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DOI: 10.1177/0149206310393503
published online 15 March 2011Journal of ManagementR. Michael Holmes, Jr., Toyah Miller, Michael A. Hitt and M. Paz Salmador
Inward Foreign Direct InvestmentThe Interrelationships among Informal Institutions, Formal Institutions, and
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The Interrelationships among Informal
Institutions, Formal Institutions, and
Inward Foreign Direct Investment
R. Michael Holmes Jr.Florida State University
Toyah MillerIndiana University
Michael A. HittTexas A&M University
M. Paz SalmadorUniversidad Autnoma de Madrid
This research contributes to institutional theory by examining the influence of informal institutions
on formal institutions and the effects of formal institutions on inward foreign direct investment.
In particular, the authors integrate prior research from multiple disciplines to identify and to
examine the roles of a countrys formal regulatory, political, and economic institutions. The
results suggest that the countrys informal institutions, in the form of the cultural dimensions of
collectivism and future orientation, shape the countrys formal institutions. In turn, each of the
three formal institutions affects the countrys level of inward foreign direct investment differ-
ently. To facilitate future research, the authors also provide a set of measures for formal institu-tions in 50 countries.
1
Acknowledgments: We benefited from comments by Jean-Luc Arregle, Don Bergh, Jean Boddewyn, Lance
Brouthers, and Doug Schuler on earlier versions of this article. We also benefited from participants comments in
research colloquia presented at the University of Connecticut, University of Illinois, University of Miami, and Rice
University. The participation of M. Paz Salmador was graciously supported by the Fulbright Program.
Corresponding author: R. Michael Holmes Jr., Florida State University, College of Business, Department of
Management, 821 Academic Way, P.O. Box 3061110, Tallahassee, FL 32306-1110
E-mail: mholmes@cob.fsu.edu
Journal of Management
Vol. XX No. X, Month XXXX xx-xx
DOI: 10.1177/0149206310393503
The Author(s) 2011
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2 Journal of Management / Month XXXX
Keywords: institutional theory; formal and informal institutions; foreign direct investment;
construct validity; internationalization
Reflecting continued globalization and internationalization efforts by firms (Beinhocker,
Davis, & Mendonca, 2009; United Nations Conference on Trade and Development, 2004),
scholarly attention to institutions continues to surge. Recent work on institutions emphasizes
their critical influence on firms strategies and performance (Peng, Sun, Pinkham, & Chen,
2009; Peng, Wang, & Jiang, 2008). In light of their importance, our study addresses three
limitations in the broader management literature on institutions. First, work to date provides
an incomplete picture of relationships between a countrys informal institutions, which reflect
the collective meanings and understandings shared by its inhabitants, and the codified rules
and standards that constitute its formal institutions. Second, we have limited and fairly incon-
sistent knowledge of which institutions and what kinds of institution [sic] (i.e., causal fac-tors) attract or do not attract the long-term investments of MNEs [multinational enterprises]
(Pajunen, 2008: 653). A third limitation underlies the previous two: A strikingly small
number of studies examine an array of informal and formal institutions across a large num-
ber of countries over time.
This study is one of the first to theoretically explain and empirically examine how a
countrys informal institutions shape its many formal institutions. Using data on 50 countries
over nine years, we accomplish this objective by developing a new set of measures for three
types of important formal institutions, each of which serves a different role in society. In
addition, we examine the influence of the three types of formal institutions on the attractive-
ness of the countrys markets for investments by MNEs, as evidenced by inward foreigndirect investment (FDI). By examining multiple and diverse institutions, we are able to pro-
vide insights into the types and characteristics of institutions that attract or discourage MNE
investments into a country.
Our theoretical framework integrates management research on institutional theory with
insights from two adjacent disciplines: organizational institutionalism (from sociology) and
institutional economics (from economics). Organizational institutionalism focuses on the
processes through which a societys collective actions and values shape the development and
maintenance of the societys institutions (e.g., Powell, 1991; Tolbert & Zucker, 1996).
Complementing this approach, research in institutional economics emphasizes the implica-
tions of institutions for important outcomes such as investment behavior, the functioning of
markets, and wealth generation (e.g., Levine & Renelt, 1992; Whitley, 1992). At the inter-
section of these fields, research in management subdisciplines (e.g., international management
and strategic management) explores how institutions affect managers decisions (Hoskisson,
Hitt, Wan, & Yiu, 1999; Rumelt, Schendel, & Teece, 1991).
Conceptual (Redding, 2005; Reed, 1996) and qualitative (Collin, 1998; Greif, 1994)
research suggests that a countrys informal institutions, which are reflected in its culture,
influence the evolution of its formal institutions. However, empirical investigations of this
relationship have generally examined a small number of countries (i.e., two to four; Witt &
Redding, 2009) or have focused on a single attribute of formal institutions (e.g., Salter &Niswander, 1995). In turn, there are questions about the extent to which such research is
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Holmes et al. / Institutions and Inward FDI 3
generalizable both to different institutions and to a broader spectrum of countries. Likewise,
identifying a possible source of inconsistent research findings linking institutions and FDI,
Redding (2005) and Jackson and Deeg (2008) argued that a vast majority of studies examine
the linkage between formal institutions and FDI using a small number of indicators or evenjust one. However, institutional environments are multidimensional, complex, and polycentric,
and the various institutions are interdependent (e.g., North, 1990; Ostrom, 2005; Scott,
1995). Thus, we can understand the true effects of such environments only by simultaneously
examining multiple institutions.
Accordingly, our study makes three contributions to the management literature. First, we
synthesize theory and research from adjacent disciplines to identify three types of formal
institutions, describe the roles they play in society, and develop measures of them. Second,
we link the countries informal institutions, as reflected in the culture, to these three types of
formal institutions. Third, we establish the consequences of each formal institution for the
countrys receipt of FDI. In short, the measures and theory we provide may improve scholarsunderstanding of the roles that different institutions serve, the forces that shape them indi-
vidually, and their distinct implications. Furthermore, this work should serve as a foundation
for future research into firm strategies and their implications for performance.
