What Unbiased Estimates for Time- Invariant Variables Reveal about the Effect of Distance on Foreign Direct Investment NOITS Stockholm University May 2007 Ronald Davies, University of Oregon Delia Ionascu, Copenhagen Business School Helga Kristjánsdóttir, University of Iceland

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Introduction This paper applies the XTFEVD procedure on panel data. Three procedures, to three FDI datasets, sometime using difference estimates for time invariant variables.

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Introduction This allows us to estimate the impact of time-invariant variables on FDI while including fixed effects. We find that the omission of fixed effects, when using OLS, significantly biases several of these variables, for example when proxying for culture.

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Introduction We also find that by eliminating estimation biases, the differences across datasets largely disappear. Thus, controversies in the literature that are driven by differences in data sets may be resolved by using this estimation technique.

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Introduction The primary goal of this paper is to apply this panel fixed effects with vector decomposition (XTFEVD) method –fevd stands for ”fixed effects vector decomposition” The idea has been around for some time but not been applied to FDI Applied to three commonly used datasets

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Literature Plümper and Troeger (forthcoming) Developed a three-stage estimation procedure –They find it to efficiently estimate the impact of time-invariant variables - while also controlling for fixed effects –1. Provides estimates for time-variant variables –2. Takes out the unexplainable part –3. Runs again, using the unexplainable part

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Literature Hofstede (2001) 5 cultural distances –Measures do not vary over time –1. Power Distance, high=>less eq society –2. Individualism, high=>indiv appreciated –3. Masculinity, high =>mas appreciated –4. Uncertainty tolerance, high=>avoid uncer –5. Long-term orientation,high=>willing to wait

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Model Setup The basic equation estimated can be described as:

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Data We use FDI data BEA, Bureau of Economic Analysis –Bilateral US inbound and outbound, combined, stocks, affiliate sales OECD –Bilateral inbound FDI stocks –Parent or host country belongs to OECD World Bank, WDI –Total inbound and total outbound FDI flows

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Estimation Results Tables 1 & 2 US stocks, sales OECD –OLS and XTFEVD –Time invariant Dis - colony - language - area

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Table 1. US ResultsTable 2. OECD StockSalesStock OLSXTFEVDOLSXTFEVDOLSXTFEVD Parent GDP2.444***1.624***3.021***3.143***2.432***2.242*** Parent Pop-0.767***-6.803***-1.103***-4.010***-1.083***-3.567*** Parent TC-8.389*** *** *** ***-6.862***8.909*** Host GDP1.536***1.684***2.030***2.146***0.709***1.674*** Host Pop-0.652***-1.871***-1.007***-2.785*** *** Host TC-5.309*** ***-7.963*** ***2.182 Host Inv Cost **0.766* ***-1.109*** Estimation Results, Tables 1 & 2 Time variant variables OLS estimates for parent and host population biased towards zero

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Estimation Results, Tables 1 & 2 Time invariant variables sometimes change sign, implying biased OLS estimates More significant results More consistent estimates Table 1. US StockTable 1. US SalesTable 2. OECD Stock OLSXTFEVDOLSXTFEVDOLSXTFEVD Parent Area-0.318***2.378***-0.105*1.014***-0.039*1.114*** Host Area *** ***0.331***1.437*** Distance10.332*** ***3.893** ***-2.573***-5.229*** Distance Sq ***1.268***-0.241**0.927***0.115***0.258*** Colony-1.070***10.599***-1.063***5.230***0.640***3.870*** Common Lang0.824***-0.878***1.236***0.391***1.273***-0.750*** Island0.653***-1.952*** ***-0.250**-1.307*** Landlock *** ***-0.334***-1.420***

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Estimation Results, Table 3 World Bank data Not bilateral data Not info on parent countries for inbound data Not info on host countries for outbound data

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration InboundOutbound OLSXTFEVDOLSXTFEVD GDP0.977***1.357***2.254***2.467*** Pop-0.193*-3.703***-0.933***-5.412*** TC *** *** *** School-0.768*** ** PD0.240*3.723***0.405***4.449*** Estimation Results, Table 3 Estimation Results, World Bank –Omission of fixed effects leads to biased estimates for trade cost and culture etc.

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration InboundOutbound OLSXTFEVDOLSXTFEVD Independence0.819***-0.733*** *** Masculinity ***-0.174*4.304*** Uncertainty ***-0.759***-5.012*** Time ***0.341**2.189*** Area0.431***1.161***0.143***0.952*** Island ***0.408***-4.234*** Landlock *** *** Estimation Results, T3 cont.

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Estimation Results, Table 4 Differences presented as parent-host –If negative, cannot take log of differences –Carr, Markusen & Maskus (2001) absolute value restricts slope of difference variable to be the same on each side of zero –Therefore, estimate two separate variables, positive differences and negative differences –Find whether the deviation from zero that

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Estimation Results, Table 4 Table 4 presents results not using differences Find to be driven by magnitude, rather than differences to be important predictor of FDI

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Estimation Results Hofstede cultural index: We find that FDI comes from and goes to countries with high –Masculine values –Long term goals –Power Distance FDI outflows from countries with high –Independence (but less into these)

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Estimation Results The XTFEVD procedure is suitable here –When apply conventional fixed effects, then cannot estimate time invariant variables –GDP POP do change if XTFEVD, but not much change if conventional fixed effects –We find culture to be a significant predictor of FDI, and that the cultural attributes of the parent and the host separately that matter, rather than the differences between them

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Overall Estimation Results Time invariant variables: Hofstede index, common language, landlocked, distance When use XTFEVD, then less biased estimates between datasets OECD, World Bank and US data Robust results between datasets if XTFEVD

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Overall Estimation Results We need to be careful in applying the conventional fixed effects estimator to the time invariant variables The OLS estimator provides us with biased results for these When use OLS, then experience unobserved country heterogeneity

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Overall Estimation Results The XTFEVD procedure is suitable here –There have been some different algorithms –But XTFEVD has turned out to be efficient and good for small samples –XTFEVD appears to provide consistent estimates across different datasets

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Conclusions The goal of this paper has been to employ the panel fixed effects with vector decomposition method developed by Plümper and Troeger (forthcoming) Examine the extent to which the omission of fixed effects gives misleading coefficients in FDI regressions. We find that the problems created by omission of fixed effects to be quite significant But that they vary across the three most commonly used FDI datasets. As a result, when including fixed effects, we find much more consistency in the estimates of time- invariant variables across data sets.

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Conclusions In addition to our main results, we find that the cultural variables constructed by Hofstede are significant determinants of FDI. Since XTFEVD yields far more comparable results across our datasets, using fixed effects may be very useful in removing the problems this variation causes when industry level data are not available. May resolve controversies in empirical literature

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration