Climbing to the top? Foreign direct investment and property rights.

Ali, Fathi ; Fiess, Norbert ; Macdonald, Ronald 等

I. INTRODUCTION

The impact of foreign direct investment (FDI) on host countries is a well-researched topic and the bulk of the literature focuses on the impact of FDI on economic growth. However, with the rapid growth of FDI inflows during the 1990s and the growing competition among countries to attract FDI inflows, researchers are showing substantial interest in studying new aspects of the impact of FDI on host countries. Most of the work in this area argues that greater competition to attract FDI has led to "bidding wars" where governments in host countries have been forced to adopt policies with an adverse economic impact, such as a reduction in tax rates, deterioration in environmental standards, and of workers' rights (see e.g., Oman 2000). Some of these adverse impacts, known as the "race to the bottom" effects, are supported by empirical evidence. For example, Garretsen and Peeters (2007) find that FDI inflows promote lower corporate tax rates. However, foreign investors not only search for lower tax rates but also demand better institutional quality. Governments competing to attract FDI may therefore have an incentive to supply a more efficient institutional framework. FDI may therefore contribute to economic development through improving institutional quality in the host country. This aspect of FDI effects has to our knowledge not been studied previously.

Institutional quality has been identified as one of the most important, if not the most important, determinant of economic growth. Hall and Jones (1999) find that differences in income growth are largely explained by differences in institutional quality. Knack and Keefer (1995) identify property rights as crucial for growth and investment. Although there is general consensus that institutions matter for growth, little is known about how efficient institutions are created and what explains differences in institutional quality between and within countries. The empirical evidence on the determinants of property rights links institutions to culture, history, and geography (see e.g., Levine 2005). If property rights are mainly determined by culture, history, or geography, what then explains institutional changes over time? Or, put differently, if property rights were only determined by time-invariant factors, there would be little scope for developing countries to achieve high-quality institutions. There appears to be a clear need to link institutions to time varying, if not controllable, variables. Such evidence would provide a basis for institutional reform that enables developing countries to build high-quality institutions.

The hypothesis that this article introduces and empirically investigates is whether FDI inflows have a positive impact on property rights in the host country. Testing this hypothesis has both academic and practical merit. First, it explores a new dimension of how FDI impacts the host country. Second, it provides an explanation as to why property rights differ across countries.

The rest of the article is organized as follows. Section II introduces arguments that link property rights to FDI inflows. Our empirical results are presented in Section III and Section IV concludes.

II. FDI AND PROPERTY RIGHTS

There is growing evidence that greater integration into the global economy impacts institutional quality. For example, Bonaglia, Braga de Macedo, and Bussolo (2001) provide robust empirical support that higher import openness lowers corruption. Li and Reuveny (2003) establish that trade openness and portfolio investment have a negative impact on democracy, whereas FDI has a positive one. Larrain and Tavares (2004) present evidence that FDI is a robust predictor of corruption and that larger FDI inflows reduce the level of corruption in the host country. A1-Marhubi (2004) finds that trade openness has a positive impact on governance indictors and concludes that openness may encourage governments to adopt better governance to reap the full benefits of the integration into the world economy. Mosley and Uno (2007) find FDI to be positively and significantly correlated with labor rights, whereas trade openness has a negative impact.

We argue that FDI affects property rights both through the demand and supply channels. Investors demand property fight protection to capture potential rents and benefits; governments, on the other hand, may be induced to supply property rights when it is advantageous to do so.

Why would foreign investors create a demand for better institutions? On one hand, there is growing evidence that foreign investors consider institutional quality, especially property rights, as an important factor when allocating FDI (Ali, Fiess, and MacDonald 2008). On the other hand, Poynter (1985) argues that multinational corporations attempt to change government policy on host countries by entering domestic political processes, and Navaretti and Venables (2006) find that foreign investors at times rely on domestic interest groups with a vested interest to pressurize government to change the FDI incentives to their favor. Moreover, according to Libman (2006), multinational corporations have played an important role in shaping the institutional reform agenda in some transitional countries. It seems therefore plausible that foreign investors, with a lasting commitment to the host country, have an incentive to lobby for institutional change when faced with poor property rights and an inefficient business climate. Hence, FDI inflows should create demand for better institutional quality and property rights.

Why would governments respond to the demand of foreign investors? North (1981) argues that the government acts as a discriminating monopolist, offering property rights protection to different constituents' groups in return for tax revenue. In this context, governments might find it beneficial to protect the property rights of foreign investors to attract further FDI inflows which ultimately strengthen the government's position. Although this might explain why governments protect property rights and enforce contracts, it does not explain why governments would commit to this role if they found it more advantageous to renege on their commitments; North and Weingast (1989) argue, for example, that governments may try to alter property rights after the investments took place.

Reputation and institutional arrangements may prevent governments from reneging on their commitments, or at least make it costly for them to do so. Concerns that existing investors may stop reinvesting or even consider reallocating, while FDI from new investors may not materialize, make governments value the long run costs of reneging on their commitment. Thus, building a good reputation can induce governments to honor commitments today as to retain the opportunity to attract FDI inflows in the future. Bullow and Rogoff (1989) show that reputation alone may not be sufficient to prevent governments from reneging on commitments and more complex institutional arrangement are necessary. In this context, Buthe and Milner (2005) stress that governments try to assure foreign direct investors about their commitments by binding themselves by various kinds of agreements and treaties, such as bilateral investment treaties, preferential trade agreements, and multilateral agreements. These international commitments are more credible than domestic commitments, as reneging is more costly.

