Foreign Direct Investment and Domestic Financial Reform: A Marriage Made in Heaven? by Nauro F. Campos and Yuko Kinoshita

March 24, 2008

By Nauro F Campos and Yuko Kinoshita
Published in Vox on March 24, 2008

Nauro F. Campos is Professor of Economics at Brunel University, CEPR Research Affiliate, IZA Research Fellow and WDI Research Fellow.

Yuko Kinoshita is Economist at the International Monetary Fund and WDI Research Fellow.1


What policy reforms can emerging economies adopt to attract foreign investment? This column presents evidence that financial reforms may be the most important, even though foreign investors are not financially constrained.

Structural reforms are more than just a signal. They generate real benefits to foreign investors by affecting the key parameters upon which the decision to invest in a foreign country is taken. This column argues that the reform of the domestic financial sector is one of these key parameters.

Many authors have highlighted this issue. For instance, Alfaro et al. (2004) examine the links among FDI, financial development, and economic growth and find that countries with better developed financial markets are able to exploit FDI more efficiently: "the potential of FDI to create backward linkages in the absence of well-developed financial markets is severely impeded" (p. 92). Prasad et al. (2003) argue that the absorptive capacity as measured by financial development of the recipient country is a precondition to the growth benefits of foreign capital inflows. Our results support and extend these findings by suggesting that financial reform is not only more important than financial development but also financial reform is much more important than other structural reforms vis-à-vis FDI.

One principal finding from our regression analyses is that of a strong relationship from structural reforms to FDI. Among the structural reforms we considered, we find a stronger effect on FDI from financial reforms than from privatization and trade liberalization. This suggests that foreign investors highly value a host country's financial system that is able to allocate capital efficiently, monitor firms, ameliorate, diversify and share risk, and ultimately mobilize savings. We argue that financial reform is a pre-condition for the maximization of the benefits of spillovers to foreign investors via backward linkages as an efficient domestic financial system greatly facilitates the establishment and growth of domestic suppliers of the foreign firms. In addition to financial reform, we find that foreign investors are attracted to countries with more stable macroeconomic environment, higher levels of economic development, and better infrastructure.

Foreign Investment in Emerging Markets

The collapse of the socialist and import-substitution systems somewhat coincided in the late 1980s and provided myriad investment opportunities. Many of the transition economies in Eastern Europe (TE) and Latin America countries (LAC) were industrialized and could count on a relatively cheap and educated workforce. FDI was perceived as an important catalyst for technological advancement necessary for making these economies competitive in the international market. With very few exceptions, these economies set out to implement economic and political reforms, choosing different strategies and ending up with dramatically different outcomes in many areas, including FDI flows. The period of our analysis corresponds to the one Anne Krueger calls "a decade of disappointment" for Latin America (Singh et al. 2005, Foreward).

Figure 1 shows FDI inflows in the two regions. Note that throughout the 1990s average FDI inflows to LAC tend to be substantially larger than to TE, with this reversing only for two years of our whole period of analysis. For the years up to the East Asian crisis, the behavior of the series in the two regions is similar, showing a rapid increase in FDI inflows. The East Asia crisis of 1997 quickly spilled over to Brazil and Russia (Kaminsky and Reinhart, 2000) but has acquired different dynamics depending on the region. In Latin America, FDI inflows came to a halt and have yet to recover, while, in the TE, these effects seem milder with FDI inflows recovering two years after the crisis. The dip in 2002 in Latin America coincides with the Argentinean Crisis.

Figure 1. Foreign Direct Investment Inflows over GDP, Latin American and Transition Economies, 1989-2004 (both in constant US$ billions)

Figure 1

Structural Reforms in Emerging Markets

We construct new measures of financial sector, privatization, and trade reforms that are significantly improved upon existing indexes as they are consistent and comparable across regions and over time for a large sample of countries. Our indicator of the efficiency of the financial sector shows that TE had been catching up with LAC and surpassed them in the late 1990s .

