161 ECONOMIC AND BUSINESS REVIEW | VOL. 22 | No. 2 | 2020 | 161-190
FORMAL AND INFORMAL INSTITUTIONS, AND 
FDI FLOWS: A REVIEW OF THE EMPIRICAL 
LITERATURE AND PROPOSITIONS FOR 
FURTHER RESEARCH
JUDIT KAPAS
1
 Received: March 9, 2018 
 Accepted: July 13, 2019
ABSTRACT: The aim of this paper is to firstly, summarize the empirical literature dealing 
with the relationship between formal and informal institutions on one side and foreign direct 
investment (FDI) on the other, and secondly, to propose a possible path for further progress in 
the field. The main proposition of the paper is that when formulating hypotheses, the empirical 
research on the institutions-FDI nexus should rely (to a greater extent) on the theories from 
institutional economics, more specifically on the theory of institutional stickiness (Boettke et 
al., 2008) and the hierarchy of institutions (Williamson, 2000), and the theory of coevolution 
of culture (informal institutions) and formal institutions (Bisin and Verdier, 2017). Within 
the framework of these theories, the paper provides four suggestions as regards the manner 
in which further progress in the empirical research on the institutions-FDI nexus can be 
achieved.
Key words: FDI, culture, institutions, corruption, political and civil rights
JEL classification: E02, F21
DOI: 10.15458/ebr100
1 INTRODUCTION
Both the theoretical and empirical analyses on the FDI flows have long been in the forefront 
of economics research. This lively interest is well justified by the enormous positive impact 
the incoming FDI exerts on the economic development of the host country, as documented 
in particular by Iamsiraroj (2016), who proves the existence of a virtuous cycle suggesting 
that FDI contributes to economic growth which in turn attracts more FDI.
2
 In this spirit, 
attracting more FDI has become a crucial goal in the economic policy of many developing 
countries, meaning that the question of what factors lead to more FDI inflows has gained 
not only economic policy interest but significance as well.
This paper has been supported by the National Research, Development and Innovation Office of Hungary 
(project number: K 120686).
1 University of Debrecen, Faculty of Economics and Business, Debrecen, Hungary, e-mail: judit.kapas@econ.
unideb.hu
2 Note that a couple of empirical studies have provided mixed evidence on the growth effect of FDI; see Azman-
Saini et al. (2010) for a brief review of the negative or zero effect.

ECONOMIC AND BUSINESS REVIEW | VOL. 22 | No. 2 | 2020 162
Answers given to the above question are largely based on empirical investigations, mostly 
of a cross-country regression type, which report the importance of various “traditional” 
factors such as market size, growth prospects, macroeconomic stability, macroeconomic 
policies, tax regime, labor cost, level of the infrastructure, agglomeration economies, 
trade policy, exchange rate policy, etc.
3
 However, the literature is not only extensive but 
controversial as well, which is evidenced in Chakrabarti’s (2001) extreme bound analysis. 
According to the latter, only the “market size” variable survives a sensitivity analysis, while 
all the other variables, found to be determinants of FDI in previous studies, are proven to 
be sensitive to small changes in the conditioning information set.
With the aim of finding more solid factors attracting FDI, institutional explanations have 
recently been enjoying a period of growth. This line of research is primarily advocated, 
firstly, by the literature proving the positive impact of various “good” institutions on 
economic development (e.g. Acemoglu et al., 2001), and secondly, by the literature on the 
development-enhancing impact of culture
4
 (e.g. Tabellini, 2010). From the perspective of 
this literature, FDI is one channel through which formal and informal institutions can 
promote development. What is more, different scholars provide evidence for the beneficial 
effect of different institutions.
The aim of this paper is to summarize the empirical literature dealing with the relationship 
between formal and informal institutions, and FDI, and to propose a possible path for 
further progress in the field. The main proposition is that when formulating hypotheses, 
the empirical research on the institutions-FDI nexus should rely, to a greater extent, on 
the theories from institutional economics, namely the theory of institutional stickiness 
(Boettke et al., 2008) and the hierarchy of institutions (Williamson, 2000), as well as 
the theory of coevolution of culture and institutions (Bisin and Verdier, 2017). Within 
the framework of these theories, the paper provides four suggestions as regards how to 
advance in empirically investigating the institutions-FDI nexus.
In my review, my focus is restricted to only those papers in which the dependent variable in 
the empirical analysis is a measure of FDI (inflow or stock), while at the same time admitting 
that both formal and informal institutions have an impact on other “characteristics” of 
multinational firms in a foreign country.
5
3 It is beyond the scope of this paper to summarize the vast literature on the “traditional” determinants of the FDI 
movements; a review can be found in Blonigen (2005).
4 When it comes to informal institutions included in empirical investigations, scholars use, almost exclusively, 
culture with an equivalent meaning. While admitting that the Northian conceptualization of informal institutions 
(North, 1991) cannot be fully equated with that of culture, which is part of informal institutions, the two concepts 
are used as synonyms in the paper, as they are in the literature in question too.
5 Amongst these “characteristics” , the choice of entry modes between wholly-owned companies or joint ventures 
(shared ownership) in the host country is probably the most frequently researched (e.g. Kogut and Singh, 1988).

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The rest of the paper is organized as follows. In Section 2, the literature analyzing the link 
between formal institutions and FDI is summarized. Section 3 deals with the empirical 
literature on how informal institutions (culture) affect the FDI flows. A critique of the 
literature together with my personal propositions on how to make further progress in the 
research are provided in Section 4, while Section 5 concludes the paper.
2 THE FORMAL INSTITUTIONS-FDI NEXUS
There are several reasons to think that high-quality institutions, e.g. low corruption, 
secure property rights, low political risk, low-level of bureaucracy etc., attract more FDI. 
The literature, except for some very rare cases, documents this by showing a significant 
positive impact of various “good” formal institutions on FDI.
6
 The papers evidencing 
a significant impact of formal institutions seem to have been converging to show the 
importance of in particular the following institutions: (1) corruption, 2) governance and 
regulatory institutions, 3) political institutions (civil and political rights) and political 
risk. In what follows, I summarize the literature as centered on the above institutions. In 
each subsection, the studies are distinguished based on whether they address a general 
or a specific question about the impact of the particular formal institution. The general 
question refers to whether the individual institution has an impact on FDI, however, the 
specific question of the paper is about how this same institution exercises its effect.
2.1. Corruption
Among formal institutions, corruption has frequently been proven to be an impediment to 
the inward FDI. Bearing in mind that the literature on corruption has provided us with the 
knowledge that corruption does affect investments in general (e.g. Lambsdorff, 2003), it is 
not a surprise that almost all investigations in the field look into a specific question about 
its impact on FDI, which contributes greatly to our understanding of this effect.
One obvious specific question that consequently arises is how corruption affects the 
composition of capital inflows, i.e. FDI versus borrowing from a foreign bank. Wei (2000) 
is an important paper addressing this issue. Relying on an econometric specification based 
on a simple optimization problem faced by multinational firms, his main finding is that 
corruption exercises an impact both on the volume and composition of capital inflows in 
the host country. In other words, on the one hand, corruption reduces the inward FDI, 
and on the other, it distorts the composition of capital inflows towards foreign bank loans. 
Focusing on a specific group of countries, namely transition economies, Smarzynska and 
Wei (2000), by using the EBRD firm-level data for the period 1989-1995, demonstrate a 
slightly different impact, namely corruption has a negative impact on the inward FDI, 
6 Amongst the rare cases not supporting the importance of formal institutions in attracting FDI, it is worth 
mentioning Wheeler and Mody (1992) who look at the US outward FDI location decisions in the 1980s. What the 
two scholars identify as affecting factors are the “traditional” variables and agglomeration benefits.