Since the beginning of the 1980s many countries have introduced changes to their regulatory frameworks to create strong incentives for foreign investors. In all, 194 out of 208 changes to FDI regulations in 71 countries aimed at created a more favorable climate for FDI in 2001 alone (United Nations Conference on Trade and Development 2002). In addition, many countries strengthened their commitment to a better regulatory framework for FDI by entering into bilateral investment treaties; the number of such treaties has increased rapidly over recent decades. It seems plausible to us that these changes to domestic regulation and increased commitments to investment treaties at least in part reflect host governments' responding to foreign investors' demand for a better investment climate, including for better institutions.

In sum, we expect that in a search for higher profits foreign investors will demand more secure property rights; host governments, aware of the potential benefits of FDI for growth and development, will respond. In an attempt to retain established FDI and attract new FDI, governments will further try to signal a high level of commitment by binding themselves through various international treaties. It seems therefore entirely plausible to expect that FDI inflows have a positive impact on institutional quality and in particular on the protection of property rights.

III. EMPIRICAL RESULTS

The previous section laid out a hypothesis about the impact of FDI inflows on property rights. We now attempt to empirically verify this hypothesis. To ensure comparability of our analysis with existing work on the determinants of institutional quality, we first replicate the cross-sectional analysis of La Porta et al. (1999), Beck, Demirguc-Kunt, and Levine (2003), and Levine (2005). We then expand on their work in several directions, which significantly adds to the literature on determinants of institutional quality and property rights. In particular, we extend the cross-sectional analysis in La Porta et al. (1999), Beck, Demirguc-Kunt, and Levine (2003), and Levine (2005) to a dynamic panel setting which allows us to study variations over time. We further control for the possibility that some of the regressors, in particular FDI, could be endogenous. Moreover, as North (1990) argues that previous levels of institutional quality determine current levels (see below), the use of a dynamic panel framework will enable us to test this hypothesis. Finally, to check the robustness of our results, we present results generated from alternative estimation techniques.

According to La Porta et al. (1999), theories that explain determinants of institutional quality, and in particular property rights protection and contract enforcement, can be grouped into three broad categories: economic, political, and cultural. Beck, Demirguc-Kunt, and Levine (2003) and Levine (2005) add the endowments view. Although economic theory stresses the role of social efficiency when creating institutions, political theory focuses on redistribution. Cultural theories emphasize the role of social beliefs, and endowment theory points to geographic determinants of institutions, in particular natural resource endowments and climate. (1)

We estimate the following model:

Proty = [B.sub.1] + [B.sub.2]polit + [B.sub.3]Econ + [B.sub.4]FDI + [B.sub.5]Cultr + [B.sub.6]Endo + [B.sub.7]V + [epsilon].

where Proty is the property rights index.

Econ is a vector of variables that captures the impact of economic development. Demsetz (1967) and North (1981) argue that institutions are created when it is efficient to do so. To repeat the example provided by La Porta et al. (1999), private property rights are created when land becomes scarce and when their benefits exceed the cost of their enforcement. As institutions are considered generally efficient, poor property rights are taken as a reflection of insufficient resources and high costs, rather than one of bad institutions. Economic development is accredited with greater demand for good institutions, and governments will oblige if benefits exceed enforcement costs.

Polit is a vector of variables of political determinants of institutions. According to Marx (1872), North (1990), and Olson (1993), institutions are designed by the elite to retain existing power structures, and history provides many examples where institutions were shaped by the ability of powerful groups to extract rents, rather than by social efficiency: Russian czars, Ottoman sultans, and Tokugawa shoguns all created institutions that increased their absolute authority and control, resulting in a poor definition and enforcement of property rights (see La Porta et al. 1999 and references therein). Political divergence within a society (social, ethnic, class, or other) is hence linked to a negative impact on government performance and property rights enforcement.

Political theories further argue that civil law, compared with common law, has an adverse impact on property rights. Common Law was partly developed to limit the authority of the crown and to protect property rights; civil law was developed in an effort to restrain sovereigns' authority over their subjects (Levine 2005).

Cultr is a vector of variables associated with Culture Theory. According to Weber (1958), Banfield (1958), Putnam (1993), and Landes (1998), institutions are a reflection of the beliefs in a society. In some societies, intolerance and distrust run so high that governments cannot function effectively, which produces poor institutional quality and insufficient property rights protection (La Porta et al. 1999). Landes (1998) argues that Catholicism and Islam are hostile to institutional development. The reason for this, according to Landes (1998) and Putnam (1993), is that these two religions tend to foster "vertical bonds of authority," which limits the security of property rights and private contracting (Levine 2005).

Endo is a vector of variables representing the endowments view. The endowment theory, represented by Engerman and Sokoloff (1997) and Acemoglu, Johnson, and Robinson (2001), states that institutions today have been shaped by factor endowments and initial conditions at the time of colonization. Two versions of the endowment theory exist: Engerman and Sokoloff (1997) emphasize that natural resource riches often gave rise to highly unequal societies, where the ruling elite prevented the development of egalitarian institutions and favored institutions that fostered their hegemony (Levine 2005). Acemoglu, Johnson, and Robinson (2001) establish a link between settler strategies of European colonialists and institutional quality in developing countries today. In areas where disease produces high mortality rates, Europeans did not settle, but set up "extractive" colonies (e.g., Congo). The institutions of these "extractive colonies" favored the elite and facilitated wealth extraction; institutions that supported property rights were only created in areas where European colonists actually settled (e.g., Australia).

FDI is the ratio of FDI inflows to gross domestic product. V is a vector of control variables and [epsilon] is the disturbance term.

A. Results from Cross-sectional Estimations

To investigate the impact of FDI inflows on property rights, we first make use of the same data set as La Porta et al. (1999). To measure property rights protection, La Porta et al. (1999) use the Property Rights Index in 1997. This index broadly tracks the degree of legal protection of private property; the extent to which the government protects and enforces laws that protect private property; the probability that the government will expropriate private property; and a country's legal protection of private property. This index takes values between 1 and 5, with higher values indicating greater protection of private property.

