Foreign direct investment and domestic financial reform: A marriage made in heaven?

Nauro Campos, Yuko Kinoshita 24 March 2008

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Structural reforms are more than just a signal. They generate real benefits for foreign investors by affecting the key parameters that guide firms’ decisions to invest in a foreign country. Reform of the domestic financial sector is one of these key parameters.

Financial development has long been highlighted as crucial to productive foreign investment. 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.” Prasad et al. (2003) argue that absorptive capacity, as measured by financial development of the recipient country, is a precondition for the growth benefits of foreign capital inflows.

In recent research (Campos and Kinoshita 2008), we examine the role of financial reform in attracting foreign investment inflows and its importance vis-à-vis other types of structural reform. Our study focuses on economies in Eastern Europe and Latin America that adopted various structural reforms during their transitions. We find that, in addition to the usual result that foreign investors are attracted to countries with more stable macroeconomic environments, higher levels of economic development, and better infrastructure, financial reforms have a strong effect on FDI and are more important than other types of structural reform.

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 (TE) in Eastern Europe and Latin America countries (LAC) were industrialized and home to 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, Foreword).

Figure 1 show FDI inflows in the two regions. Throughout the 1990s, average FDI inflows to LAC are substantially larger than to TE. For the years up to the East Asian crisis, the behavior of the series in the two regions is similar, as FDI inflows rapidly increase. The East Asia crisis of 1997 quickly spilled over to Brazil and Russia (Kaminsky and Reinhart 2000) but had different dynamics in different regions. 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)

Structural reforms in emerging markets

We construct new measures of financial sector, privatisation, and trade reforms that significantly improve upon existing indices, 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 privatisation indexes show that, somewhat surprisingly, privatisation efforts – measured based on revenues generated for the government – were much more intense in LAC than in TE in the first half of the 1990ssation. Moreover, we find that privatisation efforts are more volatile in LAC than in TE and there is a noticeable slowdown of privatisation activity after 1998 in the two regions but particularly so in LAC.

Figure 2. Index of Financial Reform

Figure 3. Privatisation Index

Empirical findings

What are the main determinants of the geographical distribution of FDI across emerging economies in the two regions? 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, we argue in our research, the host government’s structural reforms may play a crucial role in attracting foreign investment – we focus on financial sector reforms, trade reforms, and privatisation 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, structural reforms in the financial sector and privatisation are particularly important for FDI in emerging markets. The former is significant after controlling for institutional differences across countries (i.e. rule of law, quality of bureaucracy, executive constraints). We also examine 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, privatisation efforts measured as governments’ proceeds from privatisation also give an impetus to FDI inflows. Finally, we find that trade liberalisation 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.

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Topics:  Financial markets

Tags:  emerging markets, foreign direct investment, policy reforms, privatisation

Professor of Economics, Brunel University London; Research Professor at ETH-Zürich; and Research Fellow, IZA-Bonn

Deputy Head of Office at the Regional Office for Asia and the Pacific, IMF; Research Fellow of the William Davidson Institute, University of Michigan; Consulting Fellow, RIETI

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