Rev World Econ

DOI 10.1007/s10290-015-0227-8

ORIGINAL PAPER

Institutional distance and foreign direct investment

Rafael Cezar1,2 • Octavio R. Escobar3

Ó Kiel Institute 2015

Abstract This paper studies the link between foreign direct investment (FDI) and
institutional distance. Using a heterogeneous firms framework, we develop a the-
oretical model to explain how institutional distance influences FDI, and it is shown
that institutional distance reduces both the likelihood that a firm will invest in a
foreign country and the volume of investment it will undertake. We test our model
using inward and outward FDI data on OECD countries. The empirical results
confirm the theory and indicate that FDI activity declines with institutional distance.
In addition, we find that firms from developed economies adapt more easily to
institutional distance than firms from developing economies.

Keywords Foreign direct investment  Institutions  Heterogeneous firms 

Gravity model

JEL Classification F12  F23  H80  K20

The views expressed in the paper are those of the authors and do not necessarily reflect those of the
Banque de France.

& Octavio R. Escobar

oescobar@esg.fr
Rafael Cezar
rafael.cezar@banque-france.fr
1
Banque de France, 37 rue du Louvre, 75002 Paris, France
2
LEDa UMR 225 DIAL, PSL - Université Paris-Dauphine, Place du Maréchal de Lattre de
Tassigny, 75775 Paris, France
3
Paris School of Business, 59 rue Nationale, 75013 Paris, France

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 R. Cezar, O. R. Escobar

1 Introduction

Developing and transition economies increasingly attract foreign direct investment

(FDI) flows (UNCTAD 2012). Three important patterns, observable in UNCTAD
(2012) data, are helpful in understanding this trend. First, most FDI outflows are
from developed economies, but their share in total FDI outflows is decreasing over
time. Since 2003, the share of FDI outflows of developing and transition economies
has consistently increased, reducing the share of FDI from developed economies to
approximately 75 % in 2011. Second, firms primarily invest in countries with
similar levels of development as their own. More than 70 % of outward FDI from
developing and transition economies goes to other developing and transition
economies, and approximately 50 % of this outward FDI goes to economies located
in the source economy’s region. Developed economies also locate most of their
operations in other developed economies. Third, developed economies have a
greater capacity to diversify their operations than developing and transition
economies. Approximately 45 % of outward FDI from developed economies goes
to developing and transition economies. Moreover, developed economies are the
main source of FDI in developing and transition economies.
Differences in the quality of institutions across countries are the main
determinant of differences in economic development (Acemoglu and Robinson
2010); we thus expect that institutional distance is an important determinant of FDI
and that it helps explain recent FDI patterns. We develop a theoretical model, using
a heterogeneous firms framework, to explain how institutional distance influences
decisions to invest in a country and the volume of investment undertaken.
According to the heterogeneous firms literature (Helpman et al. 2008; Yeaple 2009),
a productivity threshold must be overcome to make FDI profitable. Thus, only the
most productive firms, mainly from developed countries, can invest abroad.
When entering foreign markets, multinational enterprises (MNEs) must adapt
their strategies to the requirements of local institutions, which may differ from the
institutions of their home countries. Our model suggests that MNEs face an
adaptation cost in adjusting to the institutional environments of host countries. As
adaptation costs increase with institutional distance, institutional distance determi-
nes the productivity threshold at which FDI is more profitable than exporting as a
means of accessing foreign markets. Thus, increasing institutional distance reduces
the number of firms that undertake FDI. In addition, adaptation costs reduce firm
profits and the profitability of FDI. Accordingly, firms’ FDI declines with
institutional distance.
Firms perform better in foreign markets similar to their home markets than in
markets that are dissimilar, as similarities are easier for firms to manage (Johanson
and Vahlne 2009). In addition to institutional similarities, development, geograph-
ical and cultural proximity are important determinants of FDI (Head and Ries 2008;
Helpman et al. 2008; Guiso et al. 2009). To control for differences in all of these
factors across countries, when studying the determinants of FDI, the empirical
literature uses gravity equations. Studies show that institutional distance matters for
bilateral FDI. Differences between host and source countries in terms of corruption

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Institutional distance and foreign direct investment

(Habib and Zurawicki 2002), legal rules (Guiso et al. 2009), credit market
regulations, legal constraints in recruiting and firing, and decentralisation of wage
bargaining (Bénassy-Quéré et al. 2007) reduce bilateral FDI flows. However, the
costs of institutional distance may differ for firms from developed and developing
countries, owing to firm heterogeneity. Firms from developed countries may have
more experience and better networks, which reduce the cost of institutional distance,
than firms from developing countries (Johanson and Vahlne 2009).
We proceed to an empirical validation of our model. Using alternative indicators
of institutional distance, the results suggest that FDI activity declines as institutional
distance increases. When investing in countries with weak institutions, firms from
countries with weak institutions face lower costs than firms from countries with
strong institutions. The results also suggest that institutional distance more strongly
influences firms’ decisions to invest in developing than in developed economies.
Once an investment decision is made, institutional distance equally affects the
amount of investment from developed and developing economies.
This paper is organised as follows. Section 2 presents the theoretical model.
Section 3 describes the empirical specification of the model and the estimation
strategy. Section 4 describes the data and the measures of institutional distance
used. The empirical results are presented in Sect. 5, and robustness tests are
presented in Sect. 6. Finally, Sect. 7 concludes.

