The Interrelationships Among Informal Institutions, Formal Institutions

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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: [email protected]

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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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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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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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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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.



13/37


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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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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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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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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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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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

The Interrelationships Among Informal Institutions, Formal Institutions

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