Does Openness, and Productivity Matters for FDI: A Global Interactive Analysis Based on the Complementary Role of Institutions

Abstract

Conventional wisdom suggested that investment flows in where you have abnormal returns that resulted in a high productivity area. However, FDI behaves peculiarly, as most are targeted towards developed countries where excess competition drives down returns and ultimately productivity. On the contrary, it shy in developing countries where one has more productive investment opportunities. This study tries to tackle the problem and explores the factors that influenced FDI flows. In particular, we focused on productivity, trade openness, financial liberalization, and institutions. Macro-level data was collected from 27 economies from 2004 to 2015. The analysis was done using GMM methodology. The results showed productivity remained insignificant in explaining FDI throughout the models. Trade seems to have a significant positive impact on the model without the interaction effect. Interestingly, financial liberalization seems to affect FDI negatively in all cases. GDP growth had a positive and significant effect. All Institutional variables that include control of corruption, government effectiveness, regulatory quality, rule of law, seems to have a significant positive impact on FDI individually, as well as in the combined form. We also witnessed significant and positive complementarities with each of the institutional factors and productivity, in explaining FDI. This indicated that higher productivity is not the deciding factor of FDI, however, the same productivity in a better institutional environment would produce positive complementarity that would significantly determine FDI. The findings imply that investors' prime concern is not productivity but the institutional environment. Moreover, only with quality institutions, the conventional wisdom persists.