both petty and grand corruption as well as state capture. The
scores measuring each dimension range from -2.5 to +2.5, and have a normal distribution with mean
zero and standard deviation of one in each period. For a small number of countries, scores fall
outside these boundaries when estimates of governance are especially high or low.
Critics of the KKM indicators (e.g., Arndt and Oman (2006); Knack (2006); Kurtz and
Shrank (2006)) maintain that governance cannot be compared over time and across countries using
the KKM measures because these measures are scaled to have the same global averages in each
period and are based on different underlying data sources. Further, critics contend that the KKM
indicators are too imprecise to allow appropriate comparisons of governance, and are biased in that
they tend to reflect the opinions of those in the upper echelons of business management. Also, the
data sources underlying the KKM indicators are biased towards recent economic performance and
incorporate correlated errors in their assessments of governance. Kaufmann, Kraay and Mastruzzi
(2006a and 2006b) provide a careful and exhaustive reply to these critiques. It is important to note,
however, that despite these shortcomings, the literature generally considers the KKM indicators the
best available measures of governance (e.g., Arndt and Oman (2006)).
3. Empirical Results
I present summary statistics for my data in Table 1. Panel A summarizes the knowledge-
capital model variables, and Panels B and C present summary statistics and the correlation matrix for
the KKM governance indicators, respectively. I report summary statistics for the full sample as well
as separately for the OECD and non-OECD groups. My sample is in the form of a panel with a size
of 30 parent countries by 229 host countries by 9 years (1996 through 2004).
Examination of the summary statistics reveals that, on average, OECD countries send larger
amounts of FDI to non-OECD countries than to their OECD counterparts ($US 2,394 million versus
8
$US 2,208 million). OECD countries impose lower barriers to foreign investment and trade than do
non-OECD countries (average investment and trade cost scores for OECD countries are 2.07 and
2.44, respectively, versus 2.96 and 3.77, respectively, for non-OECD countries) and they are much
better governed (OECD countries’ governance scores range from 1.03 to 1.47 while non-OECD
countries’ scores range from -0.27 to -0.08). Clearly these results are not surprising given that OECD
countries are more economically developed, tend to be more open to foreign investment and trade,
and are better governed.
Correlation coefficients among the 30 OECD parent countries’ KKM governance indicators
are strongly positive. This result too is not surprising given the similarities among these countries,
which is why they belong to the OECD ‘club’ in the first place. Correlation coefficients among host
countries’ KKM governance indicators (which include both OECD and non-OECD nations) are also
strongly positive, indicating that, on average, recipients of FDI from OECD countries have similar
levels of governance. Finally, correlation coefficients among the KKM governance indicators
between the parent and host country groups are largely negative. Even though these coefficients are
in fact close to zero, this result reveals a fundamental difference in governance between the two
groups (i.e., the senders and recipients of FDI), which I investigate in the paper.
In Table 2 I present results for the fixed effects 11 OLS estimation of the basic knowledge-
capital model of FDI with controls for host country governance. I first compare baseline knowledge-
capital estimation (Column 1 of Table 2) to the original results in Table 4 of Carr, Markusen and
Maskus (2001), and then add each of the KKM indicators separately into the model in order to assess
their importance for FDI (Columns 2 through 7 of Table 2). I include the KKM indicators separately
rather than jointly in order to avoid the multicollinearity problem, given that these indicators are
highly correlated with one another. As explained earlier, my overall approach is based on the
argument that, in light of the general equilibrium theory of FDI, one can achieve a better
understanding of the link between governance and FDI by controlling for the predictions of the model
rather than by investigating this link in a reduced-form econometric framework. Of course, such an
approach is based on the assumption that this general equilibrium model is truly general. While the
debate on the theoretical modeling of FDI continues, I assume in my paper that the CMM (2001)
knowledge-capital model of FDI is sufficiently general for my empirical exercise.
The results of the baseline estimation of the knowledge-capital model presented in Column 1
of Table 2 strongly support those of CMM (2001), and in fact actually improve upon those results. I
use the OECD FDI data, which is more extensive and more recent than the U.S. affiliate sales data of
CMM (2001) (3,148 observations for the period 1996-2004 versus 509 observations over the period
11
I include both host country and year fixed effects. I delete observations when parent and host country are the
same in order to avoid perfect collinearity.
9
1986-1994), and I generate very similar predictions regarding the relationship between the
knowledge-capital variables and FDI. Most of my coefficients are similar in size and level of
statistical significance to those of CMM (2001), and many of my coefficients attain statistical
significance in contrast to the results of CMM (2001). For example, the skill difference and trade
cost host coefficients are positive and statistically significant in my estimation while they are positive
but not statistically significant in CMM (2001). The investment cost host and the product of trade
cost host and squared skill difference coefficients are negative and statistically significant in my
estimation but negative and not significant in CMM (2001). Lastly, I identify two coefficients in my
sample whose sign contradicts the predictions of the knowledge-capital model: GDP difference
squared and trade cost parent. Each of these coefficients has a positive sign in my regression but
should have a negative sign according to the knowledge-capital model. However, since neither of
these coefficients is statistically significant in my sample, I contend that these results do not discredit
my findings. Overall, the result that my findings support those of CMM (2001) allows me to proceed
to the primary objective of my study, investigation of the relationship between governance and FDI.
In my knowledge-capital FDI regressions, I first control for the quality of host country
governance (Table 2), then for the quality of parent and host country governance jointly (Table 3),
and lastly I control for the difference in quality of governance between parent and host countries
(Table 4). In each table, I present the baseline regression so that readers can observe changes in the
coefficients once governance variables are included.
Overall, the results in Tables 2, 3 and 4 document that FDI flows from parent countries with
high quality governance to host countries with low quality governance. The coefficient of each host
country governance variable in Table 2 is negative, and three of these coefficients are statistically
significant: political stability, regulatory quality and rule of law are statistically significant at 5%,
10% and 5% levels, respectively. When in Table 3 I include parent and host country governance
indicators jointly I find that coefficients for parent country governance indicators are all positive and
highly significant (except for the political stability variable) and coefficients for host country
governance indicators are all negative and attain significance levels similar to those in Table 2.
Finally, in Table 4 I calculate differences in governance level between parent and host countries, and
use these differences in the knowledge-capital regressions. Coefficients for all pairs of parent minus
host country governance are positive and highly significant, with the exception of the difference in
political stability, which is significant but only at the 10% level.
It is important to note that the signs and statistical significance of the knowledge-capital
coefficients are essentially unaffected by inclusion of the various governance indicators. This
