80647 47 Does Doing Business matter for foreign direct investment? Many people who use Doing Business signal to foreign investors of the overall ƒ Even though Doing Business data—particularly in policy-making cir- quality of the business environment. And indicators focus on small to cles and in the private sector—associate some laws may indeed affect foreign- medium-size domestic firms, many better performance on the Doing Business owned firms in the same way that they policy makers have associated indicators with greater inflows of foreign affect domestic firms. improvements in the indicators direct investment (FDI), even though the with greater inflows of foreign methodology is not explicitly designed Given the interest of so many govern- direct investment (FDI). for this purpose. Since the launch of last ments in attracting more foreign invest- ƒ Cross-country correlations show year’s report nearly 2,000 articles in the ment, this raises an important question: that FDI inflows are indeed higher international press have drawn a con- does Doing Business actually matter for for economies performing better nection between FDI and Doing Business. FDI? If so, does this suggest that Doing on Doing Business indicators, Such articles often suggest that higher Business indicators reflect the quality even when taking into account Doing Business rankings will be associated of the investment climate at a broader differences across economies in with more foreign investment, which is level? This case study presents evidence other factors considered important believed to create jobs, bring in new tech- suggesting that they do—supporting for FDI. nologies and processes and have other a broader claim that economies that beneficial collateral effects on the real ƒ Results suggest that on average provide a good regulatory environment economy. And many senior government across economies, a difference of for domestic firms tend to also provide a officials have suggested that a better 1 percentage point in regulatory good one for foreign-owned firms. ranking for an economy implies that its quality as measured by Doing investment climate is more favorable to Business distance to frontier scores A FIRST LOOK AT THE LINK is associated with a difference in foreign investors. There is certainly a correlation between annual FDI inflows of $250–500 The case studies underpinning the Doing the overall ease of doing business and FDI million. Business indicators focus on small to flows. Grouping economies by the Doing ƒ Although this correlation does medium-size domestic firms, so the laws, Business distance to frontier score for not imply causation, the evidence regulations and practices tracked by the 2011,1 table 7.1 shows that those closest suggests that Doing Business project are not necessarily relevant to to the frontier in regulatory practice re- reflects more about the overall larger foreign-owned firms. But the qual- ceived substantially more FDI than those investment climate than what ity of the laws and regulations, and the in the middle, which in turn received sub- matters only to small and medium- extent to which this quality is reflected stantially more than those furthest from size domestic firms. in their implementation, may be a useful the frontier. Figure 7.1 demonstrates this ƒ In particular, these findings support the claim that economies TABLE 7.1 Average FDI inflows and stocks by tiers of economies grouped by their distance to that provide a good regulatory frontier, 2011 environment for domestic firms Average distance Economies grouped by Average FDI inflows Average FDI stocks to frontier tend to also provide a good one for distance to frontier (US$ millions) (US$ millions) (percentage points) foreign firms. Top 10 50,384 768,496 86.0 Middle 10 14,362 89,776 58.9 Lowest 10 1,257 8,179 34.2 Note: The distance to frontier measure is normalized to range between 0 and 100, with 100 representing the best performance (the frontier). Source: Doing Business database; United Nations Conference on Trade and Development, UNCTADstat database. 48 DOING BUSINESS 2013 FIGURE 7.1 Better overall regulation is correlated with more FDI inflows per capita well. Using a data set of regulations spe- Distance to frontier, 2011 cific to foreign investment, a study finds (percentage points) that the number of procedures required 100 to start a foreign-owned business and the strength of the arbitration regime both 80 have a significant and robust effect on FDI.6 60 What about Doing Business? Using 4 years of Doing Business data, a recent 40 study finds that a better Doing Business ranking is significantly associated with 20 larger FDI inflows7—strong support for the claim that higher Doing Business rank- 0 ings are a broad indicator of an attractive 0 300 600 900 1,200 1,500 investment climate. But the study is un- FDI inflows per capita, 2011 (US$) able to find evidence for smaller subsets Note: The distance to frontier measure is normalized to range between 0 and 100, with 100 representing the best performance of economies, such as for developing (the frontier). Sample includes 157 economies with positive 2011 FDI inflows per capita of $1,500 or less. This includes all economies.8 Related research finds that economies covered by Doing Business 2012 for which data are available, excluding outliers with negative inflows or inflows greater than $1,500 per capita. Dropping these outliers does not significantly affect the trend line. business regulations as measured by Source: Doing Business database; United Nations Conference on Trade and Development, UNCTADstat database. Doing Business influence the impact of FDI inflows: economies with more effec- graphically, using a different measure of the size of the market and its