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however, it shifts the ownership structure towards joint ventures, and the latter is exactly 
the opposite of Wei’s (2000) finding.
Aizenman and Spiegel (2006) investigate the effect of corruption across various income 
categories. They use the index of corruption in a broader context to express institutional 
inefficiency on a sample of 97 countries, 28 of which are designated as low-income and 
48 of which are designated as mid-income. Irrespective of the income category, the 
institutional variable (corruption) is always significant in the regressions, except for when 
investment cost is included.
Of course, various types of FDI may be influenced by corruption in different ways. In this 
spirit, Brouthers et al. (2008) distinguish three types, namely the market-seeking, labor-
seeking and raw materials-seeking FDIs, and provide novel insights into corruption’s role 
in the FDI flows. The results indicate that the negative effect of corruption is mitigated by 
the high attractiveness of the market when it comes to the market-seeking FDI, while in 
the case of the labor-seeking and raw materials-seeking FDIs, greater attractiveness on the 
contrary does not compensate for higher corruption.
Egger and Winner (2006) go further and provide a more nuanced picture on the corruption-
FDI relationship by showing that the effects of corruption on FDI are different across 
countries of different sizes and levels of development, and over the course of time. More 
importantly, Egger and Winner (2006) argue that while the overall effect of corruption is 
negative, it at the same time matters for the intra-OECD FDI and does not matter for the 
extra-OECD FDI.
Focusing on the Japanese investments, Voyer and Beamish (2004) differentiate between 
groups of host countries, namely emerging and industrialized ones, and find differing 
evidence for the FDI-corruption link. In practice, for the sample of all the 59 countries 
the relationship is positive and significant, as it is for the emerging countries, however, 
the relationship does not prove to be significant for the industrialized countries. Although 
Voyer and Beamish (2004) rely only on the simple OLS regressions, a method which can 
be contested in many respects, the results are nevertheless worth mentioning because they 
indeed signal the heterogeneity of findings.
Habib and Zurawicki’s (2002) study is novel in the sense that it includes a variable of 
corruption distance (calculated based on Kogut and Singh (1988) with Hofstede’s (1980, 
2001) scores) besides the host country’s corruption level. By analyzing the bilateral FDI 
flows from 7 developed countries to 89 countries in OLS and probit regressions, both 
variables are found to exercise a significant negative effect on FDI.
By using a non-parametric analysis as well, Barassi and Zhou (2012) provide more nuanced 
results on the corruption-FDI nexus. More specifically, besides reaffirming the common 

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view that the effect of corruption is negative on the likelihood of FDI taking place, the two 
scholars stress and prove the view that the relationship between corruption and FDI is not 
homogenous for different quantiles of the FDI stock distribution. In particular, in the top 
percentile the effect of corruption is not negative after controlling for other factors.
By separating corruption into two types, Cuervo-Cazurra (2008) looks deeper into the 
question of how corruption affects FDI. His idea is that on the one hand, different types 
of corruption exert different effects, and on the other, these effects can differ depending 
on the characteristics of the economic system of the host country. In this spirit, Cuervo-
Cazurra (2008) distinguishes between pervasive and arbitrary corruption, and compares 
the effects of these kinds of corruption in general with those in transition countries. Using 
a gravity framework
7
 for 1999, he finds that while both types of corruption have a negative 
impact on FDI in general, pervasive corruption has a larger negative impact in transition 
countries than in other countries, while arbitrary corruption on the contrary has a smaller 
negative impact there than in other countries. The reason behind these findings is related 
to a more nuanced view on corruption, namely corruption is perceived as “sand in the 
wheels of commerce” as opposed to “grease in the wheels of commerce” , implying that in 
quasi-market economies corruption can facilitate transactions (grease). This explains why 
transition economies “enjoy” relatively high FDI inflows while having a relatively high 
level of corruption at the same time.
Another paper to argue for the possible positive association between corruption and FDI 
is Egger and Winner (2005). As the authors argue, “in the presence of regulations and 
other administrative controls, corruption can act as a “helping hand” to foster FDI” (in 
ibid p. 933) since paying bribes may speed up bureaucratic processes and provide access 
to publicly financed projects. As a result, the “helping hand” influence of corruption may 
occur in the longer run as opposed to its short-run “grabbing hand” influence. Besides 
these theoretical considerations, Egger and Winner (2005) also think that the negative link 
found by previous studies is due to the cross-section type of the regression analysis and the 
negligence of the endogeneity of corruption.
Not satisfied with the somehow inconsistent results of previous studies, Bailey (2018) 
investigates very important specific questions in his meta-analytic regression analysis. As 
a result, he is able to reconfirm the negative link between corruption and FDI, but more 
importantly, his results suggest that the deterrent impact of corruption is much stronger in 
developing countries than in the developed ones, as well as in Asian countries rather than 
in Europe or North America.
7 The gravity model framework was designed originally for an analysis of international bilateral trade, but has 
been extended later to that of FDI flows. The model is built upon the idea that bilateral FDI (trade) depends 
positively on the size of the two economies, and negatively on the distance between them. Typical additional 
variables included in a gravity specification are income per capita, openness of the host country, and dummies 
indicating whether the two countries have a common border, a common language, or a past colonial link.

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In a unique paper (Pajunen, 2008), providing a fuzzy-set analysis, the author adds more 
nuances to our understanding of how corruption affects FDI. He determines which factors 
are a sufficient cause for a country to be classified as FDI-attractive or FDI-unattractive. 
Among less developed countries, the lack of corruption alone is found to be a sufficient 
cause for a country to be FDI-attractive, while this factor on the contrary is not as important 
for developed countries.
As can be concluded from the above review, while the majority of scholars find a negative 
relationship between corruption and FDI, the opposite link cannot be ruled out either. Of 
course, many factors can contribute to the lack of unanimity on the negative association, 
such as the use of different measures of corruption, or of different econometric models 
and different samples of countries, which underlines the need to find new routes in the 
research field, in order to be able to produce more solid results.
2.2. Governance and regulatory institutions
2.2.1. The “whether institutions matter” question 
As mentioned in the introduction, the findings of the literature about the “traditional” 
variables to explain FDI have proven to be inconclusive, which has been a motivation for 
researchers to seek after other explanatory variables. Among them, various regulatory and 
governance institutions seem to be good candidates. Consequently not surprisingly, an 
important number of studies address the general question of whether these institutions 
have a significant impact on FDI flows.
Globerman and Shapiro (2002) are concerned with analyzing both the inward and outward 
FDIs on a large sample of countries for the second half of the 1990s. Their econometric 
model is rather ad hoc, in which the dependent variable is the FDI flow (inward or outward), 
while among the independent variables one can find indexes for human development and 
environmental sustainability besides an institutional index (first principal component of 
the WGI indices) and some control variables. The results indicate that both the inward and 
outward FDI flows are affected by the same factors, amongst them governance institutions 
which have a significant positive impact on both types of FDI.
In another paper, the two scholars (Globerman & Shapiro, 2003) look at whether 
governance institutions (measured by the WGI indices) are among the determinants of the 
United States (US) outward FDI. Their empirical analysis occurs in two steps. First, they 
estimate the probability that a country is a US FDI recipient, and find that this depends 
on whether the country meets a minimum threshold for institutions. In the second step, 
Globerman and Shapiro (2003) focus only on the recipient countries and examine the 
factors affecting the amount of FDI. According to their results, governance institutions 
prove to be among the strong determinants of FDI.