signifies to me that the knowledge-capital model is robust, and continues to explain FDI even in the
presence of the governance variables. Since governance is significant in explaining FDI even after it
10
is part of the knowledge-capital model, there is an opportunity to extend the theoretical framework of
the model to include the quality of host countries’ governance institutions.
The only knowledge-capital variable that appears sensitive to inclusion of the governance
indicators is trade cost parent. According to CMM (2001), the coefficient of this variable should be
negative because “trade costs diminish the incentive to locate plants abroad for shipment back to the
home market.” In my basic knowledge-capital estimation, the coefficient of this variable is positive
and insignificant, but after including various governance controls the coefficient becomes positive
and statistically significant at 1% and 5% levels (e.g., Tables 3 and 4). I contend that this result is a
consequence of my use of FDI data rather than affiliate sales data. The knowledge-capital model was
developed to explain the international behavior of U.S. firms; here, U.S. affiliate sales data is a
perfect proxy. It is generally accepted that FDI data is a second best choice for tests of the
knowledge-capital model. Since FDI data account for foreign investment activity, rather than trade,
of MNCs, I believe the trade cost parent variable in my sample has a positive coefficient because it
reacts to the horizontal explanation of FDI (i.e., foreign investment arises as a consequence of trade
barriers).
With results from Tables 2, 3 and 4 in mind, I am able to conclude that FDI flows from
governance-abundant to governance-poor countries. From Tables 2 and 3 it is apparent that, on
average, the higher the quality of the host country’s governance the less FDI inflows it will receive
from MNCs located in OECD countries. The positive and strongly statistically significant
coefficients for the governance difference variables in Table 4 signify that countries with better
governance generate FDI and countries with worse governance receive FDI. Hence, I conclude that
globally FDI flows from governance-abundant to governance-poor countries.
The issue I now address is how to interpret this finding. My initial proposition in this paper
was that poor governance has a negative impact on FDI inflows because poor governance reduces the
synergies foreign investors generate in their cross-border M&As, the predominant vehicle for FDI.
However, the negative and statistically significant coefficients of the host country governance
indicators combined with the positive and statistically significant coefficients for differences in
governance between parent and host country imply the opposite conclusion. I suggest that this is a
consequence of the fact that better governed countries are more economically developed, and foreign
MNCs in these better governed countries possess fewer advantages vis-à-vis domestic firms; hence,
less FDI flows there.
The notion that foreign MNCs possess advantages not available to domestic firms has been a
major argument underpinning the modern theory of FDI; that is, FDI occurs because certain domestic
assets are worth more under foreign control than under domestic control (e.g., Froot and Stein
(1991)). This scenario unfolds when foreigners possess certain firm-specific capital not available to
11
domestic enterprises. Since doing business internationally is very expensive, it must be the case that
MNCs possess offsetting advantages relative to domestic firms, thereby justifying the costs of
international operations 12 . Caves (1971) maintains that direct investment is associated with such
firm-specific capital, and thus investment moves from an industry in the parent country to the same
industry in the host country. Hymer (1976) contends that MNCs develop either because they possess
some special technology or they have the ability to lower costs by virtue of scale economies, and that
13
such inherent advantages constitute an important gain for host countries . Dunning (1993) provides
a useful organizational framework for identifying these advantages and claims that, in order for a firm
to become an MNC, it requires ownership (O), location (L) and internalization (I) advantages 14 .
Given this theoretical background, I propose that in governance-poor countries, foreign
MNCs possess greater advantages in dealing with local firms, such as greater access to capital, more
advanced technology, and more efficient business processes; these advantages in fact provide the
motivation for MNC investment in governance-poor countries. It is important to remember that FDI
flows are predominantly real investment oriented transactions. 15 That is, these transactions are
typically implemented via M&As because it is easier to acquire domestic assets than it is to either
build the same assets from scratch as greenfield (de novo) investments, or develop them jointly with
local firms in JVs. The latter alternative often proves unsuccessful because of expropriation
problems arising from joint ownership of assets.
In high governance quality nations, domestic investment opportunities are accommodated by
local firms which posses the required capital and expertise, so that fewer opportunities remain
available to foreign investors. In countries with low governance quality, local firms are unable to
accommodate domestic investment opportunities because they generally do not possess the necessary
technology, skills and capital. Thus, in such countries foreign investors, especially those from
developed and capital-abundant OECD nations, have an advantage. Hence, I find in my sample that
FDI originates in governance-rich countries and flows to governance-poor countries.
In the next section of the paper, I perform a number of additional tests to further my
investigation of the link between governance and FDI. First, in Table 5 I evaluate the impact of
changes in host country governance scores on FDI inflows. Since I have established that FDI flows
12
Examples of such costs are communication and transportation expenses, customs, legal fees, and cultural and
language barriers.
13
The interested reader should refer to the literature on FDI and economic growth of host countries [e.g.,
Borensztein, De Grigorio and Lee (1998); Blomstrom, Lipsey and Zejan (1994); Stocker (2000);
Balasubramanyam, Salisu and Sapsford (1996); Alfaro, Chandra, Kalemli-Ozcan and Sayek (2003); Carkovic
and Levine (2002)].
14
Sometimes called Dunning’s OLI theory of FDI.
15
As opposed to portfolio and debt flows, which are defined as financial investments.
12
from governance-abundant to governance-poor countries, I now analyze the effect on FDI inflows
when host country governance improves or deteriorates.
Second, I investigate the efficacy of the FDI-knowledge-capital-governance link during crisis
periods. I use data compiled by Caprio and Klingebiel (1999), and re-estimate the knowledge-capital
FDI regressions with controls for host country governance during periods of systemic banking crises
(Table 6). Since such crises are clearly detrimental to host countries’ economies in general, and to
inflows of FDI in particular, my goal is to observe whether the knowledge-capital model continues to
explain FDI inflows during these periods and, if not, whether governance then becomes a viable
alternative predictor of FDI.
Lastly, I explore the possibility that there exists a simultaneous relationship between FDI and
governance. Throughout the paper, I have assumed that FDI responds to host country governance
and that the two variables are not jointly determined. However, it is conceivable that, as foreign
MNCs respond to the quality of governance in host countries, law makers in these countries adjust
their laws, and possibly governance in general, in order to attract and accommodate FDI. To control
for the possible simultaneity bias I follow the approach of Acemoglu, Johnson and Robinson (2001)
and Albouy (2006), and perform instrumental variable regressions using mortality rates faced by
European colonialists as an instrument for overall quality of host country governance, which I proxy
with an average KKM governance score.
The results in Table 5 document a largely positive relationship between changes in the KKM
measures of host country governance and FDI inflows. Most of the coefficients of changes in the
