Economic freedom, human capital, and foreign direct investment

Abstract

This paper investigates the impact of economic freedom and human capital on Foreign Direct Investment (FDI) in a large panel dataset of 137 developing and developed countries covering the period of 1995-2010. Foreign direct investment is by far the largest source of private capital flows to developing and middle income countries, far exceeding other private capital flows such as portfolio investment and remittances. Many of these countries have been liberalizing their policies in recent decades to attract more foreign direct investment. The ultimate goal of attracting more foreign direct investment is to augment limited domestic investment and spur economic growth through transfer of knowledge, technology, and managerial skills. The role of traditional determinants of FDI such as availability of natural resources, market size, and cheap labor are well researched in the literature. What has not received much attention is the impact of non-traditional determinants of FDI flows like the presence of economic freedom and high skilled labor in the recipient countries. Besides, there has not been any attempt to simultaneously model the impacts of economic freedom and human capital as well as their interaction on foreign direct investment inflows, a crucial void which this paper fills. In order to deal with potential endogeneity problem in the explanatory variables and unobserved country fixed-effects, we use dynamic panel data methods. The system generalized method of moments (S-GMM) estimator of Arellano and Bond, and Blundell and Bond are estimated in two-step procedure, using levels of the variables as instruments for the difference equation and differences of the variables as instruments for the levels equation. We test for instrument validity using Sargan’s test and second order autocorrelation AR (2) in the differenced equation. The results show that economic freedom has a positive and significant effect on foreign direct investment in middle- and high-income countries. Human capital is a significant determinant of FDI in all countries. After accounting for endogeneity of and interaction between economic freedom and human capital, we find that the marginal effect of economic freedom on FDI is contingent upon the level of human capital in the recipient country. We postulate that Transnational Corporations (TNCs) care about the quality of human capital only in the case of low-income countries when they make their decisions to locate in developing countries. We do not find this to be the case with respect to TNCs’ decisions to invest in middle-income and high-income countries.