As already mentioned above, La Porta et al. (1999) empirically evaluate the contribution of political, cultural, and economic theories in explaining institutional quality; they also control for geography. Political theory is tested by the degree of ethnolinguistic fractionalization as well as the origin of commercial law. The ethnolinguistic fractionalization index is an average of several measures of ethnic diversity. The index ranges from 0 to 1 and is expected to have a negative impact on property rights. The higher the ethnic and linguistic division, the poorer are property rights. A country's Company Law or Commercial Code can stem from five different origins: (1) English Common Law; (2) French Commercial Code; (3) German Commercial Code; (4)Scandinavian Commercial Code; and (5)Socialist/Communist laws. Given their historical context, it is expected that relative to English Law, French, German, Scandinavian, and Socialist Laws have a negative impact on property rights.

A country's relative share of Roman Catholics, Protestants, and Muslims (religious composition of population) is taken as a proxy for cultural determinants of institutional quality (La Porta et al. 1999). It is expected that relative to Protestantism, Catholicism and Islam have a negative impact on property rights.

La Porta et al. (1999) use the logarithm of the average of GNP per capita in current U.S. dollars during 1970-1995 as a proxy for economic determinants of institutional quality. Per capita income is expected to have a positive impact on the property rights index. La Porta et al. (1999) further use latitude, scaled to take values between 0 and 1, to control for geography. They argue that latitude impacts institutional quality as more temperate regions have more productive agriculture and healthier climates, which allowed them to develop better economically and possibly also institutionally.

The results are summarized in Table 1. Model 1 replicates model 3 of Table 4 in La Porta et al. (1999). Model 1 is our benchmark model to which we add the other variables discussed above and in which we explicitly test the impact of FDI on property rights. Model 1 replicates La Porta et al. (1999)'s finding that political variables, represented by ethnolinguistic fractionalization and French legal origin, have the expected negative impact on property rights. In model 2, we control for the impact of economic and geographic factors by including log of GNP per capita and latitude. The results show that both of them have the expected positive impact on property rights; however, ethnolinguistic fractionalization loses its significance. In model 3, we add the average of FDI-GDP ratio during 1970-1995 to test the impact of FDI on property rights index. Model 3 shows that FDI has a positive and significant impact on property rights. The fact that FDI maintains its significance after controlling for the income level means that FDI affects property rights beyond its impact on economic development and income level. We retain FDI as a regressor in all further model specifications. In model 4, we control for the impact of cultural factors on property rights by including the percentage of the population which belongs to Catholic, Muslim, or other non-Protestant faith. The results show that FDI does not lose significance once we control for the cultural determinants of property rights; however, the results show that culture factors do not have significant impact on property rights once we control for other factors.

Model 5 shows the results based on data from Beck, Demirguc-Kunt, and Levine (2003) and Levine (2005). Beck, Demirguc-Kunt, and Levine (2003) and Levine (2005) use the same data as La Porta et al. (1999) but restrict their sample to countries of either British or French legal origin, as most countries are based on these legal traditions, which are also the most distinct.

The other difference between La Porta et al. (1999) and Beck, Demirguc-Kunt, and Levine (2003) and Levine (2005) is that the latter two studies introduce the endowment factor as an additional determinant of institutional quality. Beck, Demirguc-Kunt, and Levine (2003) and Levine (2005) follow Acemoglu, Johnson, and Robinson (2001) and use the settler mortality rate, the log of the annualized deaths per thousand European soldiers in European colonies in the early 19th century, to test endowment theory. The model shows that French legal origin has the expected negative impact on property rights, whereas Ethnic Fractionalization has the expected negative sign but is insignificant. The results also show that FDI maintains a significant and positive impact on property rights. Model 5 shows that non-Protestant religions have a negative but insignificant impact on property rights index. Settler mortality has a negative and statistically significant correlation with Property Rights, which confirms the endowment theory expectations.

Beck, Demirguc-Kunt, and Levine (2003) and Levine (2005) argue that the longer a country has spent in independence, the more time it has had to develop sound institutions and hence the better its property rights might have become. They therefore use the percentage of years since 1776 that a country has been independent to control for the impact of independence on property rights. The results show that independence does not have a significant impact on property rights, though it has the expected sign.

So far there has been no consideration of the endogeneity problem. It should be noticed that the above results may be subject to endogeneity bias. In fact, there is a large body of literature showing that FDI is determined by institutional quality and property rights. Thus, in model 6, we have tried to control for the endogeneity by using an instrumental variable (IV) approach. The choice of appropriate instruments should be driven by the literature on FDI determinants. A good instrument should be highly correlated with FDI but not with the disturbance term in the property rights regression. Several empirical studies show that real exchange rates and infrastructure quality are among the significant determents of FDI inflows (Blonigen 1997; Dunning and Lundan 2008; Froot and Stein 1991). Therefore, we instrumented FDI with real exchange rates and infrastructure measured by the number of landlines per thousand people, in addition to continental dummies for Africa and Latin America. The result of the IV regression, reported in Table 1 model 6, shows that the estimated coefficient on FDI is still significantly positive, which can be interpreted as the impact of FDI on property rights is robust to the endogeneity problem.

The above results clearly show that the correlation between FDI and property rights is highly significant in a cross-sectional setting. These results can be interpreted as offering baseline support to our hypothesis that FDI has a positive impact on institutional quality and that countries that attracted more FDI enjoy greater property rights protection. However, these results are not without limitations, as they do not consider changes in property rights over time. This issue is taken up in more detail below.