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More recently, the impact of governance institutions on FDI has been analyzed within 
the framework of the gravity model, which allows for controlling for both countries’ 
institutions. Daude and Stein (2007) is an important paper that takes advantage of the 
gravity model when it comes to robustness checks. This paper analyzes the impact of 
formal institutions on the FDI location decisions by using the WGI indices. Their baseline 
specification follows Carr et al. (2001)’s work, which is an empirical model built upon 
a theoretical model of location of multinational enterprises. Their cross-country setting 
for 2002 controls for the size of the host and source countries, the difference in their 
size, as well as relative factor endowments, trade cost and investment cost. The authors 
find that not all institutions are equally important for FDI, namely regulatory quality, 
government effectiveness, and political stability matter the most, which is reaffirmed 
by the IV estimations. Daude and Stein (2007) provide several robustness checks. First, 
they use a transformation of the dependent variable to deal with the problems of the zero 
FDI
8
, secondly, they apply different models such as the gravity model, and thirdly, they in 
addition use different estimation techniques, including pooled OLS, random effect, and 
Poisson regression, and finally, they substitute the WGI data with different institutional 
measures. At the end of the day, the results have proven to be robust.
Bénassy-Quéré et al. (2007) is an ambitious paper in trying to provide further evidence as 
regards how formal institutions affect the FDI movements. By relying on the gravity model, 
the authors intend to take into account both the host and the source countries’ institutions, 
and take advantage of the possibility of using the bilateral FDI stocks. In addition, they 
intend to tackle multi-collinearity and endogeneity problems. Besides the usual gravity 
variables, Bénassy-Quéré et al. (2007) include a measure for institutional quality for 
both countries and at the same time, a measure of institutional distance between the two 
countries, calculated from the Institutional Profiles database which contains data about 
public governance, market freedom, security of contracts and regulation. To deal with 
the potential endogeneity of institutions, they apply IV estimations. The gravity model 
reconfirms the findings of previous studies: all gravity variables are significant and the 
fitness of the model is high. The institutional variable is positive and significant in this 
model. The authors also run cross-country regressions, which is done in three steps to 
tackle the collinearity of GDP per capita and FDI. In this setting, Bénassy-Quéré et al. 
(2007) are able to show that institutions play an independent role in promoting FDI and 
that institutional distance reduces FDI.
Although the indices of economic freedom are among the most frequently used 
institutional measures in the institutional economics empirical literature, they are very 
much missing in the studies analyzing the FDI-formal institutions link. However, in a 
recent paper, although focusing on the FDI-growth nexus, Iamsiraroj (2016) uses this 
index to check whether good institutions attract more FDI. On a sample of 124 countries 
for the period 1971-2010, by using the simultaneous system of the equations approach 
8 The dependent variable is the logarithm of the FDI bilateral stock, which is problematic if FDI is zero. See 
Daude and Stein (2007) on how to tackle this problem.

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he finds that economic freedom has a significant positive effect on the FDI flows, besides 
openness and human capital.
Examining the institutional determinants of FDI in Central and Eastern European 
transition countries has been a quite popular endeavor. For instance, Kinoshita and Campos 
(2003) look at 25 transition countries between 1990 and 1998. The paper distinguishes 
three categories of the FDI affecting factors: country-specific advantages (e.g. low-cost 
labor, skilled labor force, proximity to the Western European markets), formal institutions 
(rule of law and the quality of bureaucracy and governance), macroeconomic policies 
(e.g. inflation, budget deficit, trade liberalization), and agglomeration economies. Using 
fixed effects and GMM models, Kinoshita and Campos (2003) regress the per capita FDI 
stock on the above three broad categories of variables. The main finding is that the most 
important determinants of the FDI location are the formal institutions and agglomeration 
economies. The conclusion of Bevan et al. (2004) is very similar for this group of countries. 
However, to express governance and regulatory institutions, Bevan et al. (2004) use an 
index developed by the European Bank for Reconstruction and Development, namely the 
aggregate transition index, and its sub-indices.
When it comes to Asia and Latin America, Gani’s (2007) panel estimates show that 
governance indicators are positively linked to FDI. Bengoa and Sanchez-Robles (2003) 
focus only on Latin America by using both fixed and random effect models. This paper 
documents the positive impact of institutions proxied by an index of economic freedom on 
the share of FDI within GDP . The Middle East and North Africa (MENA) countries form 
another group towards which FDI flows are worth investigating. As an example, Daniele 
and Marani (2007) examine the role of institutional quality (measured by WGI indices) on 
FDI, unfortunately using only the cross-country OLS technique. Their regression results 
indicate that institutions play an important role in the relative performances of countries in 
attracting FDI, and call attention to the need for institutional reforms in order to improve 
the attractiveness of MENA countries. On a sample of 15 Asian countries for the period 
1996-2007, Mengistu and Adhikary’ s (2011) results confirm the positive significant impact 
of all variables of WGI, except for regulatory quality, voice and accountability.
2.2.2. Specific questions about the impact of governance institutions
Having more evidence on the impact of governance and regulatory institutions on FDI, 
scholars are becoming concerned with more specific questions.
Among the few papers dealing with institutional distance, Cezar and Escobar (2015) look 
at the link between institutional distance and both the volume of FDI and the likelihood 
that a firm will invest in a foreign country. The empirical model is based on the idea that 
firms in the host country face adaptation costs which depend on the institutions of the 
host country. The institutional distance variable is calculated from a composite index of 13 
indicators from Doing Business, mainly expressing the regulatory framework of a country. 

