Institutions as a determinant of FDI and the role of natural resources

Abstract

This study examines the link between institutional quality and foreign direct investment (FDI) flows to developing countries. The link is investigated at different levels of host countries’ natural resource endowment. Weak institutions can be expected to attract FDI in natural resource abundant countries since they facilitate rent seeking behavior which is commonly thought to be prevalent in the natural resources sector. However, weak institutions also increase uncertainty, thus discouraging investments involving initial sunk costs as large as they commonly are in the natural resources sector. The aim of this study is to empirically assess how natural resource endowment moderates the effect of institutions on FDI. Using data on 117 developing and emerging countries over the time period 1996–2019, I estimate a dynamic panel model using the system generalized method of moments (GMM) estimator. I find a positive effect of institutional quality on FDI inflows only for countries with relatively high levels of natural resource endowment. The results are significant as they provide evidence for a narrative which is inconsistent with the results of earlier empirical research. They indicate that a higher natural resource endowment increases the importance of institutional quality as a determinant of FDI.