Purpose - The purpose of this paper is to examine the relationship between foreign direct investment (FDI) flows and institutional stability. The focus country is Canada. It is one of the few countries where the economy remained relatively stable compared to other economies during the Global Financial Crisis. It is crucial for Canada to determine the optimal level of institutional development to attract more FDI and sustain the sound financial stability in future.
Design/methodology/approach - This study uses the auto-regressive distributive lag (ARDL) approach to understand the relationship between FDI and institutional stability along with other controlled variables, for instance, gross national product, inflation and exports.
Findings - The key finding of this work is that FDI and institutional stability are cointegrated in the long run. The error correction model of ARDL shed light on institutional stability being an exogenous variable, and FDI is an endogenous variable. Institutional stability affects FDI, as it is exogenous. The findings will help policymakers to implement policies to strengthen the institution’s settings, and this, in turn, will attract more investment.
Originality/value - Based on previous theoretical and empirical literature, most of the research points to FDI positively affect institutional stability. In some cases, the relationship does not always hold true. This study will fix the gap in the literature by investigating the relationship between FDI and institutional stability of Canada.
Foreign direct investment (FDI) inflows were $1.45tn in 2013 and are expected to rise about 5 per cent in 2017 to almost $1.85bn (United Nations Conference on Trade and Development [UNCTAD], 2017). The top host countries for FDI inflows as of 2016 include the USA, Ireland, Hong Kong, China and Singapore. Also, North America is the top region of FDI outflow. To further add, from the period of 2000 to 2012, about 55 countries adopted 1,082 institutional policy changes, with the goal of creating a more favourable environment for foreign investors (Demir, 2016). Prior studies indicate that proper institutions encourage private investments, improve the efficiency of the economic system and encourage economic growth (Acemoglu et al., 2005; Ahmad and Ahmed, 2014; Hall and Jones, 1999; Rodrik et al., 2004). Institutions play a crucial role in disciplining the behaviour of economic agents, thus encouraging setting rules and limit opportunism and build transactional trust in financial transactions, and ultimately enhance the confidence of foreign investor and FDI inflows (Ahmad and Ahmed, 2014). In a study by Makki and Somwaru (2004), the results pointed to FDI and exports positively impacting economic growth. The study looked at 66 developing countries from 1970 to 2000. Wang and Meng (2004) found that it is more critical to higher-income countries, whereas international trade is more critical for lower-income countries (Tekin, 2012). On the other hand, other studies were not able to find a direct link between FDI and institutional development (Buchanan et al., 2012; Wheeler and Mody, 1992). In another study by Harms and Ursprung (2002), political and civil liberties were found to be factors that attracted FDI as opposed to institutional aspects (Ahmad and Ahmed, 2014). As such, it is inconclusive as to if institutional stability plays a fundamental role in encouraging FDI. Furthermore, there is theoretical literature that suggesting FDI can adversely impact economic growth. It is because the growth accelerating the effect of FDI is based on the assumption that this does not crowd out domestic investment (Tekin, 2012). There is also theoretical literature that supports the notion of institutional stability encouraging FDI. For instance, the Douglas North approach discusses how institutions play a crucial role in economic growth. Even from a theoretical perspective, it seems that the literature is inconclusive on the exact role that institutional stability plays, and how other factors react to it.