How Does the Rule of Law Impact the FDI Attraction?

• In Event: Political Economy in China and Vietnam -- Domestic and International

Abstract

Foreign Direct Investment (FDI) has long been seen as an essential factor contributing to economic growth. Promoting FDI, therefore, is a significant goal for most governments around the world. Previous research has pointed out that the rule of law, also known as “nomocracy,” is among the determinants of a country’s FDI attraction. The rule of law refers to a situation in which “the laws are public knowledge, are clear in meaning, and apply equally to everyone” (Carothers, 1998), qualities that are beneficial for the improvement of nations’ FDI inflows.

Nevertheless, the correlation between nomocracy and FDI is still not so clear for several reasons. First, the definition of the rule of law by Carothers (1998) and other researchers indicate that nomocracy has more than one aspect. However, though some studies evaluate the rule of law as a multi-dimensional index (Haggard and Tiede, 2011), they don’t form their own measurement of these aspects. Instead, they borrow the indexes from other researchers and investigate their influence on economic development. But Haggard and Tiede (2011) don’t combine them in one regression, thus failing to control the impact of the indexes’ overlap (i.e., having the omitted variable bias).

As a result, a consistent, feasible evaluation of various aspects of the rule of law is required for studying nomocracy’s multi-dimensional influence. In fact, Peerenboom (2002) claims that a “thin theory” for nomocracy, in which some basic threshold for the rule of law are contained, is a must for the discussion of the influence of rule of law. Furthermore, Ohnesorge (2007)’s review provides a comprehensive rhetoric discussion of nomocracy both in the Anglo American tradition and the international renaissance of the rule of law. His research points to a definition, which consists of “transparent legislation, fair laws, predictable enforcement, and accountable governments” (World Bank, 2002). These four dimensions fully cover the definitions of researchers including Carothers (1998) and is accepted by many studies for its clear and measurable divisions of nomocracy. This essay, as is discussed in the second section, will focus on the influence of these sub-indicators on FDI.

Second, the case of China, where nomocracy is low but FDI is high, is understudied. Although Peerenboom (2002) and Wang (2014) focus on the development of “rule of law” in China, the first literature provides few empirical evidences on the linkage of economic growth and nomocracy. The latter one is good at statistical analysis, yet he defines the rule of law as legal activities, not covering other aspects (e.g., the governments’ functioning in accordance to laws) of nomocracy.

Third, recent research mainly treats nations as subjects (Asiedu, 2006; Campos and Kinoshita, 2003; Franck, 2006), and the effect of local governments’ rule of law is under-examined. Although some studies focus on enterprises’ datasets (Wang, Xu, and Zhu, 2012), pitifully they rule out the existence of nomocracy in their models.

Fourth, few papers explored the possibility that nomocracy’s marginal impact is determined by the economic condition of the state under study, which we will analyze in detail later. Kolstad and Wiig (2012) is among the rare ones that consider the interaction of “rule of law” and economic moderators (natural resources), yet their focus is on the outward FDI of China. In addition, they measure nomocracy with governance indexes, which measures the performance of government functions instead of the “rule of law” we mention in this essay.

However, an essential part of their results is that they find Chinese outward FDI will be attracted to countries with a combination of abundant natural resources and weak institutions. This conclusion indicates that a good performance in political indicators doesn’t guarantee higher FDI inflows, and the marginal effects of “rule of law” rely on the economic background of nations. Therefore, we can hypothesize that similar interactions exist for Chinese FDI inflows. Since such interplay has not been adequately discussed, our research will try to establish the niche by providing evidence of the rationality of interactions between local rule of law levels and economic indicators (i.e., prosperity and growth rates), and placing them into regression models to examine their influence.

This study, therefore, focuses on the impact of the rule of law on FDI attraction in Chinese cities from 2013 to 2017. We divide nomocracy into four aspects and measure their different effects on FDI inflows. Furthermore, we present credible evidence that economic backgrounds influence the rule of law's marginal effect. Our research will address the issues mentioned above and provide reasonable conclusions that rule of law, both general measurement, and its sub-indicators, has significant influence on FDI inflows, and their impacts are conditional on the cities’ performance in economic development.

Author

• Chengyu Fu, Duke University