growth tive regulations for starting a business FDI: it shows that FDI inflows per person prospects, distance to important markets, benefit more from the FDI flows that they in 2011 were higher for economies that relative labor endowments and openness receive.9 were closer to the frontier. to trade tend to be important drivers of FDI. For example, the larger the market, WHAT DO THE DATA TELL US? But these are simple statistical correla- the greater the scope for economies of To expand on this existing body of tions looking at the relationship between scale in production and thus the greater research, Doing Business conducted its performance on the distance to frontier the chances for producing at competitive own econometric analysis of the relation- measure and FDI at a particular point in prices. Economies in Central and Eastern ship between Doing Business indicators time. What does more robust research Europe have received large inflows of FDI and FDI flows. The analysis generally say about the determinants of FDI flows? over the past couple of decades because follows the model established by an ear- they are seen as entry points into the lier study,10 considering the relationship RESEARCH ON FDI huge European market and also because between an economy’s performance on DETERMINANTS they have relatively well-educated labor Doing Business indicators and total FDI A large body of research has looked at forces. inflows from all other economies and the question of what the key drivers of The institutional and regulatory frame- taking into account differences in mac- FDI are. One approach in the literature work has also been shown to be an roeconomic and governance conditions. sees FDI as being market-seeking (driven important determinant of FDI. One study But it also adds to prior analysis in several by economy size and country location), finds that judicial independence and labor ways. It uses distance to frontier scores efficiency-seeking (driven by human market flexibility are significantly associ- rather than economy rankings, as a more capital or infrastructure quality) or ated with FDI inflows, depending on the precise measure of how far business resource-seeking (driven by the avail- sector of the investment.3 Another finds regulations are from the most efficient ability of natural resources or other that corruption is a significant deterrent practice. Most specifications use 1 year strategic assets). Numerous studies have to FDI, having an effect comparable to the of distance to frontier scores to explain measured the significance of these and impact of substantial increases in the tax subsequent years of FDI inflows, rather other explanatory variables.2 rate on foreign firms.4 Indirect taxes on than panel data over time. The analysis Many studies use a “gravity model,” foreign investors, which are higher than considers differences in natural resource which seeks to explain what causes FDI the direct foreign income taxes in many exports, and it covers a larger sample of flows between 2 specific countries. This countries, also significantly reduce FDI between 145 and 160 economies across research confirms that such factors as inflows.5 Business regulations matter as specifications.11 DOES DOING BUSINESS MATTER FOR FOREIGN DIRECT INVESTMENT? 49 The basic model considers whether FIGURE 7.2 Complexity and cost of starting a domestic business are strongly correlated with distance to frontier scores in 1 year are complexity of starting a foreign one associated with total FDI inflows in the Complexity of starting a foreign business, 2010 (distance to frontier, percentage points) following year. When taking into account differences in income, inflation, popula- 100 tion size, governance measures, openness to trade and exports of primary goods, the 80 analysis finds significant results: a better distance to frontier score is significantly 60 associated with larger inflows of FDI. To account for potential fluctuations 40 in annual FDI flows, a different model examines the distance to frontier score 20 for 2005 and average FDI inflows for the subsequent 5 years, and finds similar 0 results. When considering population 20 40 60 80 100 and income levels, as well as when using Complexity and cost of starting a domestic business, 2010 (distance to frontier, percentage points) several other model specifications, the analysis finds a significant positive as- Note: Figure plots the distance to frontier in starting a (domestic) business as measured by Doing Business and the distance to sociation between the distance to frontier frontier in starting a foreign business as measured by Investing Across Borders. The distance to frontier measure is normalized to range between 0 and 100, with 100 representing the best performance (the frontier). Scores are shown for the 92 score and FDI inflows. Other research has economies for which Investing Across Borders collected data in 2010. shown that Doing Business reforms are Source: Doing Business database; Investing Across Borders database. associated with greater domestic invest- ment and GDP growth,12 supporting the be associated with a 21% increase in its similar indicators from the Investing general finding that reforms that improve annual FDI inflows.13 Across Borders project, which focuses on the quality of the regulatory environment regulation of foreign direct investment.15 are positively associated with FDI inflows. GOOD REGULATIONS The correlation between the distance to In general, these results need to be ALL AROUND frontier measures of the 2 sets of indica- The strong and statistically significant tors is 57%. interpreted cautiously. Correlation of course does not imply causation. But the relationship between FDI and the overall This general relationship