Conceptual Development
Informal Institutions and Formal Institutions
Informal institutions are enduring systems of shared meanings and collective understand-ings that, while not codified into documented rules and standards, reflect a socially con-
structed reality that shapes cohesion and coordination among individuals in a society (Scott,
2005). Representing shared values and noncodified standards, culture is an important reflection
of a countrys informal institutions (North, 1990; Peng et al., 2008). A countrys culture
constitutes created and learned standards for perception, cognition, judgment, or behavior
shared by members of a certain group (Fu et al., 2004: 288). Embedded in a nations heri-
tage (Greif, 1994), culture is durable, long-lasting, and relatively stable, with incremental
changes occurring slowly (Brett, Tinsley, Janssens, Barsness, & Lytle, 1997; McGrath,
MacMillan, Yang, & Tsai, 1992; Reed, 1996). Culture embodies societal members norms
and values by defining, for example, what actions are considered ethical, acceptable, and
desirable (Reed, 1996) and by facilitating a shared understanding of such expectations (Tsui,
Nifadkar, & Ou, 2007). Although the culture is tacitly understood by societal members, this
knowledge is largely acquired through socialization processes (Greif, 1994).
Formal institutions represent structures of codified and explicit rules and standards that
shape interaction among societal members (North, 1990). They promote order and stability
by providing authoritative behavioral guidelines and enabling the formation of expectations
regarding behavior (Scott, 1995). Although informal institutions change incrementally as
culture is transmitted from one generation to the next (Rohner, 1984), formal institutions are
more malleable in that they are a product of human agency (DiMaggio, 1988). Formal institu-tions begin as solutions to problems in society. These solutions diffuse until they crystallize
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into established rules and standards that influence subsequent behaviors (Tolbert & Zucker,
1996). As individuals in society conform to these rules and standards and they become taken
for granted and routinized, they are reproduced in subsequent time periods (Powell, 1991), and
the society recognizes and accepts them as formal institutions (Witt & Redding, 2009). Thus,as DiMaggio (1988) argued, formal institutions reflect the motivation and collective actions of
societal members seeking to solve problems that obstruct the ability to achieve goals deemed
to be important. Understanding formal institutions, therefore, requires understanding the logic
and rationale underlying the solutions societal members develop (Scott, 2005), and this logic
and rationale are embodied in the societys informal institutions (North, 1990).
Although formal institutions are relatively stable once established, they are based on the
shared cognitive understandings and acceptance of individuals in the society, both of which
evolve and produce change (Zucker, 1987). Thus, scholars have suggested that a driving
force in their development and maintenance is the societys culture (Jackson & Deeg, 2008;
Redding, 2005; Reed, 1996). Specifically, culture reflects and further influences the beliefs(Schooler, 1996), values (Hofstede, 1980), norms and priorities (Sirmon & Lane, 2004), and
assumptions (Huang & Harris, 1973) that are broadly shared by individuals in a society and
that underpin [its] formal institutions (Redding, 2005: 123). In this sense, culture repre-
sents the tool kit from which individuals select and institute solutions to the problems the
society confronts (DiMaggio & Powell, 1991: 28). To form and persist, however, the formal
institutions must be perceived by a critical mass of people in society to be efficacious solu-
tions to its problems (Tolbert & Zucker, 1996). When the formal institutions no longer provide
acceptable solutions, individuals seek new solutions that fit the evolving social context of
the society (Powell, 1991).
Cultural influences provide a foundation that shapes how a countrys people view the
world (Chui, Lloyd, & Kwok, 2002), determines how they make sense of events occurring
in that world (Witt & Redding, 2009), and helps them interpret the explanations offered by
others (Zilber, 2006). In turn, culture serves as a base for the development of formal institu-
tions by influencing what problems are identified, their perceived importance (Schwartz,
1999), the generation of potential solutions for them (Reed, 1996), the evaluation of such
solutions (Zilber, 2006), and the behaviors enacted to implement the solutions (Prasad &
Elmes, 2005). Behaviors consistent with the culture are likely to be evaluated efficaciously
(Fu et al., 2004). Therefore, culture is expressed through the resulting formal institutions
(Redding, 2005). Through this process, formal institutions reflect, embody, and reinforce the
countrys culture across the population (Inglehart & Baker, 2000). By serving as a basis of
formal institutions, culture thus leads to stable and systematic differences across countries
(Greif, 1994; Hofstede, 1980). In this way, [h]istory matters. It matters not just because we
can learn from the past, but because the present and the future are connected to the past by
the continuity of a societys institutions (North, 1990: vii).
Market exchanges are the cornerstone of economic activity and are inherently social in that
actors who have competing interests must transact with one another (Granovetter, 1985).
Because formal institutions define what is acceptable and discipline nonconforming behav-
ior, they allow individuals to form expectations about the actions and commitments of
exchange partners, enable equilibrium practices to emerge (Greif, 1994), and support theconduct of exchanges (Redding, 2005). Thus, the presence of legitimate and recognized
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Holmes et al. / Institutions and Inward FDI 5
institutions to define and oversee business behavior is critical for long-term wealth creation
(Kostova & Zaheer, 1999). In this respect, institutions not only impose constraints but also
provide opportunities (Boddewyn, 1988; Oliver, 1997).
Institutions Critical to Managers
Countries institutional environments are complex and are composed of several formal
institutions. Three types of formal institutions most likely to be important to managers include
regulatory, political, and economic institutions. As a whole, these three types of formal
institutions constitute and define an established order within which businesses operate.
Reflecting the notion that institutions are commonly state-linked (Zucker, 1987: 446),
each institution is enacted primarily by the activities of governments, based on their sover-
eign authority to devise legal and control systems that establish rules, monitor adherence tothese rules, and discipline nonconformity (Covaleski & Dirsmith, 1988). The different types
of formal institutions are identifiable by the societal functions to which certain laws and
governmental oversight apply.
