* We examine the effect of a country's governance environment on the foreign investment it attracts. We classify countries based on the dominant mode of governance into three types: (1) rule-based (strong public rule of law), (2) relation-based (weak rule of law and strong informal networks), and (3) family-based (absence of both public rules and informal networks).
* We then examine how different governance types affect foreign investment patterns among 45 countries. Our main argument is that the choice of investment--direct or portfolio--is influenced by the type of property protection associated with different governance modes.
* We find that rule-based countries attract the lowest amount of FDI relative to the total amount of foreign investment, and they have the largest stock market size relative to their economies.
* Our study contributes to the foreign investment literature by bringing the governance environment into the equation and more successfully explaining why some countries have relatively large foreign direct investment ratios and relatively small foreign portfolio investment ratios.
Keywords: Governance environment * Foreign investment * Rule-based * Relation-based * Family-based * FDI
Foreign investment has been an engine of economic growth in an increasingly globalized world economy, and has been one of the most important subjects in the study of international business. Scholars of international business have accumulated an expansive knowledge of the subject. However, there are some deficiencies in the literature. First, most research on foreign investment has focused on foreign direct investment (FDI), whereas the topic of foreign indirect investment, or foreign portfolio investment (FPI), has received less attention (Li and Filer 2007). This leads to a second deficiency in the literature. The relationship between foreign direct investment and indirect investment has not been sufficiently examined. When the proportion of FDI as a percentage of the total foreign investment into a country versus the level of the rule of law of the receiving country is plotted, it is clear that countries with a lower level of the rule of law have a higher proportion of FDI (Li and Filer 2007). Third, the effect of governance environments that lack the rule of law has not been sufficiently examined. Recently, Li and Filer (2007) used a relatively new framework of governance environments which classified countries into "rule-based" and "relation-based" environments in order to examine the effect of the governance environment upon the proportion of FDI. They found that in the incoming foreign investment, rule-based countries have a smaller proportion of FDI than do relation-based countries.
While Li and Filer (2007) made a contribution in bringing governance environment into the model to predict the relative sizes of FDI and FPI, a major drawback in their governance framework was that it was limited to two types of countries: rule-based and relation-based. As Li (2009) later pointed out, the two categories were far from exhaustive. Countries that have a strong public ordering (1) (i.e. rule-based) are usually the ones with mature market systems and advanced democracies, such as the United States and Western European countries; and countries that lack public ordering and yet have extensive informal relation-based social networks include many Asian countries such as China, Taiwan, and Indonesia. Left unexamined in the Li-Filer framework are the countries that have neither public ordering nor extensive informal social networks. For instance, according to Li's (2009) new classification, Argentina, Brazil, and Russia are neither highly rule-based nor relation-based, but belong to a category which he terms "family-based" (we will explain this in more detail later). Many of the least developed countries, such as some of the low-income African countries, may also belong to this third category. In fact, this group includes a large number of countries, but receives relatively little attention from either policy makers or scholars. More importantly, these countries can benefit significantly from increased foreign indirect investment.
If we group foreign investment according to the updated governance classification of Li (2009) (namely, rule-based, relation-based, and family-based), we can clearly see that some interesting differences exist among the three groups of countries (see Table 1). While there is almost no difference among the three types of countries in the volume of FDI inflow, the variation in FDI as a proportion of total foreign investment (FDI/FI) is quite obvious: the average FDI/FI ratio of family-based countries is highest, followed closely by that of the relation-based countries. Overall, the FDI/FI ratio of relation-based and family-based countries is almost twice that of rule-based countries.
Why do the family-based countries attract so little indirect (portfolio) investment? The prior literature suggests that it is because of their low economic development level, less developed financial markets, their geography, and/or culture (Bhardwaj et al. 2007; Jones and Teegen 2001; Loree and Guisinger 1995). These are certainly factors to consider in the investor preference for FDI. But does the governance environment play a role? If the governance environment plays a role, how and why does it play a role?
In an attempt to fill these gaps in the literature, we adopt Li's (2009) new classification of governance environments to explain why some countries attract more and some attract less FDI.
Theory Development and Hypotheses
Mode of Investment: Direct versus Indirect
Foreign investment includes two categories: direct investment and portfolio investment. In direct investment, investors invest capital into a firm for a return on the investment and the right to participate in the management of the firm. In contrast, in portfolio investment, investors purchase securities (such as stocks and bonds) for a return on their investment. The management, ownership, and control is what distinguishes FDI from portfolio investment (Ball et al. 2002, p. 69). Generally, if an investor controls more than 10% of the shares of a firm, it is considered direct investment (Ball et al. 2002, p. 69; Hill 2003, p. 204). However, the line between direct and indirect investment is increasingly blurred. In the literature, the term "portfolio investment" is used more commonly. We use the terms "indirect investment" and "portfolio investment" interchangeably in this paper.
In direct investment, the investor directly oversees his/her investment; the investor has firsthand information on the operations and does not need to rely on financial reports issued by someone else, such as an accounting firm or a board in which he/she has no control or access. In other words, the direct investor is an "insider" of the firm. Thus, in direct investment, the risk of being misinformed or being expropriated by other insiders is substantially reduced (Goldstein and Razin 2006). Even in a governance environment that lacks fair and efficient public ordering (e.g., low quality public financial information and weak financial regulation), an investor can still effectively protect his/her investment by taking private actions. Furthermore, if one has a good relationship with the political ruler(s), the protection can be extremely effective and favorable.
In contrast, for portfolio investments, such as buying securities (stocks and bonds) in the secondary markets, the investor has no direct control over his/her investment (2); nor does he/she have firsthand information about the operations. The investor has to rely on publically available information, such as annual reports or brokerage firms' recommendations, to make investment decisions, thus making the investor an "outsider." For such investment, the lack of a good public governance environment is especially harmful. First, in societies lacking in public ordering, reliable public information tends to be insufficient, and general trust is usually low. There are lower accounting and auditing standards, and less transparent operations of publicly listed companies. What makes this even worse is that financial information is easily altered by insiders. Second, since checks and balances are lacking and the press lacks freedom, a powerful dictator may manipulate the political system of a society with a poor public ordering, and the dictator may tend to view the country as his private property (Olson 1993). He may make state policies to favor industry leaders and businesses with whom he has strong relations. The Philippines under the administration of Ferdinand Marcos is a good example. Under a dictatorship situation like this, minority shareholders, such as indirect investors, are in a very disadvantageous position.
The Literature on Foreign Investment
Foreign direct investment has been extensively studied by international business scholars. They have provided many theoretical rationales for FDI, such as the costs of doing business abroad and internalization (Hymer 1960: Kindleberger 1969), the product-life-cycle theory (Vernon 1966), firm specific competitive advantage (Buckley and Casson 1976; Caves 1971), the "Uppsala Model" (Johanson and Vahlne 1977; Johanson and Wiedershelm-Paul 1975), risk diversification (Rugman 1979), the eclectic paradigm (Dunning 1980), and the liability of foreignness that highlights the MNE subsidiary's disadvantages in a host country (Kostova and Zaheer 1999; Zaheer 1995). These theories suggest various determinants of potential FDI patterns such as country-level determinants (e.g., economic and political stability, host government policies, market size, gross domestic product, cultural distance, tax rates, wages, corruption, and production and transportation costs (Hofstede 1980; Nigh 1985; Root and Ahmed 1979), industry-level determinants (e.g., sales...