Foreign Direct Investment and Economic Freedom: An Empirical. Investigation. Kirk C. Heriot. John Theis

Transcription

1 Foreign Direct Investment and Economic Freedom: An Empirical Investigation Kirk C. Heriot John Theis Turner College of Business Columbus State University 4225 University Avenue Columbus, Georgia Noel D. Campbell EFIRM College of Business Administration University of Central Arkansas 201 Donaghey Avenue Conway, Arkansas February 14, 2008

2 Foreign Direct Investment and Economic Freedom: An Empirical Investigation Abstract This research investigates the relationship between world economic freedom and foreign direct investment. The Fraser Institute's Index of Economic Freedom is the basic measure of economic freedom used in this paper. Each country in the study has been in the index for five years. The literature frequently finds a high economic freedom value leads to numerous positive economic incomes. High performance on the World Freedom Index implies the country s policies and institutions are consistent with economic freedom, a geographically defined, non-tradable benefit. The value of geographically defined benefits or amenities will be compounded into direct foreign investments into that country. Thus, more economic freedom should lead to greater foreign direct investment, ceteris paribus.

3 Foreign Direct and Investment and Economic Freedom: An Empirical Investigation This paper reports on an investigation of the relationship between the Fraser Institute's Index of Economic Freedom (FI) and foreign direct investment inward flows (FDI) between 2000 and The Fraser Index is one of several economic freedom indexes, including, the Heritage Foundation and the Cato institute each of which publishes an international freedom index as well. All three of these indexes include several different parts deemed to measure significant segments of economic and cultural factors important in economic freedom (Lau and Lam, 2002). Individual indexes have more or less sections than the others, but all cover similar headings. The Fraser Index is made up of five complex parts including measures of government size, the legal system and property rights, sound money, freedom to trade internationally, and governmental regulation. Each one of the above includes individual measures within the area and an individual index. Many of these individual measures relate to governmental intrusion into economic activity including government as a part of the GDP and various tax rates. Another index part deals with the judicial system, its independence, and the protection of intellectual and other property rights. Still another part measures economic factors including inflation, transferability of wealth and the soundness of the money supply. Another area, freedom to trade internationally, was linked negatively with economic growth by Carlson and Lundstrom (2002), but contrarily by Berggren and Jordahl (2005). Treatment of international trade with tariff and non-tariff barriers to trade is in the index. Restrictions in the finance and monetary area are the final areas in the index. Some of these may be measurable otherwise (Bloningen, 2005, and Eicher, 2002). The Fraser Index includes both numeric measures and also perception indicators. The analysis in this paper supports a statistically significant link between FI and an average of FDI from 2000 to 2005 and additional statistically significant relationships between the foreign trade component of the 2004 FI and FDI. Additional analysis focuses on further decompositions of the index and contextualizing it with the literature.

4 Literature Review FDI theory points out two interrelated questions why firms invest overseas and what factors determine which receive investments from these investing firms (Wint and Williams, 2002). The generally accepted reasons why firms invest internationally is they take advantage of ownership advantages or to acquire intermediate products they need. Wint and Williams discuss factors similar to those in FI as being important for economic freedom. While governments may look for a way to increase FDI, they must be cognizant of the fact that in 1998 the UN (1999) reported fully 72 percent of FDI went to developed countries. Galan and Gonzalez-Benito provide more on determinants of FDI. For a thorough review of the literature concerning determinants of FDI see Eicher (2002). She provides an extensive review of the literature prior to 2002, which reports mixed results for human capital, labor costs, trade deficit, and trade restrictions. The review further reports positive results for institutions, market size, openness, political stability, resource availability, and restrictions on FDI. Tax rates are almost uniformly negative The FI touches on trade restrictions, political stability, labor costs, and tax rates. In another literature review, Blonigen (2005) provided an analysis for firm and national links between determinants and FDI. Some papers show exchange rates are significant and positively linked to FDI (Grubert and Mutti, 1991, Swenson, 1994, and Kogurt and Chang, 1996). However, all of these studies are for U.S. based companies and for firm level data. Studies on tax effects are mixed. Blonigen's review affirms the importance of institutions in attracting FDI. Trade effects have mixed impact. Extensive trade protection may give rise to more FDI to avoid the increased protective rules and tariffs. Blonigen calls this tariff jumping FDI. The trade flows may be for finished goods substituted for a product to be produced by a multinational enterprise's affiliate instead of its own production or according to Blonigen (2001) they may intermediate products used by the affiliate to produce a finished product. The former tends to correlate negatively with FDI while the latter correlates positively.