B. Results from Panel Data Estimations

The cross-sectional approach helps us to explain the differences in property rights across countries, that is, identifying which characteristics explain why one country has a higher degree of property rights protection than another. A panel framework is, however, needed to assess bow institutions are affected by FDI over time, and how different determinants interact dynamically. To investigate the time dimension of variations in property rights, we use a sample of 70 developing countries over the period 1981-2005. Data availability restricts the sample size and the time period covered. Appendix A describes the sample and data sources used in the subsequent analysis. Property rights index is constructed by combining two indexes: Law and Order and Investment Profile, both of which are published by Political Risk Services Group. The index is scaled to take values between 0 and 12, with higher values meaning better protection of property rights. Law and Order index assesses the strength and impartiality of the legal system, popular observance of the law, and the effectiveness of sanctions. Investment Profile index assesses contract viability, expropriation risk, and profits repatriation.

We construct a panel dataset where data are averaged over each of the 5-year periods between 1981 and 2005. Within our sample, some countries have made remarkable improvements in their property rights indices, whereas others experienced deterioration (Table 2 and Figure A1 in Appendix A). Morocco's property rights index, for example, increased from 4.5 in 1981-1985 to 9.94 in 2000-2005. Bolivia, which started from a very low score of 2.12 in the 1980s, reached a high score of 7.4 in 2000-2005, and Chile and Tunisia witnessed similar large increases. Zimbabwe's score, on the other hand, declined from 4.25 in 1984-1985 to 2.47 in 2000-2005, and Cote d'Ivoire and Venezuela also experienced a fall in their property rights indices.

We start our panel analysis with a random effects model. This model specification allows us to capture the impact of the time-invariant variables that represent culture, political, and endowment theories. One problem with this technique is that it does not allow for the endogeneity of some of regressors, particularly FDI. To reduce the problem of endogeneity, we have lagged all endogenous variables for one period, that is, 5 years. We also use a system generalized method of moment (GMM) estimator where lagged differences and levels of the endogenous variables are used as instruments.

The results are reported in Table 3. Model 1 includes political variables, ethnolinguistic fractionalization index, and French legal origin in addition to lagged FDI inflows. Both of the political variables have the expected sign, although not statistically significant. FDI has the expected positive sign and is highly significant. In model 2, we add variables representing cultural theory; the results show that Catholicism has a negative and significant correlation with the property rights index, whereas Islam has no significant correlation with property rights. The FDI term is still significant and positive and ethnolinguistic fractionalization index becomes significantly related to property rights, whereas French legal origin dummy becomes positively but insignificantly correlated with property rights.

Model 3 controls for endowment and economic effects, by including settler mortality and GDP per capita growth. (2) The results show that while settler mortality has a negative but insignificant impact, lagged economic growth has a positive and significant impact on property rights, which confirms economic theory. FDI remains significant even after controlling for the impact of economic growth, which supports the claim that FDI influences property rights beyond its contribution to economic growth and development.

Using settler mortality reduces the sample size from 70 to 57 countries as we have only limited country coverage for settler mortality. To deal with this problem, we replace the settler mortality rate with the ratio of primary exports to GDP. This variable is widely used in the literature as a measure of natural resources abundance (Sachs and Warner 1995), and as such it also accords with Engerman and Sokoloff's endowments view. Model 4 shows the results; the coefficient on primary export ratio suggests that natural resource endowments have a negative correlation with property rights, which give some support to Engerman and Sokoloff's view; however, it is not significant. Controlling for natural resources endowment does not affect the significance of FDI; interestingly the dummy for Catholicism becomes statistically significant.

Rodrik (2000) argues that openness to trade could help developing countries to build sound institutions. A growing number of imperial evidence shows that trade has a positive impact on some aspects of institutions such as corruption (see e.g., Al-Marhubi 2004; Bonaglia, Braga de Macedo, and Bussolo 2001). Thus, in model 5, we control for trade openness by including the lagged trade GDP ratio. The result shows that the trade ratio has a positive and significant impact on property rights; the negative impact of natural resource abundance becomes significant, whereas the dummy for Catholicism loses its significance. Interestingly, FDI maintains its positive and significant correlation with property rights, whereas political and cultural variables lose their significance.

In model 6, we use fixed effects to investigate the role of FDI in determining property rights. This technique concentrates on within-country variations and provides insights as to how variations in FDI explain variations of property rights in each country around its own mean. Fixed effects allow us to investigate what causes property rights to change over time within each country. However, this advantage comes at the cost of dropping time-invariant variables. Model 6 shows that FDI remains significant, and so does GDP growth. The trade ratio also enters positively and significantly. This result suggests that these three variables did play a positive role in determining changes in property rights index during the period studied. (3) The endowment variable, on the other hand, loses significance, although it maintains a negative sign. This may be due to the fact that the primary exports to GDP ratio varies little over time. This implies that the endowments view can explain differences in property rights across countries, but not over time.

So far, we have dealt with the endogeneity of FDI by using the lagged value of FDI inflows. A more appropriate way to address endogeneity is to use an IV approach. Arellano and Bond (1991) show that in a dynamic panel setting, lagged differences of endogenous variables can be used as effective instruments. Including the lagged value of the property rights index further allows us to study to what extent past institutional quality determines present institutional quality. North (1990) argues that history matters for institutional change, in a sense that institutional quality in the past has an impact in the current institutional quality. North states that the institutional framework provides society with opportunities (both political and economic) and agents try to benefit from these opportunities within the existing institutional framework; they, however, also try to maximize profits by altering the existent institutional framework. North (1990) argues that the very nature of the existing institutional quality may provide incentives for agents to alter it. To illustrate, in an inefficient institutional framework, certain organizations will form with the specific purpose to benefit from the opportunities offered by this inefficient framework; these new organizations will then actually devote resources to maintain these inefficiencies. This mechanism, according to North (1990), explains the persistence of inefficient institutions in developing countries. On the other hand, organizations which are embedded in an efficient institutional framework will devote resources to maintain efficiency, as this serves their interests. According to North (1990), this mechanism explains the development of the American economy in the 19th century. Based on these arguments, one would expect that lagged property rights have a positive impact on the current institutional quality, as efficient institutions provide agents with incentives to further increase the level of efficiency, promoting even more efficient institutions in the future.