2 The model

This theoretical section illustrates how institutional distance impacts FDI patterns.
The model is based on the heterogeneous firms framework, as in Melitz (2003), and
on the international firms’ trade-off framework between exporting and engaging in
FDI, as developed by Helpman et al. (2004) and Yeaple (2009). We suggest that
institutional distance impacts FDI transactional costs such that the decreasing of this
distance reduces the amount needed to perform the international investment and
more firms are able to produce abroad instead of exporting. We first present the
background theory, and the subsequent subsection introduces the role of institu-
tional distance in the model.
The world economy features i countries with N firms in a monopolistic
competition market. Consumer constant elasticity of substitution (e) utility
preferences are identical across countries. The demand for variety x is
e
 1=ð1eÞ
qdi ðxÞ ¼ piPðx1eÞ Yi , and Pi ¼ r pi ðxÞ1e dx is the ideal price index. Labour
i
is the only input, and firms are heterogeneous in their productivity levels, noted as
u. The cdf (cumulative distribution function) of u, identical across countries, is
l(u) with support [uB, uH], where uH [ uB [ 0, and uB and uH indicate the
productivity levels of the least and most productive firms, respectively. Labour
costs, noted wi for country i, are country specific, and the marginal cost is wi/u.
Firms wishing to sell their products abroad chose between exporting or
performing FDI. There are two specific costs to exporting: fixed costs, noted by
fij for the country pair i, j, and variable costs, modelled as iceberg transportation

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 R. Cezar, O. R. Escobar

costs, with sij C 1. The marginal cost of exporting from country i to j is sijwi/u. FDI
allows firms to reduce transportation costs, but they incur higher fixed costs. The
marginal cost of FDI is wj/u \ sijwi/u, and the fixed cost is Fij [ fij.
Firms are assumed to use FDI neither as an export platform nor for outsourcing
production but only to access the host country’s market. From demand and price
 e1
equations, the revenue from FDI can be represented as rij ðuÞ ¼ aPj Yj mðuÞ1e ;
where m(u) is the marginal cost of a firm with productivity u. The variable FDI
e1
r ðaPj Þ
revenue is thus Rij ðuÞ ¼ eij ¼ wj mðuÞ1e ; where wj ¼ e Yj is specific to country
j and measures demand adjusted for the elasticity of substitution. Let us define px
(u)ij and pI (u)ij as export and FDI profits, respectively:
 1e e1
px ðuÞij ¼wj sij wi u  fij
1e e1
ð1Þ
pI ðuÞij ¼wj wj u  Fij

Marginal costs are decreasing in u, and thus, Rij(u), and profits are increasing in
u. Firms only sell abroad if profits are at least zero, and we have two productivity
thresholds: ux and uI, such that p(ux)ij = 0 and p(uI)ij = 0. The first threshold
indicates the productivity level above which firms generate sufficient variable
income to pay fixed export costs. The second is the productivity threshold above
which firms can pay for fixed FDI costs.
The variable income for MNEs—and their  marginal profit—is
 always higher than
dpI ðuÞ dpx ðuÞ
the marginal income of exporting firms du [ du . However, because fixed
FDI costs are higher than fixed export costs, the productivity threshold above which
firms will export is typically lower than the productivity threshold for FDI. Firms
choose the internationalisation mode that maximises their profits. For example, they
prefer FDI only if pI ðuÞ  px ðuÞ. We denote the productivity of the marginal MNE
firm as uI : This productivity threshold is country-pair specific, and all firms in
country i with productivity above uI produce directly in country j.
Because productivity levels are not directly observable, rij(u) is used as a proxy
for this FDI threshold (which is an increasing function of u). From Eq. 1, the
income level above which firms from country i invest (and produce) in country j is
   
 Fij  fij
r uIij ¼ e  1e : ð2Þ
s w
1  ijwj i
  
Because productivity follows l(u), only the fraction 1  l uIij of the Ni
firms from i invest in j. Moreover, it is possible that this proportion equals zero if
uIij [ uH , with no firm sufficiently profitable to reach the threshold. The equation
indicates that an increase in the difference between Fij and fij makes exports
relatively more attractive than FDI. Moreover, because the ratio between marginal
 1e
s w
costs is always [1, ijwj i is \1. Therefore, uIij is larger when the distance
between sij wi and wj is small.

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Institutional distance and foreign direct investment

2.1 Institutional distance and FDI margins

Firms face two types of fixed FDI costs: (i) construction of new facilities and (ii)
adaptation costs, which are the costs required to produce in the institutional,
political and economic environment of the host country.
Firms’ demand rises as prices fall, and prices decrease as firm productivity rises.
Therefore, MNEs’ demand depends on productivity, and the most productive firms
face the highest demand. Subsequently, the size of the facilities that multinationals
construct in the host country is proportional to their productivity level, with the most
productive firms building the largest facilities. This indicates that the cost of
investing in new facilities is a function of expected profits in the host market.1 For
simplicity, the investment cost function is assumed to be monotone and linear. The
cost for firms of country i of opening a subsidiary in country j is wj hpij ðuÞ, where
the parameter h is positive and strictly \1, and pij is defined as in Eq. 1. The fixed
cost of investing in new facilities depends on firm productivity.
The second fixed FDI cost is the adaptation investment in the new institutional
environment. To produce in the host country, firms must adapt to its legal system,
tax laws, political and governmental framework, conditions of access to credit,
and regulations. Such adaptation costs depend on the institutional framework of
the host country. Countries with weak institutional environments have high
adaptation costs, while improvements in the institutional environment lower these
costs (Daude and Stein 2007). Nevertheless, firms are already accustomed to the
institutional environments of their own domestic markets and have experience in
coping with them. Such experience can reduce adaptation costs, especially when
the institutional environments of the country-pair are similar (Bénassy-Quéré et al.
2007; Guiso et al. 2009; Habib and Zurawicki 2002). Thus, we assume that
adaptation costs are inversely proportional to institutional proximity. A firm
accustomed to a weak institutional environment finds it easier to invest in a
country with similar characteristics, while the same firm needs to make larger
investments to adapt to a country with an efficient but different institutional
system.
Let ki denote the level of institutional development of country i. This parameter
measures the overall institutional quality of the country, including regulations,
property rights, access to information, financial constraints, level of corruption, and
political stability, as well as the formalities involved in opening a business,
executing a contract, and registering a property. Thus, the cost of institutional
adaptation between countries i and j is an increasing function of the distance
between ki and kj. When this distance is tight, firms in country i are familiar with the
institutional environment in country j, and adaptation costs are low. Inversely, a
large distance indicates high adaptation costs.

