Association for Public Policy Analysis & Management

Institutions matter for the attraction of capital flows. In this paper we empirically examine the influence of “correlated” groups of institutions or institutional clusters on FDI flows. Using ICRG data for a large sample of 130 countries over the period 1984-2014 and Principal Component Analysis to cluster correlated institutions, we extract three institutional clusters: quality of public administration, social cohesion, and stability and property rights protection.

Building on Dunning’s (1981) location advantage hypothesis to examine the influence of those clusters on the competition to attract FDI flows, as measured by the share of world FDI flows, empirical evidence shows that “social cohesion” has a positive influence on the share of FDI flows. Results are robust to changes in the nature of unobserved effects controlled for, model specification, and sample period. This result is particularly novel in the literature.

These results have three important policy implications. First, countries should adopt a wider perspective in examining the influence of institutions on FDI. Second, such a perspective provides governments with flexibility in the design and implementation of institutional reforms. Third, by attracting more stable capital flows, social cohesion as a cluster may help avert capital flows reversal and possibly international financial crises.