The effect of institutions on foreign direct investment: What matters most?

Abstract

Foreign direct investment (FDI) represents a key driver of economic development in Central and Eastern European economies. This study examines the determinants of inward FDI, highlighting the crucial role of institutional quality in shaping the attractiveness of Central and Eastern European economies to foreign capital inflows. Using a balanced panel data from 11 Central and Eastern European economies over the period 2002–2023, the two-way fixed effects estimator provides evidence of the heterogenous effects of distinct dimensions of institutional quality on FDI inflows. The political accountability and regulatory quality constitute the two pivotal institutional dimensions that significantly drive FDI inflows in Central and Eastern European economies. The finding is robust to instrumental variable estimations and test for omitted variable bias, suggesting that the relationship is unlikely to be driven by endogeneity concerns. Moreover, robustness analyses using alternative measure of inward FDI, sample split analysis to accommodate phantom FDI, lag-augmented local projections, and panel-corrected standard errors estimator strongly support the positive effects of political accountability and regulatory quality on FDI inflows. The findings indicate that improvements in governance are not uniformly effective in attracting greater FDI inflows. Institutional reforms that enhance political accountability and regulatory quality instead play distinct but complementary roles in sustaining FDI inflows in Central and Eastern European economies.