Model 7 shows the results from system GMM estimation. In this model, we include the lagged dependent variable--the property rights index--as an additional explanatory variable. In this specification, the lagged dependent variables and the time-invariant country-specific error terms are correlated, and both random and fixed effects models produce inconsistent estimations. Arellano and Bond (1991) solve this problem by using GMM. They eliminate the country-specific error term by taking the first difference of the model and then use the lagged levels of the dependent variable as instruments for the first differences of the dependent variable. The same procedure can be applied to any endogenous variable within the set of explanatory variables. This technique is often called difference GMM (Baum 2005). Arellano and Bover (1995) and Blundell and Bond (1998) acknowledge a potential weakness in difference GMM, since the lagged levels are often poor instruments for the first-differenced variables (Baum 2005). They propose, therefore, to use lagged levels and lagged differences as instruments. This technique is generally referred to as system GMM. Both difference and system GMM require an absence of second-order serial correlation in the residuals of the differenced model. As standard errors of the difference and system GMM estimators are shown to have a severe downward bias (Baum 2005), Windmeijer (2005)'s finite-sample correction is applied to correct for this bias. A Hansen test of the over-identifying restrictions is used to test for overall appropriateness of the instruments.

In model 7, we treated FDI inflows, economic growth, and the trade ratio as endogenous variables. We find that the basic assumption of no second-order serial correlation is satisfied. The Hansen test approves the validity of the instruments for model 7. The results show that the lagged value of property fights has a positive and significant impact on the current level of property fights index, which supports North's hypothesis. More importantly, FDI still has a positive and significant impact on institutional quality index. Economic growth maintains its significance, whereas trade ratio loses its significance. Interestingly, all culture and political variables lose their significance apart from French legal origin, which becomes significant but with the wrong sign. This can be interpreted as the evidence on political and culture theory is sensitive to model specifications or sample changes. This may call for other proxies of political factors. One attempt could be by replacing the ethnolinguistic fractionalization index, which primarily measures ethnic division, with an index that captures the degree of tension resulting from racial, ethnic, or language divisions. (4) It seems reasonable to assume that the degree of social tension that results from ethnic and religious division is more important for institutional quality than ethnic division per se. One can cite many cases in developed countries where ethnic linguistic groups live in relative harmony without negative implications on institutional quality. For example, Canada and Belgium have ethnolinguistic indices of 0.376 and 0.364, which are above the sample average, but have ones of the highest score of property rights index, 10.73 and 11.95, respectively. An additional advantage of using ethnic tension index rather than ethnic division is the former is time variant and hence allows us to study the impact of political variables on institutional quality over time.

The results are shown in model 8. As can be seen from model 8, this change has led to substantial improvements in our results. Political factors, represented by ethnic tension index, now have the expected sign: improvements in the ethnic tension index have a positive and significant impact on property rights. (5) However, French legal origin is still significant but with the wrong sign. More interestingly, culture factors become significant with the fight signs and FDI maintains its significance, which can be viewed as additional support for our main hypothesis.

To summarize our results, FDI appears to be a robust predictor of property rights. The impact of FDI on institutional quality is not sensitive to model specifications, control variables, or estimation techniques. This supports our hypothesis that FDI inflows have a positive impact on the quality of property rights.

C. Robustness Check: FDI Stock versus Flows

The previous analysis is based on data of FDI inflows. Although it can be argued that FDI inflows capture the degree of the mobility of FDI, and hence the pressure that host governments face to improve institutions, it could be possible that property rights in a given host country depend more on the stock of foreign investment than on their flows. The argument could be made that FDI stocks measure the total stake of foreign investors, whereas flows only measure an increase in that stake and may capture investors who have not invested previously in the country at all. As such, FDI flows could be more of a response to improvements of property fights protection, while the quality of property fights protection has been influenced by the current stock of FDI. In order to check the robustness of our results we reran our regressions with FDI stocks rather than flow data as the independent variable. The results show that using FDI stocks also supports the hypothesis that FDI has a positive impact on institutional quality in the host country (see Tables Al and A2 in Appendix A).

IV. CONCLUSION

This article introduces a hypothesis about the impact of FDI inflows on property fights in host countries and provides an empirical assessment. The results show that FDI inflows have a positive and highly significant impact on property fights. These results seem very robust and are not affected by model specification, control variables, or estimation techniques. The main conclusion of this article is that FDI inflows can explain differences in property fights across countries and over time. In particular, FDI inflows have a positive influence on property fights in the host country.

This conclusion has several important implications for academic and practical purposes. First, it reveals a new mechanism by which FDI can positively affect economic performance in the host country; given the importance of institutional quality in determining economic growth, this new mechanism may be comparable (i.e., similar in amount and quality) to other positive effects of FDI. Our results suggest that foreign investors do not only import high-quality manufacturing and production technology to the host country but also import high-quality social technology and institutions.

Our findings are also a significant step toward a better understanding of the determinants of institutional quality and institutional change. Integration into the world economy and FDI inflows in particular are established as new determinants of property rights. A policy framework and a business environment which are more conducive to attracting FDI are therefore also expected to improve institutional quality.

