UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES HO CHI MINH CITY THE HAGUE VIETNAM THE NETHERLANDS VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS THE NEXUS BETWEEN INSTITUTIONS, FOREIGN AID, AND FOREIGN DIRECT INVESTMENT BY LE M. TUE MASTER OF ARTS IN DEVELOPMENT ECONOMICS HO CHI MINH CITY, JULY 2015 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES HO CHI MINH CITY THE HAGUE VIETNAM THE NETHERLANDS VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS THE NEXUS BETWEEN INSTITUTIONS, FOREIGN AID, AND FOREIGN DIRECT INVESTMENT A thesis submitted in partial fulfilment of the requirements for the degree of MASTER OF ARTS IN DEVELOPMENT ECONOMICS BY LE M. TUE Academic Supervisor: Dr. DINH CONG KHAI HO CHI MINH CITY, JULY 2015 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com CERTIFICATION I certify that the substance of this thesis has not already been submitted for any degree, and has not been currently submitted for any other degree.
I certify that, to the best of my knowledge, help received in preparing this thesis and all sources used have been acknowledged in this thesis. Tue LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com ACKNOWLEDGMENT I am grateful to Dinh Cong Khai, my academic supervisor, and Pham Khanh Nam, a member of the VNP scientific committee, for helpful and detailed comments. LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com ABSTRACT This paper examines the mutual relationship between foreign aid and foreign direct investment (FDI), which might be ambiguous by reverse causality or simultaneity problems. Using the dual-approach dynamics-balanced (DADB) model, we are able to point out that both bilateral and multilateral aid could lead to more FDI, and the impact of the latter could be even larger than that of the former.
The institutional effect of multilateral aid is proposed to explain this phenomenon. Interestingly, the role of political stability could surpass those of democracy and control of corruption in having more aid disbursements. LUAN VAN CHAT LUONG download : add luanvanchat@agmail. Practical Motivation and Research Problems.
MODEL AND DATA. Dual-Approach Framework. Dual-Approach Dynamics-Balanced Model. Independent Marginal Effects between Institutions, Foreign Aid, and FDI.
Reliability and Robustness Checks. Research Contribution, Implication, and Limitations. 34 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com LIST OF FIGURES Figure 1: The Nexus between Institutions, Foreign Aid, and FDI. 8 LIST OF TABLES Table 1: Descriptive Statistics.
10 Table 2: Independent Marginal Effects between Institutions, Foreign Aid, and FDI, 1996- 2012. 18 Table 3: The Impacts of Different Institutional Measures on FDI and Foreign Aid. 22 Table 4: Independent Estimation of the Dynamic FDI Equation. 25 Table 5: Independent Estimation of the Dynamic Aid Equations.
27 LIST OF APPENDICES Table A 1: Variables and Data Sources. 33 Table B 1: Regression Result of Table 2, column (1). 34 Table B 2: Regression Result of Table 2, column (2). 35 Table B 3: Regression Result of Table 2, column (3).
36 Table B 4: Coefficient of INSA index in Table 3, Panel A, column AA. 37 Table B 5: Coefficient of INSA index in Table 3, Panel A, column BA. 38 Table B 6: Coefficient of INSA index in Table 3, Panel A, column MA. 39 Table B 7: Regression Result of Table 4, column (7).
40 Table B 8: Regression Result of Table 4, column (8). 40 Table B 9: Regression Result of Table 4, column (9). 41 Table B 10: Regression Result of Table 5, column (7). 41 Table B 11: Regression Result of Table 5, column (8).
42 Table B 12: Regression Result of Table 5, column (9). 43 Figure B 1: Scree Plot of Eigenvalues of Components for Five Variables of INSF index. 44 Figure B 2: Scree Plot of Eigenvalues of Components for Three Variables of INSA index. 44 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.
Practical Motivation and Research Problems From the behavior aspect, when a country receives more aid from a donor, it will acknowledge the generosity of that donor, easily cooperate with that sovereign partner, and create a concessionary legal environment for the enterprises of that donor (Kimura & Todo, 2010; Rodrik, 1995, p. From the effectiveness aspect, when a country receives more aid from all donors, it is able to improve the social and economic infrastructures, thus the human capital as well as the total factor productivity increase accordingly (Harms & Lutz, 2006). Hence, the recipient country would be able to attract more FDI from any other countries due to its increasing competitiveness. In both of the explanations, foreign aid should be a significant factor of private capital inflows, which are generally accepted to vigorously promote growth, technology, and employment in the host country.
Nevertheless, research studies have not found a robust relationship between foreign aid and FDI (Alesina & Dollar, 2000; Harms & Lutz, 2006). Harms and Lutz (2006) suggest that one should consider the role of political and institutional characteristics when quantifying this relationship. Indeed, institutional quality of the host country itself is an important direct magnet of private capital inflows. Abundant empirical studies have pointed out the negative causality of a bad institution to the inflows of FDI.
Ironically, several countries which are perceived as having high corruption and low political, institutional profiles still have large inflows of FDI (Habib & Leon, 2002). In the aspect of modeling, the influence of foreign aid on FDI is difficult to estimate due to the problems of simultaneity and reverse causality. By using lagged variables as instruments, 2SLS and GMM methods, to some extent, could alleviate such endogeneity. However, the treatment is purely technical and does not reflect the nature of the problems.