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The results from a gravity model indicate that a greater institutional distance reduces both 
the volume of FDI and the likelihood of the investment. In addition, Cezar and Escobar 
(2015) find that the results are similar for OECD and non-OECD countries, but different 
for inward and outward FDI.
The impact of institutional distance, together with that of the levels of institutions is also 
investigated in Kuncic and Jaklic (2014). One novelty of the analysis lies in the use of a 
new institutional dataset provided by Kuncic (2014), which distinguishes three types of 
institutions, namely legal, political and economic. Another novelty of the mentioned study 
is the inclusion of informal institutions–although their meaning is reduced to liberal or 
non-liberal public opinion–together with formal institutions in the regression analyses 
based on a gravity framework. For a sample of 34 OECD countries for the period 1990-2010 
Kuncic and Jaklic (2014) evidence that except for economic institutions, institutions matter 
for FDI. On the one hand, legal institutions in the origin country exercise a positive, while 
on the contrary political institutions exercise a negative, impact on foreign investments. 
On the other hand, distances in these two institutions have a significant negative effect. 
When it comes to informal institutions–included together with formal institutions in the 
regressions–the two scholars find it is only non-liberal public opinion that matters.
Buchanan et al. ’s (2006) paper is unique within the literature in the sense that besides the 
impact of the governance institutions on FDI, the authors also look at how institutions 
affect the volatility of FDI. Based on a panel of data for 164 countries from 1996 to 2006, 
they not only reconfirm the findings of other papers, namely the positive and significant 
impact of institutions (measured by the first principal component of the WGI indices) on 
the FDI levels, but also show a significant negative link between institutions and the FDI 
volatility.
It is very rare, if not unique, in the literature to look at whether either the impact of 
institutions is conditional on any other factor, or the impact of another factor is conditional 
on institutions. Okada (2013) is concerned with such an investigation, and looks at the 
interaction between the institutional quality and financial openness in a system GMM 
setting. His main finding is that while these two factors are not significant determinants 
of FDI when entering the regression individually, their interaction term is significant with 
a negative sign. This means that the partial effect of financial openness on FDI increases 
with the level of institutional quality, and the threshold level for institutions between 
negative and positive partial affects is a 30th percentile in the sample. On the other hand, 
the partial effect of institutions on FDI depends on financial openness, namely countries 
with higher financial openness benefit more from institutions.
In a recent paper, as opposed to the linear association of institutions and FDI prevalent 
in the literature, Kurul (2017) assumes a nonlinear relationship between these two. To 
control for this nonlinearity, he applies a dynamic panel threshold model, which allows 
him to determine whether a certain level of institutional quality–measured by the 

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principal component of the WGI indices–should be reached for a country to attract 
more FDI. His results on a sample of 126 developing countries over the period 2002-2012 
provide evidence that the threshold exists. Furthermore, it is also demonstrated that when 
institutional quality is better than this threshold value, the FDI inflow measured by the net 
FDI inflow as a percentage of GDP is higher. Unfortunately, no information is given about 
the extent to which institutions have to be “good” to attract more FDI.
Besides reaffirming the view that institutions are robust determinants of FDI, Ali et al. 
(2010) provide additional insights as regards which institutions matter the most and which 
sectors are sensitive to institutional quality in attracting FDI. Their results from a random-
effects panel analysis for 69 developing countries for the period between 1981 and 2005 
evidence that institutional quality (as measured by the investment profile and law and 
order of the International Country Risk Guide (ICRG) dataset) does not matter equally 
for all sectors, namely it exerts a robust impact in manufacturing and services sectors, but 
not in the primary sector. What is more, the property rights security proves to be the most 
important determinant of FDI because once controlled for, other institutions lose their 
significance.
Sen and Sinha (2017) also ask a very specific question about how institutions affect FDI 
by taking into consideration sectorial differences in the relationship specificity of the 
investment. Their paper looks at the US outward FDI to 50 countries for the period 1984-
2010, and applies the difference GMM estimator technique. The main finding is that 
the US multinationals are likely to invest more in the sectors in which the investment is 
relation-specific if the host country’s property rights are well protected, otherwise they 
invest in the sectors with a low-level of relation-specificity.
A novel aspect of the analysis of the impact of institutions on FDI is explored by a very 
interesting paper by Aleksynska and Havrylchyk (2013). Their paper is motivated by the 
appearance of new global investors from emerging economies (South) such as China. In their 
regression analyses based on the gravity model, the two scholars look at whether investors 
from the South invest differently from their Northern counterparts, and whether the FDIs 
from the South and from the North are complements or substitutes. The results provide 
us with more nuanced insights into how institutional distance matters to investors. First, 
a greater institutional distance between the origin and the host countries deters investors 
from the North. Second, for investors from the South a greater institutional distance may 
have a heterogeneous effect, namely if a Southern country invests in a country with better 
institutions, larger distance stimulates FDI, however, if a Southern country invests in a 
country with worse institutions, i.e. the destination country is from the South as well, a 
greater institutional distance deters. At that point Aleksynska and Havrylchyk (2013) dig 
deeper and find that this deterring effect of worse institutions is counterbalanced by the 
greater attractiveness of investing in a Southern country (with worse institutions) arising 
from the abundance of natural resources. The authors also evidence that the FDI from the 
South tends to be complementary to the FDI from the North, so there is no competition 

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between them. All in all, this paper is the first to show that the FDI flows from developed 
and emerging countries are driven by different institutional factors.
As in the case of corruption, Bailey (2018) provides valuable new insights into the impact 
of institutional quality on FDI. While the positive association is confirmed, he documents 
the differences in the strength of this impact, on the one hand, between the developed and 
developing countries, with a stronger impact in the developed countries, and on the other 
hand, between the Asian and other countries, with a stronger impact in Asia.
In the same way, the analysis of Panjunen (2008), which also looks at the effects across 
different regions and developed versus developing countries, help us clarify why earlier 
studies produced heterogeneous results. His fuzzy-set analysis shows that the impact of 
regulatory institutions matters in all groups of countries, i.e. South American, Southeast 
Asian, Central and Eastern European, but they have to be combined with various other 
factors for a country to be seen as FDI-attractive. For instance, in the CEE countries 
regulatory institutions alone are not sufficient, as they only work together with democratic 
institutions and low corruption. However, in Southeast Asia they have to be combined 
with low taxation as well to make a country attractive to foreign investors.
2.3. Political institutions
A number of papers deal with the question of whether foreign investors have a preference 
for countries with democratic political institutions. The findings of various studies 
converge to the view that democratic institutions are favorable for FDI, despite the fact 
that the studies use different measures of democracy or have different samples and 
econometric specifications.
By using both cross-section and panel settings for 114 countries, Jensen (2003) evidences 
that the democratic institutions in the 1980s affected FDI in the 1990s, which is perfectly 
in line with his theoretical reasons about why democratic governments are seen as more 
credible in the eyes of foreign investors
9
. Harms and Urpsrung’s (2002) findings also 
support this result. They use the Freedom House’s index of democratic and civil rights in 
both the cross-country and panel settings for 62 emerging and developing countries for 
the period between 1989 and 1997, and show that these rights have a significant positive 
effect on FDI. Busse (2004) is another study echoing the fact that FDI is attracted by 
countries where democratic and civil rights are protected. In fact, in the period 1972-
2001, countries with improving democratic and civil rights attracted more FDI than would 
have been predicted on the basis of other country characteristics. Fukumi and Nishijima 
(2010) examine a panel of 19 countries in Latin America and the Caribbean by applying 
a simultaneous equation approach. They find that better political institutions measured 
9 Jensen (2003) highlights two reasons. First, the presence of veto players contributes to the stability of the 
political decision-making system. The second is the “audience cost” , meaning that democratic leaders may suffer 
from a loss of electoral support if they renege on their promises to foreign investors.

