The effect of governance on FDI inflows is firstly through the effect of institutions on investment environment of a country and secondly through the decreasing transaction costs, production costs, and uncertainty. The countries are divided into three clusters. A new theoretical perspective is developed considering governance as a base factor. System GMM methodology is used to deal with endogeneity problem. The empirical analysis covers 32 advanced, 70 developing, and 17 least developed countries for the period 1996-2010. Improving governance infrastructure as a base factor attracts more FDI in all country clusters. FDI made into advanced countries are efficiency seeking, FDI made into developing countries are market seeking, and FDI made into least developed countries are resource seeking. Finally, it is found that a motivation factor alone may not be sufficient for MNCs to take FDI decision since they also observe governance infrastructure in host countries and any deterioration in governance infrastructure leads to a decreasing amount of FDI inflows.
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Generally, the main reason for host countries to attract FDI is for the ultimate goal of sustaining long-run growth in the sphere of economics. But, there are conditions for host countries to reach this goal. FDI should contribute to knowledge spillovers from foreign affiliations to domestic companies in the host country. Entry of MNCs into host country market should not damage competitive market structure due to advantages gained by protection of knowledge. Governance should be established in a way that there should be no governance-impairment spillovers from domestic firms to foreign affiliations. Human capital in the host country should provide labor with necessary skill set to foreign affiliations in order the employment rate in the host country get increased. Host countries should prioritize FDI to short-term foreign capital inflows by considering above conditions at the same time, for the following reason. Because in time of economic crises, FDI inflows is less inclined to run away than short-term foreign capital inflows. Host countries should be on alert in time of economic crises for the expansion of MNCs by harming competitive market structure and to dictate their own practices, which may lead to impairment in governance structure of the host countries.
The study mainly concentrates on the effect of governance on FDI inflows by controlling other factors.
Instead of scholars who established the theories on the determinants of FDI, the most satisfying argument was established by North (1990) in his assessment of the role of institutions on economic performance of countries. North (1990) argued that formal institutions such as constitutions, prudential laws, regulations, government policies and informal institutions such as traditions, habits, customs affect the perception and willingness of investors in a country because they limit opportunism, build transactional trust in financial transactions, and ultimately influence international players to engage in cross border transactions. Together with the standard constraints of economics, institutions define the choice set and therefore determine transaction and production costs and hence the profitability and feasibility of engaging in economic activity whether it is domestic or foreign (North, 1990).
Based mainly on North (1990), Dunning and Lundan (2008) emphasize the significance of institutions for the ability of countries to attract FDI and to derive a sustained economic benefit from FDI.
All other theories of FDI referring to an aspect of governance as a determinant of FDI as follows;
According to Hymer (1976) first type of FDI requires prudent use of assets in a way that the investor seeks to control over the enterprise in order to ensure the safety of his investment. When the distrust of foreigners or when fear of expropriation are high, this type of direct investment will substitute for portfolio investment theory. Kindleberger (1969) considers the role of bribery, corruption, evasion, transgression, ethical standards, risks of confiscation, risks of governmental intervention in trade as institutional factors affecting FDI decision. According to Vernon (1966), producers setting up a new production facility in the importing country will have to balance a number of complex considerations at the maturing stage of production and political situation in the country of prospective investment is one of these considerations. According to Knickerbocker (1973), once a country has attained some threshold level of socio-political stability, or has re-established order after a period of turmoil, firms in oligopolistic industries simultaneously show an interest in making direct investments in the country. Magee (1977) argues that well-established property rights and efficient legal system are necessary conditions for the protection of knowledge created by the foreign investors. Buckley and Casson (1976) argue that political relations between nations affect FDI decision. Rugman (1980) argues that internalization allows MNE to establish property rights for information, which can be considered as an aspect of governance. Aliber (1970) argues that foreign firms operating in host countries incur political risk due to additional costs associated with management of an enterprise at some distance, which can be considered as a governance factor.