also holds for estimated magnitudes suggest that the level of regulation as measured by Doing comparable individual indicators from laws, regulations and practices captured Business indicators supports the claim Doing Business and Investing Across Borders by Doing Business may have a strong influ- that Doing Business data reflect more (figure 7.2). The correlation between the ence on FDI flows. Results suggest that about the overall investment climate complexity and cost of starting a local for an economy with an average distance than what matters only to small and company as measured by Doing Business to frontier score, moving 1 percentage medium-size local firms. These findings and the complexity of starting a local sub- point closer to the frontier regulatory en- also support the more general claim that sidiary of a foreign firm as measured by vironment is associated with $250–500 governments that regulate well in one Investing Across Borders is 81%.16 This cor- area, such as domestic business, tend million more in annual FDI inflows. These relation does not imply that the level of to also regulate well in other areas, such strong correlations, if upheld by further complexity is identical, however—indeed, as foreign investment. For example, a and more refined research, would have while it takes 8 procedures and 26 days working paper on transparency for this significant policy implications: they on average to start a local business in the year’s report highlights the positive cor- suggest that relatively modest improve- economies covered by Investing Across relation between a transparent approach ments in the regulatory environment Borders, it takes 10 procedures and 41 to governance in one regulatory area and could potentially attract substantial days on average to start a foreign-owned efficient regulation in other areas.14 increases in foreign investment. Consider company in those economies. the example of Costa Rica. If causation Comparing the Doing Business indicators is proven, the correlations suggest that with other measures of the regulatory CONCLUSION improving its score by just a percent- environment also supports this perspec- This case study presents evidence of a age point—to a regulatory environment tive. For example, some Doing Business significant correlation between the Doing comparable to that of Uruguay—would indicators are strongly correlated with Business indicators and flows of FDI. 50 DOING BUSINESS 2013 Although this does not imply causation, doing business index, which ranks economies, noting that this smaller the findings do support the claim that economies from 1 to 185. Another is the sample of economies is due to the use of distance to frontier, which measures how an unbalanced panel. Doing Business reflects more about the far an economy is from the most efficient 12. See, for example, Eifert (2009); and overall investment climate than what practice or highest score achieved by Haidar (2012). matters only to small and medium-size any economy since 2005 for each 13. These calculations were made using domestic firms. More definitive conclu- Doing Business indicator. This case study distance to frontier scores for 2009 and sions about the relationship between uses the distance to frontier measure data on FDI inflows in 2010 from the to capture not only how an economy United Nations Conference on Trade and Doing Business indicators and FDI will ranks relative to others but also how Development’s UNCTADstat database. require more refined research. One initial far it is from the most efficient busi- The calculation for Costa Rica uses a step could be to disaggregate FDI by ness regulatory practices identified by lower-end estimate of $300 million in sector—for example, to compare the Doing Business. For more details, see the FDI flows being associated with a 1 per- chapter on the ease of doing business centage point difference in the distance effect of business regulations on manu- to frontier score. and distance to frontier. facturing FDI with their effect on resource 14. Geginat, Gonzalez and Saltane 2012. 2. For an overview of such studies, see, for extraction FDI. If such research supports 15. The Investing Across Borders database example, Blonigen and Piger (2011); and the association between regulatory qual- Hornberger, Battat and Kusek (2011). launched by the World Bank Group ity as measured by Doing Business and the in 2010 presents indicators of FDI regula- 3. Walsh and Yu 2010. size of FDI flows, government officials and tion across economies. The Investing 4. Wei 2000. Across Borders indicators referenced in business analysts will have even stronger 5. Desai, Foley and Hines 2003. this case study are based on data for justification for claims that better Doing 87 economies published in the 2010 6. Waglé 2011. Business rankings should attract more FDI. Investing Across Borders report plus 5 ad- 7. Jayasuriya 2011. ditional economies for which data were 8. This suggests that the results may be collected but not included in that report. driven by differences between higher- NOTES 16. This correlation is calculated between and lower-income economies, not by This case study was written by John the distance to frontier in starting a variation within groups of economies. Anderson and Adrian Gonzalez. business as measured by Doing Business 9. Busse and Groizard 2008. 1. The Doing Business indicators can be and the distance to frontier in starting aggregated in multiple ways to create 10. Jayasuriya 2011. a foreign business as measured by composite measures of the investment 11. Jayasuriya (2011) estimates the influence Investing Across Borders, the same data as climate. One approach is the ease of of Doing Business rankings across 84 those shown in figure 7.2.