Chr. Michelsen Institute Governance and foreign direct investment: Regional and sectoral patterns Ivar Kolstad Chr Michelsen Institute 14 June 2005

Chr. Michelsen Institute Why do investors care about governance? Two extremes: Multinationals seek to exploit countries with weak, ineffective, and corrupt governments Multinationals seek countries with good governments e.g. due to a less risky operating environment This presentation: Econometric studies Four CMI studies Policy implications What we don’t know

Chr. Michelsen Institute What is governance – and foreign direct investment? Governance = Political, institutional and legal environment –Macroeconomic: Inflation, budget deficits, exchange rates –Political: Democratization, political freedom, quality of public institutions, corruption –Social: Internal and external conflict –Other: Physical infrastructure Foreign direct investment (FDI) = investment through which a foreign investor acquires a lasting and influential interest in a domestic enterprise

Chr. Michelsen Institute Does good governance increase FDI?

Chr. Michelsen Institute Good governance increases FDI - So what? Econometric studies: Governance increases FDI inflows to developing countries Aggregate studies, do not tell us: 1.Which dimensions of governance matter 2.Which industries/companies are attracted by governance factors 3.What role does governance play in attracting FDI to specific regions/countries

Chr. Michelsen Institute 1. Governance? What of it? Which dimensions of governance matter for FDI? Kolstad and Villanger (2004), How does social development affect FDI and domestic investment, CMI report R2004:2 Econometric study, 75 countries, ICRG and Freedom House governance indices Major results: Political freedom increases FDI Religious tensions deter FDI

Chr. Michelsen Institute 2. Which industries do we want to attract? Different industries have different developmental impact: –skill upgrading –technology transfer –CSR? FDI in different industries attracted by different governance dimensions.

Chr. Michelsen Institute How to attract a specific industry Kolstad and Villanger (2004), Social development and industry level FDI, CMI report R2004:1 Econometric study, 66 countries, ICRG and Freedom House governance indices FDI data for primary, secondary and tertiary industries Major results: Democratic accountability increases tertiary sector FDI, but decreases secondary sector FDI Law and order increases FDI in both secondary and tertiary sector Internal conflict deters secondary sector FDI Corruption increases FDI in tertiary sector

Chr. Michelsen Institute The rise of service sector FDI

Chr. Michelsen Institute How to attract service industries Kolstad and Villanger (2004), Determinants of foreign direct investment in services, CMI working paper WP2004:2 Econometric study, 57 countries, ICRG and Freedom House governance indices (composite) FDI data: Service sector total, and four major service industries (finance, business, transport, trade) Major results: Political risk does not affect total service sector FDI Institutional quality attracts FDI in transport sector

Chr. Michelsen Institute 3. How to attract FDI to specific regions/countries “Africa is different … policies that have been successful in other regions may not be equally successful in Africa” (Asiedu, 2002) In particular: Infrastructure affects FDI in general, but not FDI to Sub-Saharan Africa Trade openness has a lesser effect on FDI in Sub- Saharan Africa than elsewhere Implication: Tailor policy to specific regions.

Chr. Michelsen Institute Attracting FDI to the Caribbean Kolstad and Villanger (2004), Promoting investment in small Caribbean states, CMI working paper WP2004:9 Econometric study 135 countries, of which 13 Caribbean, KKZ governance indices Major results: Political stability increases FDI Excessive regulation decreases FDI FDI particularly sensitive to instability in countries like Haiti, Guyana, Dominica, and Grenada

Chr. Michelsen Institute Summing up: Aggregate studies: –Better governance means more FDI Governance dimensions: –Political freedom attracts FDI –Religious tensions deter FDI Industry-specific factors: –Some industries more conducive to development –Different effect of governance on FDI in different industries Region-specific factors: –Africa is different –Caribbean: Stability crucial in some countries

Chr. Michelsen Institute What we do not know 1.How to attract responsible companies to a country 2.Bilateral FDI data: How do differences in governance between host and source country affect FDI flows? 3.How does FDI in different industries affect growth? 4.Is Africa different in terms of impact of governance on FDI? 5.How do trade openness and infrastructure interact to affect exports and FDI?