KKM measures of host country governance are positive (an exception is the change in host country
rule of law, which has a negative, but clearly statistically insignificant coefficient) and two of the
coefficients attain statistical significance. Coefficients for both the change in voice and
accountability of host countries and the change in the regulatory quality of host countries are positive
and significant at the 10% level.
Overall, these results add to my findings and allow me to conclude that, while FDI flows
from governance-abundant to governance-poor countries (Table 4), when host countries improve
their governance regimes they tend to receive greater FDI inflows and when they allow deterioration
of governance, they are likely to receive less investment from foreign MNCs (Table 5).
The results in Table 6 indicate that the knowledge-capital model of MNC activity explains
flows of FDI around the world reasonably well, even during periods of systemic banking crises in
host countries. Although the significance of many of the coefficients in regressions 2 through 8 of
Table 6 disappears, their signs do not change and the central variable of the model (i.e., skill
difference) remains significant (except in specification 8). Regarding the issue of whether
governance assumes the role of primary explanatory variable during such periods, I find that it does
13
not. The signs of the coefficients for the parent and host country governance differences are positive
(as during all periods, i.e., the results in Table 4), and three of six governance differences attain
statistical significance at the 5% level; these are voice and accountability difference, rule of law
difference and control of corruption difference. My interpretation of the results in Table 6 is that the
knowledge-capital model is sufficiently robust to predict FDI flows even during periods of systemic
banking crises in host countries, and that during such periods FDI continues to flow from
governance-abundant to governance-poor countries. I speculate that FDI continues to flow in such a
manner because host country banking systems are less important to foreign MNCs. While, to the best
of my knowledge, this matter has not received sufficient attention in the FDI literature, it is
reasonable to assume that foreign MNCs are immunized, to some extent, from host country banking
crises because they have access to both their own domestic as well as global sources of capital. Thus,
I continue to observe positive coefficients for parent and host country governance differences in my
FDI regressions even during these periods of host country banking crises.
Lastly, I attempt to control for possible simultaneity bias between governance and FDI. As
discussed earlier, FDI and governance might be simultaneously determined, whereby FDI reacts to
the quality of host country governance but then host countries’ lawmakers adjust local governance in
order to accommodate and attract FDI. I adopt the results of Acemoglu, Johnson and Robinson
(2001), showing that differences in colonial experience might be a source of exogenous differences in
institutions, and I use the mortality rate faced by European colonialists as an instrument for the
quality of governance in 64 former colonies.
In my regressions, I adopt the Albouy (2006) version of the Acemoglu, Johnson and
Robinson (2001) data. Albouy has shown that the Acemoglu, Johnson and Robinson settler mortality
rates suffer from “a number of inconsistencies, comparability problems, and questionable geographic
assignments.” 16 I calculate an average of the six dimensions of governance and instrument this
average with Albouy’s mortality data. Graph 1 presents a scatter plot of the average yearly KKM
governance scores in 64 former colonies versus the logarithm of mortality rates. Similar to the
findings of Acemoglu, Johnson and Robinson (2001), I observe a negative association between the
two variables, indicating that those countries where European colonialists faced lower mortality rates
developed better quality governance as measured by KKM governance scores.
The results in Table 7 suggest a positive association between the quality of host country
governance and FDI inflows once the former is instrumented with mortality data. In Panel 2 of Table
7 I re-estimate the basic fixed-effects OLS knowledge-capital model of FDI while controlling for the
16
Albouy (2006) identifies 14 countries for which Acemoglu, Johnson and Robinson (2001) settler mortality
rates must be revised in order to eliminate inconsistencies (Table 1). After making the necessary changes, the
Albouy (2006) data shows a correlation of 73% with the original Acemoglu, Johnson and Robinson (2001)
results. After taking logarithms of these data, the correlation increases to 92%.
14
average KKM governance score, which has a negative coefficient that is statistically significant at the
10% level. This result supports my findings in Tables 2 and 3 indicating that FDI flows from
governance-abundant to governance-poor countries. However, in Panels 3 though 7 of Table 7,
where I instrument the average KKM governance score with settler mortality data, the coefficient
becomes positive and statistically significant at 1% and 5% levels in the years 2000 and 2002,
respectively 17 .
Although my IV regressions suffer from a substantial loss of data, to the extent that in
specifications 3 and 4 the average KKM governance indicator can not be calculated, estimates for the
years 2000 and 2002 can be accepted with some degree of caution. First, most of the coefficients in
Panels 5 and 6 have the sign predicted by the knowledge-capital model. Second, the coefficient for
the central variable of the model (i.e., skill difference) is positive and significant in both
specifications 5 and 6. Taken together, this allows me to conclude that the knowledge-capital
framework holds in IV specifications 5 and 6 of Table 7, and that there is some evidence that better
governed host countries enjoy greater FDI inflows once I control for the possible simultaneity bias.
I underscore the need for caution in interpreting my results in Table 7. It is questionable
whether FDI alone can significantly impact host country governance as a whole, given that
governance clearly develops in response to a myriad of economic, political, social, historical, and
geographic factors. While I do not contend that FDI alone, regardless of its size in a monetary sense,
would be able to generate change in the governance of a host country, I also believe that this subject
is worth pursuing in future studies.
4. Conclusion
In this paper I investigate the importance of parent and host country governance as
determinants of the amount of FDI generated and received, respectively. The uniqueness of my study
is in my treatment of the governance-FDI link. Rather than connecting the two variables in a typical
reduced-form econometric framework, I explain the impact of governance on FDI within the general
equilibrium framework of FDI, i.e., the knowledge-capital model of Carr, Markusen and Maskus
(2001).
Overall, my results show that around the globe FDI flows from governance-abundant to
governance-poor countries, and further, that those countries whose governance improves enjoy
greater FDI while those whose governance deteriorates receive less foreign investment. I also
document that the original estimation results of the knowledge-capital model of FDI of Carr,
Markusen and Maskus (2001) holds with a larger and more recent data set. The model is robust in
17
Since my dependent variable is stocks of FDI inflows I believe it makes more sense to perform yearly IV
regressions, as opposed to collapsing all of my data into a single 1996-2004 average regression. Additionally, I
select only the years 1996, 1998, 2000, 2002, and 2004 because actual KKM data are available for these years.
15
explaining FDI, even in the presence of governance variables and during periods of instability. In an
attempt to control for simultaneity bias, I instrument host country governance with the Acemoglu,
Johnson and Robinson (2001) and Albouy (2006) data on mortality rates faced by European
colonialists and find that better governed host countries enjoy greater FDI inflows.
16
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21
Appendix - Variable Definitions and Sources
Panel A. Knowledge-Capital Model Variables
Variable Name Definition Source
Outward direct investment position for 1996 through 2004 (in

SourceOECD; World
submitted currency) by 30 reporting (i.e., home) OECD nations to
Real FDI Stock Development Indicators
229 partner (i.e., host) nations. These data were deflated by 2000-
CD-Rom
base year GDP deflator and converted into 2000 U.S. dollars.
The sum of parent-country and host-country GDP in billions of 2000

U. S. dollars. GDP figures were calculated as a product of Real GDP
GDP Sum Penn World Tables
per capita (chain series: RGDPCH) and the size of the country's
population.
Difference (Squared) between parent-country and host-country GDP
in billions of 2000 U. S. dollars. GDP figures were calculated as a
GDP Difference (Squared) Penn World Tables
product of Real GDP per capita (chain series: RGDPCH) and the
size of the country's population.
Difference (Squared) between the ratio of skilled labor to total labor
force in the parent-country and that in the host-country. Skilled
ILO (LABORSTA
labor is measured as the sum of occupational categories 1
Skill Difference (Squared) Internet), (BA) Labour
(legislators, senior officials and managers) 2 (professionals) and 3
force survey, ISCO-88
(technicians and associate professionals) as reported in the ISCO-88
employment survey.
Capital Flows and Foreign Investment (Factor #5) - "... this factor
scrutinizes each country’s policies toward foreign investment in Index of Economic
Investment Cost Host order to determine its overall investment climate" The scale runs Freedom (The Heritage
from 1 to 5, where higher scores represent more restrictions on Foundation)
capital flows and foreign investment.
Trade Policy (Factor #1) - "... the trade policy score is based on a
Index of Economic
country’s weighted average tariff rate—weighted by imports from
Trade Cost Host / Parent Freedom (The Heritage
the country’s trading partners" The scale runs from 1 to 5, where
Foundation)
higher scores represent higher tariff rate.
The CEPII - "Centre
Dataset of bilateral distances (in kms) for 225 countries across the d'Etudes Prospectives et
Distance
world. d'Informations
Internationales"
Panel B. Governance Variables