ABBREVIATIONS

FDI: Foreign Direct Investment

IV: Instrumental Variable

GMM: Generalized Method of Moment

doi: 10.1111/j.1465-7295.2010.00319.x

APPENDIX A: SAMPLE AND SOURCES OF DATA

The analysis covers 70 developing countries over the period 1981-2005. All the variables are computed as 5-year averages, covering the periods 1981-1985, 1986-1990, 1991-1995, 1996-2000, and 2001-2005. Countries in the sample: Angola, Argentina, Bangladesh, Bolivia, Botswana, Brazil, Burkina Faso, Cameroon, Chile, Colombia, Congo Dem. Rep., Congo Rep., Costa Rica, Cote d'Ivoire, Dominican Republic, Ecuador, Egypt Arab Rep., El Salvador, Ethiopia, Gabon, The Gambia, Ghana, Guatemala, Guinea, Guyana, Haiti, Honduras, Hong Kong, India, Indonesia, Jamaica, Jordan, Kenya, Korea Rep., Lebanon, Madagascar, Malawi, Malaysia, Mali, Mexico, Morocco, Mozambique, Namibia, Nicaragua, Niger, Nigeria, Pakistan, Panama, Papua New Guinea, Paraguay, Peru, Philippines, Senegal, Sierra Leone, Singapore, South Africa, Sri Lanka, Sudan, Suriname, Syrian Arab Republic, Tanzania, Thailand, Trinidad and Tobago, Tunisia, Turkey, Uganda, Uruguay, Venezuela RB, Zambia, and Zimbabwe.

[FIGURE A1 OMITTED]

Variable Definition Source

FDI Net FDI inflows as United Nations,
 Percentage of GDP UNCTAD's World
 Investment
 Directory
GDP growth GDP Growth (annual %) World Bank, World
 Development
 Indicators
Property rights Average of indices Calculated from ICRG
 of Law and Order & Data, PRS Group
 Investment Profile,
 scale 0-12.

Ethnic tensions Tensions among ethnic Calculated from ICRG
 groups, scale 0-12 Data, PRS Group

Natural resources Ratio of primary World Bank, World
 abundance exports to GDP Development
 Indicators
Trade Export + imports as World Bank, World
 percentage of GDP Development
 Indicators
FDIS Inward FDI stock as United Nations,
 percentage of GDP UNCTAD's World
 Investment
 Directory.

TABLE A1
Property Rights and STOCK FDI: Cross-sectional Regressions
(Dependent Variable: Property Rights Index 1997) (a)

 Model 1 Model 2 Model 3
 OLS OLS OLS

Ethnic fractionalization -0.826 *** 0.332 0.282
 (-2.76) (1.26) (1.03)
French legal origin -0.704 *** -0.559 *** -0.517 ***
 (-3.51) (-3.84) (-3.33)
Socialist legal origin -1.386 *** -1.114 *** -1.053 ***
 (-3.65) (-4.26) (-3.81)
German legal origin 1.084 *** 0.068 0.253
 (4.91) (0.28) (0.93)
Scandinavian legal origin 0.879 *** -0.531 ** -0.332
 (3.08) (-2.03) (-1.14)
Latitude 0.417 *** 0.382 ***
 (5.79) (5.18)
Log GNP per capita 1.638 *** 1.575 ***
 (3.30) (3.17)
FDIS-GDP ratio 0.006 *
 (1.83)
Catholic

Muslim 0.002

Other religion 0.005

Independence

Settler mortality

Intercept 3.981 *** 0.191 0.340
 (16.97) (0.38) (0.64)
No. of observations 124 124 121
F 91 48 38

 Model 4 Model 5 Model 6
 OLS OLS (b) IV

Ethnic fractionalization 0.354 -0.105 0.177
 (1.24) (-0.26) (0.15)
French legal origin -0.568 *** -0.760 *** -0.684
 (-2.92) (-2.67) (-0.85)
Socialist legal origin -1.204 ***
 (-3.83)
German legal origin 0.236
 (0.92)
Scandinavian legal origin -0.001
 (-0.00)
Latitude 0.359 ***
 (3.85)
Log GNP per capita 1.785 ***
 (3.06)
FDIS-GDP ratio 0.006 0.024 *** 0.080 **
 (1.62) (3.93) (2.18)
Catholic 0.006 -0.010 -0.024
 (1.10) (-1.13) (-1.16)
Muslim -0.006 -0.019
 (0.44) (-0.83) (-1.28)
Other religion -0.010 -0.029
 (1.06) (-1.29) (-1.13)
Independence 0.701 1.645
 (1.28) (1.53)
Settler mortality -0.179 ** -0.077
 (-2.25) (-0.38)
Intercept 0.027 4.696 *** 4.193 **
 (0.03) (6.56) (2.27)
No. of observations 121 69 36
F 29 9 6

(a) Values in parentheses are White heteroskedastic adjusted
t-values. *, **, and *** denote significance at 10%, 5%, and 1%,
respectively.

(b) FDI is instrumented by the by real exchange rate, infrastructure,
and continental dummies for Africa and Latin America. The validity of
these instruments is supported by Sargan test [chi square](3) = 5.36
(p > [chi square] = (0.147)).

TABLE A2
Property Rights and STOCK FDI: Panel Data Regressions (Dependent
Variable: Property Rights Index [1981-2005] 5-Year Intervals)

 Model 1 Model 2 Model 3
 RE (a) RE (a) RE (a)

Ethnic fractionalization -0.857 ** -1.079 ** -0.300
 (-1.98) (-2.39) (-0.53)
French legal origin -0.348 0.124 0.384
 (-1.21) (0.33) (0.86)
Economic growth 0.193 ***
 (5.99)
FDIS-GDP ratio 0.028 *** 0.027 *** 0.027 ***
 (4.53) (4.49) (5.11)
Catholic -0.013 ** -0.008
 (-1.99) (-1.10)
Muslim -0.006 -0.005
 (-0.98) (-0.71)
Settler mortality -0.128
 (-0.87)
Resource endowments