First, an important responsibility of government is to regulate the activities of domestic
and foreign organizations operating within a country. Regulatory institutions establish rules
intended to reduce uncertainty about the activities of organizations by standardizing prac-
tices and demanding conformance. Although the scope and content of regulations vary, they
codify societys expectations and preferences regarding the power and autonomy of organi-
zations (North, 1991; Scott, 1995). For example, such regulatory institutions enact and enforce
laws to protect property rights and restrict the activities of foreign organizations (Bekaert,
Harvey, & Lundblad, 2005; Spicer, McDermott, & Kogut, 2000).
Second, governments establish rules and standards that define the nature of the political
process (Hillman & Keim, 1995), including how power is distributed within government
(Henisz, 2000), which individuals are allowed to participate in it, and how such rights are
exercised (Persson, 2002). The resulting political institutions constitute the rules and stan-
dards through which governments and citizens establish new formal institutions and alter
existing ones, a critical function that affects the stability of the institutional environment and
the predictability of changes in that environment (DiMaggio & Powell, 1991). Political institutions
embody a collection of arrangements. Broadly, they range from autocratic institutions that
concentrate power in the hands of a few individuals and discourage the involvement of other
citizens, on one hand, to democratic institutions that distribute power among multiple individu-
als and encourage active participation by all citizens, on the other (de Mesquita & Siverson,
1995; Fearon, 1994; Ross, 2001).
Third, some formal institutions embody the rules and standards that shape the availability
and value of the societys financial resources, which in turn support capital investments. These
economic institutions are evident in a countrys monetary and fiscal policies (e.g., Fischer,
1993; Lucas, 2003). In turn, such financial factors are an integral part of [a countrys] growth
process (Levine & Zervos, 1998: 554).
Two cultural dimensions especially likely to influence regulatory, political, and economicinstitutions are collectivism and future orientation. Collectivism reflects the extent to which
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a countrys inhabitants value membership in integrated, cohesive social units and place pri-
ority on the interests of these units. In contrast, individualistic societies tend to value and
give priority to the independent and autonomous person. Government policies result from
multiple and often conflicting interests among different groups of citizens, politicians, andorganizations (Persson, 2002). The resulting regulatory and political institutions depend on
how the society prioritizes the rights of individuals, their participation in government, the
distribution of resources, and other civic concerns (Oates, 1999). Collectivism shapes how
institutions promote or suppress the interests of specific organizations or individuals relative
to the interests of society as a whole (Gelfand, Bhawuk, Nishii, & Bechtold, 2004; Triandis,
1995). Thus, the degree of a societys emphasis on collective interests versus individual
interests likely influences the characteristics of regulatory and political institutions.
Future orientation reflects the extent to which long-term outcomes are emphasized over
short-term ones such that planning and investing are directed toward long-term gratification
and results (Ashkanasy, Gupta, Mayfield, & Trevor-Roberts, 2004; Brodbeck, Frese, &Javidan, 2002). Capital accumulates as individuals and organizations forgo current spending
by, for example, electing to save. This tendency is partially dependent on social norms
prevalent in a society (Cole, Mailath, & Postlewaite, 1992), including those related to delayed
versus immediate gratification (Hofstede & Bond, 1988). In turn, the accumulated capital
provides a means to invest in long-term growth opportunities (e.g., Feldstein, 1983). Therefore,
future orientation may influence both the demand for and the supply of capital, thereby shap-
ing the characteristics of the economic institutions that manage that capital.
Hypotheses
Collectivism and Regulatory Institutions
As the preeminent collective actor in many societies (Zucker, 1987: 455), organizations
play a pivotal role in outcomes such as wealth generation and dispersion, leisure, social
status, and the use of resources. Partly because of this influence, regulatory institutions exist
to define and enforce guidelines to control the activities of organizations conducting busi-
ness in a country (Busenitz, Gomez, & Spencer, 2000). Government officials communicate
their priorities and objectives through both actions and inactions by, for example, enacting
rules to oversee some activities while not interfering with others (Hillman & Keim, 1995).In this way, government officials also use regulatory institutions to exert control over some
of the countrys resources (Guthrie, 2006).
Collectivism can facilitate the development of regulatory institutions that tightly control
the activities of organizations operating within a country. Collectivist societies often value
adherence to social norms and attempt to standardize behavior to ensure adherence to such
norms (Greif, 1994; Newburry & Yakova, 2006). A considerable amount of research sug-
gests that individuals in collectivist societies often govern business activities by invoking
formal rules and emphasizing authority (e.g., Earley & Gibson, 1998; P. B. Smith, Peterson,
& Wang, 1996). For example, Salter and Niswander (1995) found that collectivism encour-
ages the development of well-defined and strict financial reporting rules for organizations.
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Concern for the well-being of others is also important to collectivists (Morris, Avila, &
Allen, 1993), and goodwill and cooperation among societal members is thus expected (Huff
& Kelley, 2003). Despite the desire for social harmony, in-groups and out-groups are often
salient in collectivist societies (Triandis, 1995). People sometimes take actions against theinterests of out-groups, especially when such behavior benefits the in-group (Chen, Peng, &
Saparito, 2002). A by-product of this social dynamic can be popular support for strong
regulatory institutions that tightly control the behavior of all organizations, thereby promot-
ing trust and cohesion among the disparate entities (e.g., Knack & Keefer, 1997). Such
regulatory institutions help provide order, stability, and reliability in social interactions
while disciplining nonconformity (Greif, 1994; P. B. Smith, Dugan, Peterson, & Leung,
1998). Tinsley (1998, 2001), for example, found evidence that collectivists prefer to rely on
regulations for resolution of conflicting interests in economic exchange.