Our privatization indexes show that, somewhat surprisingly, privatization efforts were much more intense in LAC than in TE in the first half of the 1990s (The privatization index is based on the revenues generated for the government). Moreover, we find that privatization efforts are more volatile in LAC than in TE and there is a noticeable slowdown of privatization activity after 1998 in the two regions but particularly so in LAC.

Figure 2. Index of Financial Reform Figure 2

Figure 3. Privatization Index

Figure 3

Empirical Findings

What are the main determinants of the geographical distribution of FDI across emerging economies in the two regions? The factors influencing the location decision of FDI are generally classified in three categories. First, there are classical sources of comparative advantages such as market size, the level of economic development, infrastructure, natural resource abundance, and macroeconomic stability. Second, there are institutional quality of the host countries such as rule of law, quality of bureaucracy, and executive constraints. Third, as we argue in the paper, the host country government's efforts in terms of structural reforms may play a crucial role in attracting foreign investment. Among various structural reforms, we focus on financial sector reforms, trade reforms, and privatization efforts.

Using the newly constructed panel data, we estimate the effects of structural reforms on FDI inflows along with other standard determinants. We find that, in addition to the classical sources of comparative advantages, two areas of structural reforms in financial sector and privatization are particularly important for FDI in emerging markets. We then perform a series of robustness checks on financial sector reform measured as the efficiency of banking sector and find that it is robust throughout even after controlling for institutional differences across countries (i.e. rule of law, quality of bureaucracy, executive constraints) . We also examined various policies in financial sector reforms to see which policy is more important for foreign investment decisions. In particular, we find that reform policies to strengthen banking sector supervision, to reduce credit ceilings for banks, and to liberalize securities markets have a positive impact on FDI inflows. By the same token, privatization efforts measured as governments' proceeds from privatization also give an impetus to FDI inflows. Finally, we find that trade liberalization raised the ability to attract FDI in LAC, not in TE.

The Most Important Reform

The fact that financial reforms have a stronger effect on FDI than privatisation and trade liberalisation suggests that foreign investors highly value a host country's financial system that is able to allocate capital efficiently, monitor firms, ameliorate, diversify and share risk, and ultimately mobilize savings. Financial reform is arguably a pre-condition for the maximisation of the benefits of spillovers to foreign investors via backward linkages as an efficient domestic financial system greatly facilitates the establishment and growth of domestic suppliers of the foreign firms.

Our findings are consistent with the view that an efficient and well-developed financial market plays a crucial role in supporting a positive effect of FDI on economic growth in emerging markets. Furthermore, a credible pledge to financial reforms may be helpful in drawing FDI inflows even when the country has not yet fully developed the domestic financial sector. Not only does financial reform matter, it is the most important reform a country can pursue in order to influence the decisions of foreign investors.

References

Alfaro, L., A. Chanda, S. Kalemli-Ozcan, and S. Sayek, 2004, "FDI and Economic Growth: the Role of Local Financial Markets," Journal of International Economics 64: 89-112.

Campos, N. F. and Y. Kinoshita, 2008, "Foreign Direct Investment and Structural Reforms: Evidence from Eastern Europe and Latin America," IMF Working Paper No. 08/26.

Kaminsky G. and C. Reinhart C, 2000, "On Crises, Contagion, and Confusion," Journal of International Economics, Volume 51, Number 1, June, pp. 145-168(24).

Prasad, E., K. Rogoff, S. Wei, and M.A. Kose, 2003, Effects of Financial Globalization on Developing Countries: Some Empirical Evidence, IMF Occasional Paper No. 220

(Washington: International Monetary Fund).

Singh, A., A. Belaisch, C. Collyns, P. Masi, R. Krieger, G. Meredith, and R. Rennhack, 2005, Stabilization and Reform in Latin America: A Macroeconomic Perspective on the Experience Since the Early 1990s, IMF Occasional Paper 238.


1 This column is based on "FDI and Structural Reforms: Evidence from Eastern Europe and Latin America" (IMF Working Paper 08/26). The views expressed in this paper are those of the authors alone and do not necessarily represent those of the IMF or IMF policy.




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