How does social development affect FDI and domestic investment?

Do FDI and domestic investment respond to institutional reforms in the same way?

Organisations such as the World Bank have tended to assume that institutional reforms designed to attract foreign direct investment (FDI) will increase overall investment levels in an economy by also increasing domestic investment. However, this paper tests the hypothesis that in fact institutional changes are likely to have differential impacts on the two sources of investment, due to differences in investors’ home country regulations, perceptions of risk, and access to alternative investment opportunities. As FDI constitutes only around one sixth of all investment in developing countries, reforms could potentially reduce overall investment.

Through an econometric analysis of data from 75 developing countries, this paper examines the impact of various institutions – both formal and informal - on investment. The analysis focuses on social development variables, using the World Bank’s definition of social development as consisting of:

empowerment: giving poor people voice and choice
inclusion: making institutions more inclusive of poor people's needs and aspirations and more effective in delivering services to them
security: enhancing social stability and human security

The analysis finds that:

reducing corruption leads to an increase in domestic investment. Evidence from other studies suggests that combating corruption can have a beneficial effect on both domestic and foreign investment
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 there is a positive impact of democratization on corruption, which makes the total effect of political freedom on domestic investment ambiguous.
religious tensions appear to be a deterrent of FDI, but have no impact on domestic investment socio-economic conditions could affect domestic investment through savings.

The authors indicate the need for more detailed analysis of firm level or industry level data on investment, or country case studies, to provide insights into the precise mechanisms by which each of these variables influence investment.

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How does social development affect FDI and domestic investment?