Conversely, given their focus on pursuing self-interest, individualists largely eschew the
involvement of authority figures in their affairs (P. B. Smith et al., 1996). They value inde-pendence and personal accomplishment over group interests (Newburry & Yakova, 2006),
favor autonomy over dependence on the collective (Spence, 1985), and prefer variety to
standardization (Mueller & Thomas, 2001). Thus, individualists may be reluctant to accept
and support strict regulatory institutions, as they discourage the unilateral pursuit of self-
interests. Therefore, we expect that societies with collectivist cultures will promote stronger
regulatory institutions than will those with individualistic cultures. These arguments lead to
the following hypothesis.
Hypothesis 1: Collectivism is positively related to the control that regulatory institutions exercise
over organizations activities.
Collectivism and Political Institutions
[R]ooted heavily in national culture (Hillman & Hitt, 1999: 830), political institu-
tions help shape future institutional changes (Powell, 1991). Specifically, they provide a
framework that affects the development and alteration of other institutions by influencing
societal members perceptions of the changes that are possible, the extent to which these
changes are needed, and how they are to be enacted (DiMaggio, 1988). Political institu-
tions also distribute power within a society (DiMaggio & Powell, 1991; Henisz, 2000)while inevitably representing the interests of powerful individuals (Scott, 1995; Zinn,
2003). Electoral laws, legislative rules, and the content of legislation define the power not
only of politicians but also of individual citizens (Persson, 2002; A. Smith, 1937). For
example, by establishing the laws that define political rights and civil liberties, political
institutions delineate how and to what extent citizens can actively participate in institution
building (Matten & Crane, 2005).
In individualistic societies, the person is considered the primary and most important
social unit (Hui, 1988). Rather than valuing submission to the state, individualists tend to
favor autonomy, independence, and freedom (Shane, 1993: 59). Thus, relative to col-
lectivist societies, individualist societies often place greater emphasis on opportunities for
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individuals to participate in the political process. Indeed, Gelfand, Triandis, and Chan
(1996) found that individualistic values are largely at odds with autocratic political institu-
tions that subjugate individual interests and demand high levels of acquiescence and sub-
mission to the state.Conversely, the need for heavy involvement by individual citizens in political processes
is partly inconsistent with the communal nature of collectivist societies. Relative to individu-
alistic societies, collectivist societies emphasize community over individual interests (Chen
et al., 2002). In addition, collectivists are more likely to view others motives and intentions
as benevolent (Huff & Kelley, 2003), to acquiesce to authority figures (Morris & Leung, 2000),
and to accept monitoring and sanctioning to ensure conformance to group norms (Yamagishi,
Cook, & Watabe, 1998). Likewise, individual initiative is not highly valued and deviance
in opinion or behavior is typically punished in many aspects of collectivist societies (Mueller
& Thomas, 2001: 59). These conditions, together with the partially fragmented nature of
most collectivist societies (Greif, 1994), often reduce the strength of organized opposition toestablished political leaders, thereby providing them discretion to solidify and concentrate
power (Persson, 2002). Thus, democratic political institutions may be less common in col-
lectivist societies and more common in societies with a strong individualistic culture. This
reasoning leads to the following hypothesis.
Hypothesis 2: Collectivism is negatively related to democratic political institutions.
Future Orientation and Economic Institutions
Future-oriented societies prioritize long-term outcomes such as economic growth and devel-
opment. Individuals and organizations in these societies value opportunities to make the capital
investments necessary to facilitate such outcomes (Brodbeck et al., 2002). These investments
are costly and forward-looking by nature (e.g., Guthrie, 2006), and a ready supply of capital is
often necessary to fund them (T. Beck, Demirguc-Kunt, & Peria, 2007). A countrys economic
institutions shape the incentives and abilities of financial intermediaries (e.g., banks) to make
the capital available, thereby influencing the capital investments of individuals and organiza-
tions (Levine, Loayza, & Beck, 2000). Specifically, governments can influence capital invest-
ments through monetary mechanisms, fiscal mechanisms, or both. Monetary mechanisms
involve alterations of the money supply through, for example, the policies of central banks andthe control of interest rates (Bernanke & Reinhart, 2004). Fiscal mechanisms include annual
surpluses and deficits in government budgets (Fischer, 1993). Using these tools, governments
can influence the supply of and the demand for capital.
Economic institutions can encourage capital investments by increasing the capital
available to individuals and organizations. In particular, they must maintain an adequate
money supply to ensure the availability of the capital necessary to fund investments. When
the money supply is high, interest rates naturally decline (Gali, 1992). In turn, declining
interest rates reduce the cost of accessing capital (i.e., the interest rate) and increase the
opportunity costs of keeping capital in cash form, thereby encouraging investment
(Romer, 1992). The propensity of individuals in a society to value and respond to such
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Holmes et al. / Institutions and Inward FDI 9
investment incentives partially depends on the extent to which the societal values empha-
size long-term outcomes (e.g., Cole et al., 1992; Hofstede & Bond, 1988).
Beyond these monetary considerations, the future orientation of a society may also be
evident in the countrys fiscal policies. When capital availability declines (e.g., due to aneconomic downturn), future-oriented societies are likely to value short-term government
deficits. Deficits enable governments to offset capital shortages by infusing more money into
the private sector than they remove through taxation. Reduced taxation also enables indi-
viduals and organizations to retain and possibly reinvest more of their investment returns,
thereby increasing capital availability further (e.g., Boskin, 1978). Governments often must
borrow to cover the budget shortfall. When they borrow domestically (i.e., from local individu-
als and organizations), they use some of the capital allocated to the private sector (Feldstein,
1983; Fischer, 1993). However, through subsequent payouts to domestic entities, govern-
ments facilitate a steady supply of liquidity in the market (e.g., Holmstrom & Tirole, 1998).
In addition, governments sometimes finance deficits with foreign borrowing (Edwards,1984). Future-oriented societies are likely to value economic institutions that promote such
fiscal policies because they facilitate capital investments by ensuring that individuals and
organizations have access to the financial resources needed to fund such investments. These
arguments suggest the following hypothesis.
Hypothesis 3: Future orientation is positively related to economic institutions promoting capital
investments by domestic entities.
Having examined the influence of informal institutions on formal institutions, we now
turn to a discussion of how the formal institutions influence countries inward FDI, whichreflects the attractiveness of the countrys institutional environments to the managers of
MNEs (Pajunen, 2008).
Regulatory Institutions and Inward FDI
MNE managers have discretion in allocating their organizations resources. FDI deci-
sions reflect their evaluation of opportunities available in a countrys markets and the sup-
port and limitations posed by the countrys institutional environment (Pajunen, 2008). Often,
MNE managers value economic growth in a country because it enhances the likelihood thatMNEs will earn acceptable returns on invested capital. Governments can enact policies that
facilitate economic growth, such as providing and promoting public goods and creating laws
to protect private property. Thus, some government actions can promote a positive environ-
ment for foreign investments. However, many regulations create an environment that dis-
courages foreign investments. In particular, government policies often lead to inefficient use
of financial resources (e.g., to satisfy special interests) and can distort private incentives
through taxes and targeted regulations that create inefficiencies (Browning, 1976; Levine &
Renelt, 1992). Taxes on certain value-adding activities, for example, can lead businesses and
individuals to engage in fewer such activities and/or to move them to locations where taxa-
tion is more favorable (e.g., Ballard, Shoven, & Whalley, 1985; Oates, 1999; Trostel, 1993).
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10 Journal of Management / Month XXXX
Furthermore, regulatory institutions sometimes impose undue costs, are ineffective, or are coun-
terproductive. When they produce such outcomes, they are unlikely to improve a countrys
economy (Collin, 1998; Hill, 1995). Thus, the impacts of regulatory institutions vary depend-
ing on the laws and policies enacted and enforced and on the way firms respond (Hennart,1989; Williamson, 1991).
Prior research suggests that managers seek to invest in countries with institutional envi-
ronments that allow MNEs to leverage their firm-specific advantages and access local
resources (e.g., human capital; Dunning, 1998; Loree & Guisinger, 1995). Government
intervention in the affairs of organizations introduces direct compliance costs as well as
indirect costs associated with distorted incentives (Guthrie, 2006; Tirole, 2003). For exam-
ple, government interventions such as wage and price controls limit MNEs flexibility and
increase their exposure to unfavorable market conditions. Likewise, many governments
restrict foreign ownership levels, thereby disallowing the use of wholly owned subsidiar-
ies by foreign firms and limiting the willingness of MNE managers to locate certainactivities in the country (Hennart, 1989). Such regulations can reduce domestic firms
exposure to foreign markets and innovations and restrict the product and service options
available to consumers. In turn, the diminished involvement in international commerce can
limit economic growth (Levine & Renelt, 1992; Moran, 2000). As a result, MNE managers
typically value institutional environments that promote free and open markets (Globerman
& Shapiro, 2003).
Because governments can maintain power without foreign managers support, regulatory
institutions largely favor local firm interests over foreign firm interests (Boddewyn, 1988).
When regulatory institutions are designed to provide governments with greater discretion-
ary control, MNEs are subjected to enhanced moral hazard by these institutions, especially
after MNE investments have been made (Teece, 1986a). Thus, managers try to avoid large
resource commitments when regulatory institutions are overly strong and unfriendly (Delios
& Beamish, 1999).
Regulations also impose costs on local organizations. The costs invoked by tight regula-
tions alter incentives and reduce employer flexibility (Saint-Paul, 2002), perhaps stifling the
development and availability of human capital and reducing the countrys attractiveness to
MNEs. In addition, tight regulations impose costs on entrepreneurs, thus reducing their
incentives and ability to innovate (Begley, Tan, & Schoch, 2005; Zapalska & Edwards,
2001) and depriving the local market of important knowledge resources sought by many
foreign investors (Almeida, 1996; Feinberg & Gupta, 2004). Conversely, regulatory institu-
tions promoting a more friendly business environment are likely to attract FDI (Globerman
& Shapiro, 2003). These arguments underlie the following hypothesis.
Hypothesis 4: Regulatory institutions exercising greater control over organizations activities are
negatively related to inward FDI.
Political Institutions and Inward FDI
MNE managers often seek to encourage government officials to enact policies in the
interests of the MNE (Vernon, 1971). Political institutions provide an avenue through
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Holmes et al. / Institutions and Inward FDI 11
which MNE managers can influence officials decisions and receive fair or even preferential
treatment (Boddewyn, 1988; Hillman & Hitt, 1999). As a result, MNE managers often work
to establish desirable relationships with local government officials (Luo, 2001).
Perhaps because government officials operating in democratic systems rely on popularsupport, which is more common when the economy is strong, relations between businesses
and governments in these systems are often more friendly than in autocratic systems
(Hillman & Keim, 1995). In addition, democratic political systems are generally more
transparent, in part because of the large number of influential and informed stakeholders.
Foreign firm managers often value such transparency because it reduces uncertainty,
enables them to identify and conform to government demands and priorities, and improves
their ability to engage government officials (e.g., Orr & Scott, 2008). Moreover, a likely
by-product of institutions promoting the interests of individual citizens and encouraging
their participation in government is more active participation in the labor market, thereby
increasing the number and skills of available workers (Edelman, 1990; Sutton, Dobbin,Meyer, & Scott, 1994).
Conversely, concentration of authority in a few individuals enables government officials to
be more self-serving and to manipulate institutions for personal gain, particularly when there
are minimal checks and balances. Such conditions may create inefficiencies (Persson, 2002),
erect barriers to entrepreneurship and innovation (Bowen & De Clercq, 2008), and reflect
elevated government consumption of a countrys resources (Ross, 2001). In turn, the managers
of MNEs are likely to limit investments in countries with autocratic political institutions.
Autocratic political institutions also facilitate instability and unpredictability in the insti-
tutional environment because policy is subject to the whims of a small number of individuals
(Henisz, 2000) and often produces institutional voids (Puffer, McCarthy, & Boisot, 2010).
In addition, whereas democratic political institutions provide opportunities to influence gov-
ernment officials through interest groups, elections, and lobbying (Hillman, Keim, & Schuler,
2004), revolution may be the primary option available to enact changes when political insti-
tutions are autocratic. MNE managers expect to experience uncertainty when investing
abroad (Zaheer, 1995), but instability in the institutional environment exacerbates this uncer-
tainty (Henisz & Delios, 2001). In particular, instability complicates managers efforts to
leverage MNEs assets (Teece, 1986a), hampers learning (Newman, 2000), and limits the
reliability and consistency of economic forecasts (Andersen, Bollerslev, Diebold, & Vega,
2003). Therefore, whereas stability in political institutions can contribute to economic
growth (Temple, 1999) and may attract foreign investments (Busse & Hefeker, 2007), the
potential instability associated with nondemocratic political regimes may contribute to lower
foreign investment (Chan & Makino, 2007; Delios & Henisz, 2003). In turn, we suggest the
following hypothesis.
Hypothesis 5: Democratic political institutions are positively related to inward FDI.
Economic Institutions and Inward FDI
Although local individuals and domestic organizations often finance investments primar-
ily using local sources, foreign MNEs also have access to capital from their home markets.
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12 Journal of Management / Month XXXX
In fact, they often rely on financial intermediaries in their home markets to fund entry into
foreign countries (Klein, Peek, & Rosengren, 2002). Nonetheless, the monetary and fiscal
policies that promote capital availability for domestic investors inevitably influence foreign
MNEs even when such policies are not primarily directed at these firms (Tirole, 2003).Monetary policies that persistently protect domestic investors access to capital may gen-
erate other consequences that are unattractive to MNE managers. Maintaining high money
supplies and maintaining low interest rates create conditions that devalue a countrys cur-
rency (Burdekin & Weidenmier, 2001; Romer & Romer, 2000). Although depreciation of
the domestic currency increases the relative wealth of foreign firms, enabling them to outbid
domestic firms in acquiring corporate assets (Klein et al., 2002: 664; Froot & Stein, 1991),
such inflation may also increase the requirements for satisfactory returns and reduce the
value of repatriated profits. Often, MNEs must mitigate such concerns through hedging and
pricing adjustments, both of which increase the complexity and uncertainty associated with
FDI (e.g., Bartram, Brown, & Minton, 2010; Lessard & Zaheer, 1996; Sundaram & Black,1992). Therefore, the potential for currency devaluation often discourages MNEs from
entering foreign markets (Woodward & Rolfe, 1993).
In addition, fiscal policies that promote capital investments by ensuring capital availabil-
ity for domestic entities may have consequences that reduce the countrys attractiveness to
foreign MNEs. In particular, governments using fiscal policies to provide capital for domes-
tic entities may lack the funds to provide financial incentives to entice FDI from MNEs. For
example, the frequent use of budget deficits raises the costs of borrowing and limits the gov-
ernments subsequent flexibility (e.g., English, 1996; Oates, 1999). Likewise, using deficits
generally increases governments default risk and illiquidity, especially if they rely heavily
on foreign borrowing (Edwards, 1984). Foreign borrowing also reduces governments incen-
tives to invest in the private sector because some of the benefits are appropriated by the
foreign investors providing the capital (Sachs, 1989). Indeed, using deficits and foreign bor-
rowing to promote capital availability for domestic entities sometimes provides incentives
for governments to behave opportunistically toward MNEs by, for example, altering policies
that attracted MNEs after they have made investments (e.g., Teece, 1986b; Tirole, 2003).
Moreover, the use of certain types of domestic bonds to promote capital investments can
commit governments to issue payouts when they are no longer needed, perhaps producing
too much liquidity in subsequent time periods (Holmstrom & Tirole, 1998). Thus, economic
institutions that prioritize capital investment by domestic entities may in turn reduce the
countrys receipt of FDI, thereby leading to the following hypothesis.
Hypothesis 6: Economic institutions promoting capital investments by domestic entities are nega-
tively related to inward FDI.
Method
Sample
To examine the influences on and implications of institutional environments, we col-lected and analyzed data on 50 countries. These 50 countries (listed in Table 1) were chosen
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Holmes et al. / Institutions and Inward FDI 13
because they are geographically and economically heterogeneous. Of these countries, 21 were
located in Europe, 15 in Asia, 9 in North, South, or Central America, 3 in Africa, and 2 on
the continent of Australia, providing an institutionally and culturally diverse sample. In addi-
tion to developed economy countries, our sample also includes a number of large emerging
economy countries, such as Brazil, Russia, India, and China (collectively known as the BRIC
countries; ONeill, 2001), and some smaller developing economy countries, including Nigeria,Slovenia, and Romania. In total, we have 450 country-year observations (i.e., nine years of
data). Because of the limited number of observations, deletion of cases due to missing values
for primary variables would dramatically reduce the useable cases for the factor and regres-
sion analyses, leading to low power and biased parameter estimates (Allison, 2001).
Therefore, we used maximum likelihood estimates to iteratively impute missing values for
the data because this technique is more accurate than mean substitution or case deletion
methods (Schafer & Graham, 2002). All measures exist at the country level.
Measures
Inward FDI. Inward FDI(measured as FDI inflows) was collected from the World
Banks World Development Indicators (WDI; World Bank, 2004). Inward FDI represents
capital investments in a country from organizations located in other countries. This
investment takes the form of manufacturing facilities, research and development centers,
joint ventures, and so on. Such entities may be owned partially or entirely by the investing
organization. We measured our institutional variables at time t, and we utilized inward FDI
at time t+1.