Variable Name Definition Source
World Bank: Worldwide
Voice and accountability "...measures political, civil and human rights." Governance Indicators
1996-2004
Political stability and "...measures the likelihood of violent threats to, or changes in,
Governance Indicators
absence of violence government, including terrorism."
1996-2004
"...measures the competence of the bureaucracy and the quality of
Government effectiveness Governance Indicators
public service delivery."
1996-2004
Regulatory quality "...measures the incidence of market-unfriendly policies." Governance Indicators
1996-2004
22
"...measures the quality of contract enforcement, the police, and the
Rule of law Governance Indicators
courts, as well as the likelihood of crime and violence."
1996-2004
"...measures the exercise of public power for private gain including
Control of corruption Governance Indicators
both petty and grand corruption and state capture."
1996-2004
"... The units in which governance is measured follow a normal
distribution with a mean of zero and a standard deviation of one in
each period. This implies that virtually all scores lie between -2.5 World Bank: Worldwide
Measurement of scores and 2.5, with higher scores corresponding to better outcomes. For a Governance Indicators
handful of cases, individual country ratings can exceed these 1996-2004
boundaries when estimates of governance are particularly high or
low."
23
Table 1 - Summary Statistics
Panel A. Summary Statistics for Knowledge-Capital Model variables
Full Sample OECD Countries Non OECD Countries
Variable N Mean STD Min Max N Mean STD Min Max N Mean STD Min Max
Real FDI Stock 7552 2342.02 28417.25 -2898.6 914238.9 2140 2208.54 21351.96 -118.68 914238.9 5412 2394.8 30768.2 -2898.6 854245
GDP Sum 49590 1080.79 1933.71 5.91 17568.55 7830 1703.78 2431.72 21.08 13818.5 41760 963.98 1801.47 5.91 17568.6
GDP Difference 49590 612.23 1948.92 -10656 10663.74 7830 0 2514.40 -10656 10655.59 41760 727.02 1800.48 -6896.7 10663.7
GDP Difference Squared 49590 4173016 1.68E+07 0.00017 1.14E+08 7830 6321414 20600000 0.01 1.14E+08 41760 3770191 1.6E+07 0.0002 1.1E+08
Skill Difference 12571 0.06 0.12 -0.38 0.48 4994 0 0.11 -0.38 0.38 7577 0.10 0.12 -0.25 0.48
Skill Difference Squared 12571 0.02 0.02 2.3E-10 0.23 4994 0.01 0.02 5.6E-09 0.14 7577 0.02 0.03 2.3E-10 0.23
Investment Cost Host 40951 2.79 0.94 1 5 7801 2.07 0.53 1 3 33150 2.96 0.94 1 5
Trade Cost Host 40951 3.52 1.15 1 5 7801 2.44 0.49 1 4.5 33150 3.77 1.12 1 5
Trade Cost Parent 61332 2.44 0.49 1 4.5 7801 2.44 0.49 1 4.5 53531 2.44 0.49 1 4.5
Distance 58320 7634.91 4554.863 59.6172 19629.5 7830 5236.02 5406.621 59.6172 19586.18 50490 8006.93 4289.6 80.9848 19629.5
Panel B. Country Governance Variables

