Summary of JOIE article ( 11 December 2023) by Rishika Nayyar, University of Sussex Business School, Brighton, UK, and John Luiz, University of Sussex Business School and University of Cape Town, Rondebosch, South Africa. The full article is available on the JOIE website.
Institutions exert an important influence on foreign direct investment (FDI) location choice – that is well-established. However, ‘how institutions matter’ and in what ways remains largely unsettled. Of particular relevance is the distinction between absolute and relative institutions for FDI location decisions. The absolute view of institutions evaluates the quality of institutions relative to some predetermined criteria and standards. The quality of institutions is assessed against the preset benchmarks and institutions in one country are juxtaposed to that of another country e.g., comparing Albania’s institutions to that of Switzerland. The relative view, on the other hand, looks at institutional distance which is defined as the differences between the home and host institutional environments. It is important to disentangle the effect of absolute and relative institutions on FDI decisions because they present different implications for managers. While the managerial concern relating to the quality of institutions is to reduce the exposure to unfavourable host location institutional milieus; with institutional distance, the concern relates to bridging the institutional divide between the home and the host location.
Intuitively one would expect that host countries with good institutions would be more attractive to foreign investment as better quality institutions make the rules of the game more transparent and consistent and thereby mitigate potential risks and lower the costs of doing business in the host locations, whilst weaker institutions would see the reverse. The core premise of institutional distance is that it leads to higher costs of doing international business because the institutional differences impose additional challenges. Therefore, when multinational enterprises (MNEs) enter host countries with different institutional environments, they must make significant adaptations to their strategies in response to different legal systems, political frameworks, tax laws, and other regulations, which entails greater uncertainty, risks and costs. However, some studies have found counterintuitive results, thereby leaving the question of ‘how institutions matter’unresolved.
In this study, we attempt to resolve this question by empirically examining how both absolute institutions (i.e., institutional quality in the host country) and relative institutions (i.e., institutional distance or difference in the institutional quality in the home and host country) influence the outward FDI decisions from India. We do so in two stages. We first examine the effect of both institutional measures on OFDI location choice (‘where to invest’). After the location choice decision is taken, the second decision that firms have to make is regarding the size of the investment (‘how much to invest’). Hence, our second focus is on examining how the two institutional measures matter for decisions relating to the scale/amount of FDI. In doing so, we also propose that the institutional influences would vary depending on where the host country is positioned/situated along the institutional profile distribution i.e., the distribution of the countries according to their institutional quality along a continuum. The institutional profile distribution is developed using six institutional measures, viz., Voice & accountability, Political Stability, Government Effectiveness, Regulatory Quality, Rule of Law, and Control of Corruption, published as World Governance Indicators by the World Bank. Various institutional thresholds that represent the state of institutional quality in the countries are used to tease out the differential effects. More specifically, we divide countries using three thresholds: first quartile– these are the countries that lie in the lower quantile of the institutional profile distribution, having the weakest quality of institutions; median– capturing the countries that lie above and below the median of the distribution; and third quartile– countries lying in the upper quantile of the distribution, having the strongest quality of institutions.
We find that both absolute and relative institutions matter but they matter differently and at different stages in the FDI decision-making. Absolute institutions matter for OFDI location choice. When making the decision on ‘where to invest’, Indian firms are more concerned about the quality of institutions in the host country. Institutional thresholds apply. The quality of institutions matters more strongly in the host countries that lie in the lower part of the institutional profile distribution – in the countries that lie below the thresholds of the median and first quartile. This suggests that institutional improvements are subject to diminishing returns when it comes to enhancing the FDI attractiveness of the country. Relative institutions matter for the scale of investment- ‘how much to invest’ decisions. That is, once the companies have made the decision to invest in the country, the size of the investment is determined by the institutional distance between its home and the host country, but institutional thresholds apply. Counterintuitively though, we find that Indian investors welcome greater institutional distance, but only when it is with countries that lie in the upper part of the institutional profile distribution- above the thresholds of the median and third quartile.
Our findings have intriguing implications at both a managerial and policy level. For managers, our research demonstrates the importance of differentiating between relative versus absolute institutional effects as these two have different consequences. Further, MNEs need to consider the different managerial strategies required depending on whether one is investing in a country towards the lower or the upper end of the institutional profile distribution. Along the lower quantiles of institutional quality, gradual institutional reforms may not translate into meaningful improvements that sufficiently alter the cost-benefit calculation from an MNE perspective, which would swing the scale of the investment volume. Even with institutional improvements, the risks remain high and require appropriate mitigating strategies or more staggered investment approaches, until specific minimum institutional improvements are visible. For policymakers, the research implies that whilst good institutions matter for location choice, threshold effects may apply in terms of the scale of investment. It implies that a gradual improvement in the quality of institutions is unlikely to result in substantial FDI inflows unless the country has met certain minimum institutional standards. Institutional reforms cannot be haphazard but must be persistent and wide-ranging and may require ‘big bang’ approaches to institutional development to attract sizeable FDI.