1
An alternative explanation would be that the return on capital is calculated based on the sum of
actualised expected profits.

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 R. Cezar, O. R. Escobar

 
We denote this adaptation cost as wi c kj  ki , and it is measured in labour cost
units of the source-country. The cost function is specific to the country-pair, is
monotone, is strictly positive and increases with institutional distance, such as
dcðkj ki Þ
dðkj ki Þ
[ 0: Thus, the fixed cost of engaging in FDI in j from i is Fij = wjhpij(-
u) ? wic(kj–ki). From Eq. 2 and the FDI fixed cost above, the income threshold
above which firms in country i perform FDI in country j is
   
 wj hpij ðuÞ þ wi c kj  ki  fij
r uIij ¼ e  1e : ð3Þ
s w
1  Tijij wij

This equation indicates a direct and negative relationship between institutional

distance and the marginal variation in the proportion of firms that engage in FDI
duIij drðu Þ  
(extensive margin), such that d k k  d k kIij [ 0, where duIij =d kj  ki is the
ð j iÞ ð j iÞ
elasticity of the FDI productivity threshold with respect to institutional distance.
This elasticity is positive, such that a positive change in (kj–ki) increases uIij and
reduces the proportion of MNEs (extensive margin).2 This relationship is
summarised in the following proposition:
Proposition 1 There is a direct and negative relationship between institutional
distance and the marginal variation in the extensive margin, such that an increase
in this distance raises the productivity threshold above which FDI is profitable and
reduces the proportion of MNE.
To examine how institutional distance affects the volume of FDI flows between
countries (intensive margin), we define below Vij as the average productivity of
firms from country i that invest in j:
(Ru
uIij u
H e1
dlðuÞ if uIij  uH
Vij ¼ ð4Þ
0 if uIij [ uH

If uIij [ uH ; Vij ¼ 0 because no firm from i is sufficiently productive to invest in

j; and if uIij  uH ; at least one firm is sufficiently productive to invest abroad. This
variable is country-pair specific, with Vij 6¼ Vji ; which allows for asymmetric FDI
flows. The intensive margin (the volume of FDI between two countries) is the sum
of all investments made by each firm (for which u  uIij ) in the construction of new
facilities.3 From the FDI fixed cost and Eq. 4, the total FDI from i to j can be written
as:

2
Because the model focuses on the productivity threshold, for simplicity, we assume that the distribution
of u is the same across countries. Nevertheless, dropping this hypothesis—which agrees with the real
condition of firms’ productivity—allows, together with unilateral FDI costs, for asymmetric FDI flows
between country pairs. These two factors can also explain the unilateral FDI flow between a country pair.
3
Because the adaptation cost is incurred in the source country before investments are complete, FDI
exclusively concerns investments in new facilities.

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Institutional distance and foreign direct investment

FDIij ¼ wj hpij ðuÞVij Ni

  !
1  wj h wj h   1e e1   ð5Þ
¼  2 wj Tij wj u  wi c kj  ki Vij Ni
1  wj h

This equation indicates that the cost of institutional adaptation has a negative
effect on
 the value
 of FDI, such that a positive change in the first variable reduces
FDI. c kj  ki also affects the number of investing firms via the productivity
threshold, which is included in Vij : Based on these observations, the second
theoretical proposition is presented as follows:
Proposition 2 Institutional distance negatively affects the intensive margin of
FDI, such that an increase in institutional distance reduces FDI flows.

3 Empirical specification

The gravity equation is commonly used to study the determinants of FDI, as they
can be derived from various theoretical models (Head and Ries 2008; Kleinert and
Toubal 2010, 2013). We develop a gravity equation to test the propositions of our
model. First, our model suggests that institutional distance influences decisions to
invest abroad (the extensive margin). Second, the model suggests that institutional
distance influences the profitability of foreign investment and the volume of
investment (the intensive margin). Because the volume of investment depends on
the extensive margin, we develop, following Helpman et al. (2008), a two-stage
gravity equation to estimate the extensive and intensive margins. In the first stage,
or the selection equation, firms choose whether to invest (extensive margin); in the
second stage, or the primary equation, firms that invest decide how much to invest
(intensive margin).

3.1 Empirical specification of the selection equation

From Eq. 4, the decision to invest depends on firms’ productivity and on the
productivity threshold. We define the variable Zij as the ratio of the productivity of
the most productive firm (uH) to the productivity threshold (uIij ). If Zij [ 1, then
firms from country i invest in country j. We assume that the productivity of the most
productive firm (uH) in country i is given; thus, variations in Zij are caused by
changes in the threshold at which FDI is more profitable than exports. Therefore, the
estimation of Zij allows us to estimate the impact of institutional distance on the
productivity threshold (uIij ) and the decisions of firms to invest abroad:
 
!e1 ðaPj Þ
e1
 1e 
e Yj w1ej  sij wi
uH e1
Zij ¼ ¼ uH : ð6Þ
uIij Fij  fij

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 R. Cezar, O. R. Escobar

We assume that differences in fixed and variable costs between exporting and
 1e
FDI are stochastic. More precisely, we suppose that w1e j  sij wi 
 
exp #1 wi þ #2 wj þ #3 Xi þ #4 Mj þ #5  ij þ ij ; where Xi is a measure of the costs
of exporting, such as customs procedures and regulations in country i, and is
independent from the export destination; Mj is a measure of trade barriers, such as
customs procedures and regulations, imposed by the importing country j on all
exporters;  ij measures country-pair characteristics,
 2 such as bilateral distance and
ease of communication; and ij N 0; r is an error term. With respect to

differences in fixed costs, we assume that Fij  fij  exp b1 wi þ b2 wj þ
   
b3 c kj  ki þ nij Þ, where nij N 0; r2n is an error term. We can express Eq. 6
in log form as
zij ¼ c0 þ ci þ cj þ cij þ gij ; ð7Þ
 