Full Sample OECD Countries Non OECD Countries
Variable N Mean STD Min Max N Mean STD Min Max N Mean STD Min Max
Voice and accountability 38430 0.06 0.92 -1.91 1.76 7830 1.20 0.47 -0.92 1.76 30600 -0.23 0.77 -1.91 1.51
Political stability 37920 0.03 0.95 -2.83 1.77 7830 1.03 0.56 -1.21 1.77 30090 -0.23 0.85 -2.83 1.58
Government effectiveness 38250 0.13 0.99 -2.07 2.59 7830 1.45 0.69 -0.31 2.53 30420 -0.21 0.74 -2.07 2.59
Regulatory quality 38430 0.19 0.89 -2.78 2.31 7830 1.22 0.44 -0.07 2.02 30600 -0.08 0.78 -2.78 2.31
Rule of law 38370 0.10 0.99 -1.97 2.36 7830 1.41 0.68 -0.38 2.36 30540 -0.24 0.74 -1.97 2.24
Control of corruption 37920 0.09 1.02 -1.98 2.58 7830 1.47 0.84 -0.40 2.58 30090 -0.27 0.72 -1.98 2.51
Panel C. Correlation Matrix of KKM Governance Indicators

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)
Voice and Accountability Parent (1) 1
Political Stability Parent (2) 0.8919 1
Government Effectiveness Parent (3) 0.8394 0.7763 1
Regulatory Quality Parent (4) 0.7522 0.6914 0.8527 1
Rule of Law Parent (5) 0.8367 0.8151 0.9451 0.8038 1
Control of Corruption Parent (6) 0.8252 0.799 0.947 0.8281 0.9645 1
Voice and Accountability Host (7) -0.0023 -0.0039 -0.0031 0.0003 -0.0038 -0.0044 1
Political Stability Host (8) -0.0047 -0.0002 -0.0025 -0.0089 -0.0005 -0.0023 0.7637 1
Government Effectiveness Host (9) -0.0037 -0.0044 -0.0045 -0.0046 -0.0046 -0.0053 0.7832 0.8025 1
Regulatory Quality Host (10) -0.0035 0.0002 -0.0022 -0.009 -0.0004 -0.002 0.8089 0.7746 0.8896 1
Rule of Law Host (11) -0.0058 -0.001 -0.004 -0.0111 -0.0021 -0.003 0.7892 0.8289 0.9546 0.8782 1
Control of Corruption Host (12) -0.0057 -0.0032 -0.0059 -0.0065 -0.005 -0.0049 0.7737 0.7924 0.9504 0.8474 0.9606 1
24
Table 2 - Fixed Effects OLS Estimation of the Basic Model with Controls for Host Country Governance
Knowledge-Capital Model's
Sing as
Model (Table 4 results Predicted (1) (2) (3) (4) (5) (6) (7)
predicted?
from CMM (2001)) Sign
GDP Sum 13.41*** (+) 0.51*** Yes 0.51*** 0.51*** 0.51*** 0.51*** 0.51*** 0.51***
[ 12.81] [2.79] [2.81] [2.81] [2.81] [2.81] [2.83] [2.80]
GDP Difference Squared -0.001*** (-) 0.0000683 No 0.0000684 0.0000685 0.0000681 0.0000686 0.0000678 0.0000684
[ -8.07] [1.28] [1.28] [1.28] [1.28] [1.28] [1.27] [1.28]
Skill Difference 20,084 (+) 9,054.60*** Yes 9,082.13*** 9,119.80*** 9,141.41*** 9,106.35*** 9,136.25*** 9,125.55***
[ 1.57] [5.47] [5.48] [5.49] [5.51] [5.50] [5.49] [5.47]
Skill Difference * -5.91** (-) -3.09* Yes -3.11* -3.12* -3.11* -3.12* -3.09* -3.11*
GDP Difference [ -2.42] [-1.87] [-1.87] [-1.87] [-1.88] [-1.87] [-1.87] [-1.87]
Investment Cost Host -198.8 (-) -478.31* Yes -492.13* -488.37* -495.62* -531.84** -514.27** -477.99*
[ -1.49] [-1.88] [-1.90] [-1.91] [-1.91] [-2.01] [-1.98] [-1.88]
Trade Cost Host 74.9 (+) 243.64* Yes 249.48** 239.00* 234.70* 211.27 206.48 232.66*
[ 0.96] [1.93] [1.97] [1.89] [1.85] [1.63] [1.62] [1.85]
Trade Cost Host * -388.2 (-) -4,813.42** Yes -4,873.91** -4,867.73** -4,861.28** -4,886.40** -4,979.75** -4,875.34**
Squared Skill Difference [ -0.24] [-2.21] [-2.20] [-2.20] [-2.19] [-2.20] [-2.25] [-2.20]
Trade Cost Parent -87.7* (-) 228.99 No 232.4 241.11 243.25 238.73 247.46 236.96
[ -1.63] [1.22] [1.24] [1.28] [1.31] [1.28] [1.31] [1.26]
Distance -1.08*** -0.18*** -0.18*** -0.18*** -0.18*** -0.18*** -0.18*** -0.18***
[ -5.45] [-4.76] [-4.76] [-4.75] [-4.76] [-4.76] [-4.77] [-4.75]
Voice and Accountability Host -552.12
[-1.48]
Political Stability Host -573.70**
[-2.16]
Government Effectiveness Host -880.76
[-1.27]
Regulatory Quality Host -484.04*
[-1.69]
Rule of Law Host -1,178.48**
[-2.42]
Control of Corruption Host -449.98
[-0.78]
Constant -22,492** 2,519.72* 292.66 -242.67 1,340.53 1,638.35 2,530.95 669.96
[ -2.00] [1.76] [0.18] [-0.19] [0.73] [0.94] [1.34] [0.45]
Observations 509 3148 3143 3141 3141 3143 3143 3141
Adjusted R-squared 0.83 0.132 0.132 0.132 0.132 0.132 0.132 0.132
White-corrected t statistics in brackets. * significant at 10%; ** significant at 5%; *** significant at 1%. Fixed effects for host countries and years are included.
25
Table 3 - Fixed Effects OLS Estimation of the Basic Model with Controls for Parent and Host Country
Governance
Predicted
(1) (2) (3) (4) (5) (6) (7)
Sign
GDP Sum (+) 0.51*** 0.47*** 0.55*** 0.38** 0.46** 0.39** 0.39**
[2.79] [2.60] [2.98] [2.05] [2.53] [2.08] [2.06]
GDP Difference Squared (-) 0.0000683 0.0000763 0.0000676 0.0000839 0.0000761 0.0000843 0.0000861
[1.28] [1.42] [1.27] [1.56] [1.40] [1.56] [1.59]
Skill Difference (+) 9,054.60*** 6,223.25*** 8,344.16*** 5,572.50*** 7,406.02*** 5,208.40*** 4,086.95***
[5.47] [3.84] [4.86] [3.24] [4.68] [3.47] [2.73]
Skill Difference * (-) -3.09* -3.05* -3.10* -2.95* -3.10* -2.98* -2.99*
GDP Difference [-1.87] [1.84] [1.87] [1.79] [1.86] [1.80] [1.80]
Investment Cost Host (-) -478.31* -490.69* -488.51* -493.24* -529.44** -512.03** -473.37*
[-1.88] [1.90] [1.91] [1.90] [2.00] [1.98] [1.87]
Trade Cost Host (+) 243.64* 267.32** 243.94* 264.07** 223.73* 235.22* 271.49**
