The Race to the Top: Institutional Clusters and World FDI Shares

The literature on the institutions-FDI nexus has treated the influence of institutions independently of each other. This implies they are not related to one another both theoretically and empirically, an important shortcoming. To address this shortcoming empirically, we use Principal Component Analysis (PCA). PCA is used to extract correlated institutional “clusters”. The influence of correlated groups of institutions or institutional clusters on FDI flows is examined empirically in this paper. Using ICRG data for a large sample of countries over the period 1987-2014, PCA extracts three institutional clusters: quality of public administration, social cohesion, and stability and property rights protection. We use an empirical model, which is based on Dunning’s (1981) location advantage hypothesis to examine the influence of those clusters on the competition to attract FDI flows. We adopt a least squares estimation methodology to account for both country and time effects. Empirical evidence shows that the three clusters have a positive influence on the share of world FDI flows. Robustness checks support the positive influence of the first two clusters in the post Asian crisis period. Distinguishing low from high FDI share countries, results show that quality of public administration and social cohesion have a positive influence, while in the high share group all three clusters have a positive influence. The approach and results are particularly novel in the literature. These results have an important policy implication. In examining the influence of institutions on economic variables countries should adopt a wider perspective that realizes the interrelationships among institutions. This perspective provides policy makers flexibility in the design and implementation of institutional reforms.