Institutional Efficiency, Monitoring Costs, and the Investment Share of FDI

This paper models and tests the implications of institutional efficiency on the pattern of foreign direct investment (FDI). We posit that domestic agents have a comparative advantage over foreign agents in overcoming some of the obstacles associated with corruption and weak institutions. We model these circumstances in a principal-agent framework with costly ex-post monitoring and enforcement of an ex-ante labor contract. Ex-post monitoring and enforcement costs are assumed to be lower for domestic entrepreneurs than for foreign ones, but foreign producers enjoy a countervailing productivity advantage. Under these asymmetries, multinationals pay higher wages than domestic producers, in line with the insight of efficiency wages and with the evidence about the ‘multinationals wage premium.’ FDI is also more sensitive to increases in enforcement costs. We then test this prediction for a cross section of developing countries. We use Mauro’s (1995) index of institutional efficiency as an indicator of the strength of property rights enforcement within a given country. We compare institutional efficiency levels for a large cross section of countries in 1989 to subsequent FDI flows from 1990 to 1999. We find that institutional efficiency is positively associated with the ratio of subsequent foreign direct investment flows to both gross fixed capital formation and to private investment. This finding is true for both simple cross-sections and for cross-sections weighted by country size.