where zij ¼ ln Zij ; c0 ¼ ðe  1Þ lnðaÞ  lnðeÞ is a constant; ci ¼ ðe  1Þ lnðuH Þ þ
ð# þ b1 Þwi þ #3 Xi represents the characteristics of the source country i; cj ¼
 1   
e  1Þ ln Pj þ lnðYj þ ð#2 þ b2 Þwj þ #4 Mj represents the characteristics of the
 
host country j; cij ¼ #5  ij þ b3 c kj  ki represents the characteristics of the
 
country-pair i, j; and gij ¼ eij þ tij N 0; r2e þ r2n is an independent and identi-
cally distributed (iid) error term.
We cannot measure zij because neither firms’ productivity levels nor the
productivity threshold are observable. However, the presence of firms from country
i in country j implies that zij [ 0. A selection indicator Sij is generated, using a latent
variable such as Sij = 1 if firms from i invest in j and Sij = 0 otherwise. Let qij be
the probability that country i invests in j, conditional on the observed variables.
Assuming r2g ¼ r2e þ r2t ¼ 1; we can specify Eq. 7 as a probit equation:
 
qij ¼ Pr Sij ¼ 1jObserved variables
  ð8Þ
¼ U c0 þ ci þ cj þ cij þ gij ;

where UðÞ is the cumulative distribution function of the unit-normal

 distribution.
We then estimate the predicted value of zij as z^ij ¼ U1 q^ij : It is important to note
that the selection equation above is derived from firm-level decisions. It shows how
changes in the characteristics of the countries affect FDI decisions. More specifi-
cally, marginal changes in the characteristics of country i or j modify the produc-
tivity threshold and affect the choice between exporting or performing FDI.
Equation 8, then, provides information on the marginal variation in the proportion
of firms from i investing in j.

3.2 Empirical specification of the primary equation

FDI
 flows
 from country
  i to j,given by Eq. 5, can be expressed in log form as
ln FDIij ¼ h þ ln wj þ ln pij þ ln Vij þ lnðNi Þ. Profits (pij) depend on demand

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Institutional distance and foreign direct investment

as well as on production and implantation costs. Thus, we estimate the following

equation
 
ln FDIij ¼ / þ /i þ /j þ /ij þ vij þ uij ; ð9Þ

where /i, /j, and /ij are the

 characteristics
 of country i, country j, and country-pair
i, j, respectively; vij ¼ ln Vij is the logarithm of the average productivity level of
 
firms from i that invest in j; and uij N 0; r2u is an error term. From Eq. 2, fol-
 
lowing Helpman et al. (2008), we specify vij  t zij as an arbitrary increasing
 
function of zij. More precisely, we control for E½Vij j:; Sij ¼ 1
; using t z^ij ; which we
approximate with a cubic polynomial in z^ij :

3.3 Estimation strategy

Equations 8 and 9 include common exogenous variables specific to the FDI source
country i, host country j, and country-pair i, j. GDP per capita proxies for wage
levels, geographical and cultural distance proxy for trade and coordination costs,
and country size or GDP levels proxy for demand. These proxies enable us to
construct a gravity equation for both the selection and primary equations. The
literature suggests that under general equilibrium, bilateral FDI depends on the same
exogenous determinants as bilateral trade flows (Bergstrand and Egger 2007; Egger
2010).
Although the exogenous variables included in the selection and primary
equations may be identical, an additional variable not included in the primary
equation is also required in the selection equation (Wooldridge 2002). In addition,
incorporating panel data estimates from the selection equation into the primary
equation entails potential autocorrelation bias. We follow Wooldridge (2002), who
proposes estimating the selection equation for each year t and using the resulting
estimates to compute z^ij : This procedure is similar to the two-stage estimators of
Heckman (1979); however, we only control for firms’ heterogeneity, not for
selection bias. To address zero flow observations, we employ the Santos-Silva and
Tenreyro (2010) Poisson pseudo-maximum-likelihood (PPML) estimator.

4 Data

We construct a panel database of the bilateral relationships between 31 OECD

countries and 125 countries in different stages of economic development. Data are
available for the 2004–2009 period. The dependent variable is the ratio of the
bilateral stock of FDI—inward into and outward from OECD countries—to the
GDP of the FDI receiving country.4 Data come from the International Direct

4
FDI stock data are widely used in the literature. The most frequent arguments used to justify the use of
FDI stock data are as follows: (i) FDI is also financed by markets in the host country, and therefore, stock
data provide a more accurate measure than flow data; (ii) Stock is much less volatile than flows; and (iii)
Stock data greatly reduce the number of zero observations in the sample.

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 R. Cezar, O. R. Escobar

Investment Statistics database, available from the OECD, and from the World
Development Indicators (WDI) of the World Bank.

4.1 Institutional distance index

Different institutional frameworks and their impact on economic activity have

received substantial attention in the recent literature on FDI (Bénassy-Quéré et al.
2007; Guiso et al. 2009). Generally, the term ‘‘institution’’ refers to structures that
affect economic relations. North (1994) defines institutions as the constraints built
by men and designed to organise social relations. Formal constraints include
regulations, property rights, the financial system and contract enforcement
(Levchenko 2007), while informal constraints include levels of social trust (Algan
and Cahuc 2010) and corruption (Habib and Zurawicki 2002).
A measure of the distance between institutional environments must therefore be
sensitive to various aspects of the institutional structures of each country. Thus, a
wide range of indicators of various formal and informal constraints is used to
construct a single composite index for each country in the sample, using principal
component analysis (PCA). The institutional indexes of countries i and j are denoted
by ki and kj. The institutional distance between two countries is then calculated from
the composite index and equals the absolute value of the difference between two
countries’ indices: Distij ¼ ki  kj :

4.1.1 Principal component analysis

Principal component analysis is used to construct the composite institutional index.

