Building Stronger Economic Institutions in Developing Countries, the Role of FDI

Foreign Direct Investment flows to developing economies have increased significantly over the last decades, bringing about important changes in the developing world. This paper is interested in the institutional aspect of these changes, a dimension weakly investigated in the development literature. More precisely, it explores how the quality of economic institutions in developing countries responds to changes in FDI inflows. The results, based on extensive data on FDI for a large sample of developing countries over the period 1990-2009, show that economic institutions improve in countries with larger FDI flows. On average, a 10-point increase in FDI inflows as a percent of GDP is associated with a 0.9-point increase in the quality of economic institutions. The results also show that this effect is driven by FDI flows from developed economies while no significant link is detected for FDI from developing economies. Furthermore, they indicate that the positive institutional impact of total FDI is likely to be mitigated in countries where the natural resources sector represents a major driver of FDI. The findings suggest that the quality of the institutions in FDI origin countries matters in the FDI/economic institutions relationship in the developing world. Overall, the results are robust to a series of sensitivity tests including the introduction of additional control variables, the exclusion of outliers, the test of income group and regional effects, and heterogeneity analysis based on the level of institutional development of the origin countries.