Asiedu, Jin, and Nandwa (2009) propose a simultaneous equations model that could solve these problems. In this approach, foreign aid and FDI are determined at the same time, and each of them is the determinant of the other. While the dual approach is undoubtedly a superb idea, the applied model and the results of this research nonetheless contain some flaws and contradictions. First, there is no institutional determinant in the aid equation.
Second, in the aid equation, the positive coefficient of FDI could be interpreted that while foreign aid reduces FDI, FDI could, however, increase foreign aid. 1 LUAN VAN CHAT LUONG download : add luanvanchat@agmail. Research Objectives This paper aims to modify the simultaneous equations model of Asiedu et al. (2009) and visualize the intricate relationship between foreign aid and FDI, which might comprise simultaneity and reverse causality.
With regard to purposes, while Asiedu et al. (2009) focus on the alleviating role of foreign aid on the adverse effect of expropriation risk on FDI, we concentrate on the effect of foreign aid on final FDI. With regard to samples, we use both low-income and middle-income subsamples to support our analysis, whereas it is only the low-income countries in Asiedu et al. In comparison with Harms and Lutz (2006), we apply a different model with different proxies of variables and a more recent period to assess the effect of foreign aid on FDI.
After setting up the framework and specifying the according model, we use the data to illustrate the mutual relationship between foreign aid and FDI. Using this result, we expect to figure out whether multilateral aid could actually lead to more FDI. As for researchers concerned with the determinants of FDI and foreign aid, this paper provides more empirical evidence on the role of institutions. In particular, we reexamine whether better institutions could attract more FDI as postulated in theory and found in many research studies.
By the way, we also appraise the importance of different institutional measures on FDI. In the other side, do democracy (freedom), control of corruption, and political stability help a country receive more foreign aid? 1. Structure In Chapter 2, this paper briefly reviews a trade theory which is widely used to explain the investment decision of foreign investors and some empirical results based on this theory. We mainly concentrate on the papers that have institutions and foreign aid as the determinants of private capital inflows.
In Chapter 3, we explain the dual-approach framework and the regression model. The variables and data sources are also described in this chapter. The empirical findings and associated explanations are located in Chapter 4. Chapter 5 recapitulates the results for making policy and research.
2 LUAN VAN CHAT LUONG download : add luanvanchat@agmail. LITERATURE REVIEW We first review the OLI theory on the investment decision of foreign investors; then we come into the papers mentioning institutions and foreign aid as separate explanatory variables of FDI; next, we have a look on the research which embeds the political and institutional factors into the influence of foreign aid on FDI. Lastly, we summarize the institutional measures which might affect foreign aid. Dunning (1988, 1998, 2001) built up the OLI paradigm as a general framework to explain the activities of foreign investors.
The ownership advantages are classified as the O component and emphasize the comparative advantages of firms which can expand their business abroad. Analyzing the O component provides us with information about the nature of products and the ability of firms. The location advantages define the L component and are related to the human and natural resources, the favorable conditions for production, business, research activities, and the market size in the host country. The internalization advantages belong to the I component and focus on the aspect of how to lower transaction costs, as firms decide whether importing intermediate products from markets or internalizing foreign suppliers into their production chain.
The I component could be taken into analysis by firms at the time of choosing the destination. Political and institutional factors of the host country are considered as the location advantages in the OLI framework. The influence mechanism of these factors on foreign investors are mentioned in the papers such as Habib and Leon (2002) and Dunning and Lundan (2008). On the empirical side, Habib and Leon (2002) find out a negative relationship between corruption levels in the host countries and their inflows of FDI.
According to Habib and Leon, foreign investors might see corruption as violating social and professional ethics and increasing unnecessary costs. 1 Moreover, paying bribes is strictly prohibited in the home countries of some foreign investors such as the United States (Hines, 1995). Busse and Hefeker (2007) examine the impacts of government stability, law and order, absence of internal and external conflicts, lack of ethnic tensions, control of corruption, democracy, and bureaucratic performance on FDI inflows to developing countries in the period 1984-2003. The paper does show positive relationships between such measures and private capital inflows.
With the same period of research, Bénassy-Quéré, Coupet, and Mayer 1 Wei (2000) views corruption as a kind of tax on foreign investors. 3 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com (2007) use the gravity model to test the influences of various institutional data on FDI stocks. In general, a country owning higher institutional quality would have a larger aggregate stock of FDI, and higher institutional distance between the home country and the host country lowers the FDI stock of the former in the latter. In other words, bad institutional measures would hinder FDI to a country.
For example, one of the results in Asiedu et al. (2009) is that expropriation risk restrains the investment decision of foreign enterprises. The samples of this research are low-income and Sub-Saharan African countries. On the other hand, the number of research studies that find out bad institutions as an incentive of FDI is quite limited.
Egger and Winner (2005) show the empirical evidence on the positive relationship between corruption and inward FDI. The research uses a sample of both developed and developing countries in the period 1995-99 to strengthen the position of Leff (1964): bribing could reduce uncertainty among low-informational countries and safeguard foreign investors under major economic and political changes.