[1.93] [2.09] [1.92] [2.06] [1.71] [1.82] [2.09]
Trade Cost Host * (-) -4,813.42** -5,247.58** -4,963.81** -5,618.41** -5,149.45** -5,630.21** -5,670.03**
Squared Skill Difference [-2.21] [2.34] [2.24] [2.51] [2.29] [2.48] [2.47]
Trade Cost Parent (-) 228.99 325.06* 280.11 356.14* 284.46 404.09** 430.75**
[1.22] [1.67] [1.46] [1.89] [1.49] [2.03] [2.10]
Distance -0.18*** -0.19*** -0.18*** -0.20*** -0.19*** -0.21*** -0.21***
[-4.76] [4.79] [4.75] [4.95] [4.78] [4.98] [4.91]
Voice and Accountability Parent 821.87***
[3.37]
Voice and Accountability Host -562.38
[1.50]
Political Stability Parent 214.53
[1.35]
Political Stability Host -569.01**
[2.14]
Government Effectiveness Parent 585.68***
[4.41]
Government Effectiveness Host -884.27
[1.28]
Regulatory Quality Parent 426.42**
[2.45]
Regulatory Quality Host -479.97*
[1.68]
Rule of Law Parent 752.72***
[4.91]
Rule of Law Host -1,212.01**
[2.49]
Control of Corruption Parent 690.42***
[4.49]
Control of Corruption Host -349.42
[0.61]
Constant 2,519.72* -293.21 -480.35 585.31 1,096.61 1,886.29 -242.23
[1.76] [0.19] [0.38] [0.32] [0.64] [1.01] [0.16]
Observations 3148 3143 3141 3141 3143 3143 3141
Adjusted R-squared 0.132 0.133 0.132 0.134 0.132 0.135 0.136
White-corrected t statistics in brackets. * significant at 10%; ** significant at 5%; *** significant at 1%. Fixed effects for host countries and
years are included.
26
Table 4 - Fixed Effects OLS Estimation of the Basic Model with Controls for Governance Difference
Between Parent and Host Countries
Predicted
(1) (2) (3) (4) (5) (6) (7)
Sign
GDP Sum (+) 0.51*** 0.48*** 0.56*** 0.37** 0.46** 0.38** 0.39**
[2.79] [2.62] [3.04] [2.03] [2.55] [2.05] [2.09]
[1.28] [1.40] [1.26] [1.55] [1.40] [1.57] [1.58]
[5.47] [3.90] [4.84] [3.12] [4.50] [3.39] [2.86]
GDP Difference [-1.87] [-1.84] [-1.86] [-1.79] [-1.86] [-1.80] [-1.81]
Investment Cost Host (-) -478.31* -496.71* -482.45* -487.15* -524.98** -498.37** -474.68*
[-1.88] [-1.94] [-1.89] [-1.92] [-2.02] [-1.96] [-1.87]
Trade Cost Host (+) 243.64* 268.21** 245.99* 267.07** 226.86* 250.46** 265.29**
[1.93] [2.09] [1.93] [2.09] [1.80] [1.97] [2.05]
Trade Cost Host * (-) -4,813.42** -5,222.85** -4,990.11** -5,652.95** -5,158.78** -5,622.93** -5,662.29**
Squared Skill Difference [-2.21] [-2.34] [-2.25] [-2.53] [-2.31] [-2.48] [-2.47]
Trade Cost Parent (-) 228.99 320.46* 288.22 358.42* 285.54 404.77** 428.69**
[1.22] [1.68] [1.50] [1.92] [1.51] [2.03] [2.09]
Distance -0.18*** -0.19*** -0.18*** -0.20*** -0.19*** -0.21*** -0.21***
[-4.76] [-4.80] [-4.76] [-4.98] [-4.83] [-5.00] [-4.91]
Voice and Accountability Difference 781.78***
[3.78]
Political Stability Difference 277.94*
[1.96]
Government Effectiveness Difference 611.85***
[4.64]
Regulatory Quality Difference 441.04***
[2.95]
Rule of Law Difference 782.18***
[5.12]
Control of Corruption Difference 676.31***
[4.47]
Constant 2,519.72* -213.75 -803.25 -1,175.66 -249 -433.61 -1,485.27
[1.76] [-0.14] [-0.65] [-0.97] [-0.18] [-0.31] [-1.18]
Observations 3148 3143 3141 3141 3143 3143 3141
White-corrected t statistics in brackets. * significant at 10%; ** significant at 5%; *** significant at 1%. Fixed effects for host countries
and years are included.
27
Table 5 - Fixed Effects OLS Estimation of the Basic Model with Controls for Changes in Host Country
Governance Indicators
Predicted
(1) (2) (3) (4) (5) (6) (7)
Sign
GDP Sum (+) 0.51*** 0.52*** 0.52*** 0.52*** 0.52*** 0.52*** 0.52***
[2.79] [2.76] [2.74] [2.73] [2.77] [2.77] [2.74]
[1.28] [1.27] [1.26] [1.27] [1.27] [1.26] [1.26]
[5.47] [5.35] [5.35] [5.38] [5.36] [5.34] [5.38]
GDP Difference [-1.87] [1.88] [1.87] [1.88] [1.89] [1.87] [1.87]
Investment Cost Host (-) -478.31* -452.57* -440.68 -505.93** -455.83* -429.08 -426.46
[-1.88] [1.71] [1.64] [1.97] [1.72] [1.61] [1.60]
Trade Cost Host (+) 243.64* 242.77* 263.46* 248.14* 247.69* 274.45* 260.03*
[1.93] [1.80] [1.85] [1.77] [1.79] [1.92] [1.84]
Trade Cost Host * (-) -4,813.42** -4,951.88** -4,948.56** -4,888.61** -4,908.06** -5,033.22** -4,935.60**
Trade Cost Parent (-) 228.99 328.89 324.02 325.28 318.49 325.31 326.1
[1.22] [1.52] [1.50] [1.51] [1.48] [1.50] [1.51]
Distance -0.18*** -0.20*** -0.20*** -0.20*** -0.20*** -0.20*** -0.20***
[-4.76] [4.81] [4.76] [4.77] [4.80] [4.79] [4.75]
Change in Voice and Accountability Host 1,336.59*
[1.90]
Change in Political Stability Host 253
[0.62]
Change in Government Effectiveness Host 1,514.09
[1.63]
Change in Regulatory Quality Host 897.44*
[1.88]
Change in Rule of Law Host -15.33
[0.02]
Change in Control of Corruption Host 27.98
[0.03]
Constant 2,519.72* -561.47 -1,051.05 -909.56 -500.35 -625.69 -1,031.13
[1.76] [0.39] [0.78] [0.69] [0.35] [0.43] [0.76]
Observations 3148 3000 2997 2997 3000 3000 2997
and years are included.
28
Table 6 - Fixed Effects OLS Estimation of the Basic Model with Controls for Governance Difference Between
Parent and Host Countries During Periods of Banking Crisis
During Periods of Systemic Banking Crisis