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by the political rights index of the Freedom House attract more FDI, but at the same 
time, the FDI contributes to improving political rights as well. Tintin (2013) looks at the 
CEE transition countries and finds that political and civil rights, together with economic 
freedom and state fragility, affect FDI from various countries (EU-15, Japan, China, US) in 
a positive and significant way. However, he also reveals some differences in the institutional 
determinants of the FDI across the investor countries.
It is quite rare to look at the FDI flows into different sectors of the economy, although 
one can intuitively think that the FDI influencing factors may vary across different 
sectors. Kolstad and Willanger (2008) provide such an analysis for the service sector of 57 
countries for the period 1989–2000. The results of the fixed effect estimation evidence that 
democracy, as measured by the ICRG index of democratic accountability, has a positive 
significant impact on FDI. Nevertheless, when it comes to the robustness of these results, it 
turns out that the above effect is not very robust to changes in the sample of countries and 
to different estimation techniques. When looking at particular service sectors, Kolstad and 
Willanger (2008) find conflicting evidence, more specifically, in the finance and transport 
sectors the role of democracy seems to be missing.
Besides the political and civil rights, political risk is another variable with regard to which 
the “whether” question is asked. Although a number of studies include a political risk 
measure in the regression analysis as a control variable
10
, only a few studies deal explicitly 
with its effect. Busse and Hefeker (2007) focus on the role of political risk by using the 
ICRG data on the various aspects of political risk in the regression analysis on a sample of 
83 developing countries covering the period from 1984 to 2003. By applying both cross-
country and panel regressions, including fixed-effects and GMM estimators, they find that 
almost all components of the political risk measure are highly significant determinants 
of FDI. Some studies try to establish the link between FDI and political risk only for a 
particular group of countries. Asiedu (2002), for instance, focuses on sub-Saharan Africa 
and finds that neither the political risk nor the expropriation risk has a significant impact 
on FDI, implying that Africa is different.
Several papers go further by addressing specific questions about the impacts of political 
rights on FDI. For instance, Li and Resnick (2003) explore the channels through which 
political rights exert their impact on FDI, by providing many theoretical grounds for the 
link. Particularly, they highlight the role of one such channel in the empirical investigations, 
namely the protection of property rights. Their theory suggests that democratic political 
institutions may exert two conflicting impacts on FDI: a positive and a negative one. The 
10 An early attempt in the field is Gastanaga et al. (1998) who together with institutional variables such as 
contract enforcement and corruption include the nationalization risk in the regressions and find that it affects 
FDI negatively. Dutta and Roy (2011) examine the role of political risk implicitly by looking at its role in the 
association between financial development and FDI. The major finding is that for each level of political risk 
the inverted U-shaped curve depicting the relationship between financial development and FDI shifts upwards; 
accordingly, the threshold level beyond which the impact of financial development becomes negative corresponds 
to even higher levels.

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positive effect works via property rights protection, namely an increase in democratic 
rights in developing countries yields better property rights thus encouraging FDI flows. 
But after controlling for democracy via property rights protection, democratic institutions 
reduce the FDI inflows, which is, as they put it, a kind of “reversal of fortune” .
11
 This view 
is contested by Jakobsen and de Soysa (2006), who report that the negative and significant 
association between democracy and FDI vanishes if they add more countries to the sample 
of Li and Resnick (2003). In addition, when using the logged value of the FDI inflows, the 
negative effect of democracy becomes positive and significant.
The conjecture that democratic institutions may discourage FDI, a thesis partly evidenced 
by Li and Resnick (2003), is further corroborated by Adam and Filippaios (2007). The two 
scholars look at the US FDI flows in 105 developing countries for the period 1989-1997 
by assuming that democracy is not one-dimensional and that different dimensions may 
affect FDI in a different way. In this spirit, Adam and Filippaios (2007) examine the impact 
of civil and political rights separately. As for political rights, they reaffirm the results of 
the above studies, but when it comes to civil rights, their results are novel. They establish 
that there exists a threshold level for civil rights below which repression of civil liberties 
is associated with more FDI, meaning that the relationship between civil rights and FDI 
is non-linear.
Asiedu and Lien (2011) is an important paper which digs deeper in the analysis of how 
democracy (political institutions) affects FDI. The novelty of this study lies in asking the 
question of whether natural resources in the host country alter the effect of democracy 
documented by the above-mentioned studies. Asiedu and Lien (2011) reassess the link 
between democracy and FDI by taking into account the interaction between democracy 
and natural resources, and the possible reverse causality between FDI and democracy. 
Using the difference and system GMM estimators, the authors provide evidence for their 
suspicion, namely the effect of democracy on FDI depends on the importance of natural 
resources in the host country’s exports, more precisely, democracy encourages FDI in 
those countries where the share of natural resources within exports is low and reduces 
FDI in the countries where exports are dominated by natural resources.
Complementing the results of the above studies, highlighting the role of political and 
civil rights as the determinants of FDI, Wisniewski and Pathan (2014) investigate more 
subtle differences in political institutions. In particular, they analyze whether foreign 
investors have a preference for leftist executives, presidential systems and for countries 
where the executive’s party controls all houses of the parliament, and where the ruling 
party is in power for a longer period. The results add some new knowledge regarding the 
11 Oneal’ s (1994) analysis on the question of whether multinationals benefit materially from autocratic regimes is 
somewhat similar to the negative impact of democracy on FDI found by Li and Resnick (2003), because he found 
that US multinationals achieved higher rates of return in autocracies during the period 1950-1985, and that FDI 
is not significantly related to this regime type.

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attractiveness of a country, namely continuous competition in the political arena together 
with democratic traditions makes a country more attractive for FDI.
Bailey’s (2018) recent meta-analysis on the results of 97 previous studies nuances the 
conflicting results documented by other scholars such as Li and Resnick (2003). When 
distinguishing between developed and developing countries, Bailey (2018) finds that 
democratic institutions “behave” differently, i.e. they exercise a positive significant impact 
on the FDI in the developing countries, while their impact is negative, but not significant, 
in the developed countries. This finding clearly provides support for the claim that 
researchers have to ask very specific questions instead of general ones.
3. HOW INFORMAL INSTITUTIONS AFFECT FDI
When it comes to the informal institutions-FDI link, the vast majority of papers center on 
culture (see footnote 3), which is taken into account in two ways, that is in terms of the 
“level” of culture and cultural distance.
12
Several papers asking the “whether” question have not brought too much insight. For 
instance, Davidson (1980), relying on a very simple methodology of country-pair entry 
frequencies, argues that cultural similarity encourages direct investments, which is a 
somewhat everyday observation. By focusing on institutions, Habib and Zurawicki (2002) 
also include the cultural distance variable in the regression, however, the authors do not 
consider it important and leave it outside further investigations. Another simple analysis 
was done by Jones and Teegen (2001) who restricted their attention only to FDI in the 
field of research and development (R&D) from the perspective of US firms. The paper 
documents a limited role of culture in the R&D activities. Mac-Dermott and Mornah 
(2015) provide only a qualitative analysis of the GLOBE cultural data (House et al. 2004) on 
FDI by pairing high and/or low levels of various cultural dimensions between the host and 
source country that attract FDI. Grosse and Trevino (1996) explore the factors affecting the 
US inward FDI by country of origin, but they do not document the significant impact of 
cultural distance except for one specification. No significant association between cultural 
proximity and FDI is found by Voyer and Beamish (2004) for Japan. When analyzing 
trends in the US FDI location, Sethi et al. (2003) find that cultural distance as measured by 
Hofstede’s scores exerts a significant negative impact on the FDI flows.
Nevertheless, a couple of studies provide us with more consolidated results by asking more 
specific questions. Bhardwaj et al. (2007) examine the impact of two cultural variables, that 
is the uncertainty avoidance (Hofstede 2001) and the trust from the World Values Survey 
(WVS), as well as their interaction effect on FDI. The results confirm their hypotheses, 
namely a higher level of uncertainty avoidance is associated with a lower inward FDI, and 
12 The most frequently used composite measure of cultural distance is introduced by Kogut and Singh (1988) 
based on Hofstede’s (1980, 2001) cultural dimensions.