This method allows for a set of multivariate observations to be described by a linear
combination of these observations so as to maximise the variance explained by the
new variable. Specifically, the original variables x1i ; . . .; xni are transformed into a
new variable y, such that the variance of y in the total sample is maximal. In other
words, the weighting coefficients of the first component maximise the variance and
minimise the loss of information from the original sample.5
We estimate the institutional index using the first component of the analysis. This
component alone explains approximately 68 % of the total variance in the sample
constructed,6 a high level of explanatory power that fully justifies the use of this
component to summarise the information contained in the various selected
variables.

5
Because the growth of these coefficients increases the variance indefinitely, the sum of the squared
coefficients is constrained to equal unity. Furthermore, to address the different scales and units of the
variables, the initial sample is centred-reduced, such that the mean is equal to zero and the standard
deviation is equal to one.
6
For index 1, 68 %; 40 % in index 2.

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Institutional distance and foreign direct investment

4.1.2 Institutional data

We use 13 indicators of the efficiency of structures that affect economic relations to

measure the functioning of the economic and institutional environment. Two
different composite indicators are constructed from the combination of these
variables, and one distance measure is constructed for each indicator (see Table 1).
The first institutional index we construct is composed of six indicators. Four of
these indicators measure the quality of governments and their policies: corruption
index, government effectiveness, political stability, and regulatory quality. The first
captures the extent to which public power is exercised for private gain. The second
is sensitive to the quality of public services, their independence from political
pressure and the credibility of government commitments. Political stability indicates
views about the probability that a government could be destabilised or overthrown
by unconstitutional or violent means. The final indicator measures the ability of
government to formulate and implement policies and regulations that promote
development of the private sector. These indicators are made available by the World
Governance Indicators project of the World Bank. Two additional variables, which
also measure the quality of regulatory policy and the institutional environment faced
by firms and their access to information, are employed in the construction of this
first index. Credit rights measures the degree to which collateral and bankruptcy
laws protect the rights of borrowers and lenders and thus the functioning of the
credit market. The Information index measures rules affecting the scope,
accessibility, and quality of information available through either public or private
credit registries. These two variables are made available by the Doing Business
project of the World Bank.

Table 1 Institutional indexes

Variables Index 1 Index 2

Corruption Yes Yes

Government effectiveness Yes Yes
Political stability Yes Yes
Regulatory quality Yes Yes
Credit rights Yes Yes
Information index Yes Yes
Cost to execute a contract Yes
Cost to register a property Yes
Cost to start a business Yes
Cost to export Yes
Cost to import Yes
Protectionist policy Yes
Private credit Yes

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 R. Cezar, O. R. Escobar

The second institutional index is composed of the six indicators presented below
and seven others.7 Three of the indicators concern bureaucratic practices and laws
imposed on businesses: the costs of executing a contract, of registering a property
and of starting a business. Two other indicators measure trade institutions: cost to
export and cost to import, both measured as cost per container in U.S. dollars. These
five indicators are provided by the World Bank’s Doing Business project. An
additional indicator is employed to measure governments’ protectionist policies,
namely, the simple mean applied tariff rate, as a percentage of price, for all traded
goods. This indicator is calculated in the Global Development Indicators, using data
from the Trade Analysis and Information System of the United Nations and the
Integrated Data Base of the World Trade Organization. The seventh measure used is
the private credit to GDP ratio, which indicates the financial resources provided to
the private sector through loans, purchases of non-equity securities, and trade
credits. This variable indicates financial constraints in the economy and is provided
by the International Monetary Fund.8

4.2 Control variable data

The control variables included in the model are commonly used in the literature.
They are the GDP per capita of both the source (i) and the host (j) country; the GDP
GDPi GDPj
similarity, measured as 2 (Bergstrand and Egger 2007); the geographical
ðGDPi þGDPj Þ
distance between the two countries; and dummies for contiguity, common language,
colonial ties, and bilateral investment treaty. The GDP and GDP per capita (in PPP
USD) data are from the World Bank WDI database. Geographical distance and
dummies for contiguity, common language, and colonial ties are from CEPII’s
databases. Finally, the bilateral investment treaty dummy is constructed from
UNCTAD’s IIA databases. This variable equals one if a bilateral investment treaty
between the two countries is in force and zero otherwise.

5 Results

Our model suggests that institutional distance reduces both the extensive and
intensive margins of FDI. This section presents empirical results that verify the
propositions of the model, using two alternative datasets. The first uses data on
OECD countries’ outward FDI, while the second uses data on the OECD countries’
inward FDI. We find differences between the determinants of outward and inward
FDI, differences that help explain the contrasting patterns of FDI outflows between
developing and developed countries.

7
The main criterion used in selecting variables and in their division into the two composite indexes is the
availability of data.
8
An increase in all 13 indicators employed in both indexes indicates development of the institutional
environment, such that an increase in the two composite indexes proposed in this section indicates an
improvement in institutional quality. Nevertheless, this is not the objective of this exercise, which is
mainly to measure the difference in institutional environments across countries.