Predicted (Caprio, Klingebiel (1999))
Sign (1) (2) (3) (4) (5) (6) (7) (8)
GDP Sum (+) 0.51*** 0.32 0.74 0.75 0.29 0.32 0.35 0.41
[2.79] [0.56] [1.23] [1.11] [0.53] [0.57] [0.63] [0.73]
GDP Difference (-) 0.0000683 -0.00* -0.00* -0.00* -0.00* -0.00* -0.00* -0.00*
[1.28] [1.75] [1.86] [1.86] [1.74] [1.75] [1.80] [1.78]
Skill Difference (+) 9,054.60*** 16,167.05** 8,850.07* 14,077.49* 14,997.49* 15,665.72* 11,226.50* 8,370.01
[5.47] [2.03] [1.66] [1.87] [1.72] [1.91] [1.72] [1.58]
Skill Difference * (-) -3.09* 3.44 2.18 2.62 3.34 3.32 3.06 2.44
GDP Difference [-1.87] [1.27] [0.91] [1.00] [1.21] [1.20] [1.17] [0.99]
Investment Cost Host (-) -478.31* 193.63 5.27 198.87 169.67 201.3 159.19 90.66
[-1.88] [0.19] [0.01] [0.19] [0.17] [0.19] [0.15] [0.09]
Trade Cost Host (+) 243.64* 43.13 211.8 145.22 70.7 59.61 55.4 -50.48
[1.93] [0.08] [0.39] [0.26] [0.13] [0.11] [0.10] [0.10]
Trade Cost Host * (-) -4,813.42** -12,236.31* -14,175.37* -12,920.78* -12,429.46* -12,337.77* -12,704.26* -12,940.02*
Squared Skill Difference [-2.21] [1.78] [1.85] [1.82] [1.83] [1.80] [1.81] [1.81]
Trade Cost Parent (-) 228.99 1,273.70 1,397.85 1,337.62 1,269.71 1,266.98 1,256.95 1,190.86
[1.22] [1.35] [1.43] [1.41] [1.34] [1.34] [1.35] [1.31]
Distance -0.18*** -0.28** -0.27** -0.27* -0.28** -0.28** -0.30** -0.30**
[-4.76] [1.98] [1.98] [1.96] [2.00] [1.98] [2.03] [2.03]
Voice and Accountability Difference 3,193.42**
[2.08]
Political Stability Difference 896.21
[1.54]
Government Effectiveness Difference 196.04
[0.63]
Regulatory Quality Difference 150
[0.35]
Rule of Law Difference 925.37**
[2.17]
Control of Corruption Difference 1,029.38**
[2.05]
Constant 2,519.72* -4143.562 -6,446.95* -5,896.52 -4,247.00 -4,164.10 -4,845.83 -3,888.49
[1.76] [-1.29] [1.72] [1.54] [1.31] [1.29] [1.48] [1.24]
Observations 3148 466 466 466 466 466 466 466
Adjusted R-squared 0.132 0.03 0.032 0.029 0.028 0.028 0.03 0.033
White-corrected t statistics in brackets. * significant at 10%; ** significant at 5%; *** significant at 1%. Fixed effects for host countries and
years are included.
29
Table 7 - IV Regressions of the Basic Model with Controls for the Average Level of Host Country
Governance
IV Regressions
Fixed Effects Fixed Effects using the Albouy (2006) version of the Acemoglu, Johnson and
OLS OLS Robinson (2001) mortality data as an instrument for the average
Predicted KKM Governance Score
Sign (1) (2) (3) (4) (5) (6) (7)
year-1996 year-1998 year-2000 year-2002 year-2004
GDP Sum (+) 0.51*** 0.51*** 3.49** 1.39*** 1.61*** 0.84* 0.71*
[2.79] [2.82] [2.82] [2.84] [2.76] [1.68] [1.87]
GDP Difference Squared (-) 0.0000683 0.0000681 -0.00** -0.00** -0.00** 0 0
[1.28] [1.28] [2.38] [2.59] [2.00] [0.98] [0.69]
Skill Difference (+) 9,054.60*** 9,142.61*** 8,794.89*** 3,846.53 6,109.95** 4,859.14** 1,500.11
[5.47] [5.51] [3.64] [1.52] [2.59] [2.28] [0.66]
Skill Difference * (-) -3.09* -3.11* -11.73* 0.55 2.53 -2.83* -0.24
GDP Difference [-1.87] [1.87] [1.88] [0.21] [0.76] [1.93] [0.18]
Investment Cost Host (-) -478.31* -522.25** 0 0 846.00*** 48.93 0
[-1.88] [1.98] [.] [.] [2.71] [0.30] [.]
Trade Cost Host (+) 243.64* 219.81* 0 -65.99 9.97 42.54 -154.96
[1.93] [1.74] [.] [0.63] [0.01] [0.18] [1.29]
Trade Cost Host * (-) -4,813.42** -4,906.29** -45,632.24** 903.39 -2,999.50 -868.56 -2,910.62
Trade Cost Parent (-) 228.99 244.18 133.79 -505 -159.47 167.38 -156.8
[1.22] [1.31] [0.95] [0.81] [0.59] [0.16] [0.38]
Distance -0.18*** -0.18*** -0.06 -0.02 -0.03 -0.02 -0.01
[-4.76] [4.76] [0.97] [0.37] [0.69] [0.35] [0.47]
Average KKM Governance Score -1,245.79* 0 0 1,884.60*** 1,182.02** -243.29
[1.94] [.] [.] [2.98] [2.11] [1.29]
Constant 2,519.72* 1,991.11 117.46 781.14 -2,716.33* -1,114.69 888.89
[1.76] [1.07] [0.14] [0.51] [1.67] [0.39] [0.74]
Observations 3148 3143 19 47 83 153 23
and years are included. The average KKM governance score is calculated as a simple average of the host country scores of voice and
accountability, political stability, government effectiveness, regulatory quality, rule of law and control of corruption.
30
Graph 1
Mortality Rate
Average_governance_host is a simple yearly average of host countries' KKM governance indicators (voice and
accountability, political stability, government effectiveness, regulatory quality, rule of law and control of corruption).
Mortality Rate is a logarithm of settler mortality figures collected by Acemoglu, Johnson and Robinson (2001) and corrected
by Albouy (2006). The observtions are for all years in the sample (1996-2004).
31

FDIand Governance

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Governance

Keywords: Foreign direct investment; Governance; Knowledge-capital model of FDI

Current version: February 2007

Electronic copy of this paper is available at: http://ssrn.com/abstract=959905

Electronic copy of this paper is available at: http://ssrn.com/abstract=959905

Electronic copy of this paper is available at: http://ssrn.com/abstract=959905

2. Background, Data and Empirical Methodology

Brainard, S. L., 1993b. An empirical assessment of the factor proportions explanation of

Brainard, L., 1997. An empirical assessment of the proximity-concentration tradeoff between

Coase, R., 1937. The nature of the firm. Economica 4, 386--406.

Goldberger, A., 1972. Maximum likelihood estimation of regressions containing unobservable

Hayek, F. A., 1960. The Constitution of Liberty. University of Chicago Press.

Outward direct investment position for 1996 through 2004 (in

The sum of parent-country and host-country GDP in billions of 2000

Panel B. Governance Variables

Panel B. Country Governance Variables

Panel C. Correlation Matrix of KKM Governance Indicators

During Periods of Systemic Banking Crisis

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