5 In another study, Kyrkilis and Pantelidis (2003) finds home country real GNP, home country effective exchange rate, and human capital as important determinants of FDI among a small group of European and developing countries. Notably, openness was not significant. However, Harms and Ursprung (2001) find that indices of political rights and civil liberties have a significant positive influence on FDI per capita. The FI has significant support for factors in being related to FDI. In the rest of the paper the model with the natural log of average FDI for 2000 to 2005 as a dependent variable and segments of FI and the average FI as the independent variables explores the import of each in determining FDI. Data The data for FDI came from the United Nations (2006) which includes foreign direct investment flows inward from 1970 to 2005 in U.S. dollars as given by the reporting economy. Data are selected from the reporting economy to have a consistent source of data. Countries with average negative flows for 2000 to 2005 were excluded from the sample. The Fraser Institute' Economic Freedom Index includes 132 countries on its list of countries. Combining the countries with usable data from the United Nations with the Fraser Institute resulted in 121 countries in the sample. A complete listing of the sample is in Appendix 1. Regression Models Recent literature looked for a link between governmental policy and FDI. Powel (2005) look at state planning while others such as Pradbuddha (2004) examine the property protection afforded by the receiving country. This paper uses seven regression models to test the impact of five separate determinant areas in the FI and the total FI. The first regression model is the natural log of the average FDI for 2000 to 2005 as a dependent variable and the FI for 2004 as the independent variable. The results for FI 2004 are reported in the table because there is little difference between it and the average FI from 2000 to 2004 which is in the text, below. Results are comparable to Berggren and Jordahl (2005). Considering the lead time in making a direct foreign investment, the lag should not be significant. The average is used to smooth sharp fluctuations in reporting countries

6 which should also provide more meaningful results. The next model includes the five sub-indices and eliminates the average for the FI as a whole. Then each sub-index is a single independent variable with natural log of FDI as the dependent variable in five separate regressions. The seven models then are as follows: LNFDIAVG=a+b 1 AVGFI+b 2 SIZEGOVT+b 3 LEGAL+b 4 MONEY+b 5 FREE+b 6 REG (1) LNFDIAVG=a+bSIZEGOVT (2) LNFDIAVG=a+bLEGAL (3) LNFDIAVG=a+bMONEY (4) LNFDIAVG=a+bFREE (5) LNFDIAVG=a+bREG (6) LNFDIAVG=a+b 1 FI2004 (7) Where: LNFDIAVG is the natural log of foreign direct investment average for the country from 2000 to FI2004 is the FI for the country in Each of the indexes below combines with the other indexes to form the Fraser Economic Freedom index. The expected relationship with FDI is positive. SIZEGOVT is the Fraser index number for size of the government in Government size is a proportion of the size of the economy. Thus a country with a small economy with a modest size government may still have a large number as a measure of government size. The construction of the index allows for the less relative size for the index the greater the index number. A positive relationship between FDI and size index of the government is anticipated. LEGAL is the 2004 Fraser index number for the rule of law in the country and includes independence of courts and protection of intellectual property. The higher the number, the greater the protection the country provides for legal and property rights. The more strength in the legal institutions, the greater FDI should be.

7 MONEY is the 2004 Fraser index number for the target county's money supply. It has measures for stability and convertibility. The higher the money index number, the greater the country protects its currency's soundness. The greater the target country's measure of monetary stability and convertibility, the greater FDI should be. FREE is the 2004 Fraser index number for the target county's populace to trade freely with others. It includes measures of tariffs and restraint of trade. The greater the Fraser index number for free trade, the more the country permits its citizens to trade internationally. A positive relationship between freedoms and FDI should prevail. REG is the 2004 Fraser index number for the target country's interference with business formation and development. It includes measures of time delays occasioned by dealing with the local bureaucracy. Regulation is inversely related to the regulation index. More regulation means more interference in business and a corresponding decline in FDI. Estimation of each model by ordinary least squares provides the descriptive statistics including R 2, F statistics for the equation, and T statistics for each parameter. The next section reports the regression results. Regression Results An evaluation of the relationship between economic freedom and foreign direct investment in a sample of 121 countries for the period shows a significant statistical relationship at the 99% level. The individual components of the FI have their own relationship with the natural log of FDI which Table One shown with more particularity. The relationship between LNFDI and the Fraser Freedom Index for 2004 reveals a less significant result that is available from the authors. Insert Table One about here Model 1 results appear to come from the influence of the characterization of the legal system, whether individuals can trade freely with the outside world, and the amount of