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a higher level of trust is associated with a greater inward FDI. Furthermore, the authors 
report that the effect of trust is reduced as the country’s uncertainty avoidance increases. 
Although the econometric methodology includes only cross-country OLS regressions and 
no robustness checks are provided, the merit of this paper lies in calling our attention to 
the complexity of the effects various cultural dimensions may have on FDI.
Unlike those scholars who have used a composite cultural distance measure, Tang (2012) 
assumes that the four dimensions of Hofstede (2001) might affect FDI activities differently. 
Accordingly, she investigates the effects of the dimensions separately. Her empirical 
strategy is based on a gravity model in which she includes the cultural distance variables 
for all four of Hofstede’s dimensions, defined as the net difference between the source and 
host countries’ scores. Besides including the usual gravity variables, Tang also controls for 
whether the host and source country have an agreement on the taxation of income and 
capital, the political environment of the host country, whether in the two countries the 
same language is spoken and whether they belong to the same trade agreement. According 
to the results, the Hofstede dimensions clearly exert different impacts on FDI. More 
specifically, FDI has a U-shaped relationship with the net difference in individualism
13
 
and an inverted U-shaped relationship with the net difference in power distance
14
. When 
it comes to the net difference in uncertainty avoidance and masculinity, the impact is 
negative.
15
 Based on the results, Tang’s final conclusion is that the “cultural difference does 
not always imply cultural conflicts” (in ibid p. 249).
To my knowledge, Siegel et al. (2012) provide the most scrupulous analysis on how 
cultural distance affects FDI. A distinctive feature of this paper is its strict reliance on 
theory when it comes to the conceptualization of culture itself, and its link with firm-
level characteristics of the multinational firms’ decisions about the FDI location. The 
conceptualization of culture comes from Schwartz’s (1999) theory developed in cross-
cultural psychology. As the authors argue, this theory offers a number of advantages vis-
à-vis the other conceptualizations and measurements of culture, more particularly the 
theory of Hofstede (1980, 2001). As regards the mechanism via which cultural distance 
has an impact on FDI, Siegel et al. (2012) emphasize (uniquely) firm-level factors, most 
importantly the possible difficulty in interacting with stakeholders in the host country. 
Of Schwartz’ s three cultural dimensions, namely egalitarianism-hierarchy, embeddedness-
autonomy and harmony-mastery, they associate only one dimension (egalitarianism-
13 This implies that greater differences in absolute values have a positive impact on FDI, which shows a 
harmonious “marriage of difference” (p. 237). According to Tang (2012), this is caused, on the one hand, by 
the fact that when the FDI from a collectivist country goes to an individualistic country, the leadership style of 
the collectivist country can help accommodate the parent company in the local culture. And when the opposite 
direction of the FDI flow occurs, the host country’s collectivist culture is favorable to mitigating the more 
individualistic (entrepreneurial) leadership style of the source country.
14 The reason behind this is related to the fact that the FDI flows from a low power distance country to a high 
power distance country can cause problems for the employees in the host country since they are accustomed to 
directives.
15 That is, FDI increases when it flows from a low to a high uncertainty avoidance (or masculine) country.

ECONOMIC AND BUSINESS REVIEW | VOL. 22 | No. 2 | 2020 176
hierarchy) and one of its polars (egalitarianism) with the above firm-level factor. In this 
spirit, their main hypothesis is that the greater the distance in terms of egalitarianism 
between the source and the host country, the greater the adjustments the multinational 
firm has to make to engage effectively with its stakeholders.
The regression results based on gravity equations provide evidence for the significant 
negative link between cultural distance and FDI. The instrumental variable estimations, 
by using societal fractionalization, dominant religion, countries’ 19
th
-century war history, 
and communist rule as instruments, reaffirm the main finding. Besides the significance 
of cultural distance, it has proven to be economically meaningful, namely a one-standard-
deviation increase in egalitarianism leads to an 11.76% decrease in the log FDI. It is worth 
mentioning that cultural distance enters the regression in two forms, i.e. sheer (the square 
of the difference between the host and source country egalitarianism) and directional (with 
a positive or negative sign). Although Siegel et al. ’s (2012) focus is on egalitarianism, as a 
robustness check the scholars also include embeddedness and harmony in the regressions 
and find they have a significant impact on FDI, together with egalitarianism. The results 
indicate that FDI moves from the low-embeddedness towards the high-embeddedness 
countries.
In a recent paper, on a panel of 29 source and 65 host countries for the period 1995-2009, 
Lucke and Eicher (2016) analyze the impact of a broad set of institutional and cultural 
determinants of FDI, but separately from one another. Besides including (institutional 
and) cultural distance between the source and host countries in the regressions, they also 
include the host country (institutions and) culture. Lucke and Eicher (2016) pay special 
attention to whether foreign investors invest differently in the developed versus developing 
and transition economies. Using the ethnic, linguistic and religious fractionalization of 
Alesina et al. (2003) to express cultural diversity, they find that investors prefer to invest 
in the developed countries with less or similar cultural diversity than their own, and are 
deterred by larger cultural distance. When it comes to developing countries as source 
countries, foreign investors tend to invest more in the less diverse countries than their 
own, and are attracted by large cultural distance.
Amongst the few papers including both culture and formal institutions at the same time 
in the analysis, Holmes et al. (2013), relying on the insight that culture shapes formal 
institutions, investigate the influence of culture on formal institutions, and then the effects 
of formal institutions on the FDI inflows. In-group collectivism and future orientation 
stand for the proxies for culture and data are taken from the GLOBE dataset (House et 
al. 2004), while to express the formal institutions they use four factors determined on 
the basis of a principal components analysis of 20 institutional variables from different 
institutional datasets. The results indicate that formal institutions affect both culture and 
FDI, however, there is no evidence that culture influences FDI.

