Foreign Direct Investment vs. Foreign Portfolio Investment

Abstract

We examine the effect of a country’s governance environment on the foreign investment it attracts. We classify countries based on the dominant mode of governance into three types: (1) rule-based (strong public rule of law), (2) relation-based (weak rule of law and strong informal networks), and (3) family-based (absence of both public rules and informal networks). We then examine how different governance types affect foreign investment patterns among 45 countries. Our main argument is that the choice of investment—direct or portfolio—is influenced by the type of property protection associated with different governance modes. We find that rule-based countries attract the lowest amount of FDI relative to the total amount of foreign investment, and they have the largest stock market size relative to their economies. Our study contributes to the foreign investment literature by bringing the governance environment into the equation and more successfully explaining why some countries have relatively large foreign direct investment ratios and relatively small foreign portfolio investment ratios.