8 regulation in the receiving country. Comparing the individual model results with the complete model yields different results. Size of government in the economy is not significant in the model or in the regression by itself, but each of the other independent variables is significant when alone in the regression. The signs of both Money and Regulation change between regressions alone and within the full model. This change of signs may indicate multicolinearity with other variables in the full equation. Variation in the freedom sub-index captures about 43% of the variability in the dependent variable. The R 2 of the legal sub-index is second with.32. The construction of the sub-indexes is such that the greater the value of the index number, the more free the country. The results imply the rate of change increases with the freedom to trade with other countries and legal protection of persons and property within the country receiving FDI. Individual regressions support control of the money supply and regulation as also being significant in their own right, but colored somewhat by inclusion in the general model. Conclusions Results from this study indicate the Fraser Freedom Index captures some important factors in predicting the change in Foreign Direct Investment. Some of the literature notes most of the foreign direct investment goes to countries with large economies. This study does not differentiate between larger and smaller countries. Further research should investigate the size effect on the relationship. If there is a significant difference between the large country relationship and the smaller country relationship in FDI and FI, the link between the two variables may be an anomaly based on a cultural lens. An aggregation of variables, some measurements from the economy and others perceptions of observers through index numbers comprise the Fraser Freedom Index and the various sub-indexes. Another area for investigation would be a review of the relationship between the various measurements in the economy and FDI. If the basic economic measurements are more significant than the index number, more information is in the raw numbers and the sub-index numbers add little to the discussion about what increases FDI.

9 The freedom index takes into account many different variables, but it does not take into account other cultural variables which impact other aspects of life in the receiving country. In particular, the freedom index does not take into account fertility, life span, debt of the receiving country, and religion or culture that impact the manner of existing in the foreign country. All of these characteristics remain open for further study in additional research. References Berggren, Niclas and Henrik Jordahl, 2005, "Does Free Trade Really Reduce Growth? Further Testing using the Economic Freedom Index," Public Choice, 122 pp Blonigen, B. A., 2005, "A Review of the Empirical Literature on FDI Determinants," Atlantic Economic Journal, 33: Carlson, F. and S. Lundstrom, 2002, "Economic Freedom and Growth: Decomposing the Effects," Public Choice, 112, pp Eicher, S. E., 2002, "Determinants of International Capital Flows: The Saving-Retention Phenomenon and Factors Prompting Foreign Direct Investment," Unpublished Dissertation Kansas State University. Fraser Institute of Economic Freedom, Galan, Jose and Javier Gonzalez-Benito, 2001, "Determinant Factors of Foreign Direct Investment: Some Empirical Evidence," European Business Review, 13:5 p Grubert, Harry and John Mutti, 1991, "Taxes, Tariffs, and Transfer Pricing in Multinational Corporate Decision Making" Review of Economics and Statistics, 73:2 pp Harms, P. and Ursprung H.W. (October 2002). Do civil and political repression really boost foreign direct investments? Economic Inquiry. 40 (4): Kogurt, Bruce and Sea Lin Chang, 1996, "Platform Investments and Volatile Exchange Rates: Direct Investment in the U.S. by Japanese Electronics Companies," Review of Economics and Statistics, 78:2 pp Kyrkilis, Dimitrios and Pantelis Pantelidis, 2003, "Macroeconomic Determinants for Outward Foreign Direct Investment," International Journal of Social Economics, 30 7/8 p. 837.

10 Lau, K-N and P-Y Lam, 2002, "Economic Freedom Ranking of 161 Countries in Year 2000: a Minimum Disagreement Approach," Journal of the Operational Research Society, 53 pp Li, Quan and Adam Resnick (Winter 2003). Reversal of Fortunes: Democratic Institutions and Foreign Direct Investment Inflows to Developing Countries. International Organization, Vol. 57, Powell, Benjamin, 2005, "State Development Planning: Did it Create and East Asian Miracle?" The Review of Austrian Economics, 18:3/4 pp Pradbuddha, Sanyal, 2004, "Intellectual Property Right Protection and Location of R&D by Multinational Companies," Journal of Intellectual Capital, 5:1 p.59. Swenson, Deborah, 1994, "The Impact of U.S. Tax Reform on Foreign Direct Investment in the United States." Journal of Public Economics, 54:2 p United Nations (1999) United Nations (2006) Wint, Alvin and Densil Williams, 2002, "Attracting FDI to Developing Countries a Changing Role for Government?" The International Journal of Public Sector Management, 15, 4/5, p. 361.

11 Model Parameter 1 All a R 2 =.50 F = Intercept.50 (.34) Size.23 (1.42) Legal.63 a (3.94) Money -.22 (-1.37) Free 1.57 a (5.44) Regulation -.68 b (-2.43) AVGFI Size R 2 =.018 F = (5.32).238 (1.50) Table One Regression Results 3 Legal a R 2 =.32 F = (6.06).66 a (7.58) 4 Money a R 2 =.16 F = (1.62).608 a (4.78) 5 Free a R 2 =.43 F = (-2.38) 1.31 a (9.47) 6 Reg a R 2 =.134 F = (.71).93 a (4.32) 7 FI2004 b R 2 =.31 F= (-2.53) 1.56 a (7.51) (-.15) Superscripts indicate the statistical significance of each model or parameter. The a superscript denotes models and parameters with statistical significance at the.001 level or greater. The b superscript indicates models and parameters with a statistical significance at the.01 level or better. The t scores are in parenthesis below the individual parameters. The F score gives the overall model significance.