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5.1 Determinants of OECD countries’ outward FDI

First, we nominated an exogenous variable correlated with the selection indicator

Sij, but not with FDI stocks. Column 1 of Table 2 shows that the contiguity and
colonial tie dummy variables are good candidates, as they are not significantly
correlated with FDI. The estimates of the probit model indicate that the colonial tie

Table 2 Extensive and intensive margins of outward FDI

Estimation method PPML Probit PPML Probit PPML
Dependent variable FDIij Sij FDIij Sij FDIij
(1) (2) (3) (4) (5)

GDP per capita source 2.273** 2.434** 2.663** 2.432** 2.612**

(0.868) (0.504) (0.984) (0.510) (0.963)
GDP per capita host 1.143** -0.160 1.163** -0.094 1.106**
(0.245) (0.255) (0.264) (0.259) (0.255)
GDP similarity 0.171** 0.164** 0.215** 0.161** 0.234**
(0.054) (0.037) (0.051) (0.037) (0.049)
Geographical distance -0.482** -0.695** -0.395** -0.696** -0.403**
(0.062) (0.045) (0.051) (0.046) (0.053)
Contiguity dummy -0.020 -0.114 0.036 -0.101 0.024
(0.151) (0.230) (0.132) (0.233) (0.129)
Common language dummy 0.675** 0.369** 0.716** 0.366** 0.668**
(0.132) (0.094) (0.116) (0.094) (0.110)
Colonial tie dummy 0.231 1.113** 1.116**
(0.138) (0.146) (0.147)
Bilateral investment treaty dummy 0.116 0.231** -0.014 0.229** -0.027
(0.114) (0.052) (0.115) (0.052) (0.114)
Institutional distance
Index 1 -0.062* -0.098**
(0.024) (0.027)
Index 2 -0.065* -0.093**
(0.027) (0.026)
z^ij 1.148** 1.147**
(0.147) (0.152)
z^2ij -0.437** -0.436**
(0.102) (0.103)
z^3ij 0.057** 0.057**
(0.018) (0.019)
Observations 23,064 22,755 22,755 22,476 22,476
R-squared 0.88 0.89 0.89

* Significant at 5 %, ** significant at 1 %. Standard errors robust to country-pair clustering recorded in

parentheses. Each regression includes a constant. Time, source-country and host-country dummies are not
reported. Reported R-squared values for probit regressions correspond to pseudo R-squared values

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 R. Cezar, O. R. Escobar

dummy variable is significantly correlated with the selection indicator, but the
contiguity dummy is not. Thus, we use the colonial tie dummy variable as an
exogenous variable in the selection equation and not in the primary equation.
Column 2 presents the probit estimates of the selection equation, or the extensive
margin. The results indicate that GDP per capita in the source country, similarity in
size between the countries, common language, colonial ties, and a bilateral
investment treaty increase the number of firms from country i investing in country j,
but geographical and institutional distance reduce this number. This result is robust
to estimates based on the second index of institutional distance (column 4).
The probit estimates provide information regarding the main determinants of the
extensive margin. However, using these estimates can lead to serious bias when
estimating the primary equation, or the intensive margin (Wooldridge 2002). We
estimate the parameter for the number of MNEs from country i in country j (^ zij ),
using different probit estimates for each year t. We then add z^ij to the primary
equation to estimate the determinants of the amount of FDI, or the intensive margin.
Column 3 presents the results for the primary equation, using the first index of
institutional distance. On the one hand, bilateral FDI increases in the number of
investing firms (^zij ), GDP per capita of both the source and host countries, similarity
in size and common language. On the other hand, bilateral FDI declines with both
geographical and institutional distance. Like the probit estimates, the PPML
estimates are quite similar for the second index of institutional distance presented in
column 5.
The results show similar determinants of the intensive margin (selection
equation) and the extensive margin (primary equation). However, the extensive
margin is more sensitive to similarities in GDP level, common language, and
institutional distance, but less sensitive to geographical distance and bilateral
investment treaty. GDP per capita of the host country is not significant for the
intensive margin but is significant for the extensive margin. However, similar GDP
levels are more important than the host country’s GDP per capita.

5.2 Determinants of OECD countries’ inward FDI

We proceed to estimate the results using inward FDI instead of outward FDI. The
results are presented in Table 3. First, we identify an exogenous variable correlated
with Sij and not with FDIij. Column 1 indicates that the colonial ties dummy is not
correlated with FDI. Thus, we use the colonial ties variable as an exogenous
variable in the selection equation, but we exclude it from the primary equation.
Columns 2 and 4 present the probit estimates of the selection equation. The
likelihood that a firm from country i invests in country j increases with similarities
in size and culture, but this likelihood decreases with geographical and institutional
distance. The results are robust to changing the institutional index. Institutional
distance reduces the number of firms that engage in FDI, as suggested by the model.
We estimate z^ij using different probit estimates for each year t; we then add z^ij to
the primary equation to estimate the determinants of FDI volume. Columns 3 and 5
indicate that FDI volume also increases in the number of MNEs, GDP per capita of

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Table 3 Extensive and intensive margins of inward FDI

Estimation method PPML Probit PPML Probit PPML
Dependent variable FDIij Sij FDIij Sij FDIij
(1) (2) (3) (4) (5)

GDP per capita source 0.782 -0.363 0.911 -0.357 0.950

(0.727) (0.259) (0.734) (0.263) (0.712)
GDP per capita host 2.285** 0.691 2.277** 0.794 2.218**
(0.576) (0.503) (0.602) (0.507) (0.569)
GDP similarity 0.332** 0.251** 0.364** 0.252** 0.380**
(0.064) (0.039) (0.066) (0.039) (0.064)
Geographical distance -0.473** -0.606** -0.439** -0.605** -0.463**
(0.057) (0.044) (0.047) (0.045) (0.047)
Contiguity dummy 0.215 -0.058 0.226 -0.068 0.164
(0.129) (0.196) (0.121) (0.197) (0.123)
Common language dummy 0.528** 0.469** 0.572** 0.469** 0.545**
(0.132) (0.102) (0.128) (0.102) (0.109)
Colonial tie dummy 0.167 0.682** 0.690**
(0.117) (0.144) (0.145)
Bilateral investment treaty dummy -0.185 0.179** -0.168 0.182** -0.169
(0.176) (0.055) (0.169) (0.055) (0.168)
Institutional distance
Index 1 -0.086** -0.074*
(0.026) (0.029)
Index 2 -0.113** -0.109**
(0.028) (0.028)
z^ij 1.137** 1.122**
(0.200) (0.205)
z^2ij -0.616** -0.609**
(0.131) (0.132)
z^3ij 0.094** 0.093**
(0.023) (0.023)
Observations 23,064 22,755 22,755 22,476 22,476
R-squared 0.90 0.90 0.91

* Significant at 5 %, ** significant at 1 %. Standard errors robust to country-pair clustering recorded in

parentheses. Each regression includes a constant. Time, source-country and host-country dummies are not
reported. Reported R-squared values for probit regressions correspond to pseudo R-squared values

the host country, similarities in size between the source and host countries and
common language but declines in geographical and institutional distance. Among
these variables, only GDP per capita is not correlated with the selection indicator.
More importantly, the extensive margin is more sensitive than the intensive margin
to GDP and language similarities but less sensitive to geographical distance. The

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difference in sensitivity to institutional distance between the two margins is,

however, small.