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Seyoum (2011) goes further into the issue of how culture and formal institutions affect 
the inward FDI by exploring both the direct and indirect impacts of culture on FDI, with 
the indirect impact mediated via formal institutions.
16
 To measure trust and reputation, 
i.e. culture, Seyoum (2011) takes six indicators
17
 from the World Economic Forum Global 
Competitiveness Report, and to measure institutions he uses the rule of law measure from 
World Governance Indicators. His cross-country regression results indicate on the one 
hand that trust and reputation have a significant and greater effect on FDI than formal 
institutions, and on the other, that informal institutions affect FDI in an indirect way as 
well, which is mediated by formal institutions. Although the very unusual proxy used for 
informal institutions (culture) and the lack of the robustness of the results may cast some 
doubts on the results, the merit of this paper lies in the fact that it looks at the impact of 
culture together with formal institutions.
Slangen and Beugelsdijk (2010) are unique in the literature in asking a very specific 
question and at the same time examining the impact of both the institutional and cultural 
hazards multinational companies face. The two scholars intend to look at the composition 
of FDI, more specifically, they ask the question of which hazard affects which type of 
FDI to a greater extent. The main result is that both hazards related to formal institutions 
such as high-level of bureaucracy and corruption, weak property rights protection or high 
political risk, and cultural distance exert a greater impact on the vertical FDI than on the 
horizontal FDI. Furthermore, the impact of institutions is greater for both types of FDI 
than that of the cultural distance.
T o my knowledge, the only investigation addressing the issue of the interplay of institutions 
and cultural distance is Du et al. (2012). The paper analyzes how cultural distance from 6 
countries affects their FDI in various Chinese mainland regions with different institutional 
quality. As the authors argue, cultural proximity may play an important role in mitigating 
the negative impact of poor institutions on FDI. Although the institutional variables do 
not come from well-established institutional databases but are instead calculated on the 
basis of private firms’ answers in Chinese surveys, the results reveal a novelty within the 
relevant literature. More specifically, Du et al. (2012) are able to show that FDI coming 
from a country that is more culturally different from China exhibits higher sensitivity 
towards regional economic institutions in the FDI location choice.
Mondolo (2019) provides a meta-analysis of 20 empirical papers investigating the 
informal institutions-FDI link. She focuses on three types of informal institutions, namely 
16 Although he uses the term informal institutions and argues that culture and informal institutions are not the 
same, his understanding of informal institutions in terms of trust and reputation, in our opinion, makes him part 
of the culture-FDI literature since trust is clearly seen as (part of) culture in the literature (e.g. Tabellini, 2010).
17 These are as follows: ethical behavior of firms, importance of corporate social responsibility, strength of 
accounting and auditing standards, strength of corporate boards, firm dependence on professional management, 
and willingness to delegate authority within a firm.

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corruption
18
, trust and social network. Mondolo’s (2019) findings from a meta probit 
model suggest that informal institutions do affect FDI, and their impact is especially 
relevant for developing countries. The author has also shown that the significance of 
informal institutions does not depend on whether studies use panel or cross-section data.
4 HOW TO PROGRESS FURTHER IN THE EMPIRICAL RESEARCH
As can be concluded from the summary in the previous chapter of the paper, the literature 
on the FDI-formal institutions nexus has provided us with much empirical evidence. The 
major finding of the studies is that “good” institutions such as low level of corruption, 
low level of expropriation risk, good governance etc. attract more FDI on their own. In 
addition, a number of specific questions which dig deeper into how these institutions 
matter for FDI have also been investigated.
And while the role of formal institutions in directing FDI has been analyzed to a 
considerable degree, it is however somewhat astonishing that an analysis of the role of 
culture or cultural distance in attracting the FDI flows is still in its early infancy. On the 
one hand, as can be seen from the above review, empirical examinations on the relationship 
between culture or cultural distance and the FDI flows are very limited in number, and on 
the other, several important aspects of how culture matters in attracting FDI have not yet 
been examined.
No doubt there is still a huge potential in (both formal and informal) institutions providing 
us with more knowledge about the attractiveness of different countries for FDI. In what 
follows I state what I think the main critique vis-à-vis the literature summarized above 
might be, which allows me to come up with four propositions as regards how to advance 
in empirically investigating the institutions-FDI nexus. In this spirit, I do not intend 
to criticize the literature from all possible angles, nor go into detail as regards all of its 
shortcomings. Instead, my aim is to identify the root problem the improvement of which 
can help us find fruitful ways forward in future research.
19
My argument is that the root problem–from which many controversies apparent in the 
literature stem–is the weak link between the economic theory and empirical investigation. 
The research is driven by empiricism, and once a particular variable is found to exercise 
18 Note that Mondolo’s (2019) procedure to consider corruption an informal institution goes against the view of 
the institutional economics literature in which corruption is primarily seen as a formal institution because it is 
“caused” by weak governmental institutions. For more details, see the papers reviewed in Section 2.
19 Of course, a number of general critiques can be stated, starting from the one that instead of the cross-country 
regressions which still dominate the investigations, panel techniques should have been used to a greater extent. 
In addition, the bilateral structure of the FDI flows would quite naturally require an empirical framework able to 
make use of this structure, i.e. the gravity framework. And when applying the gravity framework, an additional 
problem is that researchers consider a large set of variables, including those that are not justified by the gravity 
theory of international trade (FDI), thus making the empirical model inconsistent.

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a significant impact on FDI, the results are explained ex post, which is like putting the 
cart before the horse. Instead, in my opinion research should be designed based on the 
principle of “theory first, empiricism after” .
More particularly, empirical researchers should rely (to a greater extent) on institutional 
economics theories which can provide them with more solid (theoretical) grounds to 
formulate hypotheses about how both formal and informal institutions matter for FDI. 
In this respect, the theory of institutional stickiness (Boettke et al. 2008) and that of the 
hierarchy of institutions (Williamson 2000) are of particular importance, as both suggest 
that formal institutions are embedded in culture, or are in other words constrained by 
culture.
20
 These two theories are closely connected to the theory of the coevolution of 
culture (informal institutions) and formal institutions (Bisin and Verdier 2017), which 
originates from the Hayekian theory and is generally accepted among economists. This 
theory sees formal institutions and culture as coevolving in an evolutionary process, 
mutually reinforcing one other. On the other hand, when designing empirical research 
we should rely to a greater extent on the ideas from the non-neoclassical approaches to 
culture, especially. In this respect, historical approaches to culture, such as are the insights 
of McCloskey (2015) or Mokyr (2017), are of key importance too. These theories are in line 
with the theory of the coevolution of culture and institutions. Accordingly, adopting this 
historical-evolutionary view of culture requires us, of course together with the institutional 
stickiness theory, to include both culture and institutions and their interaction term in the 
regressions, suggesting the following for the empirical strategy which should be adopted.
1. An analysis of the simultaneous role of formal institutions and culture
If we look at the literature, we observe that the impacts of culture and formal institutions 
are treated separately in explaining FDI movements, with the exception of very rare cases 
such as Du et al. 2012 or Kuncic and Jaklic 2014. However, when relying on the above 
theories, the question we should be asking is “How do formal institutions together with 
culture (in which they are embedded) attract more FDI?”, instead of “How do formal 
institutions affect FDI?” and “How does culture affect FDI?” . Besides the reliance on the 
existing theory, which is a merit in itself, the proposed procedure offers two additional 
advantages.
On the one hand, in the regressions the proposed procedure helps minimize the omitted 
variable bias which, unfortunately, characterizes many studies that include only a small 
number of explanatory variables, basically only those which the researchers’ interest is 
focused on.
21
 On the other hand, this procedure makes it possible to ask new specific 
20 As it is beyond the scope of this paper to go into details as regards these theories, see Boettke et al. (2008) and 
Williamson (2000) for details.
21 When applying the extreme bound analysis on previous studies, Chakrabarti (2001) also argues that leaving 
outside the variables that have been proven by other investigations to have a significant effect on FDI can cause 
serious biases.

