Almost 2,000 articles in the international press have made a connection between a high Doing Business ranking and foreign direct investment. These articles were written after the World Bank’s 2016 Doing Business report launch. The articles drew parallels between a higher Doing Business ranking and the job creation, new technologies, and processes that direct foreign investment can bring. As a result, many business owners look at Doing Business data to see which countries are good choices to do business with.
To be able to decide whether a high Doing Business ranking is an effective indicator of a business-friendly economic climate. This guide looks at whether a high Doing Business indicator reflects a climate which is favourable overall to investing in a different economy.
Direct foreign investment and Doing Business scores
Even though Doing Business indicators focus on small to medium-size domestic firms, many policy makers have associated improvements in the indicators with greater foreign direct investment (FDI).
World Bank Doing Business data shows that in 2011 economies closer to the top score in regulatory practice received significantly more foreign direct investment than those with a middle-rank score.1 Economies with a middle-rank score received more foreign direct investment than those with the lowest scores.
How Doing Business measures economies
The Doing Business indicators used here are composite measures of the investment climate gained by measuring what is called the distance to frontier.
The frontier is a measurement of how far an economy is from the most efficient practice or highest score achieved by any economy since 2005 for each Doing Business indicator.
In 2011, foreign direct investment was higher per person for economies that were closer to the frontier.
The key drivers of foreign direct investment
There has been much research on what the key drivers of foreign direct investment are. One approach sees foreign direct investment drivers as either:
- Market-seeking — driven by economy size and country location
- Efficiency-seeking — driven by human capital or infrastructure quality
- Resource-seeking — driven by availability of natural resources or other strategic assets
These three drivers have been studied extensively.2 There are other studies, which are outlined below.
The Gravity Model study
This seeks to explain what causes foreign direct investment flows between two specific countries. The research confirms that the following factors are important drivers of foreign direct investment:
- Market size
- Growth prospects
- Distance to important markets
- Relative labour endowments
- Openness to trade
For example, the larger the market is, the greater the scope for economies of scale in production. This increases the chance for production at competitive prices.
Economies in Central and Eastern Europe have received large inflows of foreign direct investment over the past few decades because they are seen as entry points into the huge European market. They also have a relatively well-educated labour force.
Institutional and regulatory framework
A country’s institutional and regulatory framework has also been shown to be an important factor of determining foreign direct investment.
One study shows that judicial independence and a flexibly labour market are significantly associated with foreign direct investment, depending on the sector of the investment.3
Barriers to foreign direct investment
Corruption is a significant deterrent to foreign direct investment. It has an equivalent effect of a high tax rate on foreign firms.
Indirect taxes make foreign investment unattractive to investors as these are higher than the direct foreign income taxes in many countries.
Business regulations and the number of procedures relating to setting up a foreign-owned business are barriers to investment.
Doing Business findings
A recent study of four years of Doing Business data shows that a higher Doing Business ranking is significantly associated with larger foreign direct investment4 in a country because it is seen as an attractive investment climate.
Related research has shown that business regulations as measured by Doing Business influence the impact of foreign direct investment. For example, economies with more effective regulations for starting a business benefit more from the foreign direct investment that they receive.
What Doing Business data reveals
Doing Business conducted an economic analysis of the relationship between Doing Business indicators and foreign direct investment flows.
The analysis generally followed the model used by a 2011 study.5 This study considered the relationship between an economy’s performance on Doing Business indicators and the total foreign direct investment inflows from all other economies. It took into account differences in macroeconomic and governance conditions.
The new study used “distance to frontier” scores rather than economy rankings, as this was felt to be a more accurate measure of how far business regulations are from the most efficient practice.
The analysis considered differences in natural resource exports, and it covered a larger sample of between 145 and 160 economies across specifications.6
This study considered whether distance to frontier scores in one year are associated with total foreign direct investment inflows in the following year.
Findings of the new study
The new study took into account differences in income, inflation, population size, governance measures, openness to trade and exports of primary goods.
The findings clearly showed that a frontier score is significantly associated with larger inflows of foreign direct investment.
Other research findings
Greater domestic investment and gross domestic product growth7 are associated with reforms that improve the quality of the regulatory environment.
Good regulations mean a good business climate
Doing Business data shows there is a strong, statistically significant link between foreign direct investment and the overall level of regulation measured by Doing Business indicators. This is more reflective of the overall investment climate, and not just what is important to small or medium-sized businesses.
The finding also reflects a general idea that governments that regulate well in one area such as domestic business, tend to also regulate well in other areas such as foreign investment.8
Comparing the Doing Business indicators with other measures of the regulatory environment also supports this view.
For example, Doing Business indicators are strongly correlated with similar indicators form the Investing Across Borders project, which focuses on regulation of foreign direct investment. The correlation between the distance to frontier measures of the two sets of indicators is 57%.
The correlation between the complexity and cost of starting a local company as measured by Doing Business and the complexity of starting a local subsidiary of a foreign firm as measured by Investing Across Borders is 81%.
It takes eight procedures and 26 days on average to start a local business in the economies covered by Investing Across Borders, but it takes 10 procedures and 41 days on average to start a foreign-owned company in those economies.
The correlation was calculated between the distance to frontier in starting a business as measured by Doing Business, and the distance to frontier in starting a foreign business as measured by Investing Across Borders. This is the same data shown in figure 1 above.
What is the Investing Across Borders project?
The Investing Across Borders project was launched by the World Bank Group in 2010 showing indicators of foreign direct investment regulation across economies. The indicators referenced in this guide are based on data for 87 economies published in the 2010 Investing Across Borders report, plus five additional economies for which data was collected but not included in the original report.
Foreign direct investments are higher for economies performing better on Doing Business indicators, even when taking into account differences across economies in other factors which are considered important for foreign direct investments. A strong regulatory environment is also an encouragement to foreign investment.
1: The Doing Business indicators can be aggregated in multiple ways to create composite measures of the investment climate.
2: For an overview of such studies see, for example, Blonigen and Piger (2011); and Hornberger, Battat and Kusek (2011).
3: Walsh and Yu (2010)
4: Jayasuriya (2011)
5: Jayasuriya (2011)
6: Jayasuriya (2011) estimates the influence of Doing Business rankings across 84 economies, noting that this smaller sample of economies is due to the use of an unbalanced panel.
7: For example, Eifert (2009) and Haidar (2012).
8: Geginat, Gonzalez and Saltane (2012).