Inward FDI and the quality of domestic institutions: a cross-country panel VAR analysis

Domestic institutions are recognized as important factors in attracting foreign direct investment (FDI) and spurring economic development in host countries. However, there is increasing evidence that FDI may in turn affect and shape domestic institutions, and it is generally difficult to disentangle these two effects. The present paper aims to shed light on this issue using extensive data on the quality of institutions and on inward FDI in 102 countries over a period of 25 years. We distinguish between different types of institutions, FDI, and countries, and adopt a panel VAR approach to detect the direction of causality between the two variables. Our findings suggest that not only does institutional quality matter for attracting FDI, but also that higher inflows of FDI have a short-term significant impact on the institutional quality of recipient economies. We also find that such a relationship varies with the type of FDI considered and between transition and developing economies.