Formal institutions.Formalinstitutions served as both dependent variables (Hypotheses 13)and independent variables (Hypotheses 46).We utilized a number of data sets as sources
Table 1
Sampled Countries
Argentina France The Netherlands South Korea
Australia Germany New Zealand Spain
Austria Greece Nigeria Sweden
Brazil Hong Kong Pakistan Switzerland
Bulgaria Hungary Peru Taiwan
Canada India The Philippines Thailand
Chile Indonesia Poland Turkey
China Ireland Portugal United Kingdom
Colombia Israel Romania United States
Czech Republic Italy Russia Venezuela
Denmark Japan Singapore Vietnam
Egypt Malaysia Slovenia
Finland Mexico South Africa
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14 Journal of Management / Month XXXX
for the data on formal institutions: Euromonitor International, Index of Economic Freedom
(IEF; Gwartney, Lawson, & Block, 1996), Freedom Houses annual survey of political
rights and civil liberties, the Political Constraint Index (POLCON) data set (Henisz, 2000),
International Country Risk Guide (ICRG), Political Risk Services (PRS), and the WorldBanks WDI.1 Using these sources, we constructed an extensive data set of institutional
measures. We performed a principal components analysis, an appropriate data reduction
technique, to reduce this large number of measures to a set of representative indicators
(Conway & Huffcutt, 2003; Pedhazur & Schmelkin, 1991). Table 2 contains the large set of
variables (organized by the formal institution on which we expected them to load), their
units of measurement, definitions, and data sources. Below, we describe the 20 variables that
loaded on the regulatory, political, and economic institutions factors.
In the principal components analysis, the factors were extracted using the following
three criteria: (a) Kaisers (1956) criterion rule specifying the use of factors with unrotated
eigenvalues greater than one, (b) the scree test (Cattell, 1966), and (c) conceptual interpre-tation of the factors (Tabachnick & Fidell, 2001). Scholars have utilized several rotation
methods, broadly categorized as orthogonal and oblique (Fabrigar, Wegener, MacCallum,
& Strahan, 1999). Although orthogonal rotations (e.g., varimax) do not allow factors to be
correlated, oblique rotations (e.g., oblimin) permit correlated factors. Thus, oblique rotation
is appropriate when there are theoretical reasons to expect that the optimal factor structures
are correlated (Fabrigar et al., 1999). A countrys institutions generally share common vari-
ance and are interdependent (Jackson & Deeg, 2008; Whitley, 1992).2 Therefore, oblique
rotation was used.
Using the Kaiser criterion, five factors were selected. However, this rule sometimes
leads to overextraction (Fabrigar et al., 1999; Floyd & Widaman, 1995). Therefore, we
also used the scree test to identify the last substantial reduction in the magnitude of eigen-
values. Evaluation of the scree plot indicated that the reduction occurred between four and
five factors, thereby providing support for a four-factor solution. Items were excluded
when they had high cross-loadings (greater than 0.4) on more than one factor. After
items were deleted, the initial solution was recalculated to ensure the appropriate number
of factors.
Table 3 shows the results of the final four-factor solution. Overall, 20 variables exhibited
a simple structure, wherein they have high loadings on only one factor (Tabachnick & Fidell,
2001). The bivariate correlations of the variables loading on the factors are presented in the
appendix. To assess the stability of our institutional factors over time, we conducted the fac-
tor analysis a second time after dividing the data into two time periods (19951999 and
20002003). The results showed that the factors were stable in the composition and magni-
tude of factor scores. These four factors explain about 70.8% of the total variation in the
items. Correlations among these factors are shown in Table 4. Thus, empirically, this factor
solution is a sound representation of the individual variables, and the factors relate well to
the institutions predicted by the theory.
Regulatory institutions. Regulatory institutions establish and enforce laws and policies that
govern business activities. Seven items loaded on the first factor, which represents regulatoryinstitutions. This factor reflects several ways governments exercise control over organizations.
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Holmes et al. / Institutions and Inward FDI 15
Table 2
Variable Units, Definitions, and Data Sources
Institution Name
Untransformed
Units Definition
Data
Source
Regulatory Corruption Index, 0 (high) to
6 (low)
The use of a public office for private gain,
thereby reducing the integrity of regulatory
institutions
ICRG
Contract and
property
rights
Index, 1 (few) to
5 (more)
The extent to which governments protect
individuals and organizations from
violations of exchange commitments and
asset expropriations
IEF
Fiscal burden
(taxation and
government
spending)
Index, as above The financial impact on organizations of
government policies
IEF
Foreign
investment
restrictions
Index, as above Government limitations and monitoring that
pertain to foreign firms, including which
firms are allowed to enter
IEF
Government
control over
wages and
prices
Index, as above The extent to which governments interfere
with free market transactions
IEF
Government
intervention
in banking
Index, as above The influence of regulations on the financial
services industry
IEF
Government
restrictionson industry
Index, as above The extent to which governments interfere
with private sector activities
IEF
Informal
markets
Index, as above Reflects the prevalence of unregulated and
untaxed markets that operate outside the
governments formal authority
IEF
Monetary
policy
Index, as above Reflects the level of government involvement
in managing the countrys money supply
IEF
Regulatory
burden
Index, as above Reflects government influence over business
behavior through, for example, licensing
and registration requirements
IEF
Trade policy Index, as above Captures the governments control over a
countrys exports and imports through, for
example, the use of quotas and tariffs
IEF
Political Civil liberties Index, 1 (high) to
7 (low)
Measures a countrys approach to governing
human rights, such as freedom of speech,
religion, and assembly
Freedom
House
Executive
political
restrictions
Index, 0 (low) to
1 (high)
Indicates specific restrictions on executive
behavior
POLCON
Political
constraints
Index, 0 (low) to
1 (high)
The degree of restrictions on policy changes
from veto power and the distribution of
power across political branches
POLCON
Political rights Index, 1 (high) to
7 (low)
Extent to which the countrys laws allow
citizens to participate in government through,
for example, voting and running for office
Freedom
House
(continued)
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16 Journal of Management / Month XXXX
Table 2 (continued)
Institution Name
Untransformed
Units Definition
Data
Source
Economic Budget
balance
Billions of
dollars
The difference between a countrys tax
revenue and spending
PRS
Capital
investments
Billions of
dollars
The money paid to purchase capital assets and
fixed assets
PRS
Change in real
wages
% change in real
wages (year
over year)
The change in money wages, corrected for
inflation over time
PRS
Credit transfers Billions of
dollars
The amount of payment order(s) made to
disburse money for another party
PRS
Exchange rate Exchange rate vs.