5.3 Institutional distance and FDI patterns

The results, presented in Tables 2 and 3, highlight similarities and differences in the
patterns of outward and inward FDI. GDP per capita of the host economy increases
the volume of FDI but does not affect the likelihood that new firms will engage in
both outward and inward FDI. Average income in the host economy appears to
increase the profitability of investment, which encourages firms to undertake the
largest investments in the most developed countries.
GDP per capita of the source country is very important in outward FDI of OECD
countries but insignificant in inward FDI. The wealthiest OECD countries are
present in more countries and invest larger amounts than less developed OECD
countries. OECD countries also attract FDI from various locations but not
necessarily from the most developed countries.
Similarities in economic size and culture increase both the number of investing
firms and the volume of FDI. Similarity of GDP levels is, however, a stronger
determinant of inward FDI than of outward FDI. As OECD countries are among the
largest economies in the world, this result suggests that among non-OECD
countries, differences in the investment capacities between small and large countries
are larger than differences in the abilities of small and large countries to attract FDI
from OECD countries.
As our model suggests, institutional distance influences which firms will engage
in FDI, or the extensive margin. However, the costs of institutional distance for
developed and developing countries are asymmetric. OECD inward FDI is more
sensitive to institutional distance than OECD outward FDI. According to our model,
institutional distance is a cost that increases the productivity threshold above which
FDI is profitable. As firms from non-OECD countries are on average less productive
than firms from OECD countries, the probability that the productivity of such firms
will exceed the productivity threshold is lower than for firms from OECD countries.
The theoretical model proposes that institutional distance also reduces the
profitability of investment and the volume of FDI undertaken. The empirical results
validate this proposition. In addition, our results show that the sensitivity of FDI
volume to institutional distance is similar for OECD and non-OECD firms. The
effect of institutional distance on the profitability of investment is thus similar for
OECD and non-OECD countries.

6 Robustness

This section presents results that validate the importance of institutional distance.
First, we control for the host country’s institutional quality. Finally, we analyse the
effects of distance on different indicators of institutional quality.

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6.1 Sensitiveness to host country’s institutional quality

The results presented in the previous section show that institutional distance reduces
both the probability of bilateral FDI and the amount of bilateral FDI flows and that
the effects of institutional distance differ between inward FDI and outward FDI for
OECD countries. However, because there is less heterogeneity in the OECD source
countries’ institutional quality than in the host economy (see Fig. 1), we might
wonder if most of the effects of institutional distance come from the institutional
quality of the host countries. Moreover, the literature highlights the importance of
the host country’s institutional quality in attracting FDI flows (Bénassy-Quéré et al.
2007; Daude and Stein 2007). Thus, we include the host country’s institutional
quality variable to the empirical specification.
Table 4 presents the estimates for the new specification using institutional index
1. Columns 1 and 2 present the results for outward FDI, and columns 3 and 4 present
the results for inward FDI. Concerning outward FDI, the host country’s institutional
quality is not significant for either the extensive or intensive margins when
controlling for institutional distance. Moreover, the institutional distance estimates
presented in columns 1 and 2 do not differ from those presented in Table 2. These
results confirm the intuition of our model that adaptation costs are lower with
similarities in countries’ institutional quality.
Concerning inward FDI determinants, Table 4 columns 3 and 4 present the
estimates for both the extensive and intensive margins. The estimates for the
institutional distance variable are still significant, and the values of their coefficients
are nearly the same as those presented in Table 3. Concerning the host country’s
institutional quality, the results suggest that ‘‘low’’ institutional quality increases the
likelihood that new firms will engage in FDI activity, but it does not influence the
amount of the investment. Hence, this result confirms that it is more difficult for
countries with poor institutional quality to adapt to a good institutional environment
than those with a good institutional quality.

Source OECD country Host country

1
Density
.5
0

−2 −1 0 1 2
Index 1

Fig. 1 Distribution of institutional index 1 for outward FDI

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 R. Cezar, O. R. Escobar

Table 4 Effects of institutional distance on FDI controlled by institutional quality of the host country
Estimation method Probit PPML Probit PPML
Dependent variable Outward Sij Outward FDIij Inward Sij Inward FDIij
(1) (2) (3) (4)

GDP per capita source 2.435** 2.669** -0.373 0.902

(0.505) (0.986) (0.258) (0.734)
GDP per capita host -0.113 1.016** 1.141* 2.737**
(0.264) (0.329) (0.511) (0.617)
GDP similarity 0.164** 0.215** 0.251** 0.364**
(0.037) (0.051) (0.039) (0.066)
Geographical distance -0.695** -0.395** -0.607** -0.439**
(0.045) (0.051) (0.044) (0.047)
Contiguity dummy -0.114 0.036 -0.058 0.225
(0.230) (0.132) (0.196) (0.121)
Common language dummy 0.369** 0.716** 0.469** 0.573**
(0.094) (0.116) (0.102) (0.128)
Colonial tie dummy 1.113** 0.684**
(0.146) (0.145)
Bilateral investment treaty dummy 0.231** -0.014 0.180** -0.168
(0.052) (0.115) (0.055) (0.169)
Institutional distance (index 1) -0.063* -0.098** -0.087** -0.075*
(0.025) (0.027) (0.026) (0.029)
Institutional index 1 host -0.086 0.194 -0.535** -0.537
(0.118) (0.177) (0.085) (0.290)
z^ij 1.148** 1.136**
(0.147) (0.200)
z^2ij -0.436** -0.616**
(0.102) (0.131)
z^3ij 0.057** 0.094**
(0.018) (0.023)
Observations 22,755 22,755 22,755 22,755
R-squared 0.89 0.90