Trade

Lagged property right

Ethnic tensions

Intercept 6.320*** 6.753 *** 6.059 ***
 (17.91) (15.70) (7.59)
No. of groups 70 70 57
No. of observations 273 273 219
Wald )(2 31.54 (3) 36.74 (5) 98.04 (7)

 Model 4 Model 5 Model 6
 RE (a) RE (a) FE (b)

Ethnic fractionalization -0.202 -0.131
 (-0.40) (-0.25)
French legal origin 0.400 0.418
 (1.01) (1.05)
Economic growth 0.167 *** 0.162 *** 0.133 ***
 (5.02) (4.73) (3.78)
FDIS-GDP ratio 0.033 *** 0.030 *** 0.026 ***
 (5.17) (4.05) (4.02)
Catholic -0.012 * -0.010
 (-1.78) (-1.59)
Muslim -0.009 -0.008
 (-1.45) (-1.30)
Settler mortality

Resource endowments -0.021 * -0.024 ** -0.004
 (-1.85) (-2.01) (-0.13)
Trade 0.003 0.006
 (0.96) (0.86)
Lagged property right

Ethnic tensions

Intercept 5.923 *** 5.733 *** 5.020 ***
 (12.27) (11.11) (10.54)
No. of groups 68 68 67
No. of observations 237 237 237
Wald )(2 74.53 (7) 85.18 (8) --

 Modell Model 8
 Sys GMM (c) Sys GMM (d)

Ethnic fractionalization -0.447 *
 (-1.75)
French legal origin 0.340 0.525 **
 (1.26) (2.34)
Economic growth 0.232 *** 0.232
 (3.57) (3.62)
FDIS-GDP ratio 0.011 *** 0.007 **
 (3.02) (2.00)
Catholic -0.003 -0.007*
 (-0.95) (-1.94)
Muslim -0.004 -0.006*
 (-0.83) (-1.76)
Settler mortality

Resource endowments -0.001 0.001
 (-0.31) (0.14)
Trade -0.001 0.001
 (-0.37) (0.30)
Lagged property right 0.509 *** 0.501 ***
 (5.08) (5.47)
Ethnic tensions 0.267 ***
 -4.94
Intercept 2.418 *** 1.417 **
 -3.13 -2.18
No. of groups 67
No. of observations 237 237
Wald )(2 497.30 (12) 741.25 (12)

(a) Random effects model, z-values reported in parentheses.

(b) Fixed effects model, t-values reported in parentheses.

(c) System GMM. Arellano-Bond test for AR (2) in first differences:
z = -0.76, p > z = 0.449. Hansen test of overidentification
restrictions: [chi square](28) = 25.14, p > [chi square] = 0.620.

(d) System GMM. Arellano-Bond test for AR (2) in first differences:
z = -0.89, p > z = 0.371. Hansen test of overidentification
restrictions: [chi square](32) = 32.19, p > [chi square] = 0.457.
Models 7 and 8 include time dummies. *, **, and ***
denote significance at 10%, 5%, and 1%, respectively.

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(1.) This section is a summary of the discussions in La Porta et al. (1999) and Beck, Demirguc-Kunt, and Levine (2003).

(2.) We also used GDP per capita to control for economic effect but it provided poor results.

(3.) Note that, as in the previous models, we lagged all of these variables one period, that is, 5 years, in order to mitigate the problem of the endogeneity.

(4.) The Ethnic Tension index is published by PRS Group. See Appendix A for details about this index.

(5.) Note that the index is scaled to take values between 0 and 12, with higher values meaning less tension.

Ali: Economics Department, University of Garyounis, Bengazi, P.O. Box 1308, Libya. Phone 218-64-224-0730, Fax 218-61-224-0731, E-mail fali@ garyounis.edu

Fiess: The World Bank, 1818 H Street, NW, Washington, DC. Phone 202-473-7585, Fax 202-522-2119, E-mail nfiess @worldbank.org

Macdonald: Department of Economics, Adam Smith Building, University of Glasgow, Glasgow, GI2 8RT, UK. Phone 44-141-330-1988, Fax 44-141-330-4940, E-mail r.macdonald @lbss.gla.ac.uk

TABLE 1
Property Rights and FDI: Cross-sectional Regressions
(Dependent Variable: Property Rights Index 1997) (a)

 Model l Model 2 Model 3
 OLS OLS OLS

Ethnic fractionalization -0.826 *** 0.332 0.387
 (-2.76) (1.26) (1.39)
French legal origin -0.704 *** -0.559 *** -0.483 ***
 (-3.51) (-3.84) (-3.14)
Socialist legal origin -1.386 *** -1.114 *** -1.133 ***
 (-3.65) (-4.26) (-4.47)
German legal origin 1.084 *** 0.068 0.285
 (4.91) (0.28) (1.07)
Scandinavian legal origin 0.879 *** -0.531 ** -0.394
 (3.08) (-2.03) (-1.42)
Latitude 1.638 *** 1.964 ***
 (3.30) (3.83)
Log GNP per capita 0.417 *** 0.365 ***
 (5.79) (5.09)
FDI-GDP ratio 0.110 **
 (2.57)
Catholic

Muslim

Other religion

Independence

Settler mortality

Intercept 3.981 *** 0.191 0.262
 (16.97) (0.38) (0.51)
No. of observations 124 124 121
F 91 48 39