the U.S. dollar
Rate at which one countrys currency may be
converted to anothers currency
PRS
Debt service
cost
Billions of
dollars
The interest cost of payment on debt PRS
Industry work
force
% of population Individuals employed in manufacturing
industries
PRS
Inflation rate Inflation rate (%) The percentage increase in the price of goods
and services
PRS
Liabilities Billions of
dollars
The amount of a countrys financial
commitments or debt
PRS
Liquidity Months import
cover
Ability to convert assets into cash quickly to
cover obligations
PRS
Money supply Billions of
dollars
The year-end money in circulation in the
economy
PRS
Net reserves Billions of
dollars
The amount of change in a countrys holdings
of international reserves due to financial
transactions (calculated as year-end gross
reserves, including gold, minus liabilities)
PRS
Nominal GDP Billions of
dollars
(nominal)
A measure of economic output for a country,
not accounting for inflation
PRS
Size of
population
Total population
(in millions)
The number of people within a country PRS
Services work
force
% of population Individuals employed in service industries PRS
Value of stocks
traded
Total value of
stocks traded /
GDP
The total value of stock traded within a
country
WDI
Trade balance Billions of
dollars
The difference between imports and exports PRS
Total foreigndebt
Billions ofdollars
The amount of money that a country owesother countries
PRS
Unemployment
rate
% of population The percentage of a countrys workforce
population that is without a job
PRS
Unionized
work force
% of persons
employed
The percentage of a countrys workforce that
consists of union members
PRS
Note: ICRG = International Country Risk Guide; IEF = Index of Economic Freedom; POLCON = PoliticalConstraint Index; PRS = Political Risk Services; WDI = World Development Indicators.
Consistent with expectations, regulatory burden, trade policy, contract and property rights,
foreign investments restrictions, government intervention in banking, monetary policy, andinformal markets all have positive loadings, indicative of greater involvement by government
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Holmes et al. / Institutions and Inward FDI 17
in the affairs of organizations. We refer to this factor as Regulatory Controland use it in the
tests of Hypotheses 1 and 4.
Political institutions. The second factor, political institutions, reflects the means throughwhich government officials and other individuals enact changes in institutions. As expected,
bothpolitical constraints and executive political restrictions load positively on this factor,
and both civil liberties andpolitical rights load negatively (both of the latter two variables
are reverse scored). The resulting combination of variables and their loadings on this factor
suggest that political institutions concentrating more authority in a few government branches
and officials are also associated with fewer civil liberties and political rights. Thus, high
scores on this variable indicate more democratic political systems and low scores indicate
more autocratic systems. We name this factorPolitical Democracy, and we use it in tests of
Hypotheses 2 and 5.
Table 3
Institutional Dimensions: Results of Factor Analysis
Factor 1Regulatory
Control
Factor 2Political
Democracy
Factor 3Capital
Availability
Factor 4Market
Liquidity
Regulatory burden .80 .02 -.06 .06
Contract and property
rights
.79 -.21 -.09 .01
Trade policy .77 -.09 -.04 .01
Informal markets .77 -.10 -.18 .04
Government intervention
in banking
.77 -.02 .06 -.11
Foreign investment
restrictions
.75 .07 .23 -.06
Monetary policy .58 -.04 -.22 .23
Money supply -.03 -.01 .96 -.04
Capital investments -.07 -.02 .94 .12
Total foreign debt .00 .06 .93 .12
Nominal GDP -.10 .01 .89 .18
Budget balance -.15 -.10 -.73 .07
Net reserves -.06 -.19 .71 -.37
Liabilities .10 -.08 .09 .78
Liquidity .17 -.09 .09 -.72
Exchange rate .04 -.04 .08 .64
Political constraints .24 .96 -.02 -.01
Political rights .12 -.87 -.03 .02
Civil liberties .28 -.76 -.02 .07
Executive political
restrictions
-.31 .68 .01 .08
Total proportion of
variance explained
70.8
Note: N= 450. The bold font indicates the factor on which the variable loads.
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18
T
able4
CorrelationsofCountryData
Varia
ble
M
SD
1
2
3
4
5
6
7
8
9
10
11
1.InwardFDI
3.6
7
4.28
2.In-groupcollectivism
5.0
7
0.73
-.0
3
3.Futureorientation
3.8
1
0.50
.11*
-.4
3***
4.RegulatoryControl
0.0
0
1.00
-.3
2***
.57***
-.4
5***
5.PoliticalDemocracy
0.0
0
1.00
-.1
2*
-.4
8***
.16***
-.3
9***
6.CapitalAvailability
0.1
8
0.15
-.1
7***
-.1
8***
.28***
-.1
4*
.10*
7.MarketLiquidity
0.7
0
0.08
-.1
0*
-.0
1
-.1
0*
.02
-.2
3***
.02
8.Industryworkforce
26.2
3
7.46
.13**
-.0
5
-.0
1
-.2
9***
.09
-.1
2*
.34***
9.P
opulation
1.5
0
0.60
-.3
7***
.34***
-.1
2*
.57***
.48***
.07
-.3
8***
-.3
7***
10.Digitalmainlines
1.9
3
0.22
.09*
-.0
5
.38***
-.2
1***
.19***
-.1
0*
.01
-.1
1*
.09*
11.R
ailwayfreight
5.6
5
0.32
-.1
4
-.0
2
-.0
9*
.14**
.29***
.06
-.0
3
-.1
3**
.36***
-.05
12.Merchantshipping
3.9
4
0.28
.04
.00
.18***
-.1
1**
.40***
-.0
6
-.1
8***
.00
.24***
-.14**
.10*
Note:N=4
50.
*p
Recommended