* Significant at 5 %, ** significant at 1 %. Standard errors robust to country-pair clustering recorded in

parentheses. Each regression includes a constant. Time, source-country and host-country dummies are not
reported. Reported R-squared values for probit regressions correspond to pseudo R-squared values

6.2 Distance of alternative institutional variables

In previous sections, we employed a composite institutional index to measure

institutional quality. In this subsection, we study the aspects of institutions that
matter individually. Hence, we estimate the model using institutional distance
separately for each of the 13 variables used to compute the composite institutional
indexes. Table 5 presents estimates for different institutional quality indicators. To

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Table 5 Effects of different institutional distance indicators on FDI

Estimation method Probit PPML Probit PPML
Dependent variable Outward S Outward FDI Inward S Inward FDI
(1) (2) (3) (4)

Distance in
Corruption -0.085** -0.040 -0.061* -0.060
(0.025) (0.033) (0.025) (0.031)
Government effectiveness -0.033 -0.050* -0.053 -0.016
(0.028) (0.020) (0.028) (0.021)
Regulatory quality -0.121** -0.091** -0.115** -0.068**
(0.026) (0.022) (0.027) (0.025)
Information index -0.011 -0.016 0.008 -0.034**
(0.006) (0.011) (0.007) (0.010)
Cost to execute a contract -0.002 -0.035* -0.021 -0.023
(0.021) (0.017) (0.020) (0.015)
Cost to register a property 0.014 -0.022 0.033* -0.055
(0.016) (0.032) (0.016) (0.033)
Protectionist policy -0.006 -0.066* -0.029 -0.087**
(0.015) (0.027) (0.016) (0.031)
Private credit -0.100** -0.056** -0.036 -0.053**
(0.021) (0.017) (0.022) (0.017)

* Significant at 5 %, ** significant at 1 %. Standard errors robust to country-pair clustering recorded in

parentheses. We compute each estimate separately from different regressions. Each regression also
includes control variables used in previous estimates. A constant as well as time, source-country and host-
country dummies are not reported. Reported R-squared values for probit regressions correspond to pseudo
R-squared values

conserve space, we present only estimates for those institutional distance variables
that have at least one significant estimate. Note that each estimate is obtained for
different regressions, but to conserve space, they are presented in the same column
according to the dependent variables.
Table 5 shows that the extensive and intensive margins are influenced differently
according to the type of institution. There are also differences between the outward
and inward FDI of OECD countries. Distance in corruption reduces the probability
of new FDI, but it has no influence on the amount of FDI. Distance in protectionist
policy, on the other hand, has a negative influence on FDI intensity, but not on the
extensive margin. The extensive margin is more sensitive to different types of
institutional distance. Distances in government effectiveness and in the cost of
executing a contract negatively influence the amount of outward FDI, while the
amount of inward FDI is negatively influenced by the distance in information index.
Among the institutional dimensions included in our study, private credit and
regulatory quality are significant to most of the specifications. Distance in private
credit reduces both the extensive and intensive margins of outward FDI, but only the

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 R. Cezar, O. R. Escobar

intensive margin of inward FDI. This result is similar to the findings of Bénassy-
Quéré et al. (2007), who find that the amount of FDI is negatively influenced by
differences in credit market regulation. Distance in regulatory quality is the only
variable that negatively impacts the extensive and intensive margins for both inward
and outward FDI. Hence, we can deduce that regulatory quality is one of the most
important dimensions of institution quality, as previously found by Daude and Stein
(2007).

7 Conclusion

We propose a theoretical model to explain the impact of institutional distance on

FDI. We assume that institutional distance imposes a cost on investors. Precisely,
investors must interact with foreign institutions to obtain credit and complete
administrative, bureaucratic, and legal procedures when investing abroad; institu-
tional proximity increases the expertise available to cope with these procedures. The
model suggests that institutional distance influences both the decision to invest
abroad (extensive margin) and the volume of investment a firm undertakes
(intensive margin). As adaptation costs increase with institutional distance between
source and host countries, institutional distance determines the productivity
threshold at which FDI is more profitable than exporting as a means of entering a
foreign market. Increases in institutional distance raise this threshold and the
number of firms that undertake FDI decreases. Institutional distance also affects the
total volume of FDI undertaken by the source country in the host economy by
affecting the extensive margin and firms’ profitability.
We conduct an empirical investigation to validate our model, using data on FDI
of OECD countries. Using alternative indicators of institutional distance, the results
suggest that both the extensive and intensive margins of FDI decrease as
institutional distance increases. Institutional distance plays an important role in
FDI. First, institutional distance reduces the number of firms for which FDI is
sufficiently profitable that they prefer exporting over this mode of implantation.
Second, institutional distance reduces the profitability of FDI such that the amount
of firms’ FDI decreases with this distance.
Institutional distance has differing effects on OECD countries’ outward and
inward FDI. In particular, institutional distance is more important for OECD
countries’ inward FDI than for their outward FDI. This indicates that there is an
asymmetry in bilateral FDI flows between developed and developing countries.
Perceived institutional distance from a developed country to a developing country
and from the same developing to the developed country are not equal. Firms from
developed countries can more easily cope with the costs of institutional distance,
which explains why FDI flows from developed countries are larger than FDI flows
from developing countries.
In addition to institutional distance, differences in economic size and in
geographical and cultural distance discourage FDI. To date, therefore, proximity has
been a major determinant of bilateral FDI. Because cultural and economic proximity

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cannot be modified in the short run, authorities in developing countries should focus
on improving institutions to improve FDI performance.

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