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questions about the effects of formal institutions and culture, which can enrich our 
understanding of what countries attract more FDI. One important question of this type can 
be whether there exists a complementary or substitution effect between formal institutions 
and culture in attracting FDI. Thus, within the framework of the institutional stickiness 
theory, a priori we can assume that culture can compensate for poor formal institutions, 
a question that has been partly raised in the literature (for instance in Du et al. 2012) but 
nevertheless not investigated in depth.
2. An analysis of the possible interaction of formal institutions and culture
Institutional economics has taught us a lot about the relationship between the formal 
institutions and culture insights which have converged into two lines of arguments. The 
first, suggested by the theory of institutional stickiness, argues that formal institutions are 
shaped and partly determined by culture. Accordingly, one might expect that the impact 
of culture on FDI is conditional on formal institutions. At the same time, we cannot rule 
out an effect in the opposite direction either, because, as argued by Williamson (2000), 
feedbacks from formal institutions towards culture are possible as well, meaning that the 
impact of formal institutions on FDI may be conditional on culture. The second line, in 
harmony with the first one, puts forth the view that institutions and culture evolve jointly 
in an endogenous process (e.g. Bisin & Verdier, 2017).
In the light of the coevolution of culture and formal institutions, when it comes to the 
question of how culture affects economic outcomes (income level or FDI), the right 
question to put forward is how culture in conjunction with formal institutions affects 
economic outcomes, a question which requires us to assess the interplay of culture and 
formal institutions in shaping economic outcomes. In Bisin and Verdier’s (2017) formal 
model of this coevolution, culture and formal institutions are jointly and endogenously 
determined, and jointly affect economic outcomes. In this process of coevolution, 
both culture and institutions can reinforce the impact of the other by ending up either 
weakening or strengthening the equilibrium outcome. The two scholars emphasize that 
the joint evolution of culture and institutions is likely to be non-linear, which suggests that 
under some “conditions” culture and formal institutions may act as substitutes, and under 
different “conditions” as complements.
To check for the presence of the above effects, an interaction term of formal institutions 
and culture should be accounted for in the empirical investigations, which can also lead to 
further questions being raised about the details of the interplay of formal institutions and 
culture (e.g. threshold levels, marginal effects).

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3. Instrumenting formal institutions and culture
The view suggested by the theory of the hierarchy of institutions (Williamson, 2000), 
namely that institutions (including even culture) can change, although slowly, and adapt 
to one other, calls for concerns about the possible endogeneity of institutions in economic 
development which is, at least partly, induced by the FDI flows. Accordingly, the suspicion 
arises that institutions are endogenous in the institutions-FDI nexus as well. In this light, 
the instrumental variable approach should be standard in future research rather than 
being exceptional, which has been the case up to present time. In turn, the instrumental 
variable estimation strategy poses challenges in finding valid and relevant instruments, 
and what is more, in coping with instrumenting more than one variable.
4. Distinguishing between the “distance” and the “level” effects
Previous studies differ in terms of whether they control for institutional distance or level. 
As can be seen from the summary under point 3, when it comes to formal institutions 
included in the regressions, researchers account almost exclusively for the level of formal 
institutions (see section 2). As regards culture, the practice is just the opposite, that is, 
we can hardly find regression investigations that include the level of culture as they most 
frequently include cultural distance only (see section 3).
This practice, however, is not fully justified by the mentioned theories (Boettke et al., 2008; 
Williamson, 2000) suggesting that both distance and level can matter for both formal 
institutions and culture. Why is this so? The answer is that the level of formal institutions 
indicates the degree of “quality” they should have to satisfy foreign investors, referring 
to the idea that “good” formal institutions reduce uncertainty, restrain opportunistic 
behavior and lower transaction costs (North, 1991). Nevertheless, the distance in formal 
institutions expressing institutional dissimilarity also matters because of its embeddedness. 
In other words, since formal institutions find their roots in culture, investors with their 
own institutional arrangements would not find it easy to work in a foreign institutional 
environment that was not in harmony with their culture. As far as culture is concerned, 
besides cultural distance, the culture of the host country also matters in attracting 
FDI. The latter is simply because some cultures are more favorable for investments 
(entrepreneurship).
As stems from the previous paragraph, since both the distance and the level of both culture 
and formal institutions can contribute to the attractiveness of a country simultaneously, 
we have to account for both in the regression analyses. However, including both the 
distance and the level terms in regressions lead to serious problems. On the one hand, 
if the origin country dummies, otherwise needed in general, are included together with 
the level term of the destination country, the distance term becomes determined, and 
accordingly, the inclusion of the distance together with the level proves meaningless. And 
what is more, even if it were included, it would be very difficult to see what the coefficient 

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of the distance variable means. On the other hand, including both terms would also lead 
to multi-collinearity.
The fact that the literature has not adequately distinguished between the distance and 
level effects is clearly shown by van Hoorn and Maseland (2014) in relation to culture, and 
by van Hoorn and Maseland (2016) in relation to institutions. When it comes to cultural 
distance, these authors argue that the cultural distance measures used in the literature 
cannot be meaningfully compared across countries because they correlate uniquely with 
the destination country culture for each origin country. In relation with institutions, 
they emphasize the risk of a strong correlation between the institutional distance and 
the institutional level. Based on their empirical results, they consequently propose using 
multiple reference points when calculating distance. All in all, the above suggests that 
researchers have to find a novel econometric method to control for both the distance and 
the level terms in future empirical investigations.
22
5 CONCLUSIONS
In this paper I have summarized the empirical results on how both formal and informal 
institutions can contribute to the attractiveness of a country for FDI. When it comes to 
formal institutions, it has turned out that the literature has focused mainly on the role 
of three institutions, namely (1) corruption, (2) governance and regulatory institutions, 
and (3) political institutions. This branch of the literature has provided much evidence 
about the positive impact of the high quality of the above institutions, and in addition, 
has given much detail about how they do that. As for the informal institutions (culture), 
the results of the literature have not proven to be as convincing as in the case of formal 
institutions, leaving several important aspects of how culture matters in attracting FDI not 
yet examined.
I have argued that institutional explanations can contribute to further enriching our 
knowledge about the FDI flows if empirical investigations rely, to a greater extent, on 
institutional economics theories in their empirical design. In particular, the view that 
formal institutions are embedded in culture, and are stuck to it (Boettke et al., 2008; 
Williamson, 2000), together with the theory of the coevolution of formal institutions and 
culture (Bisin and Verdier, 2017) have led me to make four propositions regarding how to 
progress further in empirical research on the institutions-FDI nexus, although of course, I 
do not claim that the suggestions outlined in this paper represent the only way to progress 
further in the field.
22 Kapás and Czeglédi (2020) propose a possible fruitful way of distinguishing the distance and level effects, 
and provide an econometric method to separate the level and the distance effects of culture, thus ensuring at the 
same time that the cultural distance does not depend on the origin country’s culture. Since they include only the 
level term with the origin country dummies, but not the distance term, the multi-collinearity problem does not 
appear in their regression.

J. KAPAS | FORMAL AND INFORMAL INSTITUTIONS, AND FDI FLOWS: A REVIEW ... 183
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