 Model 4 Model 5 Model 6 (b)
 OLS OLS IV

Ethnic fractionalization 0.474 -0.103 -0.257
 (1.64) (-0.24) (-0.34)
French legal origin -0.560 *** -0.728 ** -0.604
 (-2.99) (-2.37) (-1.15)
Socialist legal origin -1.273 *** -- --
 (-4.30)
German legal origin 0.270 -- --
 (1.08)
Scandinavian legal origin -0.030 -- --
 (-0.06)
Latitude 2.178 *** -- --
 (3.67)
Log GNP per capita 0.342 *** -- --
 (3.82)
FDI-GDP ratio 0.113 *** 0.182 *** 0.468 **
 (2.71) (2.74) (2.16)
Catholic 0.007 -0.011 -0.031
 (1.27) (-1.22) (-1.59)
Muslim 0.003 -0.007 -0.018
 (0.56) (-0.85) (-1.39)
Other religion 0.006 -0.012 -0.033
 (1.06) (-1.40) (-1.40)
Independence 0.502 1.379
 (0.91) (1.67)
Settler mortality -0.191 ** 0.023
 (-2.07) (0.19)
Intercept -0.091 5.039 *** 4.988 ***
 (-0.12) (6.65) (4.59)
No. of observations 121 69 36
F 31 7 6

(a) Values in parentheses are White heteroskedastic adjusted
t-values. *, **, and *** denote significance at 10%, 5%, and 1%,
respectively. F is F-statistics.

(b) FDI is instrumented by the real exchange rate, infrastructure,
and continental dummies for Africa and Latin America. The validity
of these instruments is supported by Sargan test [chi square](3) =
5.36 (p > [chi square] = (0.147)).

TABLE 2
Changes in Averages of Property Rights Index

Country 1981-1885 1986-1990 1991-1995 1996-2000 2001-2005

Morocco 4.542 4.542 7.567 9.875 9.938
Bolivia 2.125 3.092 5.150 7.533 7.400
Chile 5.417 7.000 8.108 9.475 10.483
Tunisia 4.500 4.500 7.025 9.367 9.225
Venezuela, RB 6.104 6.892 6.883 6.300 4.925
Cote d'1voire 7.167 6.775 5.908 6.208 5.517
Zimbabwe 4.250 4.708 5.750 6.050 2.475

TABLE 3
Property Rights and FDI: Panel Data Regressions (Dependent Variable:
Property Rights Index [1981-2005] 5-year intervals)

 Model 1 Model 2 Model 3
 RE (a) RE (a) RE (a)

Ethnic fractionalization -0.671 -0.947 ** -0.327
 (-1.50) (-2.07) (-0.59)
French legal origin -0.352 0.232 0.490
 (-1.23) (0.63) (1.15)
Economic growth -- -- 0.163 ***
 (4.65)
FDI-GDP ratio 0.237 *** 0.241 *** 0.172 ***
 (6.50) (6.59) (4.93)
Catholic -- -0.016 ** -0.011
 (-2.47) (-1.57)
Muslim -- -0.007 -0.005
 (-1.25) (-0.76)
Settler mortality -- -- -0.174
 (-1.31)
Resource endowments -- -- --

Trade -- -- --

Lagged property right -- -- --

Ethnic tensions -- -- --

Intercept 6.342 *** 6.860 *** 6.596 ***
 (18.59) (16.97) (9.50)
No. of groups 70 70 57
No. of observations 278 278 224
Wald [chi square] 51.44(3) 58.62(5) 86.72(7)

 Model 4 Model 5 Model 6
 RE (a) RE (a) FE (b)

Ethnic fractionalization -0.246 -0.074 --
 (-0.47) (-0.14)
French legal origin 0.373 0.415 --
 (0.91) (1.02)
Economic growth 0.133 *** 0.129 *** 0.119 ***
 (3.87) (3.71) (3.27)
FDI-GDP ratio 0.200 *** 0.173 *** 0.162 ***
 (5.00) (4.59) (3.13)
Catholic -0.014 ** -0.011 --
 (-2.20) (-1.63)
Muslim -0.010 -0.008 --
 (-1.58) (-1.19)
Settler mortality -- -- --

Resource endowments -0.019 -0.025 ** -0.009
 (-1.62) (-2.13) (-0.28)
Trade -- 0.007 ** 0.014 **
 (2.49) (1.98)
Lagged property right -- -- --

Ethnic tensions -- -- --

Intercept 6.432 *** 5.877 *** 4.991 ***
 (14.42) (11.33) (10.60)
No. of groups 68 68 68
No. of observations 240 240 240
Wald [chi square] 69.37(7) 77.67(8) --

 Model 7 Model s
 Sys GMM (c) Sys GMM (d)

Ethnic fractionalization 0.019 --
 (0.07)
French legal origin 0.648 ** 0.688 ***
 (2.47) (3.05)
Economic growth 0.209 *** 0.236 ***
 (2.71) (3.38)
FDI-GDP ratio 0.116 ** 0.124 ***
 (2.24) (2.71)
Catholic -0.004 -0.008 **
 (-1.08) (-2.12)
Muslim -0.004 -0.006 *
 (-1.06) (-1.88)
Settler mortality -- --

Resource endowments -0.010 -0.005
 (-1.38) (-0.76)
Trade 0.004 0.004 *
 (1.49) (1.87)
Lagged property right 0.619 *** 0.492 ***
 (5.90) (4.83)
Ethnic tensions -- 0.231 ***
 (4.67)
Intercept 1.081 1.211 *
 (1.3) (1.73)
No. of groups 68 68
No. of observations 240 240
Wald [chi square] 644.64(12) 902.91(12)

(a) Random effects model, z-values reported in parentheses.

(b) Fixed effects model, r-values reported in parentheses.

(c) System GMM. Arellano-Bond test for AR (2) in first differences:
z = -1.01, p > z = 0.312. Hansen test of overidentification
restrictions: [chi square](32) = 34.29, p > [chi square] = 0.359.

(d) System GMM. Arellano-Bond test for AR (2) in first differences:
z = -1.24, p > z = 0.215. Hansen test of overidentification
restrictions: [chi square](32) = 33.67, p > [chi square] = 0.386.
Models 7 and 8 include time dummies.

**, and *** denote significance at 10%, 5%, and 1%, respectively.