Social development is important in and of itself. Improved rights and liberties, socio-political stability and human security, and accountable and responsive institutions, signal a society that is more sensitive to the situation of the poor and vulnerable. In addition, the question is whether social development has an economic payoff, in terms of increased investment, increased growth, and reduced poverty. In this study, we have explored the link between social development and foreign direct investment and domestic investment, using panel data from 75 developing countries for the period 1989-2000. To our knowledge, this is the first study to provide comparable results on the determinants of FDI and domestic investment.
Our results point to corruption as a major deterrent of domestic investment.
Though we do not find a significant relationship between corruption and FDI, previous studies have demonstrated that a similar relationship might be found here. The policy implications of these results are therefore fairly straightforward; countries seeking to increase their total level of investment, should aim to reduce corruption.
The implications of the results on political freedom are less obvious. In our econometric analyses, we find that improvements in political rights and civil liberties tend to increase FDI, while reducing domestic investment. On the face of it, this implies that the net effect of political liberalization on total investment is unclear. However, the results of Treisman (2000) suggest that democratization reduces corruption, at least over time. The analytical argument for such a relationship is that officials are held accountable for their actions in a democracy, through elections, critical scrutiny from the press and other interest groups, and an independent judiciary. Though we find that the direct effect of political freedom on domestic investment is negative, it is therefore possible that there is an additional indirect effect whereby political freedom reduces corruption which in turn promotes domestic investment.
Political freedom might thus have a more positive effect on total investment than our results would indicate.
Furthermore, our results suggest that religious tensions appear to be a robust deterrent of FDI. We also find some evidence that socio-economic conditions affect domestic investment through increased savings. Other results from previous studies of domestic investment are not confirmed by our analyses. In particular, indices of internal socio -political instability, and institutional indices such as bureaucratic quality and the rule of law, exhibit no significant effect on domestic investment.
The econometric analyses performed here, identify some general relationships between social development variables and FDI and domestic investment. To more precisely elicit the mechanisms through which political freedom and other variables affect investment, further theoretical and empirical studies are needed. One aspect of this is that the use of aggregate investment data, lumps together agents who might have very different motivations for investing. By
using firm level or industry level data on investment, one might be able to provide a more detailed account of investment determinants (cf. Kolstad and Villanger, 2003).
Another way to get a more detailed view of the mechanisms connecting investment and social development variables, is to use country case studies. In light of the results of this study, identifying case countries that can provide additional information on the interplay of democratization, corruption and foreign and domestic investment, would be of interest. Candidate case countries would be countries that have undergone democratization in the not too distant past.
Though previous studies find a close association between some social development variables and investment in developing countries, we attempt to test for causality by using lagged variables. However, this procedure does not fully establish whether there is a strict causal link from the former to the latter. Possible endogeneities produce additional analytical complications that future studies should address.
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Appendix
Country sample:
Algeria, Argentina, Bangladesh, Bolivia, Brazil, Bulgaria, Burundi, Cambodia, Cameroon, Cap Verde, Central African Republic, Chad, Chile, China, Colombia, Republic of Congo, Costa Rica, Cote d’Ivoire, Dominican Republic, Ecuador, Egypt, El Salvador, Gabon, Gambia, Ghana, Guatemala, Guinea, Guyana, Haiti, Honduras, India, Indonesia, Iran, Jordan, Kenya, Rep.
Korea, Lesotho, Madagascar, Malawi, Malaysia, Mali, Mauritania, Mauritius, Mexico, Morocco, Namibia, Nepal, Nicaragua, Niger, Nigeria, Pakistan, Panama, Papa New Guinea, Paraguay, Peru, Philippines, Poland, Romania, Rwanda, Senegal, Sierra Leone, South Africa, Sri Lanka, Tanzania, Thailand, Togo, Trinidad and Tobago, Tunisia, Turkey, Uganda, Uruguay, Venezuela, Vietnam, Zambia, Zimbabwe.
Table 5: Correlation matrix
Lfdi lgdp Trade Year Linflat GDP
gr Infrastr Private
invest Rights
& Lib.
Lfdi 1.000
lgdp 0.702 1.000
Trade 0.307 0.073 1.000
year 0.290 0.187 0.091 1.000
Linflat -0.092 -0.014 -0.227 -0.157 1.000
GDPgr 0.202 0.117 0.066 0.112 -0.321 1.000 Infrastr 0.449 0.725 0.075 0.250 0.104 -0.005 1.000 private
invest 0.321 0.360 0.375 0.020 -0.148 0.275 0.195 1.000 Rights
& Lib. -0.423 -0.500 -0.056 -0.061 -0.179 0.019 -0.438 -0.123 1.000
An L indicates that the variable is logged.
Table 6: Descriptive statistics
Variable Obs Mean Std. Dev. Min Max
Year 589 5.646859 3.083461 1 11
GDP growth 588 3.490685 4.989847 -50.2 18.83
Trade 587 64.80077 34.95145 13.24 282.40
Corruption 523 3.082218 .9898572 0 5
Relig. tens. 523 4.500956 1.285604 1 6
Socio-econ. 523 5.581262 1.564266 0 11
Dummy oil 589 .2003396 .4005947 0 1
Illiteracy 579 28.0421 21.51635 .3 88.4
lfdi 589 2.385194 1.961534 -4.72 6.49
lgdp 589 6.971753 1.025491 4.80 9.34
grdomsav 587 16.04249 12.6123 -59.69 48.48
Infrastructure 497 57.9163 73.82998 .4 444
linflat 552 2.553223 1.408683 -2.15 8.92
Rights and lib. 589 3.827674 1.601317 1 7
CorrRigh 523 11.18164 5.732753 0 35
InvestN 589 9.475812 1.388295 4.75 12.78
InvestN is log(gross domestic savings per capita).
lgdp is log (FDI per capita)
Summary
Creating a favourable investment climate is crucial for economic development. In this study, we explore the impact of social development variables on FDI and private domestic investment, using panel data from 75 countries for the period 1989-2000. Our results show that reducing corruption leads to an increase in domestic investment.
Though we do not find a significant impact of corruption on FDI, previous studies have established a similar relationship for FDI. Thus there is evidence to suggest that combating corruption can have a beneficial effect on both domestic and foreign investment.
Our results indicate that improvements in political rights and civil liberties tend to increase FDI. In contrast, political freedom appears to have a negative effect on domestic investment. However, other studies suggest that democratization has a positive impact on corruption, which makes the total effect of political freedom on domestic investment ambiguous.
A few other social development variables are found to have an impact on one of the two types of investment. Religious tensions appear to deter FDI, but have no impact on domestic investment. In addition, socio-economic conditions could affect domestic investment through savings.
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